Split (1)

train · 19.6k rows

url stringlengths 38 46	title stringlengths 19 231	description stringlengths 1 553 ⌀	date stringdate 1996-09-10 00:00:00 2024-12-18 00:00:00	text stringlengths 263 32.8k	processed_text stringlengths 261 33.8k	author stringclasses 965 values	affiliation stringclasses 129 values	position stringclasses 263 values	country stringclasses 115 values
https://www.bis.org/review/r970211c.pdf	Mr. Chen discusses monetary relations between China and Hong Kong (Central Bank Articles and Speeches, 10 Sep 96)	Speech by the Deputy Governor of the People's Bank of China, Mr. Chen Yuan, at the Bank of England Seminar held in London on 10/9/96.	1996-09-10 00:00:00	Mr. Chen discusses monetary relations between China and Hong Kong Speech by the Deputy Governor of the People's Bank of China, Mr. Chen Yuan, at the Bank of England Seminar held in London on 10/9/96. INTRODUCTION In less than three hundred days, China will resume the exercise of sovereignty over Hong Kong. Given Hong Kong's role as an international financial centre, it is natural for the international investment community to be interested in the future of Hong Kong. I am grateful to Governor George for giving me this opportunity to share with this distinguished audience the Chinese Government's policy on the monetary relationship between the mainland of China and Hong Kong after 1997. By way of introduction, let me first explain the origin of the basic principle of "one country, two systems", which forms the backbone of China's policy towards the Hong Kong Special Administrative Region as from 1 July 1997. This will help people to understand why China is so committed to implementing this very important principle in Hong Kong. THE "ONE COUNTRY, TWO SYSTEMS" PRINCIPLE What does "one country, two systems" mean? It means that after 1997, the socialist system and policies shall not be practised in the Hong Kong Special Administrative Region, and the previous capitalist system and way of life shall remain unchanged for 50 years. This principle was not a compromise solution reached in the Sino-British negotiations for political expedience. It was not even an idea floated by the British side. It was in fact a paramount guiding principle adopted by the Chinese Government for advancing the unification of China. The principle was also the outcome of intense research by the Chinese Government on what factors contributed to the economic success and stability of Hong Kong and how they could be preserved beyond 1997. We are convinced that this principle would serve not only China's long-term national interest but also that of Hong Kong. It was against this background that the Chinese Government put forward in the negotiations the concept of "One Country, Two Systems" and the guiding principles. These were subsequently incorporated in the Sino-British Joint Declaration in 1984 and then in the Basic Law promulgated by our National People's Congress in 1990. I should add that the principle of "one country, two systems" as a fundamental policy for the unification and development of China has been written into our country's constitution and become a long-term irreversible national policy. The Sino-British Joint Declaration is a treaty registered with the United Nations. The Chinese Government is committed to implementing fully and faithfully the provisions of the Joint Declaration and the Basic Law. My second point is that notwithstanding our commitment, there is no lack of sceptics who doubt that the Chinese Government would abide by the Basic Law and fulfil its commitments after 1997. This brings to mind those sceptics who doubted China's commitment to the open door policy and the economic reform which China initiated in late 1979. Such critics thought that the problems faced by China in the reform process were so huge that we were doomed to fail. They also doubted how our economic reform could square with China's socialist economy. Today, you and I can both see that these critics have been proven wrong. Between 1979 and 1995, China's GDP has increased by an average of 9.9% every year and the standard of living has improved significantly. The economic and monetary conditions and the legal and institutional reform of our financial sector have made progress beyond the expectations of many. China's foreign reserves reached a record high of US$ 90.7 billion in early August 1996. The critics are right in pointing out that China is a vast country, with a large population of over 1.2 billion people. It is natural that in the implementation of our reform we could run into difficulties of one sort or another. At times we need to adjust our pace a bit to resolve those problems but there is no question that China is firmly resolved to continuing with economic reform. Equally, China remains firmly and totally committed to maintaining the prosperity and stability of Hong Kong, in accordance with the provisions of the Joint Declaration and the Basic Law. I am sure that the facts and events will demonstrate that the sceptics will once again be proven to be wrong. Ladies and gentlemen, let me now proceed to outline first the legal and policy framework and then the seven basic principles governing the monetary relationship between the mainland of China and Hong Kong. Finally, I will describe China's policy on Hong Kong's participation in international and regional financial institutions and forums. THE LEGAL AND POLICY FRAMEWORK According to the Joint Declaration and the Basic Law, Hong Kong will enjoy autonomy in all areas other than foreign affairs and defence matters. The key provisions on the monetary and financial sides provide that: The Government of the Hong Kong Special Administrative Region shall provide an appropriate economic and legal environment for the maintenance of its status as an international financial centre. Hong Kong shall, on its own, formulate monetary and financial policies, safeguard the free operation of financial business and financial markets, and regulate and supervise financial activities in accordance with the law. The Hong Kong dollar, as the only legal tender in Hong Kong, shall continue to circulate, and the existing currency issue mechanism shall continue. The Hong Kong dollar shall remain freely convertible, with free flow of capital and no exchange controls. The Exchange Fund, which holds Hong Kong's foreign reserves, shall be managed and controlled by the Government of the Hong Kong Special Administrative Region, primarily for regulating the exchange value of the Hong Kong dollar. The above provisions form the foundation for defining and establishing the monetary relationship between the mainland and Hong Kong under the principle of "one country, two systems". Under these provisions, this relationship can be best summarised as one country, two currencies, two monetary systems and two monetary authorities, under two different social and economic systems within a sovereign state. SEVEN PRINCIPLES GOVERNING THE MONETARY RELATIONSHIP BETWEEN THE MAINLAND AND HONG KONG I will now set out the seven principles governing the monetary relationship between the mainland of China and Hong Kong. The first principle concerns the relationship between the two currencies and between the two monetary systems. According to the Basic Law, Hong Kong will continue to maintain its own system of currency issuance and management after 1997. The Hong Kong dollar and the renminbi will circulate as legal tender in Hong Kong and the mainland respectively. The Hong Kong dollar will be treated as a foreign currency in the mainland. Likewise, the renminbi will be treated as a foreign currency in Hong Kong. The three note-issuing banks in Hong Kong will continue to issue Hong Kong dollar bank notes, with 100% backing by US dollars under the linked exchange rate system. The currency in circulation in Hong Kong is in fact backed over five times by foreign reserves. Here I would like to stress that China supports Hong Kong's commitment to the maintenance of the linked exchange rate system, which has served Hong Kong well by providing monetary stability since its introduction in 1983. Corresponding to the two currencies will be two monetary systems. They possess their own characteristics, reflecting the differences between the two economies. The two monetary systems are of equal importance to China in its reform and liberalisation. One does not precede or be subsidiary to the other. They will operate in a mutually independent manner. The second principle relates to the relationship between the two monetary authorities. It follows from the two mutually independent monetary systems of the mainland and Hong Kong that the two monetary authorities will also be mutually independent. The Hong Kong Monetary Authority will be accountable solely to the Hong Kong government. The People's Bank of China will not take the place of the Hong Kong Monetary Authority and will not set up any office there. As Hong Kong and the mainland develop increasingly close economic ties in both trade and investment, close co-operation between the two monetary authorities becomes even more important. The two monetary authorities must, therefore, strengthen further the present sound co-operation of central banking functions, including monetary management, banking supervision and the development of the financial infrastructure. The third principle concerns co-operation in prudential supervision. According to the Basic Law, the Hong Kong government will continue to supervise financial institutions in Hong Kong, including financial institutions from the mainland. Supervision will continue to be undertaken in accordance with international rules and practices. Notwithstanding different business practices in the mainland and Hong Kong, we have reached consensus on licensing procedures and supervision of each other's financial institutions. It has been agreed that : Financial institutions based in the mainland and Hong Kong setting up offices in each other's territory shall be approved on the same basis as foreign financial institutions. The mainland offices of Hong Kong-based financial institutions shall continue to enjoy the same preferential treatment in the mainland as other foreign financial institutions. mainland financial institutions in Hong Kong shall not enjoy any privileges. They shall abide by the law of Hong Kong and be regulated by the relevant supervisory authorities in Hong Kong. This arm's length treatment will certainly help to underscore the implementation of the "one country, two systems" principle. The fourth principle is that the People's Bank of China will support the currency stability of Hong Kong. On behalf of the PBOC, I have early this year signed a bilateral agreement with the HKMA on the repurchase of US treasury paper. We are prepared to offer liquidity support to the HKMA for the purpose of stabilising the exchange rate of the Hong Kong dollar. We also stand ready to use our foreign reserves to support the Hong Kong dollar, if necessary. However, I must point out that under no circumstances will China draw on or resort to Hong Kong's Exchange Fund or other assets in any way and for any reason. I mentioned earlier that the Basic Law states that the Exchange Fund shall be managed and controlled by the Hong Kong government. It is also stated that the financial revenues of the Hong Kong Special Administrative Region shall be used exclusively for its own purposes. In addition, the Basic Law stipulates that the Chinese Government shall not levy taxes in Hong Kong. These triple safeguards are evidence that China does not have its eyes on siphoning off the resources of Hong Kong. The fifth principle relates to the treatment of financial business between China and Hong Kong. After 1997, all financial business between the two places will be conducted in accordance with the rules and practices of international financial activities. Claims and liabilities between banks and companies from the mainland and those in Hong Kong will continue to be regarded as external claims and liabilities. When raising funds in Hong Kong, Chinese entities will have equal treatment as other international and local market participants, without any special privileges. Disputes relating to contracts between banks and companies of the mainland and those of Hong Kong shall be handled in accordance with international practice. Where China's Arbitration Law and other relevant laws and regulations are applied, the provisions relating to arbitration involving foreign parties will apply. The sixth principle is about the standing of mainland financial institutions in Hong Kong. As discussed earlier, mainland financial institutions in Hong Kong must abide by the law of Hong Kong and be regulated by relevant regulatory authorities there. I would like to stress that the Bank of China group, though being one of the three note-issuing banks and a leading commercial bank in Hong Kong, shall not be treated more favourably than other banks. It shall not carry out any activities beyond the role of a commercial bank. The seventh principle is on the complementarity between Shanghai and Hong Kong. As you know, Shanghai used to be China's financial centre. With China's deepening reforms and open-door policy, Shanghai is becoming a vibrant city with tremendous potential for further development. To a certain extent, Shanghai has met the conditions for reviving herself as a financial centre. While there are concerns as to whether Shanghai will replace Hong Kong, I would like to emphasise that these are groundless speculations because the Basic Law has already stipulated that Hong Kong shall maintain its status as an international financial centre. We are of the view that Hong Kong and Shanghai will have a complementary and mutually reinforcing relationship. In the short run, and at least before the renminbi becomes fully convertible, it will not be possible for Shanghai to become an international financial centre. Given the size of China's economy, there is plenty of room for more than one financial centre. Hong Kong and Shanghai will likely become two complementary and mutually reinforcing financial centres that will each develop with its own characteristics. HONG KONG IN INTERNATIONAL MONETARY RELATIONS Apart from these seven principles, it is also important for Hong Kong as an international financial centre to continue to develop its international monetary relations and participate in the activities of international and regional financial institutions, central bank forums etc. There are therefore provisions in the Joint Declaration and the Basic Law that Hong Kong may, on its own, maintain and develop financial relations and conclude and implement agreements with other countries, regions and relevant international organisations, using the name of "Hong Kong, China". Some international financial organisations restrict their membership to sovereign states. In those cases, where negotiations are held on matters involving Hong Kong, the Chinese Government would normally consult Hong Kong and include its representatives in the Chinese delegation. When entering into international financial agreements which may involve Hong Kong, the Chinese government will first seek the views of Hong Kong before deciding whether such agreements will apply to it. Taken together, these provisions will enable Hong Kong to continue and also develop its current international monetary relationship. PROSPECTS FOR HONG KONG AFTER 1997 I believe Hong Kong will remain prosperous and stable after 1997. Why? This is because: First, the strong economic fundamentals of Hong Kong and the entrepreneurial and management skills of the people of Hong Kong are the basis for its continued prosperity and stability. Secondly, the Basic Law has provided a legal safeguard for the maintenance of the prosperity and stability of Hong Kong. Thirdly, the economic development of the mainland has created excellent conditions for Hong Kong's continued prosperity and stability. As pointed out by China's VicePremier Zhu Rongji at his meeting on 29 May this year with senior officials of four main financial regulators and institutions from Hong Kong including the Hong Kong Monetary Authority - China is confident in Hong Kong's maintaining prosperity and stability and its status as an international financial centre after 1997 because we have full confidence in the economic development of China. As Hong Kong will continue its role as an international financial centre, it will become the most important funding centre for China and very likely for the Asian region as a whole. With the ongoing reform and open-door policy, the mainland of China has achieved sustained and strong economic growth. Our target for economic growth in 1996 is 8% but it could exceed 9%. Inflation should be within the range of 7 to 8% for 1996. The mainland of China's growth will obviously benefit Hong Kong's economy tremendously as we are its largest trading partner. The mainland of China is also one of the leading investors in Hong Kong, with total investment reaching US$ 25 billion last year. At the same time, Hong Kong has also contributed greatly to the mainland of China's reform and modernisation, both in terms of investment and know-how. Hong Kong is the largest investor in the mainland. Total cumulative direct investment from Hong Kong has now reached US$ 78.6 billion, accounting for 58% of total foreign direct investment. In 1995 alone, about half of the foreign direct investment in the mainland came from Hong Kong, which amounted to some US$ 20 billion. Also, for the 23 Chinese companies listed on overseas stock markets, the trading of such overseas stocks is most active in Hong Kong. Out of the 23 companies, 21 had their primary listing in Hong Kong. As China continues with its financial and economic reforms, Hong Kong's role as a financial centre for China will become even more important. It is therefore vital that Hong Kong remain the vibrant financial centre with its own economic system that we know now. We certainly would not do anything which would jeopardise Hong Kong's prospects. To conclude, I have no doubt that Hong Kong will continue to do well after 1997 as it has done in the past three decades during which Hong Kong survived numerous shocks and market turbulence. History has shown that Hong Kong has been extremely resilient to external shocks and was able to regain its vitality and competitiveness through swift internal adjustments. Investors who had the foresight and wisdom of capitalising on the opportunities in Hong Kong have done well and will be able to continue to share in the prosperity of Hong Kong. Ladies and gentlemen, 1997 is not a time when Hong Kong will need a miracle in order to survive the transition. I hope you will also come to the conclusion that China, particularly Hong Kong, offers tremendous business potential for investors, both local and overseas.	["mr. chen discusses monetary relations between china and hong kong speech by the deputy governor of the people's bank of china, mr. chen yuan, at the bank of england seminar held in london on 10/9/96.", 'introduction in less than three hundred days, china will resume the exercise of sovereignty over hong kong.', "given hong kong's role as an international financial centre, it is natural for the international investment community to be interested in the future of hong kong.", 'i am grateful to governor george for giving me this opportunity to share with this distinguished audience the chinese government\'s policy on the monetary relationship between the mainland of china and hong kong after 1997. by way of introduction, let me first explain the origin of the basic principle of "one country, two systems", which forms the backbone of china\'s policy towards the hong kong special administrative region as from 1 july 1997. this will help people to understand why china is so committed to implementing this very important principle in hong kong.', 'the "one country, two systems" principle what does "one country, two systems" mean?', 'it means that after 1997, the socialist system and policies shall not be practised in the hong kong special administrative region, and the previous capitalist system and way of life shall remain unchanged for 50 years.', 'this principle was not a compromise solution reached in the sino-british negotiations for political expedience.', 'it was not even an idea floated by the british side.', 'it was in fact a paramount guiding principle adopted by the chinese government for advancing the unification of china.', "the principle was also the outcome of intense research by the chinese government on what factors contributed to the economic success and stability of hong kong and how they could be preserved beyond 1997. we are convinced that this principle would serve not only china's long-term national interest but also that of hong kong.", 'it was against this background that the chinese government put forward in the negotiations the concept of "one country, two systems" and the guiding principles.', 'these were subsequently incorporated in the sino-british joint declaration in 1984 and then in the basic law promulgated by our national people\'s congress in 1990. i should add that the principle of "one country, two systems" as a fundamental policy for the unification and development of china has been written into our country\'s constitution and become a long-term irreversible national policy.', 'the sino-british joint declaration is a treaty registered with the united nations.', 'the chinese government is committed to implementing fully and faithfully the provisions of the joint declaration and the basic law.', "my second point is that notwithstanding our commitment, there is no lack of sceptics who doubt that the chinese government would abide by the basic law and fulfil its commitments after 1997. this brings to mind those sceptics who doubted china's commitment to the open door policy and the economic reform which china initiated in late 1979. such critics thought that the problems faced by china in the reform process were so huge that we were doomed to fail.", "they also doubted how our economic reform could square with china's socialist economy.", 'today, you and i can both see that these critics have been proven wrong.', "between 1979 and 1995, china's gdp has increased by an average of 9.9% every year and the standard of living has improved significantly.", 'the economic and monetary conditions and the legal and institutional reform of our financial sector have made progress beyond the expectations of many.', "china's foreign reserves reached a record high of us$ 90.7 billion in early august 1996. the critics are right in pointing out that china is a vast country, with a large population of over 1.2 billion people.", 'it is natural that in the implementation of our reform we could run into difficulties of one sort or another.', 'at times we need to adjust our pace a bit to resolve those problems but there is no question that china is firmly resolved to continuing with economic reform.', 'equally, china remains firmly and totally committed to maintaining the prosperity and stability of hong kong, in accordance with the provisions of the joint declaration and the basic law.', 'i am sure that the facts and events will demonstrate that the sceptics will once again be proven to be wrong.', 'ladies and gentlemen, let me now proceed to outline first the legal and policy framework and then the seven basic principles governing the monetary relationship between the mainland of china and hong kong.', "finally, i will describe china's policy on hong kong's participation in international and regional financial institutions and forums.", 'the legal and policy framework according to the joint declaration and the basic law, hong kong will enjoy autonomy in all areas other than foreign affairs and defence matters.', 'the key provisions on the monetary and financial sides provide that: the government of the hong kong special administrative region shall provide an appropriate economic and legal environment for the maintenance of its status as an international financial centre.', 'hong kong shall, on its own, formulate monetary and financial policies, safeguard the free operation of financial business and financial markets, and regulate and supervise financial activities in accordance with the law.', 'the hong kong dollar, as the only legal tender in hong kong, shall continue to circulate, and the existing currency issue mechanism shall continue.', 'the hong kong dollar shall remain freely convertible, with free flow of capital and no exchange controls.', "the exchange fund, which holds hong kong's foreign reserves, shall be managed and controlled by the government of the hong kong special administrative region, primarily for regulating the exchange value of the hong kong dollar.", 'the above provisions form the foundation for defining and establishing the monetary relationship between the mainland and hong kong under the principle of "one country, two systems".', 'under these provisions, this relationship can be best summarised as one country, two currencies, two monetary systems and two monetary authorities, under two different social and economic systems within a sovereign state.', 'seven principles governing the monetary relationship between the mainland and hong kong i will now set out the seven principles governing the monetary relationship between the mainland of china and hong kong.', 'the first principle concerns the relationship between the two currencies and between the two monetary systems.', 'according to the basic law, hong kong will continue to maintain its own system of currency issuance and management after 1997. the hong kong dollar and the renminbi will circulate as legal tender in hong kong and the mainland respectively.', 'the hong kong dollar will be treated as a foreign currency in the mainland.', 'likewise, the renminbi will be treated as a foreign currency in hong kong.', 'the three note-issuing banks in hong kong will continue to issue hong kong dollar bank notes, with 100% backing by us dollars under the linked exchange rate system.', 'the currency in circulation in hong kong is in fact backed over five times by foreign reserves.', "here i would like to stress that china supports hong kong's commitment to the maintenance of the linked exchange rate system, which has served hong kong well by providing monetary stability since its introduction in 1983. corresponding to the two currencies will be two monetary systems.", 'they possess their own characteristics, reflecting the differences between the two economies.', 'the two monetary systems are of equal importance to china in its reform and liberalisation.', 'one does not precede or be subsidiary to the other.', 'they will operate in a mutually independent manner.', 'the second principle relates to the relationship between the two monetary authorities.', 'it follows from the two mutually independent monetary systems of the mainland and hong kong that the two monetary authorities will also be mutually independent.', 'the hong kong monetary authority will be accountable solely to the hong kong government.', "the people's bank of china will not take the place of the hong kong monetary authority and will not set up any office there.", 'as hong kong and the mainland develop increasingly close economic ties in both trade and investment, close co-operation between the two monetary authorities becomes even more important.', 'the two monetary authorities must, therefore, strengthen further the present sound co-operation of central banking functions, including monetary management, banking supervision and the development of the financial infrastructure.', 'the third principle concerns co-operation in prudential supervision.', 'according to the basic law, the hong kong government will continue to supervise financial institutions in hong kong, including financial institutions from the mainland.', 'supervision will continue to be undertaken in accordance with international rules and practices.', "notwithstanding different business practices in the mainland and hong kong, we have reached consensus on licensing procedures and supervision of each other's financial institutions.", "it has been agreed that : financial institutions based in the mainland and hong kong setting up offices in each other's territory shall be approved on the same basis as foreign financial institutions.", 'the mainland offices of hong kong-based financial institutions shall continue to enjoy the same preferential treatment in the mainland as other foreign financial institutions.', 'mainland financial institutions in hong kong shall not enjoy any privileges.', 'they shall abide by the law of hong kong and be regulated by the relevant supervisory authorities in hong kong.', 'this arm\'s length treatment will certainly help to underscore the implementation of the "one country, two systems" principle.', "the fourth principle is that the people's bank of china will support the currency stability of hong kong.", 'on behalf of the pboc, i have early this year signed a bilateral agreement with the hkma on the repurchase of us treasury paper.', 'we are prepared to offer liquidity support to the hkma for the purpose of stabilising the exchange rate of the hong kong dollar.', 'we also stand ready to use our foreign reserves to support the hong kong dollar, if necessary.', "however, i must point out that under no circumstances will china draw on or resort to hong kong's exchange fund or other assets in any way and for any reason.", 'i mentioned earlier that the basic law states that the exchange fund shall be managed and controlled by the hong kong government.', 'it is also stated that the financial revenues of the hong kong special administrative region shall be used exclusively for its own purposes.', 'in addition, the basic law stipulates that the chinese government shall not levy taxes in hong kong.', 'these triple safeguards are evidence that china does not have its eyes on siphoning off the resources of hong kong.', 'the fifth principle relates to the treatment of financial business between china and hong kong.', 'after 1997, all financial business between the two places will be conducted in accordance with the rules and practices of international financial activities.', 'claims and liabilities between banks and companies from the mainland and those in hong kong will continue to be regarded as external claims and liabilities.', 'when raising funds in hong kong, chinese entities will have equal treatment as other international and local market participants, without any special privileges.', 'disputes relating to contracts between banks and companies of the mainland and those of hong kong shall be handled in accordance with international practice.', "where china's arbitration law and other relevant laws and regulations are applied, the provisions relating to arbitration involving foreign parties will apply.", 'the sixth principle is about the standing of mainland financial institutions in hong kong.', 'as discussed earlier, mainland financial institutions in hong kong must abide by the law of hong kong and be regulated by relevant regulatory authorities there.', 'i would like to stress that the bank of china group, though being one of the three note-issuing banks and a leading commercial bank in hong kong, shall not be treated more favourably than other banks.', 'it shall not carry out any activities beyond the role of a commercial bank.', 'the seventh principle is on the complementarity between shanghai and hong kong.', "as you know, shanghai used to be china's financial centre.", "with china's deepening reforms and open-door policy, shanghai is becoming a vibrant city with tremendous potential for further development.", 'to a certain extent, shanghai has met the conditions for reviving herself as a financial centre.', 'while there are concerns as to whether shanghai will replace hong kong, i would like to emphasise that these are groundless speculations because the basic law has already stipulated that hong kong shall maintain its status as an international financial centre.', 'we are of the view that hong kong and shanghai will have a complementary and mutually reinforcing relationship.', 'in the short run, and at least before the renminbi becomes fully convertible, it will not be possible for shanghai to become an international financial centre.', "given the size of china's economy, there is plenty of room for more than one financial centre.", 'hong kong and shanghai will likely become two complementary and mutually reinforcing financial centres that will each develop with its own characteristics.', 'hong kong in international monetary relations apart from these seven principles, it is also important for hong kong as an international financial centre to continue to develop its international monetary relations and participate in the activities of international and regional financial institutions, central bank forums etc.', 'there are therefore provisions in the joint declaration and the basic law that hong kong may, on its own, maintain and develop financial relations and conclude and implement agreements with other countries, regions and relevant international organisations, using the name of "hong kong, china".', 'some international financial organisations restrict their membership to sovereign states.', 'in those cases, where negotiations are held on matters involving hong kong, the chinese government would normally consult hong kong and include its representatives in the chinese delegation.', 'when entering into international financial agreements which may involve hong kong, the chinese government will first seek the views of hong kong before deciding whether such agreements will apply to it.', 'taken together, these provisions will enable hong kong to continue and also develop its current international monetary relationship.', 'prospects for hong kong after 1997 i believe hong kong will remain prosperous and stable after 1997. why?', 'this is because: first, the strong economic fundamentals of hong kong and the entrepreneurial and management skills of the people of hong kong are the basis for its continued prosperity and stability.', 'secondly, the basic law has provided a legal safeguard for the maintenance of the prosperity and stability of hong kong.', "thirdly, the economic development of the mainland has created excellent conditions for hong kong's continued prosperity and stability.", "as pointed out by china's vicepremier zhu rongji at his meeting on 29 may this year with senior officials of four main financial regulators and institutions from hong kong including the hong kong monetary authority - china is confident in hong kong's maintaining prosperity and stability and its status as an international financial centre after 1997 because we have full confidence in the economic development of china.", 'as hong kong will continue its role as an international financial centre, it will become the most important funding centre for china and very likely for the asian region as a whole.', 'with the ongoing reform and open-door policy, the mainland of china has achieved sustained and strong economic growth.', 'our target for economic growth in 1996 is 8% but it could exceed 9%.', "inflation should be within the range of 7 to 8% for 1996. the mainland of china's growth will obviously benefit hong kong's economy tremendously as we are its largest trading partner.", 'the mainland of china is also one of the leading investors in hong kong, with total investment reaching us$ 25 billion last year.', "at the same time, hong kong has also contributed greatly to the mainland of china's reform and modernisation, both in terms of investment and know-how.", 'hong kong is the largest investor in the mainland.', 'total cumulative direct investment from hong kong has now reached us$ 78.6 billion, accounting for 58% of total foreign direct investment.', 'in 1995 alone, about half of the foreign direct investment in the mainland came from hong kong, which amounted to some us$ 20 billion.', 'also, for the 23 chinese companies listed on overseas stock markets, the trading of such overseas stocks is most active in hong kong.', 'out of the 23 companies, 21 had their primary listing in hong kong.', "as china continues with its financial and economic reforms, hong kong's role as a financial centre for china will become even more important.", 'it is therefore vital that hong kong remain the vibrant financial centre with its own economic system that we know now.', "we certainly would not do anything which would jeopardise hong kong's prospects.", 'to conclude, i have no doubt that hong kong will continue to do well after 1997 as it has done in the past three decades during which hong kong survived numerous shocks and market turbulence.', 'history has shown that hong kong has been extremely resilient to external shocks and was able to regain its vitality and competitiveness through swift internal adjustments.', 'investors who had the foresight and wisdom of capitalising on the opportunities in hong kong have done well and will be able to continue to share in the prosperity of hong kong.', 'ladies and gentlemen, 1997 is not a time when hong kong will need a miracle in order to survive the transition.', 'i hope you will also come to the conclusion that china, particularly hong kong, offers tremendous business potential for investors, both local and overseas.']	Chen Yuan	People's Bank of China	Deputy Governor	China
https://www.bis.org/review/r970211b.pdf	Mr. Dai looks at the possibilities of strengthening financial co-operation between China and Hong Kong in order to promote economic prosperity and stability (Central Bank Articles and Speeches, 13 Nov 96)	Speech by the Governor of the People's Bank of China, Mr. Dai Xianglong, at the Hong Kong Association of Banks' Dinner on 13/11/96.	1996-11-13 00:00:00	Mr. Dai looks at the possibilities of strengthening financial co-operation between China and Hong Kong in order to promote economic prosperity and stability Speech by the Governor of the People's Bank of China, Mr. Dai Xianglong, at the Hong Kong Association of Banks' Dinner on 13/11/96. I would like to thank the Hong Kong Association of Banks for inviting me to Hong Kong to meet with you and to attend this dinner function. Although this is my first visit to Hong Kong since taking up my post in the central bank, we follow closely the economic developments of Hong Kong. All of you have contributed to the prosperity of Hong Kong. I greatly appreciate the wisdom and the spirit of the people of Hong Kong. They are industrious and always striving for the better. Hong Kong's success is partly attributable to the characteristics of its people. We have good reasons to believe that through our joint efforts, Hong Kong will have an even better future. I would like to take this opportunity to give a brief description of the current situation of the economic and financial reforms in the mainland as well as the basic principles and policies towards the financial relationship between China and Hong Kong after 1997. In addition, I would also say something on co-operation and joint development between the financial sectors of China and Hong Kong. I. Mainland China's economy is experiencing a stable development First of all, I would like to talk about the financial and economic conditions of China which is a hot topic for discussion among professionals from the Hong Kong financial sector. This is because Hong Kong's future is closely linked with the economic and financial developments of China. China's economy began to pick up in 1992 with a dynamic national economy. However, there was also hyper-inflation. During the latter half of 1993, the Chinese Government began to adopt an appropriately tight monetary policy. The adoption of this policy means firstly, price increases should be kept at a level lower than the rate of economic growth. Secondly, the growth of money supply should be slightly above the sum of the rate of economic growth and the target rate of the price increase. Thirdly, indirect monetary instruments should be used more frequently for relating money supply so that the economy will not be too volatile. Our efforts in the past three years are beginning to pay off. We have successfully curbed inflation by making macro-economic adjustments. Firstly, the growth of the money supply has slowed down. It is expected that the total money supply at the end of this year will be 26% higher than the previous year. This growth rate is 3.7% lower than the average annual growth rate during the period under the "Eighth FiveYear Plan". Secondly, price increases have slackened noticeably. During the period from January to October, retail prices have risen by 6.4% as compared to the same period last year. It is expected that the growth rate for the whole year will be around 6.5%. Thirdly, the economy continues to grow at a relatively high rate. During the period from January to September, GDP rose by 9.6%. It is anticipated that the annual growth rate will exceed 9.5%. Fourthly, our foreign reserves continue to grow. As at the end of October, our foreign reserves reached US$ 98.8 billion. We are certain that our reserves will exceed US$ 100 billion by the end of the year. The trade surplus is estimated to be over US$ 100 billion this year. There is also US$ 40 billion of foreign direct investment. The supply of foreign exchange exceeds demand and the exchange rate of the renminbi remains stable. Moreover, the renminbi has become fully convertible in the current account. Our experience proves that we are right in adopting an appropriately tight financial and economic policy. Our ability in performing macro-economic operations has improved greatly and our achievements are recognised internationally. Despite the foregoing, several major problems remain to be solved. The percentage of financial revenues in GDP is still falling. The asset quality of banks still needs to be improved. The basic elements of the agricultural sector remain relatively weak and it is unlikely to have any improvement in the operational efficiency of state-owned enterprises in the short run. In view of the current economic situation, the focus of economic and financial reforms in the coming year will be placed on promoting the reform of the economic system and changing the pattern of economic growth. We will continue to adopt an appropriately tight financial and monetary policy. Further efforts will be made to adjust the structure of the economy so as to foster new areas of economic growth. In order to ensure steady growth of the national economy, efforts will also be made to develop domestic as well as overseas markets. Based on the above considerations, it is desirable that next year's target annual GNP growth rate should be set at 8-9% while the retail price increase be contained at a level below 6%. In order to achieve these targets, the People's Bank of China is prepared to: 1. Control money supply. Our preliminary proposal is to contain the increase of next year's total money supply (M2) within the range of 23% to 25%. 2. Adjust the credit structure. The total amount of loans to the agricultural sector will be increased. Economic integration and the setting up of conglomerates will be encouraged. Efforts will also be made to promote the development and sale of residential property. 3. Conduct monetary operations. Employ more frequently monetary policy instruments such as interest rate policy, reserve requirements and open market operations to regulate the money supply. 4. Deepen financial reforms. Reforms of state banks should be stepped up. New commercial banks will be set up. The policy of transforming rural credit co-operatives into co-operative financial institutions will be maintained. Direct financing will be developed in a prudent way with better management. In addition, the financial sector will continue to open up. 5. Foster risk management. Continue the rationalisation of financial order and prevent and eliminate financial risks. It is envisaged that China's economy and society will continue to develop steadily in the coming years and objectives embodied in the "Ninth Five-Year Plan" can be achieved. China will enter the 21st century with a dynamic economy and society. II. Basic principles and policies governing the financial relationship between mainland China and Hong Kong after 1997 As China and Hong Kong have different currencies and financial systems, people from Hong Kong as well as the international community are very much concerned with how the principle of "one country, two systems" can be implemented as regards financial issues. It is because the implementation of this principle has direct bearings on the prosperity and stability of Hong Kong as well as the status of Hong Kong as an international financial centre. "The Basic Law of the Hong Kong Special Administrative Region of the People's Republic of China" lays down specific provisions relating to Hong Kong's status as an international financial centre, its monetary and financial policies, the status of the Hong Kong dollar and the issuing arrangements, capital flows and the role of the Exchange Fund. Our national leaders have reiterated on different occasions that the People's Bank of China, which is the central bank of the People's Republic of China, should insist on implementing the "Basic Law" and the principle of "one country, two systems". We should also protect the financial relationship between Hong Kong and the mainland which can be summarised as "one country, two currencies, two monetary systems and two monetary authorities" within a sovereign state and deal with issues relating to this relationship in an appropriate manner. At the IMF/World Bank Annual Meeting which was held in late September this year, I stated in my speech our principles governing the financial relationship between the mainland and Hong Kong. Mr Chen Yuan, the Deputy Governor of the People's Bank of China, also presented these principles in a systematic manner at the Bank of England seminar which was held in September this year. Both the People's Bank of China and the Hong Kong Monetary Authority (HKMA) have been offered membership in the Bank for International Settlements. This is a clear demonstration of the above principles and shows that the mutually independent financial relationship between the mainland and Hong Kong are widely accepted by international financial organisations. Now I am going to give an outline of the main issues relating to the financial relationship between the mainland and Hong Kong after 1997. Hong Kong will continue to maintain its own system of currency issuance and management after 1997. The Hong Kong dollar and the renminbi will circulate as legal tender in Hong Kong and the mainland respectively. Hong Kong's existing note-issuing arrangements will remain unchanged. Moreover, China supports Hong Kong's commitment to the maintenance of the linked exchange rate system. It follows from the two mutually independent monetary systems of the mainland and Hong Kong that the two monetary authorities, i.e. the People's Bank of China and the HKMA, will also be mutually independent. The HKMA will be accountable solely to the Hong Kong Government. The People's Bank of China will not take the place of the HKMA and will not set up any office in Hong Kong. The People's Bank of China will strengthen further its present sound co-operation with the HKMA. The HKMA has made great contributions to the stability of the local currency and the supervision of financial institutions. Such efforts by the HKMA help promote the prosperity and smooth transition of Hong Kong. The Hong Kong Government will continue to supervise local financial institutions. The supervision will continue to be undertaken in accordance with Hong Kong's laws and international rules and practices. mainland financial institutions in Hong Kong shall not enjoy any privileges. They shall be regulated by the relevant supervisory authorities in Hong Kong. The Exchange Fund of Hong Kong shall be managed and controlled by the Hong Kong Government. The financial revenues of the Hong Kong Special Administrative Region shall be used exclusively for its own purposes and the Chinese Government shall not levy taxes in Hong Kong. Moreover, China will not draw on or resort to Hong Kong's Exchange Fund or other assets in any way and for any reason. All financial transactions between the mainland and Hong Kong will be conducted in accordance with the rules and practices of international financial activities. Claims and liabilities between institutions from the mainland and those from Hong Kong will continue to be regarded as external claims and liabilities. When participating in the Hong Kong market, Chinese entities will have equal treatment as other international and local market participants. Apart from the above, it is also important for Hong Kong as an international financial centre to continue to develop its international monetary relations and participate in the activities of international and regional financial institutions. There are therefore provisions in the Joint Declaration and the Basic Law that Hong Kong may, on its own, maintain and develop financial relations with other countries, regions and relevant international organisations after 1997. The 1997 World Bank/IMF Annual Meeting will be held in Hong Kong just a few months after China resumes the exercise of sovereignty over Hong Kong. This is a magnificent financial event and I am confident that it will be successful. III The strengthening of financial co-operation and the promotion of economic prosperity and stability between the mainland and Hong Kong Mainland China and Hong Kong have close financial links with each other. Since the implementation of financial reforms and the open-door policy, such links have been strengthened further. It is necessary to further enhance such a mutually beneficial relationship between the two places. First of all, the mainland and Hong Kong should work together for the prosperity, stability and smooth transition of Hong Kong. China's commitment to the implementation of the "one country, two systems" principle is increasingly accepted and appreciated by the people of Hong Kong and the international community. Worries and doubts about the future of Hong Kong which emerged in the early 1980's have largely subsided. We are pleased to note that the financial situation in Hong Kong is heading towards a smooth transition. We are confident that Hong Kong will enjoy financial stability before and after 1997. Even though there may be some fluctuations in Hong Kong's financial market, we believe that the HKMA is fully capable of handling these situations satisfactorily. If necessary, the People's Bank of China will, at the request of the HKMA and in accordance with the Basic Law and market practices, offer support to the HKMA. Financial stability in Hong Kong before and after 1997 is not only essential to the prosperity of Hong Kong and China but also to financial stability in the Asia-Pacific Region. We are confident that the international financial community, including the central banks in the Asia-Pacific Region, will be actively involved in the efforts to maintain Hong Kong's financial stability. Secondly, the two places should work closely together to maintain and enhance Hong Kong's status as an international financial centre. Hong Kong has some unique competitive advantages in being an international financial centre in a number of aspects such as opportunities, geographic location and people. I have made it clear to the international financial community on many occasions that after China's resumption of sovereignty over Hong Kong, the status of Hong Kong as an international financial centre will not be undermined but, rather, it will be further strengthened. This is because the many unique advantages which Hong Kong enjoys now will continue to exist after 1997. There is also the Basic Law which guarantees that Hong Kong will remain unchanged. More importantly, with the sustained, rapid and healthy growth of the economy in China - the vast hinterland at the back of Hong Kong - numerous opportunities will be created for Hong Kong's financial sector. All these are favourable conditions for the maintenance and strengthening of Hong Kong's status as an international financial centre. Economic developments in the mainland have given rise to strong demand for funds and Hong Kong will continue to be our major funding centre. We will strengthen our coordination and cooperation with Hong Kong in areas such as the development of markets and infrastructures in response to the needs of financial developments in both places. I have met with many central bankers and major international bankers and they all agreed that Hong Kong should be able to maintain its status as an international financial centre as regards the future relationship between Hong Kong and Shanghai. I think as a national economic centre, Shanghai's financial status will become increasingly important. However, it will not be possible for Shanghai to become an international financial centre in the longer term and it will not replace Hong Kong. Thirdly, the mainland and Hong Kong should co-operate fully with each other so as to promote prosperity and stability. Since the implementation of economic reforms and the opendoor policy, financial co-operation between the two places has been strengthened which, in turn, helps to develop economic and trading ties. At present, China and Hong Kong are each other's major investment and trading partner. As at the end of 1995, Hong Kong's total cumulative investment in China reached US$ 78.6 billion, accounting for 58% of total foreign investment in China. In 1995, 90% of the syndicated loans to China were arranged in Hong Kong and 90% of the Chinese companies listed on overseas stock markets have their primary listing in Hong Kong. The volume of import and export trade between the two places amounted to US$ 44.6 billion last year, accounting for 15.9% of China's total external trade. If Hong Kong's entrepôt trade which came from China is also taken into account, the figure reached US$ 124.1 billion, accounting for 34.1% of Hong Kong's total external trade in that year. The number of mainland financial institutions in Hong Kong is on the rise and vice versa. These institutions are going to provide a whole range of financial services which are conducive to the continuous and stable development of the economic relationship between the two places. China will further open up its financial markets. This includes the opening up of more districts, the gradual relaxation of renminbi business and the gradual introduction of the investment banking mechanism. The Hong Kong financial sector will directly benefit from these moves since they will offer numerous business opportunities. In the course of stepping up our pace of financial reforms, we have to keep on learning from advanced international management experience and to provide training to outstanding personnel. We hope that the financial community in Hong Kong will provide us with assistance and support in these areas. Before ending my speech, I would like to point out that the Hong Kong Association of Banks has contributed a lot in assisting the HKMA to ensure the financial stability of Hong Kong. I hope all of you will continue to give your support to the HKMA and play a more active role in promoting economic and financial developments in Hong Kong and its smooth transition. I would also like to announce that an association of mainland banks will be formed this year. I hope that the two banking associations will strengthen their exchanges and co-operation and work together for a more prosperous future. A delegation from the Hong Kong Association of Banks will visit Beijing in a few days. I would like to welcome the delegation on behalf of the People's Bank of China. I will meet with some of you again on that occasion. We can further exchange views on the strengthening of co-operation between the banking sectors on the mainland and in Hong Kong.	["mr. dai looks at the possibilities of strengthening financial co-operation between china and hong kong in order to promote economic prosperity and stability speech by the governor of the people's bank of china, mr. dai xianglong, at the hong kong association of banks' dinner on 13/11/96.", 'i would like to thank the hong kong association of banks for inviting me to hong kong to meet with you and to attend this dinner function.', 'although this is my first visit to hong kong since taking up my post in the central bank, we follow closely the economic developments of hong kong.', 'all of you have contributed to the prosperity of hong kong.', 'i greatly appreciate the wisdom and the spirit of the people of hong kong.', 'they are industrious and always striving for the better.', "hong kong's success is partly attributable to the characteristics of its people.", 'we have good reasons to believe that through our joint efforts, hong kong will have an even better future.', 'i would like to take this opportunity to give a brief description of the current situation of the economic and financial reforms in the mainland as well as the basic principles and policies towards the financial relationship between china and hong kong after 1997. in addition, i would also say something on co-operation and joint development between the financial sectors of china and hong kong.', "i. mainland china's economy is experiencing a stable development first of all, i would like to talk about the financial and economic conditions of china which is a hot topic for discussion among professionals from the hong kong financial sector.", "this is because hong kong's future is closely linked with the economic and financial developments of china.", "china's economy began to pick up in 1992 with a dynamic national economy.", 'however, there was also hyper-inflation.', 'during the latter half of 1993, the chinese government began to adopt an appropriately tight monetary policy.', 'the adoption of this policy means firstly, price increases should be kept at a level lower than the rate of economic growth.', 'secondly, the growth of money supply should be slightly above the sum of the rate of economic growth and the target rate of the price increase.', 'thirdly, indirect monetary instruments should be used more frequently for relating money supply so that the economy will not be too volatile.', 'our efforts in the past three years are beginning to pay off.', 'we have successfully curbed inflation by making macro-economic adjustments.', 'firstly, the growth of the money supply has slowed down.', 'it is expected that the total money supply at the end of this year will be 26% higher than the previous year.', 'this growth rate is 3.7% lower than the average annual growth rate during the period under the "eighth fiveyear plan".', 'secondly, price increases have slackened noticeably.', 'during the period from january to october, retail prices have risen by 6.4% as compared to the same period last year.', 'it is expected that the growth rate for the whole year will be around 6.5%.', 'thirdly, the economy continues to grow at a relatively high rate.', 'during the period from january to september, gdp rose by 9.6%.', 'it is anticipated that the annual growth rate will exceed 9.5%.', 'fourthly, our foreign reserves continue to grow.', 'as at the end of october, our foreign reserves reached us$ 98.8 billion.', 'we are certain that our reserves will exceed us$ 100 billion by the end of the year.', 'the trade surplus is estimated to be over us$ 100 billion this year.', 'there is also us$ 40 billion of foreign direct investment.', 'the supply of foreign exchange exceeds demand and the exchange rate of the renminbi remains stable.', 'moreover, the renminbi has become fully convertible in the current account.', 'our experience proves that we are right in adopting an appropriately tight financial and economic policy.', 'our ability in performing macro-economic operations has improved greatly and our achievements are recognised internationally.', 'despite the foregoing, several major problems remain to be solved.', 'the percentage of financial revenues in gdp is still falling.', 'the asset quality of banks still needs to be improved.', 'the basic elements of the agricultural sector remain relatively weak and it is unlikely to have any improvement in the operational efficiency of state-owned enterprises in the short run.', 'in view of the current economic situation, the focus of economic and financial reforms in the coming year will be placed on promoting the reform of the economic system and changing the pattern of economic growth.', 'we will continue to adopt an appropriately tight financial and monetary policy.', 'further efforts will be made to adjust the structure of the economy so as to foster new areas of economic growth.', 'in order to ensure steady growth of the national economy, efforts will also be made to develop domestic as well as overseas markets.', "based on the above considerations, it is desirable that next year's target annual gnp growth rate should be set at 8-9% while the retail price increase be contained at a level below 6%.", "in order to achieve these targets, the people's bank of china is prepared to: 1. control money supply.", "our preliminary proposal is to contain the increase of next year's total money supply (m2) within the range of 23% to 25%.", '2. adjust the credit structure.', 'the total amount of loans to the agricultural sector will be increased.', 'economic integration and the setting up of conglomerates will be encouraged.', 'efforts will also be made to promote the development and sale of residential property.', '3. conduct monetary operations.', 'employ more frequently monetary policy instruments such as interest rate policy, reserve requirements and open market operations to regulate the money supply.', '4. deepen financial reforms.', 'reforms of state banks should be stepped up.', 'new commercial banks will be set up.', 'the policy of transforming rural credit co-operatives into co-operative financial institutions will be maintained.', 'direct financing will be developed in a prudent way with better management.', 'in addition, the financial sector will continue to open up.', '5. foster risk management.', 'continue the rationalisation of financial order and prevent and eliminate financial risks.', 'it is envisaged that china\'s economy and society will continue to develop steadily in the coming years and objectives embodied in the "ninth five-year plan" can be achieved.', 'china will enter the 21st century with a dynamic economy and society.', 'basic principles and policies governing the financial relationship between mainland china and hong kong after 1997 as china and hong kong have different currencies and financial systems, people from hong kong as well as the international community are very much concerned with how the principle of "one country, two systems" can be implemented as regards financial issues.', 'it is because the implementation of this principle has direct bearings on the prosperity and stability of hong kong as well as the status of hong kong as an international financial centre.', '"the basic law of the hong kong special administrative region of the people\'s republic of china" lays down specific provisions relating to hong kong\'s status as an international financial centre, its monetary and financial policies, the status of the hong kong dollar and the issuing arrangements, capital flows and the role of the exchange fund.', 'our national leaders have reiterated on different occasions that the people\'s bank of china, which is the central bank of the people\'s republic of china, should insist on implementing the "basic law" and the principle of "one country, two systems".', 'we should also protect the financial relationship between hong kong and the mainland which can be summarised as "one country, two currencies, two monetary systems and two monetary authorities" within a sovereign state and deal with issues relating to this relationship in an appropriate manner.', 'at the imf/world bank annual meeting which was held in late september this year, i stated in my speech our principles governing the financial relationship between the mainland and hong kong.', "mr chen yuan, the deputy governor of the people's bank of china, also presented these principles in a systematic manner at the bank of england seminar which was held in september this year.", "both the people's bank of china and the hong kong monetary authority (hkma) have been offered membership in the bank for international settlements.", 'this is a clear demonstration of the above principles and shows that the mutually independent financial relationship between the mainland and hong kong are widely accepted by international financial organisations.', 'now i am going to give an outline of the main issues relating to the financial relationship between the mainland and hong kong after 1997. hong kong will continue to maintain its own system of currency issuance and management after 1997. the hong kong dollar and the renminbi will circulate as legal tender in hong kong and the mainland respectively.', "hong kong's existing note-issuing arrangements will remain unchanged.", "moreover, china supports hong kong's commitment to the maintenance of the linked exchange rate system.", 'it follows from the two mutually independent monetary systems of the mainland and hong kong that the two monetary authorities, i.e.', "the people's bank of china and the hkma, will also be mutually independent.", 'the hkma will be accountable solely to the hong kong government.', "the people's bank of china will not take the place of the hkma and will not set up any office in hong kong.", "the people's bank of china will strengthen further its present sound co-operation with the hkma.", 'the hkma has made great contributions to the stability of the local currency and the supervision of financial institutions.', 'such efforts by the hkma help promote the prosperity and smooth transition of hong kong.', 'the hong kong government will continue to supervise local financial institutions.', "the supervision will continue to be undertaken in accordance with hong kong's laws and international rules and practices.", 'mainland financial institutions in hong kong shall not enjoy any privileges.', 'they shall be regulated by the relevant supervisory authorities in hong kong.', 'the exchange fund of hong kong shall be managed and controlled by the hong kong government.', 'the financial revenues of the hong kong special administrative region shall be used exclusively for its own purposes and the chinese government shall not levy taxes in hong kong.', "moreover, china will not draw on or resort to hong kong's exchange fund or other assets in any way and for any reason.", 'all financial transactions between the mainland and hong kong will be conducted in accordance with the rules and practices of international financial activities.', 'claims and liabilities between institutions from the mainland and those from hong kong will continue to be regarded as external claims and liabilities.', 'when participating in the hong kong market, chinese entities will have equal treatment as other international and local market participants.', 'apart from the above, it is also important for hong kong as an international financial centre to continue to develop its international monetary relations and participate in the activities of international and regional financial institutions.', 'there are therefore provisions in the joint declaration and the basic law that hong kong may, on its own, maintain and develop financial relations with other countries, regions and relevant international organisations after 1997. the 1997 world bank/imf annual meeting will be held in hong kong just a few months after china resumes the exercise of sovereignty over hong kong.', 'this is a magnificent financial event and i am confident that it will be successful.', 'iii the strengthening of financial co-operation and the promotion of economic prosperity and stability between the mainland and hong kong mainland china and hong kong have close financial links with each other.', 'since the implementation of financial reforms and the open-door policy, such links have been strengthened further.', 'it is necessary to further enhance such a mutually beneficial relationship between the two places.', 'first of all, the mainland and hong kong should work together for the prosperity, stability and smooth transition of hong kong.', 'china\'s commitment to the implementation of the "one country, two systems" principle is increasingly accepted and appreciated by the people of hong kong and the international community.', "worries and doubts about the future of hong kong which emerged in the early 1980's have largely subsided.", 'we are pleased to note that the financial situation in hong kong is heading towards a smooth transition.', "we are confident that hong kong will enjoy financial stability before and after 1997. even though there may be some fluctuations in hong kong's financial market, we believe that the hkma is fully capable of handling these situations satisfactorily.", "if necessary, the people's bank of china will, at the request of the hkma and in accordance with the basic law and market practices, offer support to the hkma.", 'financial stability in hong kong before and after 1997 is not only essential to the prosperity of hong kong and china but also to financial stability in the asia-pacific region.', "we are confident that the international financial community, including the central banks in the asia-pacific region, will be actively involved in the efforts to maintain hong kong's financial stability.", "secondly, the two places should work closely together to maintain and enhance hong kong's status as an international financial centre.", 'hong kong has some unique competitive advantages in being an international financial centre in a number of aspects such as opportunities, geographic location and people.', "i have made it clear to the international financial community on many occasions that after china's resumption of sovereignty over hong kong, the status of hong kong as an international financial centre will not be undermined but, rather, it will be further strengthened.", 'this is because the many unique advantages which hong kong enjoys now will continue to exist after 1997. there is also the basic law which guarantees that hong kong will remain unchanged.', "more importantly, with the sustained, rapid and healthy growth of the economy in china - the vast hinterland at the back of hong kong - numerous opportunities will be created for hong kong's financial sector.", "all these are favourable conditions for the maintenance and strengthening of hong kong's status as an international financial centre.", 'economic developments in the mainland have given rise to strong demand for funds and hong kong will continue to be our major funding centre.', 'we will strengthen our coordination and cooperation with hong kong in areas such as the development of markets and infrastructures in response to the needs of financial developments in both places.', 'i have met with many central bankers and major international bankers and they all agreed that hong kong should be able to maintain its status as an international financial centre as regards the future relationship between hong kong and shanghai.', "i think as a national economic centre, shanghai's financial status will become increasingly important.", 'however, it will not be possible for shanghai to become an international financial centre in the longer term and it will not replace hong kong.', 'thirdly, the mainland and hong kong should co-operate fully with each other so as to promote prosperity and stability.', 'since the implementation of economic reforms and the opendoor policy, financial co-operation between the two places has been strengthened which, in turn, helps to develop economic and trading ties.', "at present, china and hong kong are each other's major investment and trading partner.", "as at the end of 1995, hong kong's total cumulative investment in china reached us$ 78.6 billion, accounting for 58% of total foreign investment in china.", 'in 1995, 90% of the syndicated loans to china were arranged in hong kong and 90% of the chinese companies listed on overseas stock markets have their primary listing in hong kong.', "the volume of import and export trade between the two places amounted to us$ 44.6 billion last year, accounting for 15.9% of china's total external trade.", "if hong kong's entrepôt trade which came from china is also taken into account, the figure reached us$ 124.1 billion, accounting for 34.1% of hong kong's total external trade in that year.", 'the number of mainland financial institutions in hong kong is on the rise and vice versa.', 'these institutions are going to provide a whole range of financial services which are conducive to the continuous and stable development of the economic relationship between the two places.', 'china will further open up its financial markets.', 'this includes the opening up of more districts, the gradual relaxation of renminbi business and the gradual introduction of the investment banking mechanism.', 'the hong kong financial sector will directly benefit from these moves since they will offer numerous business opportunities.', 'in the course of stepping up our pace of financial reforms, we have to keep on learning from advanced international management experience and to provide training to outstanding personnel.', 'we hope that the financial community in hong kong will provide us with assistance and support in these areas.', 'before ending my speech, i would like to point out that the hong kong association of banks has contributed a lot in assisting the hkma to ensure the financial stability of hong kong.', 'i hope all of you will continue to give your support to the hkma and play a more active role in promoting economic and financial developments in hong kong and its smooth transition.', 'i would also like to announce that an association of mainland banks will be formed this year.', 'i hope that the two banking associations will strengthen their exchanges and co-operation and work together for a more prosperous future.', 'a delegation from the hong kong association of banks will visit beijing in a few days.', "i would like to welcome the delegation on behalf of the people's bank of china.", 'i will meet with some of you again on that occasion.', 'we can further exchange views on the strengthening of co-operation between the banking sectors on the mainland and in hong kong.']	Dai Xianglong	People's Bank of China	Governor	China
https://www.bis.org/review/r970211a.pdf	Mr. Dai assesses the outlook for Hong Kong as Asia's financial centre (Central Bank Articles and Speeches, 30 Sep 96)	Speech by the Governor of the People's Bank of China, Mr. Dai Xianglong, at the luncheon hosted by the Hong Kong Financial Secretary in Washington on 30/9/96.	1996-09-30 00:00:00	Mr. Dai assesses the outlook for Hong Kong as Asia's financial centre Speech by the Governor of the People's Bank of China, Mr. Dai Xianglong, at the luncheon hosted by the Hong Kong Financial Secretary in Washington on 30/9/96. The 1997 World Bank/IMF Annual Meetings will be held in Hong Kong next year. Mr Liu Zhongli, the Minister of Finance and myself will be there welcoming you as the host of the occasion. I foresee that the Annual Meetings to be held next year will be a magnificent event which commands far-reaching historical significance. This is because the Annual Meetings of the two important international financial organisations are to be held in Hong Kong just a few months after China resumes the exercise of sovereignty over Hong Kong. Representatives from various countries will have the opportunity to witness the realisation of the principle of "one country, two systems" in Hong Kong. I believe that nobody will wish to miss such an opportunity. Mr Tsang has just expressed his views on the economy of Hong Kong before and after 1997. I would like to say a few words from the perspective of the People's Bank of China (PBOC). I have stated on many occasions that we are confident that after China resumes the exercise of sovereignty over Hong Kong, the territory will not only remain prosperous and stable, but its status as an international financial centre will also be further enhanced. And I have good reasons for this confidence. First, there are the strong economic fundamentals of Hong Kong and the entrepreneurial and management skills of the people of Hong Kong. These form the basis for Hong Kong's continued prosperity and stability and for maintaining Hong Kong's status as an international financial centre. As you all know, Hong Kong is an international trade, transport, financial and information centre. With the rapid economic developments taking place in the Asia-Pacific region, Hong Kong's role as an international financial centre will not be weakened; instead, its importance will certainly increase. According to the "Joint Declaration of the Government of the United Kingdom of Great Britain and Northern Ireland and the Government of the People's Republic of China on the Question of Hong Kong" and "The Basic Law of the Hong Kong Special Administrative Region of the People's Republic of China", Hong Kong will become a Special Administrative Region of the People's Republic of China from 1 July 1997. It will enjoy a high degree of autonomy with Hong Kong people ruling Hong Kong. Hong Kong will become an independent tariff and trade region and an international financial centre in China but with its own currency. In order to maintain its status as an international financial centre, Hong Kong will inevitably face various challenges. However, Hong Kong will continue to have a sound legal system, advanced communication facilities and infrastructures, professional and management expertise, and strong foreign reserves. Currently, Hong Kong's foreign reserves rank seventh in the world while China's rank second. With the backing of such strong economic strength, we are confident that Hong Kong's status as an international financial centre will be maintained and further enhanced. Secondly, from the legal angle, the Basic Law assures the continuation and enhancement of Hong Kong's status as an international financial centre. Articles 109 to 113 of the Basic Law lay down specific provisions relating to Hong Kong's status as an international financial centre, its monetary and financial policies, the status of the Hong Kong dollar and the issuing arrangements, capital movements and the role of the Exchange Fund. These principles establish the basic monetary relationship between China and Hong Kong under the principle of "one country, two systems", and this can conveniently be summarised as "one country, two currencies, two monetary systems and two monetary authorities" within a sovereign state. It should be pointed out that the co-existence of two currencies, that is, the Hong Kong dollar and the renminbi, is a clear demonstration of the differences between the economies of Hong Kong and the mainland. It is therefore essential that the two monetary systems should be mutually independent. The renminbi will not replace the Hong Kong dollar. We are of the view that the co-existence of two monetary systems is significant to the economic reform of China. It follows from the two mutually independent monetary systems of the mainland and Hong Kong that the two monetary authorities will also be mutually independent and one is not superior to the other. The Hong Kong Monetary Authority (HKMA) will be accountable solely to the Hong Kong Special Administrative Region Government from 1 July 1997. The PBOC will not take the place of the HKMA and will not set up any branch office in Hong Kong. I am glad that international organisations and other central banks also acknowledge the mutually independent relationship between the PBOC and the HKMA. Both the PBOC and the HKMA were offered membership in the Bank for International Settlements in early September this year. This shows that the work done by the PBOC and the HKMA are widely accepted and appreciated by the central banking fraternity. This also shows that the international financial community fully supports the principle of "one country, two systems" laid down by the Basic Law. The Basic Law also states that the Exchange Fund shall be managed and controlled by the Hong Kong government. It also states that the revenues of the Hong Kong Special Administrative Region shall be used exclusively for its own purposes. In addition, the Basic Law stipulates that the Chinese Government will not levy taxes in Hong Kong. These three-fold safeguards are evidence that China will not interfere with Hong Kong's financial matters. We have reiterated time and again that under no circumstances will China draw on or resort to Hong Kong's Exchange Fund or other assets in any way or for any reason. On the contrary, the PBOC will support the currency stability of Hong Kong. The PBOC and the HKMA entered into a bilateral agreement on repurchase of US treasury paper early this year. We also stand ready to provide funds to support the Hong Kong dollar, if necessary. Thirdly, the economic development of the mainland has created excellent conditions for the continuity and further strengthening of Hong Kong's prosperity and stability. Economic development in the mainland provides a strong support to Hong Kong's economic development. China is confident in Hong Kong's maintaining prosperity and stability after 1997 because we have full confidence in the economic development in China. China is firmly committed to continuing with its economic reform and our achievements are widely recognised. Currently, the macro-economic situation in mainland China is steady. The various macro-economic indicators do meet our targets laid down early this year and some even out-perform our expectations. It is anticipated that this year's economic growth will be around 9%. The retail price is expected to rise by about 7% and is expected to remain steady over the next two years or may even ease further. At present, our foreign reserves are over US$ 90 billion and are expected to exceed US$ 95 billion by the end of this year. Since the beginning of the second quarter this year, external trade has posted some steady growth. There is a significant inflow of capital and our balance of payments is in a healthy position. Therefore the exchange rate of the renminbi, which is determined by the market, will remain stable. The renminbi, for all intents and purposes has become fully convertible in the current account. We are in advance of our schedule in satisfying the requirement stipulated in Article VIII of the IMF Articles of Agreement. In the next five years, China will continue to adopt an appropriately tight monetary policy. The adoption of this policy means firstly, we will have an appropriately tight monetary stance to keep inflation at a level lower than the rate of economic growth. Secondly, money supply should grow at an appropriate level. In the next five years, the annual growth rate of M1 will be kept at around 18% and M2 at 21% to 23%. Thirdly, reforms and improvements will continuously be made to the approach in making macro-economic adjustment. That is, we will move from reliance on direct control of the volume of credit towards regulating money supply by means of indirect monetary policy instruments such as reserve requirements, open market operations and interest rate policy. Appropriately tight monetary policy is not limited to the control of total credit but also adjustment of the credit structure, deepening of monetary reforms, and timely adjustments to the different aspects of the monetary system. An appropriately tight monetary policy is conducive to the healthy, stable and sustained growth of the national economy. It also helps to create favourable conditions for the resumption of sovereignty and the continued prosperity of Hong Kong. Stability in China is the very basis for Hong Kong's stability while Hong Kong's stability will certainly enhance economic reform and developments in China. Foreign investors in Hong Kong will, at the same time, benefit from the stability of China and Hong Kong. Those sceptics who have doubted China's commitment to the open door policy no longer can have such doubts after witnessing the implementation of our economic reforms and its achievements. I hope you will recognise that China is firmly committed to implementing the principle of "one country, two systems" and maintaining the prosperity and stability of Hong Kong, just as we have been firmly committed to the implementation of economic reform in China. The principle of "one country, two systems" is the realisation of the spirit of our constitution and has become a long-term irreversible national policy. As China continues to pursue its economic reform, Hong Kong's role as the international financial centre in China will become more and more important. We will do our best to help maintain the existing economic system of Hong Kong and keep up its economic dynamism. We also hope that the international financial community will join us in our efforts to maintain Hong Kong's prosperity and stability. Ladies and gentlemen, when you come to next year's Annual Meetings in Hong Kong, you will all see for yourselves the realisation of the principle of "one country, two systems" in Hong Kong. In addition, I believe that the 1997 World Bank/IMF Annual Meetings will be an impressive event as a result.	["mr. dai assesses the outlook for hong kong as asia's financial centre speech by the governor of the people's bank of china, mr. dai xianglong, at the luncheon hosted by the hong kong financial secretary in washington on 30/9/96.", 'the 1997 world bank/imf annual meetings will be held in hong kong next year.', 'mr liu zhongli, the minister of finance and myself will be there welcoming you as the host of the occasion.', 'i foresee that the annual meetings to be held next year will be a magnificent event which commands far-reaching historical significance.', 'this is because the annual meetings of the two important international financial organisations are to be held in hong kong just a few months after china resumes the exercise of sovereignty over hong kong.', 'representatives from various countries will have the opportunity to witness the realisation of the principle of "one country, two systems" in hong kong.', 'i believe that nobody will wish to miss such an opportunity.', "mr tsang has just expressed his views on the economy of hong kong before and after 1997. i would like to say a few words from the perspective of the people's bank of china (pboc).", 'i have stated on many occasions that we are confident that after china resumes the exercise of sovereignty over hong kong, the territory will not only remain prosperous and stable, but its status as an international financial centre will also be further enhanced.', 'and i have good reasons for this confidence.', 'first, there are the strong economic fundamentals of hong kong and the entrepreneurial and management skills of the people of hong kong.', "these form the basis for hong kong's continued prosperity and stability and for maintaining hong kong's status as an international financial centre.", 'as you all know, hong kong is an international trade, transport, financial and information centre.', "with the rapid economic developments taking place in the asia-pacific region, hong kong's role as an international financial centre will not be weakened; instead, its importance will certainly increase.", 'according to the "joint declaration of the government of the united kingdom of great britain and northern ireland and the government of the people\'s republic of china on the question of hong kong" and "the basic law of the hong kong special administrative region of the people\'s republic of china", hong kong will become a special administrative region of the people\'s republic of china from 1 july 1997. it will enjoy a high degree of autonomy with hong kong people ruling hong kong.', 'hong kong will become an independent tariff and trade region and an international financial centre in china but with its own currency.', 'in order to maintain its status as an international financial centre, hong kong will inevitably face various challenges.', 'however, hong kong will continue to have a sound legal system, advanced communication facilities and infrastructures, professional and management expertise, and strong foreign reserves.', "currently, hong kong's foreign reserves rank seventh in the world while china's rank second.", "with the backing of such strong economic strength, we are confident that hong kong's status as an international financial centre will be maintained and further enhanced.", "secondly, from the legal angle, the basic law assures the continuation and enhancement of hong kong's status as an international financial centre.", "articles 109 to 113 of the basic law lay down specific provisions relating to hong kong's status as an international financial centre, its monetary and financial policies, the status of the hong kong dollar and the issuing arrangements, capital movements and the role of the exchange fund.", 'these principles establish the basic monetary relationship between china and hong kong under the principle of "one country, two systems", and this can conveniently be summarised as "one country, two currencies, two monetary systems and two monetary authorities" within a sovereign state.', 'it should be pointed out that the co-existence of two currencies, that is, the hong kong dollar and the renminbi, is a clear demonstration of the differences between the economies of hong kong and the mainland.', 'it is therefore essential that the two monetary systems should be mutually independent.', 'the renminbi will not replace the hong kong dollar.', 'we are of the view that the co-existence of two monetary systems is significant to the economic reform of china.', 'it follows from the two mutually independent monetary systems of the mainland and hong kong that the two monetary authorities will also be mutually independent and one is not superior to the other.', 'the hong kong monetary authority (hkma) will be accountable solely to the hong kong special administrative region government from 1 july 1997. the pboc will not take the place of the hkma and will not set up any branch office in hong kong.', 'i am glad that international organisations and other central banks also acknowledge the mutually independent relationship between the pboc and the hkma.', 'both the pboc and the hkma were offered membership in the bank for international settlements in early september this year.', 'this shows that the work done by the pboc and the hkma are widely accepted and appreciated by the central banking fraternity.', 'this also shows that the international financial community fully supports the principle of "one country, two systems" laid down by the basic law.', 'the basic law also states that the exchange fund shall be managed and controlled by the hong kong government.', 'it also states that the revenues of the hong kong special administrative region shall be used exclusively for its own purposes.', 'in addition, the basic law stipulates that the chinese government will not levy taxes in hong kong.', "these three-fold safeguards are evidence that china will not interfere with hong kong's financial matters.", "we have reiterated time and again that under no circumstances will china draw on or resort to hong kong's exchange fund or other assets in any way or for any reason.", 'on the contrary, the pboc will support the currency stability of hong kong.', 'the pboc and the hkma entered into a bilateral agreement on repurchase of us treasury paper early this year.', 'we also stand ready to provide funds to support the hong kong dollar, if necessary.', "thirdly, the economic development of the mainland has created excellent conditions for the continuity and further strengthening of hong kong's prosperity and stability.", "economic development in the mainland provides a strong support to hong kong's economic development.", "china is confident in hong kong's maintaining prosperity and stability after 1997 because we have full confidence in the economic development in china.", 'china is firmly committed to continuing with its economic reform and our achievements are widely recognised.', 'currently, the macro-economic situation in mainland china is steady.', 'the various macro-economic indicators do meet our targets laid down early this year and some even out-perform our expectations.', "it is anticipated that this year's economic growth will be around 9%.", 'the retail price is expected to rise by about 7% and is expected to remain steady over the next two years or may even ease further.', 'at present, our foreign reserves are over us$ 90 billion and are expected to exceed us$ 95 billion by the end of this year.', 'since the beginning of the second quarter this year, external trade has posted some steady growth.', 'there is a significant inflow of capital and our balance of payments is in a healthy position.', 'therefore the exchange rate of the renminbi, which is determined by the market, will remain stable.', 'the renminbi, for all intents and purposes has become fully convertible in the current account.', 'we are in advance of our schedule in satisfying the requirement stipulated in article viii of the imf articles of agreement.', 'in the next five years, china will continue to adopt an appropriately tight monetary policy.', 'the adoption of this policy means firstly, we will have an appropriately tight monetary stance to keep inflation at a level lower than the rate of economic growth.', 'secondly, money supply should grow at an appropriate level.', 'in the next five years, the annual growth rate of m1 will be kept at around 18% and m2 at 21% to 23%.', 'thirdly, reforms and improvements will continuously be made to the approach in making macro-economic adjustment.', 'that is, we will move from reliance on direct control of the volume of credit towards regulating money supply by means of indirect monetary policy instruments such as reserve requirements, open market operations and interest rate policy.', 'appropriately tight monetary policy is not limited to the control of total credit but also adjustment of the credit structure, deepening of monetary reforms, and timely adjustments to the different aspects of the monetary system.', 'an appropriately tight monetary policy is conducive to the healthy, stable and sustained growth of the national economy.', 'it also helps to create favourable conditions for the resumption of sovereignty and the continued prosperity of hong kong.', "stability in china is the very basis for hong kong's stability while hong kong's stability will certainly enhance economic reform and developments in china.", 'foreign investors in hong kong will, at the same time, benefit from the stability of china and hong kong.', "those sceptics who have doubted china's commitment to the open door policy no longer can have such doubts after witnessing the implementation of our economic reforms and its achievements.", 'i hope you will recognise that china is firmly committed to implementing the principle of "one country, two systems" and maintaining the prosperity and stability of hong kong, just as we have been firmly committed to the implementation of economic reform in china.', 'the principle of "one country, two systems" is the realisation of the spirit of our constitution and has become a long-term irreversible national policy.', "as china continues to pursue its economic reform, hong kong's role as the international financial centre in china will become more and more important.", 'we will do our best to help maintain the existing economic system of hong kong and keep up its economic dynamism.', "we also hope that the international financial community will join us in our efforts to maintain hong kong's prosperity and stability.", 'ladies and gentlemen, when you come to next year\'s annual meetings in hong kong, you will all see for yourselves the realisation of the principle of "one country, two systems" in hong kong.', 'in addition, i believe that the 1997 world bank/imf annual meetings will be an impressive event as a result.']	Dai Xianglong	People's Bank of China	Governor	China
https://www.bis.org/review/r970203b.pdf	Mr. Rangarajan examines the objectives of monetary policy and price stability in relation to the economy of India (Central Bank Articles and Speeches, 28 Dec 96)	Address by the Governor of the Reserve Bank of India, Mr. C. Rangarajan, at the Second Conference of the Econometric Society's Regional Chapter for India and South Asia in Delhi on 28/12/96.	1996-12-28 00:00:00	Mr. Rangarajan examines the objectives of monetary policy and price stability in relation to the economy of India Address by the Governor of the Reserve Bank of India, Mr. C. Rangarajan, at the Second Conference of the Econometric Society's Regional Chapter for India and South Asia in Delhi on 28/12/96. 1. It gives me indeed very great pleasure to be in your midst this morning. It is indeed very gratifying to note that the Second Conference of the Econometric Society's Regional Chapter for India and South East Asia is being held in Delhi. 2. Econometrics as a discipline has come a long way. Enriched by the developments both in mathematical economics and statistical methods, econometrics has today become an indispensable tool to all practitioners. Without a numerical evaluation of economic magnitudes, economic theory would have been of little use in economic policy. The original motto of Cowles Foundation was 'Science is measurement'. It used to be said that in economics the tendency of theory to lag behind observations seemed to be endemic. We have definitely moved away from that situation. While alternative theories to explain a set of phenomena are not necessarily a weakness and may even be regarded as a sign of vitality, the continued co-existence of alternative theories over a substantial period of time without being able to discriminate among them can result in the loss of credibility in the discipline itself. This in part is the present status of economics. The future scope of econometrics is thus immense. 3. I would like to take this opportunity given to me this morning to raise one issue in monetary policy that still remains contentious despite overwhelming agreement among policy makers in industrially advanced countries. The issue relates to the objective of monetary policy. The question is: What should be the objective or objectives of monetary policy and whether in the Indian context, maintenance of price stability should be the dominant objective of monetary policy? 4. The issue of objective has become important because of the need to provide clear guidance to monetary policy makers. Indeed this aspect has assumed added significance in the context of the increasing stress on autonomy of central banks. While autonomy has to go with accountability, accountability itself requires a clear enunciation of goals. 5. Monetary policy has now moved to the centre stage of economic policy-making the world over. In the 1930s and in the first two decades after the Second World War, monetary policy was relegated to the background. The ascendancy of fiscal policy during this period was due in part to the depression of the 1930s, and the process of reconstruction immediately after the Second World War and the acceptance of the Keynesian dictum that fiscal action was necessary to prevent deficiency in the aggregate demand. However, the 1970s saw the emergence of a combination of high inflation and low growth - 'stagnation' as it came to be called - and the standard Keynesian analysis was hard put to explain that phenomenon. Consequently, monetary policy re-emerged as an instrument of economic policy particularly in the fight against inflation. Issues relating to the conduct of monetary policy came to the forefront of policy debates in the 1980s. The relative importance of growth and price stability as the objective of monetary policy as well as the appropriate intermediate target of monetary policy became the focus of attention. Over the years, a consensus has emerged among the industrially advanced countries that the dominant objective of monetary policy should be price stability. Incorporation of this objective in the Maastrischt Treaty is indeed a reflection of this consensus. Differences however, exist among central banks even in industrially advanced countries as regards the appropriate intermediate target. While some central banks consider monetary aggregates and therefore monetary targeting as operationally meaningful, some others focus exclusively on interest rate even though the inter-relationship between the two targets is well recognised. 6. A similar trend regarding monetary policy is discernible in developing economies as well. Much of the early literature on development economics focused on real factors such as savings, investment and technology as main springs of growth. Very little attention was paid to the financial system as a contributory factor to economic growth. In fact, many writers felt that inflation was endemic in the process of economic growth and it was accordingly treated more as a consequence of structural imbalance than as a monetary phenomenon. However, with the accumulated evidence, it became clear that any process of economic growth in which monetary expansion was disregarded also led to inflationary pressures with a consequent impact on economic growth. Accordingly, importance of price stability and therefore the need to use monetary policy for that purpose also assumed importance in developing economies. Nonetheless, the debate on the extent to which price stability should be deemed to be the over-riding objective of monetary policy in such economies continues. 7. Monetary policy is an arm of economic policy and in that sense, the objectives of monetary policy are no different from the overall objectives of economic policy. The broad objectives of monetary policy in India have been a) to regulate monetary expansion so as to maintain a reasonable degree of price stability; and b) to ensure adequate expansion in credit to assist economic growth. The emphasis between the two objectives has changed from year to year depending upon the conditions prevailing in that and the previous year. 8. The question of a dominant objective arises essentially in view of the multiplicity of objectives and the inherent conflict among such objectives. Jan Tinbergen had argued decades ago that it was necessary to have at least one instrument for each target. In this regard, it must be recognised that certain objectives are better suited or more easily achieved with certain instruments than with others. This 'assignment rule' favours monetary policy as the most appropriate instrument to achieve the objective of price stability. 9. The crucial question that arises is whether the pursuit of the objective of price stability by monetary authorities undermines the ability of the economy to attain and sustain higher growth. A great deal of research effort has been spent on the examination of the trade-off between economic growth and price stability. 10. The well known Phillips curve showed that there was an inverse relationship between rate of change in wage rate and unemployment rate suggesting thereby a trade-off between inflation and unemployment. The original article of Prof. Phillips was published in 1958. The Phillips curve relationship has subsequently been challenged both from theoretical and empirical standpoints. The downward slope of the curve arises basically because of the presence of money illusion and expected inflation deviating from actual inflation. 11. At present the controversy is centred around the possible short-run and long-run 'trade-off' between inflation and unemployment. This distinction primarily stems from the assumption of 'error-learning' process in the determination of inflationary expectations workers do have an anticipation on the inflation, but because they judge the inflation performance from the past data, the adjustment between the expected and actual inflation is slow. This implies that in the short-run, nominal wage rise will not fully absorb the actual inflation, and as such, it is argued, there is scope for reducing unemployment through inflation. As people adjust their expectations of inflation, the short-run Phillips curve shifts upward and the unemployment rate returns towards its 'natural' level. As the expected inflation catches up with actual inflation, the Phillips curve becomes vertical, denying thereby a 'trade-off' between inflation and unemployment in the long run. The Phillips curve thus provides at best a temporary trade-off between inflation and unemployment when the economy is adjusting to shocks to aggregate demand and as long as expected inflation is lower than actual inflation. The long-run Phillips curve becomes almost vertical at the natural rate of unemployment. 12. Of course, there is a possibility of lengthening the short-run 'trade-offs' indefinitely, since inflation surprises in each period can elongate the long-run perpetually. But, in that case the 'trade-offs' will become sharper in each successive period. In other words, to maintain the unemployment below the 'natural' rate, policy authorities will have to inflate the economy at higher rates in each successive period. This has a major policy implication even if the economy does not operate on the long-run vertical Phillips curve. Under the 'rational expectations hypothesis', as there are no deviations between 'actual', and 'expected' inflation, both in the short-run and long-run, Phillips curves are treated as being vertical with no trade-off between inflation and unemployment. 13. Another policy related question is the shape of the short-run Phillips curve itself. In the real world wages and prices remain sticky, as employment contracts are fairly long and there is also a cost in changing the individual prices too often, or renegotiating wages each time after a price rise. As argued by Fischer (1994), the nature of stickiness in wages and prices could be different in different economies and this could also be a function of the inflation history of the country concerned. Countries with high inflation rates tend to find themselves on the steeper portion of the short-run Phillips curve than low inflation countries which are more likely to be on the flatter side. Therefore, 'trade-off' between price stability and employment or output even when it does exist, is sharper for countries with relatively high inflation rates than those with low inflation rates. 14. The case of price stability as the objective of monetary policy rests on the fact that volatility in prices creates uncertainty in decision making. Rising prices affect savings adversely while making speculative investments more attractive. The most important contribution of the financial system to an economy is its ability to augment savings and allocate resources more efficiently. A regime of rising prices vitiates the atmosphere for promotion of savings and allocation of investment. Apart from all of these, there is also a social dimension. Inflation affects adversely those who have no hedges against inflation and that includes all the poorer sections of the community. Of course, a critical question in this context is at what level of inflation the adverse consequences begin to set in. 15. Inflation affects fiscal balance in several ways. It adversely affects fiscal deficit when elasticity of expenditure to inflation is higher than that of revenue. A more significant impact of inflation arises from its effect on interest rate and the dynamic sustainability of the fiscal situation. High rates of inflation signal weak resolve to control inflation and imply higher expected inflation in future. This gives rise to upward rigidity in nominal interest and leads to high debt service burden on the budget, thus reducing the manoeuvrability of fiscal management. 16. It is well recognised that adverse implications of inflation are higher at high rates of inflation, while a moderate inflation rate could be manageable without implying severe costs. International evidence suggests that the costs of uncertainty tend to rise in a non-linear fashion with inflation rate exceeding a threshold. One important caveat in interpreting the threshold of inflation rate beyond which costs exceed benefit is the provision of inflation protection measures available in the economy, which tends to moderate the adverse implications to some extent. Countries with a moderate inflation rate but inadequate indexation provision may show a higher degree of sensitivity to inflation, than those with low inflation. Most of the industrialised countries in the recent years have moved into an inflation rate ranging between two to three per cent. Among the developing countries, some of the fast growing East-Asian economies have in recent years not only demonstrated low inflation rates ranging between three to five per cent, but the growth rate at these inflation rates has been fairly high at around eight per cent. 17. Empirical evidence on the relationship between the inflation and growth in cross-country frameworks is somewhat inconclusive because such studies include countries with inflation rate of as low as one to two per cent as well as countries with inflation rates going beyond 200 and 300 per cent. While a number of studies have concluded that the negative impact of inflation on growth is high at high rates of inflation, there is no consensus about the threshold inflation rate beyond which the negative impact becomes pronounced. A study by Bruno indicated that growth rates declined steeply as the inflation rate went beyond 25 per cent. Another study also based on cross section of countries reported that the negative effect of inflation was very pronounced and powerful at inflation rates exceeding eight per cent. What the appropriate inflation threshold beyond which costs tend to exceed benefits need to be estimated for each country separately. Nevertheless, people worry about even moderate inflation levels because if not held in check, a little inflation can lead to higher inflation and eventually affect growth. 18. A macro-econometric model of the Indian economy shows that a 10 per cent sustained increase in real public investment in non-agriculture sector, financed by money creation leads to an annual inflation rate of about 2.3 per cent and additional GDP growth of one percent, on an average, during the first two years, while in the span of 10 to 15 years, inflation rate rises to about 17 per cent per annum and additional output growth slows down considerably to average 2.7 per cent during this period. This implies that in the long run a sustained improvement in the growth scenario through monetary financing of the deficit could involve a severe trade-off in terms of inflation - every one per cent additional output growth implies nearly 6 to 6.5 per cent rise in inflation rate in the long run. 19. Obviously, there are some critics of price stability as the dominant objective of monetary policy. For example Prof. Paul Krugman writes '.....the belief that absolute price stability is a huge blessing, that it brings large benefits with few if any costs, rests not on evidence but on faith. The evidence actually points the other way: the benefits of price stability are elusive, the costs of getting there are large, and zero inflation may not be a good thing even in the long run.' The observations of Prof. Krugman as they stand are not directed against price stability as an objective but are aimed against a policy which seeks 'absolute' price stability and attempts to bring down the inflation rate from around two per cent to almost zero. This is evident from what he himself advocates: '.....adopt as a long run target fairly low but not zero inflation, say threefour per cent. This is high enough to accommodate most of the real wage cuts that markets impose, while the costs of the inflation itself will still be very small. Interestingly, in India, the Chakravarty Committee (1985) treated an inflation rate of four per cent as 'the acceptable rise in prices' purported to reflect 'changes in relative prices necessary to attract resources to growth sectors'. 20. We, in India, need to have an appropriate fix on the acceptable level of inflation rate. In the 1970s, the average annual inflation rate as measured by the wholesale price index was nine per cent. In the 1980s, it was eight per cent. However, in the period between 1990 and 1995, the average inflation rate has remained around 10 per cent. The objective of the policy should be to keep the inflation rate around six per cent. This itself is much higher than what the industrial countries are aiming at and therefore will have some implications for the exchange rate of the rupee. Monetary growth should be so moderated that while meeting the objective of growth it does not push the inflation rate beyond six per cent. 21. A question that arises in this context is whether monetary policy by itself is able to contain inflationary pressures particularly in developing economies like ours. It is true that developing economies like India are subject to greater supply shocks than developed economies. Fluctuations in agricultural output have an important bearing on the price situation. Nevertheless, continuous increase in prices which is what inflation is about cannot occur unless it is sustained by a continuing increase in money supply. Control of the money supply has thus to play an important role in any scheme aimed at controlling inflation. 21. The controversy over the objective of monetary policy has reached such a pitch that some have described central bankism as a religion with hard money as supreme god and inflation as devil. Let me however say that the commitment to a reasonable degree of price stability is not a dogma. It is good economics.	["mr. rangarajan examines the objectives of monetary policy and price stability in relation to the economy of india address by the governor of the reserve bank of india, mr. c. rangarajan, at the second conference of the econometric society's regional chapter for india and south asia in delhi on 28/12/96.", '1. it gives me indeed very great pleasure to be in your midst this morning.', "it is indeed very gratifying to note that the second conference of the econometric society's regional chapter for india and south east asia is being held in delhi.", '2. econometrics as a discipline has come a long way.', 'enriched by the developments both in mathematical economics and statistical methods, econometrics has today become an indispensable tool to all practitioners.', 'without a numerical evaluation of economic magnitudes, economic theory would have been of little use in economic policy.', "the original motto of cowles foundation was 'science is measurement'.", 'it used to be said that in economics the tendency of theory to lag behind observations seemed to be endemic.', 'we have definitely moved away from that situation.', 'while alternative theories to explain a set of phenomena are not necessarily a weakness and may even be regarded as a sign of vitality, the continued co-existence of alternative theories over a substantial period of time without being able to discriminate among them can result in the loss of credibility in the discipline itself.', 'this in part is the present status of economics.', 'the future scope of econometrics is thus immense.', '3. i would like to take this opportunity given to me this morning to raise one issue in monetary policy that still remains contentious despite overwhelming agreement among policy makers in industrially advanced countries.', 'the issue relates to the objective of monetary policy.', 'the question is: what should be the objective or objectives of monetary policy and whether in the indian context, maintenance of price stability should be the dominant objective of monetary policy?', '4. the issue of objective has become important because of the need to provide clear guidance to monetary policy makers.', 'indeed this aspect has assumed added significance in the context of the increasing stress on autonomy of central banks.', 'while autonomy has to go with accountability, accountability itself requires a clear enunciation of goals.', '5. monetary policy has now moved to the centre stage of economic policy-making the world over.', 'in the 1930s and in the first two decades after the second world war, monetary policy was relegated to the background.', 'the ascendancy of fiscal policy during this period was due in part to the depression of the 1930s, and the process of reconstruction immediately after the second world war and the acceptance of the keynesian dictum that fiscal action was necessary to prevent deficiency in the aggregate demand.', "however, the 1970s saw the emergence of a combination of high inflation and low growth - 'stagnation' as it came to be called - and the standard keynesian analysis was hard put to explain that phenomenon.", 'consequently, monetary policy re-emerged as an instrument of economic policy particularly in the fight against inflation.', 'issues relating to the conduct of monetary policy came to the forefront of policy debates in the 1980s.', 'the relative importance of growth and price stability as the objective of monetary policy as well as the appropriate intermediate target of monetary policy became the focus of attention.', 'over the years, a consensus has emerged among the industrially advanced countries that the dominant objective of monetary policy should be price stability.', 'incorporation of this objective in the maastrischt treaty is indeed a reflection of this consensus.', 'differences however, exist among central banks even in industrially advanced countries as regards the appropriate intermediate target.', 'while some central banks consider monetary aggregates and therefore monetary targeting as operationally meaningful, some others focus exclusively on interest rate even though the inter-relationship between the two targets is well recognised.', '6. a similar trend regarding monetary policy is discernible in developing economies as well.', 'much of the early literature on development economics focused on real factors such as savings, investment and technology as main springs of growth.', 'very little attention was paid to the financial system as a contributory factor to economic growth.', 'in fact, many writers felt that inflation was endemic in the process of economic growth and it was accordingly treated more as a consequence of structural imbalance than as a monetary phenomenon.', 'however, with the accumulated evidence, it became clear that any process of economic growth in which monetary expansion was disregarded also led to inflationary pressures with a consequent impact on economic growth.', 'accordingly, importance of price stability and therefore the need to use monetary policy for that purpose also assumed importance in developing economies.', 'nonetheless, the debate on the extent to which price stability should be deemed to be the over-riding objective of monetary policy in such economies continues.', '7. monetary policy is an arm of economic policy and in that sense, the objectives of monetary policy are no different from the overall objectives of economic policy.', 'the broad objectives of monetary policy in india have been a) to regulate monetary expansion so as to maintain a reasonable degree of price stability; and b) to ensure adequate expansion in credit to assist economic growth.', 'the emphasis between the two objectives has changed from year to year depending upon the conditions prevailing in that and the previous year.', '8. the question of a dominant objective arises essentially in view of the multiplicity of objectives and the inherent conflict among such objectives.', 'jan tinbergen had argued decades ago that it was necessary to have at least one instrument for each target.', 'in this regard, it must be recognised that certain objectives are better suited or more easily achieved with certain instruments than with others.', "this 'assignment rule' favours monetary policy as the most appropriate instrument to achieve the objective of price stability.", '9. the crucial question that arises is whether the pursuit of the objective of price stability by monetary authorities undermines the ability of the economy to attain and sustain higher growth.', 'a great deal of research effort has been spent on the examination of the trade-off between economic growth and price stability.', '10. the well known phillips curve showed that there was an inverse relationship between rate of change in wage rate and unemployment rate suggesting thereby a trade-off between inflation and unemployment.', 'the original article of prof. phillips was published in 1958. the phillips curve relationship has subsequently been challenged both from theoretical and empirical standpoints.', 'the downward slope of the curve arises basically because of the presence of money illusion and expected inflation deviating from actual inflation.', "11. at present the controversy is centred around the possible short-run and long-run 'trade-off' between inflation and unemployment.", "this distinction primarily stems from the assumption of 'error-learning' process in the determination of inflationary expectations workers do have an anticipation on the inflation, but because they judge the inflation performance from the past data, the adjustment between the expected and actual inflation is slow.", 'this implies that in the short-run, nominal wage rise will not fully absorb the actual inflation, and as such, it is argued, there is scope for reducing unemployment through inflation.', "as people adjust their expectations of inflation, the short-run phillips curve shifts upward and the unemployment rate returns towards its 'natural' level.", "as the expected inflation catches up with actual inflation, the phillips curve becomes vertical, denying thereby a 'trade-off' between inflation and unemployment in the long run.", 'the phillips curve thus provides at best a temporary trade-off between inflation and unemployment when the economy is adjusting to shocks to aggregate demand and as long as expected inflation is lower than actual inflation.', 'the long-run phillips curve becomes almost vertical at the natural rate of unemployment.', "12. of course, there is a possibility of lengthening the short-run 'trade-offs' indefinitely, since inflation surprises in each period can elongate the long-run perpetually.", "but, in that case the 'trade-offs' will become sharper in each successive period.", "in other words, to maintain the unemployment below the 'natural' rate, policy authorities will have to inflate the economy at higher rates in each successive period.", 'this has a major policy implication even if the economy does not operate on the long-run vertical phillips curve.', "under the 'rational expectations hypothesis', as there are no deviations between 'actual', and 'expected' inflation, both in the short-run and long-run, phillips curves are treated as being vertical with no trade-off between inflation and unemployment.", '13. another policy related question is the shape of the short-run phillips curve itself.', 'in the real world wages and prices remain sticky, as employment contracts are fairly long and there is also a cost in changing the individual prices too often, or renegotiating wages each time after a price rise.', 'as argued by fischer (1994), the nature of stickiness in wages and prices could be different in different economies and this could also be a function of the inflation history of the country concerned.', 'countries with high inflation rates tend to find themselves on the steeper portion of the short-run phillips curve than low inflation countries which are more likely to be on the flatter side.', "therefore, 'trade-off' between price stability and employment or output even when it does exist, is sharper for countries with relatively high inflation rates than those with low inflation rates.", '14. the case of price stability as the objective of monetary policy rests on the fact that volatility in prices creates uncertainty in decision making.', 'rising prices affect savings adversely while making speculative investments more attractive.', 'the most important contribution of the financial system to an economy is its ability to augment savings and allocate resources more efficiently.', 'a regime of rising prices vitiates the atmosphere for promotion of savings and allocation of investment.', 'apart from all of these, there is also a social dimension.', 'inflation affects adversely those who have no hedges against inflation and that includes all the poorer sections of the community.', 'of course, a critical question in this context is at what level of inflation the adverse consequences begin to set in.', '15. inflation affects fiscal balance in several ways.', 'it adversely affects fiscal deficit when elasticity of expenditure to inflation is higher than that of revenue.', 'a more significant impact of inflation arises from its effect on interest rate and the dynamic sustainability of the fiscal situation.', 'high rates of inflation signal weak resolve to control inflation and imply higher expected inflation in future.', 'this gives rise to upward rigidity in nominal interest and leads to high debt service burden on the budget, thus reducing the manoeuvrability of fiscal management.', '16. it is well recognised that adverse implications of inflation are higher at high rates of inflation, while a moderate inflation rate could be manageable without implying severe costs.', 'international evidence suggests that the costs of uncertainty tend to rise in a non-linear fashion with inflation rate exceeding a threshold.', 'one important caveat in interpreting the threshold of inflation rate beyond which costs exceed benefit is the provision of inflation protection measures available in the economy, which tends to moderate the adverse implications to some extent.', 'countries with a moderate inflation rate but inadequate indexation provision may show a higher degree of sensitivity to inflation, than those with low inflation.', 'most of the industrialised countries in the recent years have moved into an inflation rate ranging between two to three per cent.', 'among the developing countries, some of the fast growing east-asian economies have in recent years not only demonstrated low inflation rates ranging between three to five per cent, but the growth rate at these inflation rates has been fairly high at around eight per cent.', '17. empirical evidence on the relationship between the inflation and growth in cross-country frameworks is somewhat inconclusive because such studies include countries with inflation rate of as low as one to two per cent as well as countries with inflation rates going beyond 200 and 300 per cent.', 'while a number of studies have concluded that the negative impact of inflation on growth is high at high rates of inflation, there is no consensus about the threshold inflation rate beyond which the negative impact becomes pronounced.', 'a study by bruno indicated that growth rates declined steeply as the inflation rate went beyond 25 per cent.', 'another study also based on cross section of countries reported that the negative effect of inflation was very pronounced and powerful at inflation rates exceeding eight per cent.', 'what the appropriate inflation threshold beyond which costs tend to exceed benefits need to be estimated for each country separately.', 'nevertheless, people worry about even moderate inflation levels because if not held in check, a little inflation can lead to higher inflation and eventually affect growth.', '18. a macro-econometric model of the indian economy shows that a 10 per cent sustained increase in real public investment in non-agriculture sector, financed by money creation leads to an annual inflation rate of about 2.3 per cent and additional gdp growth of one percent, on an average, during the first two years, while in the span of 10 to 15 years, inflation rate rises to about 17 per cent per annum and additional output growth slows down considerably to average 2.7 per cent during this period.', 'this implies that in the long run a sustained improvement in the growth scenario through monetary financing of the deficit could involve a severe trade-off in terms of inflation - every one per cent additional output growth implies nearly 6 to 6.5 per cent rise in inflation rate in the long run.', '19. obviously, there are some critics of price stability as the dominant objective of monetary policy.', "for example prof. paul krugman writes '.....the belief that absolute price stability is a huge blessing, that it brings large benefits with few if any costs, rests not on evidence but on faith.", "the evidence actually points the other way: the benefits of price stability are elusive, the costs of getting there are large, and zero inflation may not be a good thing even in the long run.'", "the observations of prof. krugman as they stand are not directed against price stability as an objective but are aimed against a policy which seeks 'absolute' price stability and attempts to bring down the inflation rate from around two per cent to almost zero.", "this is evident from what he himself advocates: '.....adopt as a long run target fairly low but not zero inflation, say threefour per cent.", 'this is high enough to accommodate most of the real wage cuts that markets impose, while the costs of the inflation itself will still be very small.', "interestingly, in india, the chakravarty committee (1985) treated an inflation rate of four per cent as 'the acceptable rise in prices' purported to reflect 'changes in relative prices necessary to attract resources to growth sectors'.", '20. we, in india, need to have an appropriate fix on the acceptable level of inflation rate.', 'in the 1970s, the average annual inflation rate as measured by the wholesale price index was nine per cent.', 'in the 1980s, it was eight per cent.', 'however, in the period between 1990 and 1995, the average inflation rate has remained around 10 per cent.', 'the objective of the policy should be to keep the inflation rate around six per cent.', 'this itself is much higher than what the industrial countries are aiming at and therefore will have some implications for the exchange rate of the rupee.', 'monetary growth should be so moderated that while meeting the objective of growth it does not push the inflation rate beyond six per cent.', '21. a question that arises in this context is whether monetary policy by itself is able to contain inflationary pressures particularly in developing economies like ours.', 'it is true that developing economies like india are subject to greater supply shocks than developed economies.', 'fluctuations in agricultural output have an important bearing on the price situation.', 'nevertheless, continuous increase in prices which is what inflation is about cannot occur unless it is sustained by a continuing increase in money supply.', 'control of the money supply has thus to play an important role in any scheme aimed at controlling inflation.', '21. the controversy over the objective of monetary policy has reached such a pitch that some have described central bankism as a religion with hard money as supreme god and inflation as devil.', 'let me however say that the commitment to a reasonable degree of price stability is not a dogma.', 'it is good economics.']	Bimal Jalan	Reserve Bank of India	Governor	India
https://www.bis.org/review/r970115a.pdf	M. Trichet presents the monetary policy guidelines of the Bank of France for 1997 (Central Bank Articles and Speeches, 17 Dec 96)	BANK OF FRANCE, PRESS RELEASE, 17/12/96.	1996-12-17 00:00:00	M. Trichet presents the monetary policy guidelines of the Bank of France for 1997 BANK OF FRANCE, PRESS RELEASE, 17/12/96. 1. The ultimate goal of monetary policy is to ensure price stability, as required by legislation. The objective of the Monetary Policy Council is that the increase in prices, as measured by the consumer price index, should not exceed 2% in 1997, as in the medium term. 2. To meet this ultimate goal, the Banque de France uses two intermediate objectives, one of which is external and the other internal: -The objective of a stable external value of the currency: as it has been for ten years, the stability of the franc will be maintained against the group of the most credible currencies in the European Exchange Rate Mechanism. -An intermediate internal growth target for the money supply as assessed by the development of the narrow and broad monetary aggregates: in 1997, the money supply should be able to show a medium-term growth trend of 5%. This figure is consistent with price inflation of no more than 2% and non-inflationary real GDP growth of about 2.5%, which could be exceeded, in view of the potential for growth to catch up in the medium term. The Monetary Policy Council has decided to simultaneously monitor the main narrow and broad money aggregates in order to obtain a concise estimate of all monetary developments. 3. Total domestic debt is an important indicator. It helps the Banque de France make sure that the economy is supplied with enough financing to grow, and it enables us to track developments in financing for businesses, households and general government simultaneously. The Monetary Policy Council will keep a close eye on other indicators, including all leading indicators of changes in prices, such as capacity utilization rates, production costs, developments in incomes and commodity prices. The Monetary Policy Council will also monitor long-term interest rates and the current account balance. * * * Before announcing the Council's monetary policy decisions for 1997, I would like to discuss the results achieved in 1996. 1. The 1996 results are in line with the targets we set. The ultimate monetary policy goal, which is price stability, was met. Businesses delayed passing on part of the August 1995 two-point increase in the standard rate of VAT until the beginning of 1996. The twelve-month rise in consumer prices was equal to and then above 2% during the first seven months of 1996, but subsequently fell back to 1.ó% in August and September, once the VAT effect had disappeared. The twelve-month increase stood at 1.5% to 1.ó% in November and the latest forecasts predict a price rise of close to 1.5% for the end of 1996. The twelve-month price increase thus resumed its pre-August 1995 trend and will be less than 2% at the end of 1996, in line with the objective set by the Monetary Policy Council. The objective of a stable external value of the French franc vis-à-vis the most credible currencies in the European Exchange Rate Mechanism was met. Since the beginning of 1996, the franc has continued to move gradually closer to its central rates against the other currencies in the European Exchange Rate Mechanism. This firmness of the franc has gone hand in hand with the continuing overall competitiveness of the French economy. The real effective exchange rate of the French franc has improved and exports, as in previous years, helped to boost activity. The seasonally-adjusted current account surplus for the first nine months of 1996 stood at almost FRF 84 billion. This was much greater than the FRF 64 billion surplus posted for the same period of 1995. On the basis of current forecasts, France will record the third largest current account surplus in the world for 1996. Growth in the M3 reference aggregate, which is the reference for our internal intermediate objective, showed a reversal in its trend. The expansion of M3 at the end of the third quarter of 1995 was close to its medium-term growth target path of 5%, but subsequently slowed sharply. The twelve-month increase of 4% in December 1995 gave way to a contraction of 0.4% in October 1996, the last month for which figures are available. This reversal in the growth of M3 was to a very great extent the result of a large-scale reallocation of investment flows stemming from the fall in short-term interest rates since autumn 1995, which has been of unprecedented magnitude and rapidity. The M3-M2 aggregate, which includes assets paying money market rates of interest, posted a twelve-month fall of 10.1 % at the end of October 1996. In response to the fall in short-term interest rates and also a heavier tax burden on money market mutual funds, economic agents reallocated their portfolios towards assets covered by the investment aggregates, and particularly the Pl aggregate covering contractual savings products, including housing saving plans. Year-on-year growth in P1 accelerated from 12.3% in December l995 to 18.5% in October 1996. The rate of interest paid on housing savings plans has remained unchanged at 5.25% since February 1994, whereas comparable market rates have fallen sharply. This gave a strong boost to the reallocation of investment flows. Year-on-year growth in housing savings plans accelerated significantly, rising from 14.1% at the end of 1995 to almost 26% in October 1996. In addition, twelve-month growth in the P2 aggregate covering investment in bonds and life insurance products remained buoyant. It stood at 12.3% in June 1996, with new investment accounting for 9%. At the same time, formation of liquidity was dynamic. The narrow money aggregates M1 and M2, which cover transaction balances and liquid savings, showed annual growth trends in October 1996 of around 5.8% and 7.5%, respectively. In particular, the growth of M2-M1, covering passbook savings deposits, accelerated from 7.6% in December 1995 to 9.6% in October 1996. In such a context, it is important to monitor closely the investments which, within the P investment aggregates, constitute fairly close substitutes for monetary assets in the strictest sense. M3 + P1 posted significant annual growth of around 4%. On the financing side, total domestic debt showed a yearly growth trend of around 3.3%. Total domestic debt incorporates the debt financing obtained by resident non-financial agents in the corporate, personal and public sectors, be it in the form of borrowing from credit institutions or debt issues on domestic or international markets, and is thus a valuable yardstick for analyzing the financing provided to the economy. Even though government debt continues to be the most dynamic component of total domestic debt, its twelve-month growth slowed sharply from 13.4% in December 1995 to ó.9% in September 1996. Outstanding lending by credit institutions to the private sector is practically stable, particularly owing to the corporate sector's sizeable cash surplus. According to the National Institute for Statistics and Economic Studies (INSEE), the self-financing rate of companies and near-companies stood at around 114% in the second quarter of 1996. I shall now make a few comments concerning interest rates, which fell across the board in 1996. This decline in interest rates, which began in October 1995, corresponds to a considerable increase in confidence in the French franc and in the creditworthiness of France in connection with the policies set forth by the President of the Republic and the Government for the reduction of government deficits, the stability of the franc and Monetary Union in 1999. In 1996, the Banque de France's repurchase tender rate was cut from 4.45% to 3.2% today. It is one of the lowest rates in the G7 countries in both nominal and real terms. The five-to-ten-day repo rate fell from 5.85% to 4.75%. Short-term market rates eased substantially, with three-month rates shedding almost 400 basis points since October 1995 and currently standing at around 3.4%. The easing in short-term rates went hand in hand with a significant decline in long-term rates, which are the reference for a large share of lending to the private sector. Ten-year rates have fallen by more than 100 basis points since October 1995. Thanks to the credibility of every component of its economic policy, France today enjoys the lowest medium- and long-term market rates in the European Union, and the third lowest rates in the world, bettered only by Japan and Switzerland. This brings me to the monetary policy decisions for 1997. 1. The ultimate goal of monetary policy is to ensure price stability, as required by legislation. The objective of the Monetary Policy Council is that the increase in 2% in 1997. as in the prices, as measured by the consumer price index, should not exceed medium term. 2. To meet this ultimate goal, the Banque de France uses two intermediate one of which is external and the other internal: objectives, -The objective of a stable external value of the currency: as it has been for ten years, the stability of the franc will be maintained against the group of the most credible currencies in the European Exchange Rate Mechanism. -An intermediate internal growth target for the money supply assessed in by the development of the narrow and broad monetary aggregates: 1997, the money supply should be able to show a medium-term growth trend of 5%. This figure is consistent with price inflation of no more than 2% and non-inflationary real GDP growth of about 2.5%, which could be exceeded, in view of the potential for growth to catch up in the medium term. The Monetary Policy Council has decided to simultaneously monitor the main narrow and broad money aggregates in order to obtain a concise estimate of all monetary developments. 3. Total domestic debt is an important indicator. It helps the Banque de France make sure that the economy is supplied with enough financing to grow, and it enables us to track developments in financing for businesses, households and general government simultaneously. The Monetary Policy Council will keep a close eye on other indicators, including all leading indicators of changes in prices, such as capacity utilization rates, production costs, developments in incomes and commodity prices. The Monetary Policy Council will also monitor and the long-term interest rates current account balance. * * * These decisions call for two remarks. First, on a technical level, the Monetary Policy Council has decided to monitor several narrow and broad money aggregates simultaneously in order to obtain a concise estimate of all monetary developments. As we have seen, certain data, and particularly, but not exclusively, M3 data, have been severely disrupted recently by several factors, such as the very substantial fall in short-term rates and the ensuing large-scale reallocation of investment flows towards non-monetary assets, higher taxes on money market mutual funds, and the continuing very high level of interest paid on housing saving plans. We will therefore keep a very close eye on the M1, M2, M3, and M3+P1 aggregates as expressions of the underlying growth of the money supply. Particular attention will be paid to the growth of the M3+P1 aggregate covering monetary assets and contractual savings. A very large proportion of the outflows from M3 in the past year was directed towards investments covered by P1, and particularly housing savings plans with a residual maturity of one year or less. In fact, this type of investment at present constitutes a very close substitute for monetary assets. Second, the Monetary Policy Council has set monetary policy against the background of potential growth for the French economy of around 2.5% per year. We consider the average growth of our economy in the medium-term, and it could be exceeded given that we have a potential to catch up in the medium term. We reckoned with a maximum price increase of 2% and potential real growth of between 2.5% and 3% in the medium term to arrive at a figure of 5% for the medium-term growth trend of the money supply. * * * It is very important to bear in mind the essence of the policy implemented by the Monetary Policy Council. Parliament confers on the Banque de France an objective, namely the objective of price stability. Maintaining the value of the currency preserves the purchasing power of the currency, and therefore that of French citizens. In addition, Parliament has sought to create the conditions for growth and for job creation, via the stability of the currency. This is also the goal of the Monetary Policy Council. To achieve this goal, we use two means. First, by preserving the value of the currency, we enhance its credibility in France, in Europe and in the world and allow our economy to benefit from financing at favourable market interest rates. It is very important for future French growth, for investment and for job creation that we have the lowest medium- and long-term market rates in the European Union today and the third lowest interest rates in the world. Second, price stability curbs cost increases in our productive sector. In doing so, the competitiveness of our economy-other things being equal-is preserved and enhanced. This is good for future French growth and for job creation. It is important to note that we currently have a dynamic export sector and, according to the latest forecasts for 1996, the third highest current account surplus in the world. One other indicator of competitiveness is encouraging, namely the flow of foreign direct investment into France. It stood at FRF 120 billion in 1995. The latest figures for the first nine months of 1996 show inward foreign direct investment totalling FRF 74 billion. In all, since the beginning of 1995, a total of FRF 194 billion, the equivalent of USD 39 billion, has been invested directly in France, making us the third-ranking industrialized economy in terms of inward foreign direct investment, behind the United States and the United Kingdom. Thus, when the Monetary Policy Council makes interest-rate decisions, it bears in mind first the objective of preserving the purchasing power of the currency, for and on behalf of all French people, and second, its corollary, namely the creation of monetary, financial and competitive conditions that will allow our economy to achieve its full potential for sound and sustained growth, for job creation and therefore for combating unemployment. Central Banks cannot "command" growth. Growth is the fruit of the labour of men and women, of the efficiency of employees, workers and engineers, of the imagination and skill of business leaders, and also, more broadly, of the influence of European and international business conditions. It is stimulated, in the medium and long term, by structural reforms that liberate initiative, strengthen the dynamism of the economy, combat unemployment effectively and encourage the creation of the greatest possible number of jobs for a given level of wealth and growth. However, it is up to Central Banks to create the best possible monetary and financial conditions, through the credibility and stability of the currency. These conditions now exist in our country and the Monetary Policy Council is convinced that the time has come for firms and households to invest. In many sectors and firms, the financing exists. The self-financing rate of the entire French productive sector is above 100% overall. Interest rates as a whole are at historic lows. The French economy has substantial potential for growth in the medium term. In the last three years, potential growth has averaged a little more than 2% a year for the years 1994, 1995 and 1996. We can do better. We believe that our economy's potential non-inflationary growth is around 2.5% in the medium term, and this can be exceeded given the capacity for growth to catch up. The requirements for investment are financing terms, self-financing, competitiveness, and medium-term growth. We believe these requirements exist today. If I had to sum up briefly the message of the Monetary Policy Council, I would say: "The investment plans exist. The time has come today to implement them. Let us invest. It is the surest way for us to contribute to non-inflationary growth that creates jobs and thus to help in the fight against unemployment." * * * French monetary policy is in line with the European strategy of the President of the Republic and the Government, and therefore with the creation of an economic and monetary union on 1 January 1996. The advance towards the single currency was decisively confirmed at the European Summit in Dublin, where an agreement was reached on the legal status of the euro, on the new European Monetary System and on the stability and growth pact intended to guarantee fiscal discipline in the Monetary Union. The Banque de France's monetary policy contributes directly to our country's success in meeting three of the five criteria for entry into Monetary Union: the criterion of price stability, which is the ultimate goal of our monetary policy; that of the stability of the franc visà-vis the most solid European currencies, which is an intermediate objective to which the Banque de France is steadfastly committed, and that of the level of long-term interest rates, which is a result and an important indicator of our monetary strategy. l) Today, the Monetary Policy Council is happy to note that we fully meet these three entry criteria. The Council will continue to make sure that we abide by them throughout 1997 so that the Heads of State and Government can draw up the list of countries eligible for the euro in the best possible conditions, in accordance with the terms of the Dublin decision of the Heads of State and Government, "as soon as possible in 1998". The euro will be created on 1 January 1999. Our market interest rates on maturities of more than two years already incorporate the credibility and soundness of the euro, the future single currency of European citizens. The agreement on the stability and growth pact drawn up in Dublin is a decisive element in inspiring confidence in the euro in French citizens and investors from around the world that is at least equal to the confidence in the French franc. This will give us low market interest rates in the euro area, which is good for growth, job creation and the fight against unemployment.	['m. trichet presents the monetary policy guidelines of the bank of france for 1997 bank of france, press release, 17/12/96.', '1. the ultimate goal of monetary policy is to ensure price stability, as required by legislation.', 'the objective of the monetary policy council is that the increase in prices, as measured by the consumer price index, should not exceed 2% in 1997, as in the medium term.', '2. to meet this ultimate goal, the banque de france uses two intermediate objectives, one of which is external and the other internal: -the objective of a stable external value of the currency: as it has been for ten years, the stability of the franc will be maintained against the group of the most credible currencies in the european exchange rate mechanism.', '-an intermediate internal growth target for the money supply as assessed by the development of the narrow and broad monetary aggregates: in 1997, the money supply should be able to show a medium-term growth trend of 5%.', 'this figure is consistent with price inflation of no more than 2% and non-inflationary real gdp growth of about 2.5%, which could be exceeded, in view of the potential for growth to catch up in the medium term.', 'the monetary policy council has decided to simultaneously monitor the main narrow and broad money aggregates in order to obtain a concise estimate of all monetary developments.', '3. total domestic debt is an important indicator.', 'it helps the banque de france make sure that the economy is supplied with enough financing to grow, and it enables us to track developments in financing for businesses, households and general government simultaneously.', 'the monetary policy council will keep a close eye on other indicators, including all leading indicators of changes in prices, such as capacity utilization rates, production costs, developments in incomes and commodity prices.', 'the monetary policy council will also monitor long-term interest rates and the current account balance.', "* * * before announcing the council's monetary policy decisions for 1997, i would like to discuss the results achieved in 1996.", '1. the 1996 results are in line with the targets we set.', 'the ultimate monetary policy goal, which is price stability, was met.', 'businesses delayed passing on part of the august 1995 two-point increase in the standard rate of vat until the beginning of 1996. the twelve-month rise in consumer prices was equal to and then above 2% during the first seven months of 1996, but subsequently fell back to 1.ó% in august and september, once the vat effect had disappeared.', 'the twelve-month increase stood at 1.5% to 1.ó% in november and the latest forecasts predict a price rise of close to 1.5% for the end of 1996. the twelve-month price increase thus resumed its pre-august 1995 trend and will be less than 2% at the end of 1996, in line with the objective set by the monetary policy council.', 'the objective of a stable external value of the french franc vis-à-vis the most credible currencies in the european exchange rate mechanism was met.', 'since the beginning of 1996, the franc has continued to move gradually closer to its central rates against the other currencies in the european exchange rate mechanism.', 'this firmness of the franc has gone hand in hand with the continuing overall competitiveness of the french economy.', 'the real effective exchange rate of the french franc has improved and exports, as in previous years, helped to boost activity.', 'the seasonally-adjusted current account surplus for the first nine months of 1996 stood at almost frf 84 billion.', 'this was much greater than the frf 64 billion surplus posted for the same period of 1995. on the basis of current forecasts, france will record the third largest current account surplus in the world for 1996. growth in the m3 reference aggregate, which is the reference for our internal intermediate objective, showed a reversal in its trend.', 'the expansion of m3 at the end of the third quarter of 1995 was close to its medium-term growth target path of 5%, but subsequently slowed sharply.', 'the twelve-month increase of 4% in december 1995 gave way to a contraction of 0.4% in october 1996, the last month for which figures are available.', 'this reversal in the growth of m3 was to a very great extent the result of a large-scale reallocation of investment flows stemming from the fall in short-term interest rates since autumn 1995, which has been of unprecedented magnitude and rapidity.', 'the m3-m2 aggregate, which includes assets paying money market rates of interest, posted a twelve-month fall of 10.1 % at the end of october 1996. in response to the fall in short-term interest rates and also a heavier tax burden on money market mutual funds, economic agents reallocated their portfolios towards assets covered by the investment aggregates, and particularly the pl aggregate covering contractual savings products, including housing saving plans.', 'year-on-year growth in p1 accelerated from 12.3% in december l995 to 18.5% in october 1996. the rate of interest paid on housing savings plans has remained unchanged at 5.25% since february 1994, whereas comparable market rates have fallen sharply.', 'this gave a strong boost to the reallocation of investment flows.', 'year-on-year growth in housing savings plans accelerated significantly, rising from 14.1% at the end of 1995 to almost 26% in october 1996. in addition, twelve-month growth in the p2 aggregate covering investment in bonds and life insurance products remained buoyant.', 'it stood at 12.3% in june 1996, with new investment accounting for 9%.', 'at the same time, formation of liquidity was dynamic.', 'the narrow money aggregates m1 and m2, which cover transaction balances and liquid savings, showed annual growth trends in october 1996 of around 5.8% and 7.5%, respectively.', 'in particular, the growth of m2-m1, covering passbook savings deposits, accelerated from 7.6% in december 1995 to 9.6% in october 1996. in such a context, it is important to monitor closely the investments which, within the p investment aggregates, constitute fairly close substitutes for monetary assets in the strictest sense.', 'm3 + p1 posted significant annual growth of around 4%.', 'on the financing side, total domestic debt showed a yearly growth trend of around 3.3%.', 'total domestic debt incorporates the debt financing obtained by resident non-financial agents in the corporate, personal and public sectors, be it in the form of borrowing from credit institutions or debt issues on domestic or international markets, and is thus a valuable yardstick for analyzing the financing provided to the economy.', "even though government debt continues to be the most dynamic component of total domestic debt, its twelve-month growth slowed sharply from 13.4% in december 1995 to ó.9% in september 1996. outstanding lending by credit institutions to the private sector is practically stable, particularly owing to the corporate sector's sizeable cash surplus.", "according to the national institute for statistics and economic studies (insee), the self-financing rate of companies and near-companies stood at around 114% in the second quarter of 1996. i shall now make a few comments concerning interest rates, which fell across the board in 1996. this decline in interest rates, which began in october 1995, corresponds to a considerable increase in confidence in the french franc and in the creditworthiness of france in connection with the policies set forth by the president of the republic and the government for the reduction of government deficits, the stability of the franc and monetary union in 1999. in 1996, the banque de france's repurchase tender rate was cut from 4.45% to 3.2% today.", 'it is one of the lowest rates in the g7 countries in both nominal and real terms.', 'the five-to-ten-day repo rate fell from 5.85% to 4.75%.', 'short-term market rates eased substantially, with three-month rates shedding almost 400 basis points since october 1995 and currently standing at around 3.4%.', 'the easing in short-term rates went hand in hand with a significant decline in long-term rates, which are the reference for a large share of lending to the private sector.', 'ten-year rates have fallen by more than 100 basis points since october 1995. thanks to the credibility of every component of its economic policy, france today enjoys the lowest medium- and long-term market rates in the european union, and the third lowest rates in the world, bettered only by japan and switzerland.', 'this brings me to the monetary policy decisions for 1997.', '1. the ultimate goal of monetary policy is to ensure price stability, as required by legislation.', 'the objective of the monetary policy council is that the increase in 2% in 1997. as in the prices, as measured by the consumer price index, should not exceed medium term.', '2. to meet this ultimate goal, the banque de france uses two intermediate one of which is external and the other internal: objectives, -the objective of a stable external value of the currency: as it has been for ten years, the stability of the franc will be maintained against the group of the most credible currencies in the european exchange rate mechanism.', '-an intermediate internal growth target for the money supply assessed in by the development of the narrow and broad monetary aggregates: 1997, the money supply should be able to show a medium-term growth trend of 5%.', 'this figure is consistent with price inflation of no more than 2% and non-inflationary real gdp growth of about 2.5%, which could be exceeded, in view of the potential for growth to catch up in the medium term.', 'the monetary policy council has decided to simultaneously monitor the main narrow and broad money aggregates in order to obtain a concise estimate of all monetary developments.', '3. total domestic debt is an important indicator.', 'it helps the banque de france make sure that the economy is supplied with enough financing to grow, and it enables us to track developments in financing for businesses, households and general government simultaneously.', 'the monetary policy council will keep a close eye on other indicators, including all leading indicators of changes in prices, such as capacity utilization rates, production costs, developments in incomes and commodity prices.', 'the monetary policy council will also monitor and the long-term interest rates current account balance.', '* * * these decisions call for two remarks.', 'first, on a technical level, the monetary policy council has decided to monitor several narrow and broad money aggregates simultaneously in order to obtain a concise estimate of all monetary developments.', 'as we have seen, certain data, and particularly, but not exclusively, m3 data, have been severely disrupted recently by several factors, such as the very substantial fall in short-term rates and the ensuing large-scale reallocation of investment flows towards non-monetary assets, higher taxes on money market mutual funds, and the continuing very high level of interest paid on housing saving plans.', 'we will therefore keep a very close eye on the m1, m2, m3, and m3+p1 aggregates as expressions of the underlying growth of the money supply.', 'particular attention will be paid to the growth of the m3+p1 aggregate covering monetary assets and contractual savings.', 'a very large proportion of the outflows from m3 in the past year was directed towards investments covered by p1, and particularly housing savings plans with a residual maturity of one year or less.', 'in fact, this type of investment at present constitutes a very close substitute for monetary assets.', 'second, the monetary policy council has set monetary policy against the background of potential growth for the french economy of around 2.5% per year.', 'we consider the average growth of our economy in the medium-term, and it could be exceeded given that we have a potential to catch up in the medium term.', 'we reckoned with a maximum price increase of 2% and potential real growth of between 2.5% and 3% in the medium term to arrive at a figure of 5% for the medium-term growth trend of the money supply.', '* * * it is very important to bear in mind the essence of the policy implemented by the monetary policy council.', 'parliament confers on the banque de france an objective, namely the objective of price stability.', 'maintaining the value of the currency preserves the purchasing power of the currency, and therefore that of french citizens.', 'in addition, parliament has sought to create the conditions for growth and for job creation, via the stability of the currency.', 'this is also the goal of the monetary policy council.', 'to achieve this goal, we use two means.', 'first, by preserving the value of the currency, we enhance its credibility in france, in europe and in the world and allow our economy to benefit from financing at favourable market interest rates.', 'it is very important for future french growth, for investment and for job creation that we have the lowest medium- and long-term market rates in the european union today and the third lowest interest rates in the world.', 'second, price stability curbs cost increases in our productive sector.', 'in doing so, the competitiveness of our economy-other things being equal-is preserved and enhanced.', 'this is good for future french growth and for job creation.', 'it is important to note that we currently have a dynamic export sector and, according to the latest forecasts for 1996, the third highest current account surplus in the world.', 'one other indicator of competitiveness is encouraging, namely the flow of foreign direct investment into france.', 'it stood at frf 120 billion in 1995. the latest figures for the first nine months of 1996 show inward foreign direct investment totalling frf 74 billion.', 'in all, since the beginning of 1995, a total of frf 194 billion, the equivalent of usd 39 billion, has been invested directly in france, making us the third-ranking industrialized economy in terms of inward foreign direct investment, behind the united states and the united kingdom.', 'thus, when the monetary policy council makes interest-rate decisions, it bears in mind first the objective of preserving the purchasing power of the currency, for and on behalf of all french people, and second, its corollary, namely the creation of monetary, financial and competitive conditions that will allow our economy to achieve its full potential for sound and sustained growth, for job creation and therefore for combating unemployment.', 'central banks cannot "command" growth.', 'growth is the fruit of the labour of men and women, of the efficiency of employees, workers and engineers, of the imagination and skill of business leaders, and also, more broadly, of the influence of european and international business conditions.', 'it is stimulated, in the medium and long term, by structural reforms that liberate initiative, strengthen the dynamism of the economy, combat unemployment effectively and encourage the creation of the greatest possible number of jobs for a given level of wealth and growth.', 'however, it is up to central banks to create the best possible monetary and financial conditions, through the credibility and stability of the currency.', 'these conditions now exist in our country and the monetary policy council is convinced that the time has come for firms and households to invest.', 'in many sectors and firms, the financing exists.', 'the self-financing rate of the entire french productive sector is above 100% overall.', 'interest rates as a whole are at historic lows.', 'the french economy has substantial potential for growth in the medium term.', 'in the last three years, potential growth has averaged a little more than 2% a year for the years 1994, 1995 and 1996. we can do better.', "we believe that our economy's potential non-inflationary growth is around 2.5% in the medium term, and this can be exceeded given the capacity for growth to catch up.", 'the requirements for investment are financing terms, self-financing, competitiveness, and medium-term growth.', 'we believe these requirements exist today.', 'if i had to sum up briefly the message of the monetary policy council, i would say: "the investment plans exist.', 'the time has come today to implement them.', 'it is the surest way for us to contribute to non-inflationary growth that creates jobs and thus to help in the fight against unemployment."', '* * * french monetary policy is in line with the european strategy of the president of the republic and the government, and therefore with the creation of an economic and monetary union on 1 january 1996. the advance towards the single currency was decisively confirmed at the european summit in dublin, where an agreement was reached on the legal status of the euro, on the new european monetary system and on the stability and growth pact intended to guarantee fiscal discipline in the monetary union.', "the banque de france's monetary policy contributes directly to our country's success in meeting three of the five criteria for entry into monetary union: the criterion of price stability, which is the ultimate goal of our monetary policy; that of the stability of the franc visà-vis the most solid european currencies, which is an intermediate objective to which the banque de france is steadfastly committed, and that of the level of long-term interest rates, which is a result and an important indicator of our monetary strategy.", 'l) today, the monetary policy council is happy to note that we fully meet these three entry criteria.', 'the council will continue to make sure that we abide by them throughout 1997 so that the heads of state and government can draw up the list of countries eligible for the euro in the best possible conditions, in accordance with the terms of the dublin decision of the heads of state and government, "as soon as possible in 1998".', 'the euro will be created on 1 january 1999. our market interest rates on maturities of more than two years already incorporate the credibility and soundness of the euro, the future single currency of european citizens.', 'the agreement on the stability and growth pact drawn up in dublin is a decisive element in inspiring confidence in the euro in french citizens and investors from around the world that is at least equal to the confidence in the french franc.', 'this will give us low market interest rates in the euro area, which is good for growth, job creation and the fight against unemployment.']	Bank of France	Banque de France	Governor	France
https://www.bis.org/review/r970108c.pdf	Mr. Davies gives his personal view of EMU (Central Bank Articles and Speeches, 16 Dec 96)	Speech by the Deputy Governor of the Bank of England, Mr. Howard Davies, at the EFMA Conference on the Single Currency in Brussels on 16/12/96.	1996-12-16 00:00:00	Speech by the Deputy Governor Mr. Davies gives his personal view of EMU of the Bank of England, Mr. Howard Davies, at the EFMA Conference on the Single Currency in Brussels on 16/12/96. Like many British men of my generation, I spent a good part of my spare time as a boy involved with the Scouting movement, first as a Wolf Cub, then as a Boy Scout. I have to confess that I have forgotten many of the useful things I learned in the Boy Scouts. I can no longer light a camp-fire using only two sticks. I can no longer tie a clove hitch. But I can remember the Boy Scout's motto - 'Be Prepared'. And that motto strikes me as a useful injunction to bear in mind, as we approach the D-Day for Economic and Monetary Union of 1 January 1999. It applies, I think, just as much to those who may, for one reason or another, find themselves outside the first group of EMU countries, as it does to those who firmly intend to surf on the first wave. The preparations, though, may be slightly different in each case. Now some of you may think, if you read the British press, or hear echoes of the British political debate on EMU through the media elsewhere in Europe, that in present circumstances one of the other pieces of advice which Lord Baden-Powell handed down to Boy Scouts who followed him would be more appropriate. I am thinking particularly of the injunction to smile and whistle through all difficulties. Certainly I am sometimes tempted, when asked to explain the state of opinion in London, to take refuge in a cheery smile, and to begin to whistle a mournful tune (not easy to do at the same time, you will find). Fortunately, it is not my responsibility to discuss the politics of EMU in the United Kingdom. Another good reason for me not to do so is that I would like to keep my job. As a humble central banker, a mere technician, it is more appropriate for me to focus on the economic dimension of EMU and to say something, also, about the financial market implications which concern us, particularly given the Bank of England's position at the heart of the City of London. In both these areas - economic and financial - the Boy Scout motto is particularly apposite today. Let me explain why. At the Bank of England we have always held the view that Economic and Monetary Union is a momentous enterprise, with huge consequences for European economies. The act of irrevocably fixing exchange rates, between economies which have in many cases been managed separately for centuries, is not a step to be undertaken lightly. It is an exciting venture, almost too exciting for some, perhaps. Those who have operated for decades with a regime of low inflation, interest rates set by a strong independent central bank, and a strong and appreciating currency, may rightly think they have little to fear from the disciplines implied by EMU. Others will find EMU more bracing, particularly those whose inflation record has been poor, whose currency has undergone successive devaluations, and whose fiscal position is less than robust. For those countries, the EMU mission is potentially dangerous. Joining EMU would for them be to embark on a stiff mountain ascent, in weather which might be colder and less forgiving than one is used to. In those circumstances, the Boy Scout ensures that he is well prepared. He equips himself with waterproofs in the event of rain, with thick pullovers for the cold, with stout boots and, probably, a Swiss army knife in case it should prove necessary, at some point on the journey, to extract a stone from a horse's hoof. He would also, I think, wish to ensure that he was fit, and had undertaken some strenuous rambles in the foothills before making an assault on the mountain range. At this point you may be tired of hearing about Boy Scouts, and be ready to accuse me of the typical British trick of hiding behind down-home metaphors, and reducing topics of high seriousness to wry jokes. So let me be entirely clear about what I mean. We fully appreciate the great potential advantages of EMU for Europe's economies. The Chancellor of the Exchequer, Kenneth Clarke, described them in the House of Commons on Wednesday of last week. As he said then "if EMU can be made to work it would eradicate exchange rate movements which can disrupt trade and have disrupted trade in our recent history. EMU would also reduce transaction costs, making it easier for smaller businesses to enter into and compete in the European market. The members of a strong euro zone could also expect to enjoy lower interest rates . . . countries with a history of devaluation or bursts of inflation pay a lasting premium in terms of higher interest rates, as we in Britain know only too well!" And in his response to the debate Gordon Brown, the Shadow Chancellor, said that he was in principle in favour of a single currency for the United Kingdom. So the attractions of EMU are well understood in Britain. They were in the minds of the architects of the Maastricht Treaty five years ago. But those architects also knew that the advantages would only be accessible to those countries whose economies were equipped to accept the disciplines which go alongside. If that were not true, then the EU would have discovered the economic equivalent of alchemy. We are convinced that if a single currency is to be a success, then all the participants must be satisfied that they can survive within the EMU disciplines in the long term, as well as the short. This applies to the 1997 convergence criteria themselves, of course. It also applies to performance against those criteria in later years. And, in our view, perhaps more controversially, it applies to other aspects of the real economies of applicant countries, particularly to the structures of their labour markets. In the case of the convergence criteria, our attitude is straightforward. They must be rigorously respected. And that applies to the substance, as well as the form. So it would be unwise for a country to seek to qualify in 1998 by massaging down its 1997 public sector deficit through artificial, unrepeatable devices, even if those devices are not technically disallowed. It would be unwise, because the deficit limit is not a one-off requirement. Continued discipline on individual member states' budget positions is a crucial element of EMU in the future. Friday's agreement at Dublin provides for such discipline, albeit with an element of political judgement over the way that discipline will be exercised in certain circumstances. But the general conclusion is clear. Member states will need to live with continued fiscal discipline. In our view, unless a country can show that its fiscal position is structurally sound - in other words that in mid-cycle, with the economy growing at trend on its potential growth path, the budget of the government would tend to be close to balance - then it may find the fiscal discipline of EMU difficult to sustain. That is both a long-term point, and one relevant to the transition period. It would be potentially destabilising of the whole project if countries found themselves obliged to take extremely difficult political decisions in the early years because their fiscal positions had not been properly corrected beforehand. Of course it goes without saying that if a country's outstanding debt burden is well above the Maastricht guideline it will be much more difficult to achieve a sustainable deficit position, since it will be necessary to run sizeable primary surpluses at high points in the cycle. It is worth recalling that when the Treaty set a figure of 60 per cent of GDP the EU average was 55 per cent. This year it will be over 73 per cent, and only Luxembourg, France and the UK will be below 60 per cent. Any country with a very large outstanding debt to GDP ratio will find the going particularly tough. As far as the UK is concerned, our debt to GDP ratio is relatively low at 56 per cent, but while we have made considerable progress towards fiscal consolidation in recent years, our deficit remains above the Maastricht guideline, even after almost five years of growth. A UK government of any political colour, as it comes to make a decision on our readiness for EMU membership next year, will be bound to take that into consideration. The latest government forecast, after the recent Budget, shows us achieving a figure of a touch below 3 per cent in calendar 1997. I could make similar points about the exchange rate criterion where, once again, we believe it is important to focus on the substance rather than on the form. Has a country shown that its anti-inflation discipline, over a lengthy period, has allowed its currency to hold its own without generating significant current account imbalances? For some applicant countries, the answer is evidently yes; for others, no. Once again, that is an issue which we will have to consider carefully as we assess the position of the United Kingdom next year. I imagine that these points would be very widely accepted across the EU, certainly by my central banking colleagues. But our view of the optimal state of preparedness for EMU is rather broader than this. And, here - as I said earlier - we may be less obviously in the mainstream of European opinion. Because we have concerns about the sustainability of an Economic and Monetary Union in which there is too little flexibility in product and labour markets, particularly the latter. Is the monetary union being designed one which retains sufficient flexibility to cope with the kind of differential shocks which may affect different countries within it? This point is, I think, not the same as asking whether the EU is an optimal currency area. I suspect the answer to that question would be no. But one might well give the same answer in relation to the United States, or even to the United Kingdom itself. The question is whether there is sufficient flexibility within the proposed currency union to cope with asymmetric shocks. We know that, in the United States, there is considerable fiscal flexibility, some through automatic stabilisers, like federally-funded welfare benefits, and some through direct transfer payments from prosperous to less prosperous states. We also know that there is considerable labour mobility in the United States, and that wages vary widely from region to region. In Europe, the central EU budget is very small, less than 1.5 per cent of European GDP, and there is no strong current of opinion in favour of expanding it significantly. It is also the case that labour mobility is low, for linguistic and cultural reasons, which cannot easily be overcome by government fiat. Now I would certainly not argue that an EMU could not be attempted without a huge central EU budget, or without teaching everyone commercial German. But we need to make sure that labour markets are as prepared as they can be for the future, a future in which there will be no possibility of the use of the exchange rate to cope with changes in competitiveness, from country to country, whether driven by supply-side shocks or by differential rates of productivity growth. Our concern is that, unless EMU is accompanied by measures to free up Europe's labour markets, existing high rates of unemployment in disfavoured regions will be ossified, with unpredictable and possibly unpleasant social consequences in the long term. Looking at Europe's regional economies, it is striking that relativities between them have remained so stubbornly large for so long, even within individual member states. Indeed only in the UK have there been some recent signs that relative unemployment rates, from prosperous to less prosperous regions, have begun to converge. That appears to be related in changes in relative wages which have come about as a result of the dismantling of centralised pay bargaining, and of other labour market restrictions, in the 1980s. Elsewhere in Europe those changes have not been made; without them we would have to enter a reserve on the preparedness of some European economies for the rigours of a single currency. That is another point which, I am sure, any British government will wish to take into account in making its final decision. And we would feel more comfortable about the likely success of EMU as a whole - and I emphasise that the success of EMU is strongly in the British national interest, whether we are in or out were we to see faster progress towards greater labour market flexibility elsewhere in Europe. It may be argued that EMU itself will act as a stimulus to reforms needed in fiscal policy, and in labour markets; indeed that the prospect of EMU is already doing so. We cautious, pragmatic, non-visionary people that we are - would like to see the needed reforms implemented first. These preparations, both in the financial and the real economies, are the preparations which prospective 'ins' need to make, in particular. But there are of course preparations in financial markets which apply to everyone. We are in no doubt that the introduction of the euro in 1999, if the current timetable is maintained, will have profound consequences for financial markets, initially for wholesale markets, and later for the retail financial sector too. It is incumbent on all central banks to seek to ensure that the financial markets in which they sit are as well prepared as they can be for this momentous change. We must also ensure that the central banks themselves are well prepared. At the Bank of England we now have a steering group, which I chair, focused on preparing the Bank itself. We have made a clear decision that the Bank will be ready for UK membership of EMU in January 1999, if a future government decides that that is the right course for the country. But our more important work in the short term is focused on preparing the City of London and on preparing the financial infrastructure which the City will need to maintain its position as the most innovative and dynamic financial market in Europe. I should emphasise that we see the City as a financial market for the whole of Europe, not just for the United Kingdom. That explains why we are always ready to welcome overseas financial institutions to London, why we rigorously avoid discrimination on grounds of nationality in our financial market dealings, and why we have greatly welcomed the decisions by German, French and Swiss banks in particular to concentrate many of their wholesale market activities in London in recent years. Europe needs a broad and deep market like London to rival those in Tokyo and New York. I would not wish, today, to talk at length about the preparations being made in the City for EMU. Partly because this afternoon, in London, we shall be releasing our latest quarterly report on Practical Issues Arising from the Introduction of the Euro, which sets out in some detail the progress that has been made over the last three months, and how we propose to take things forward. In short, we are confident that London will be as well prepared for EMU as any market, when the time comes. As we say in that paper, we are fully involved in preparing the wholesale financial sector of the economy for the euro and, of course, in the extensive work being undertaken at the European Monetary Institute. For the most part that work is proceeding successfully and we are happy with the decisions made. Some are, inevitably, compromises. But that is what building Europe is all about, and we are always ready to seek compromise solutions. We understand that to build one European wholesale financial market will require a staple diet of solid Bundesbank fare, seasoned with a soupçon of Banque de France, a ración of Banco de España, and so on, as well as a couple of pints of Bank of England pragmatism. There is one important area, I think, in which it has not so far been possible to reach an agreed solution, and one on which I might just conclude with one or two observations. That is the question of TARGET, the inter-linking of real time gross settlement systems across Europe. There are two issues of interest, here. First, pricing policy. We have argued that the pricing of the national element of cross-border payments should relate to national costs, rather than being set uniformly. So far we have not prevailed on that point and, as long as the competition authorities approve, it is likely that there will be a common price within the TARGET system for cross-border transactions. Unfortunately, some of our colleagues do not believe this is an area in which competition should intrude. The second important question relates to the terms on which 'out' central banks might link to TARGET in the future. We can see no reason why out central banks should not be able to link to TARGET on the same terms as those which apply to the ins. We accept, of course, the need in both in and out countries for rigorous policing to prevent unintended spillover of intra-day credit into the overnight market. That policing can be achieved through penal interest rates. But we can see no monetary policy issue in relation to intra-day credit. The extension of sterling intra-day liquidity in our present domestic RTGS system is of no interest to, and never considered in the context of, monetary policy decisions. The same holds for all other countries. Indeed we could go further and say that denying even-handed access to TARGET through out central banks will negate one of the main purposes of the whole exercise, to reduce the risk inherent in systems in which banks are exposed to each other for a period of hours. Banks would find other ways round the restriction which would be more risky. So central banks across Europe will have scored an own goal. We shall need to look carefully at this issue as we move towards 1999. If restrictions were to be applied to out central banks which made TARGET unattractive to banks in London, thereby encouraging them to use less secure cross-border mechanisms for euro payments, then we shall need to think about the other options we could adopt. One possible option might be to develop our own euro RTGS arrangements to allow quick, efficient and safe euro payments within the UK which would not rely on access to intra-day credit from the euro area. We would prefer a pan-European solution which, we strongly believe, would be in the interests of the EU as a whole in the long run. But one thing is clear. Safe, efficient and competitive payment and settlement systems must be available in our own marketplace, and they will be. London has huge advantages as a strong and competitive financial centre in or out of EMU. We are confident that those advantages will remain. The fact that more and more banks are centring their foreign exchange, corporate finance and investment business in London suggests that they share our confidence in the future of London. In these matters it always seems to me to be best to take one's cue from 'revealed preferences' - where financial institutions choose to base themselves, taking account of all the uncertainties. Those revealed preferences remain strongly in London's favour. The preparations for EMU are now hotting up. All over Europe, Boy Scouts are packing their rucksacks with the kit they will need for this determined assault on what, in deference to its German roots, we should perhaps call the Magic Mountain, with apologies to Thomas Mann. The Magic Mountain is perhaps a more tactful title to choose than The Confessions of Felix Krull, Confidence Man, or Death in Venice, as some others in London might suggest. I hope that this morning I have given you some insights into what we think should be in the central banker's rucksack, and how the United Kingdom will assess its own preparedness next year, when the time comes.	['speech by the deputy governor mr. davies gives his personal view of emu of the bank of england, mr. howard davies, at the efma conference on the single currency in brussels on 16/12/96.', 'like many british men of my generation, i spent a good part of my spare time as a boy involved with the scouting movement, first as a wolf cub, then as a boy scout.', 'i have to confess that i have forgotten many of the useful things i learned in the boy scouts.', 'i can no longer light a camp-fire using only two sticks.', 'i can no longer tie a clove hitch.', "but i can remember the boy scout's motto - 'be prepared'.", 'and that motto strikes me as a useful injunction to bear in mind, as we approach the d-day for economic and monetary union of 1 january 1999. it applies, i think, just as much to those who may, for one reason or another, find themselves outside the first group of emu countries, as it does to those who firmly intend to surf on the first wave.', 'the preparations, though, may be slightly different in each case.', 'now some of you may think, if you read the british press, or hear echoes of the british political debate on emu through the media elsewhere in europe, that in present circumstances one of the other pieces of advice which lord baden-powell handed down to boy scouts who followed him would be more appropriate.', 'i am thinking particularly of the injunction to smile and whistle through all difficulties.', 'certainly i am sometimes tempted, when asked to explain the state of opinion in london, to take refuge in a cheery smile, and to begin to whistle a mournful tune (not easy to do at the same time, you will find).', 'fortunately, it is not my responsibility to discuss the politics of emu in the united kingdom.', 'another good reason for me not to do so is that i would like to keep my job.', "as a humble central banker, a mere technician, it is more appropriate for me to focus on the economic dimension of emu and to say something, also, about the financial market implications which concern us, particularly given the bank of england's position at the heart of the city of london.", 'in both these areas - economic and financial - the boy scout motto is particularly apposite today.', 'let me explain why.', 'at the bank of england we have always held the view that economic and monetary union is a momentous enterprise, with huge consequences for european economies.', 'the act of irrevocably fixing exchange rates, between economies which have in many cases been managed separately for centuries, is not a step to be undertaken lightly.', 'it is an exciting venture, almost too exciting for some, perhaps.', 'those who have operated for decades with a regime of low inflation, interest rates set by a strong independent central bank, and a strong and appreciating currency, may rightly think they have little to fear from the disciplines implied by emu.', 'others will find emu more bracing, particularly those whose inflation record has been poor, whose currency has undergone successive devaluations, and whose fiscal position is less than robust.', 'for those countries, the emu mission is potentially dangerous.', 'joining emu would for them be to embark on a stiff mountain ascent, in weather which might be colder and less forgiving than one is used to.', 'in those circumstances, the boy scout ensures that he is well prepared.', "he equips himself with waterproofs in the event of rain, with thick pullovers for the cold, with stout boots and, probably, a swiss army knife in case it should prove necessary, at some point on the journey, to extract a stone from a horse's hoof.", 'he would also, i think, wish to ensure that he was fit, and had undertaken some strenuous rambles in the foothills before making an assault on the mountain range.', 'at this point you may be tired of hearing about boy scouts, and be ready to accuse me of the typical british trick of hiding behind down-home metaphors, and reducing topics of high seriousness to wry jokes.', 'so let me be entirely clear about what i mean.', "we fully appreciate the great potential advantages of emu for europe's economies.", 'the chancellor of the exchequer, kenneth clarke, described them in the house of commons on wednesday of last week.', 'as he said then "if emu can be made to work it would eradicate exchange rate movements which can disrupt trade and have disrupted trade in our recent history.', 'emu would also reduce transaction costs, making it easier for smaller businesses to enter into and compete in the european market.', 'the members of a strong euro zone could also expect to enjoy lower interest rates .', 'countries with a history of devaluation or bursts of inflation pay a lasting premium in terms of higher interest rates, as we in britain know only too well!"', 'and in his response to the debate gordon brown, the shadow chancellor, said that he was in principle in favour of a single currency for the united kingdom.', 'so the attractions of emu are well understood in britain.', 'they were in the minds of the architects of the maastricht treaty five years ago.', 'but those architects also knew that the advantages would only be accessible to those countries whose economies were equipped to accept the disciplines which go alongside.', 'if that were not true, then the eu would have discovered the economic equivalent of alchemy.', 'we are convinced that if a single currency is to be a success, then all the participants must be satisfied that they can survive within the emu disciplines in the long term, as well as the short.', 'this applies to the 1997 convergence criteria themselves, of course.', 'it also applies to performance against those criteria in later years.', 'and, in our view, perhaps more controversially, it applies to other aspects of the real economies of applicant countries, particularly to the structures of their labour markets.', 'in the case of the convergence criteria, our attitude is straightforward.', 'they must be rigorously respected.', 'and that applies to the substance, as well as the form.', 'so it would be unwise for a country to seek to qualify in 1998 by massaging down its 1997 public sector deficit through artificial, unrepeatable devices, even if those devices are not technically disallowed.', 'it would be unwise, because the deficit limit is not a one-off requirement.', "continued discipline on individual member states' budget positions is a crucial element of emu in the future.", "friday's agreement at dublin provides for such discipline, albeit with an element of political judgement over the way that discipline will be exercised in certain circumstances.", 'but the general conclusion is clear.', 'member states will need to live with continued fiscal discipline.', 'in our view, unless a country can show that its fiscal position is structurally sound - in other words that in mid-cycle, with the economy growing at trend on its potential growth path, the budget of the government would tend to be close to balance - then it may find the fiscal discipline of emu difficult to sustain.', 'that is both a long-term point, and one relevant to the transition period.', 'it would be potentially destabilising of the whole project if countries found themselves obliged to take extremely difficult political decisions in the early years because their fiscal positions had not been properly corrected beforehand.', "of course it goes without saying that if a country's outstanding debt burden is well above the maastricht guideline it will be much more difficult to achieve a sustainable deficit position, since it will be necessary to run sizeable primary surpluses at high points in the cycle.", 'it is worth recalling that when the treaty set a figure of 60 per cent of gdp the eu average was 55 per cent.', 'this year it will be over 73 per cent, and only luxembourg, france and the uk will be below 60 per cent.', 'any country with a very large outstanding debt to gdp ratio will find the going particularly tough.', 'as far as the uk is concerned, our debt to gdp ratio is relatively low at 56 per cent, but while we have made considerable progress towards fiscal consolidation in recent years, our deficit remains above the maastricht guideline, even after almost five years of growth.', 'a uk government of any political colour, as it comes to make a decision on our readiness for emu membership next year, will be bound to take that into consideration.', 'the latest government forecast, after the recent budget, shows us achieving a figure of a touch below 3 per cent in calendar 1997. i could make similar points about the exchange rate criterion where, once again, we believe it is important to focus on the substance rather than on the form.', 'has a country shown that its anti-inflation discipline, over a lengthy period, has allowed its currency to hold its own without generating significant current account imbalances?', 'for some applicant countries, the answer is evidently yes; for others, no.', 'once again, that is an issue which we will have to consider carefully as we assess the position of the united kingdom next year.', 'i imagine that these points would be very widely accepted across the eu, certainly by my central banking colleagues.', 'but our view of the optimal state of preparedness for emu is rather broader than this.', 'and, here - as i said earlier - we may be less obviously in the mainstream of european opinion.', 'because we have concerns about the sustainability of an economic and monetary union in which there is too little flexibility in product and labour markets, particularly the latter.', 'is the monetary union being designed one which retains sufficient flexibility to cope with the kind of differential shocks which may affect different countries within it?', 'this point is, i think, not the same as asking whether the eu is an optimal currency area.', 'i suspect the answer to that question would be no.', 'but one might well give the same answer in relation to the united states, or even to the united kingdom itself.', 'the question is whether there is sufficient flexibility within the proposed currency union to cope with asymmetric shocks.', 'we know that, in the united states, there is considerable fiscal flexibility, some through automatic stabilisers, like federally-funded welfare benefits, and some through direct transfer payments from prosperous to less prosperous states.', 'we also know that there is considerable labour mobility in the united states, and that wages vary widely from region to region.', 'in europe, the central eu budget is very small, less than 1.5 per cent of european gdp, and there is no strong current of opinion in favour of expanding it significantly.', 'it is also the case that labour mobility is low, for linguistic and cultural reasons, which cannot easily be overcome by government fiat.', 'now i would certainly not argue that an emu could not be attempted without a huge central eu budget, or without teaching everyone commercial german.', 'but we need to make sure that labour markets are as prepared as they can be for the future, a future in which there will be no possibility of the use of the exchange rate to cope with changes in competitiveness, from country to country, whether driven by supply-side shocks or by differential rates of productivity growth.', "our concern is that, unless emu is accompanied by measures to free up europe's labour markets, existing high rates of unemployment in disfavoured regions will be ossified, with unpredictable and possibly unpleasant social consequences in the long term.", "looking at europe's regional economies, it is striking that relativities between them have remained so stubbornly large for so long, even within individual member states.", 'indeed only in the uk have there been some recent signs that relative unemployment rates, from prosperous to less prosperous regions, have begun to converge.', 'that appears to be related in changes in relative wages which have come about as a result of the dismantling of centralised pay bargaining, and of other labour market restrictions, in the 1980s.', 'elsewhere in europe those changes have not been made; without them we would have to enter a reserve on the preparedness of some european economies for the rigours of a single currency.', 'that is another point which, i am sure, any british government will wish to take into account in making its final decision.', 'and we would feel more comfortable about the likely success of emu as a whole - and i emphasise that the success of emu is strongly in the british national interest, whether we are in or out were we to see faster progress towards greater labour market flexibility elsewhere in europe.', 'it may be argued that emu itself will act as a stimulus to reforms needed in fiscal policy, and in labour markets; indeed that the prospect of emu is already doing so.', 'we cautious, pragmatic, non-visionary people that we are - would like to see the needed reforms implemented first.', "these preparations, both in the financial and the real economies, are the preparations which prospective 'ins' need to make, in particular.", 'but there are of course preparations in financial markets which apply to everyone.', 'we are in no doubt that the introduction of the euro in 1999, if the current timetable is maintained, will have profound consequences for financial markets, initially for wholesale markets, and later for the retail financial sector too.', 'it is incumbent on all central banks to seek to ensure that the financial markets in which they sit are as well prepared as they can be for this momentous change.', 'we must also ensure that the central banks themselves are well prepared.', 'at the bank of england we now have a steering group, which i chair, focused on preparing the bank itself.', 'we have made a clear decision that the bank will be ready for uk membership of emu in january 1999, if a future government decides that that is the right course for the country.', 'but our more important work in the short term is focused on preparing the city of london and on preparing the financial infrastructure which the city will need to maintain its position as the most innovative and dynamic financial market in europe.', 'i should emphasise that we see the city as a financial market for the whole of europe, not just for the united kingdom.', 'that explains why we are always ready to welcome overseas financial institutions to london, why we rigorously avoid discrimination on grounds of nationality in our financial market dealings, and why we have greatly welcomed the decisions by german, french and swiss banks in particular to concentrate many of their wholesale market activities in london in recent years.', 'europe needs a broad and deep market like london to rival those in tokyo and new york.', 'i would not wish, today, to talk at length about the preparations being made in the city for emu.', 'partly because this afternoon, in london, we shall be releasing our latest quarterly report on practical issues arising from the introduction of the euro, which sets out in some detail the progress that has been made over the last three months, and how we propose to take things forward.', 'in short, we are confident that london will be as well prepared for emu as any market, when the time comes.', 'as we say in that paper, we are fully involved in preparing the wholesale financial sector of the economy for the euro and, of course, in the extensive work being undertaken at the european monetary institute.', 'for the most part that work is proceeding successfully and we are happy with the decisions made.', 'some are, inevitably, compromises.', 'but that is what building europe is all about, and we are always ready to seek compromise solutions.', 'we understand that to build one european wholesale financial market will require a staple diet of solid bundesbank fare, seasoned with a soupçon of banque de france, a ración of banco de españa, and so on, as well as a couple of pints of bank of england pragmatism.', 'there is one important area, i think, in which it has not so far been possible to reach an agreed solution, and one on which i might just conclude with one or two observations.', 'that is the question of target, the inter-linking of real time gross settlement systems across europe.', 'there are two issues of interest, here.', 'we have argued that the pricing of the national element of cross-border payments should relate to national costs, rather than being set uniformly.', 'so far we have not prevailed on that point and, as long as the competition authorities approve, it is likely that there will be a common price within the target system for cross-border transactions.', 'unfortunately, some of our colleagues do not believe this is an area in which competition should intrude.', "the second important question relates to the terms on which 'out' central banks might link to target in the future.", 'we can see no reason why out central banks should not be able to link to target on the same terms as those which apply to the ins.', 'we accept, of course, the need in both in and out countries for rigorous policing to prevent unintended spillover of intra-day credit into the overnight market.', 'that policing can be achieved through penal interest rates.', 'but we can see no monetary policy issue in relation to intra-day credit.', 'the extension of sterling intra-day liquidity in our present domestic rtgs system is of no interest to, and never considered in the context of, monetary policy decisions.', 'the same holds for all other countries.', 'indeed we could go further and say that denying even-handed access to target through out central banks will negate one of the main purposes of the whole exercise, to reduce the risk inherent in systems in which banks are exposed to each other for a period of hours.', 'banks would find other ways round the restriction which would be more risky.', 'so central banks across europe will have scored an own goal.', 'we shall need to look carefully at this issue as we move towards 1999. if restrictions were to be applied to out central banks which made target unattractive to banks in london, thereby encouraging them to use less secure cross-border mechanisms for euro payments, then we shall need to think about the other options we could adopt.', 'one possible option might be to develop our own euro rtgs arrangements to allow quick, efficient and safe euro payments within the uk which would not rely on access to intra-day credit from the euro area.', 'we would prefer a pan-european solution which, we strongly believe, would be in the interests of the eu as a whole in the long run.', 'but one thing is clear.', 'safe, efficient and competitive payment and settlement systems must be available in our own marketplace, and they will be.', 'london has huge advantages as a strong and competitive financial centre in or out of emu.', 'we are confident that those advantages will remain.', 'the fact that more and more banks are centring their foreign exchange, corporate finance and investment business in london suggests that they share our confidence in the future of london.', "in these matters it always seems to me to be best to take one's cue from 'revealed preferences' - where financial institutions choose to base themselves, taking account of all the uncertainties.", "those revealed preferences remain strongly in london's favour.", 'the preparations for emu are now hotting up.', 'all over europe, boy scouts are packing their rucksacks with the kit they will need for this determined assault on what, in deference to its german roots, we should perhaps call the magic mountain, with apologies to thomas mann.', 'the magic mountain is perhaps a more tactful title to choose than the confessions of felix krull, confidence man, or death in venice, as some others in london might suggest.', "i hope that this morning i have given you some insights into what we think should be in the central banker's rucksack, and how the united kingdom will assess its own preparedness next year, when the time comes."]	Mervyn King	Bank of England	Deputy Governor	UK
https://www.bis.org/review/r970108b.pdf	Ms. Rivlin discusses the prudential regulation of banks and how to improve it (Central Bank Articles and Speeches, 19 Dec 96)	Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the The Brookings Institution National Issues Forum in Washington on 19/12/96.	1996-12-19 00:00:00	Ms. Rivlin discusses the prudential regulation of banks and how to improve it Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the The Brookings Institution National Issues Forum in Washington on 19/12/96. I discovered when I joined the Board of Governors of the Federal Reserve System about six months ago that most of my friends -- including my sophisticated public policy oriented friends -- had only a hazy notion what their central bank did. Many of them said, enthusiastically, "Congratulations!" Then they asked with a bit of embarrassment, "Is it a full-time job?" or "What will you find to do between meetings?" The meetings they were aware of, of course, were those of the Federal Open Market Committee. They knew that the FOMC meets every six weeks or so to "set interest rates." That sounds like real power, so the FOMC gets a lot of press attention even when, as happened again this week, we meet and decide to do absolutely nothing at all. The group gathered here today, however, realizes that monetary policy, while important, is not actually very time-consuming. If you cared enough to come to this conference, you also have a strong conviction that the health and vigor of the American economy depends not only on good macro-economic policy, although that certainly helps, but also on the safety, soundness and efficiency of the banking system. We need a banking system that works well and one in which citizens and businesses, foreign and domestic, have high and well placed confidence. So I want to talk today, as seems appropriate on the fifth anniversary of FDICIA, about the subject that occupies much of our attention at the Federal Reserve: the prudential regulation of banks and how to improve it. Indeed, I want to focus today, not so much on what Congress needs to do to ensure the safety and soundness of the bank system in this rapidly changing world -- there are others on the program to take on that task -- but more narrowly on how bank regulators should go about their jobs of supervising bank risk-taking. The evolving search for policies that would guarantee a safe, sound and efficient banking system has featured learning from experience. In the 1930s, Americans learned, expensively, about the hazards of not having a safety net in a crisis that almost wiped out the banking system. In the 1980s, they learned a lot about the hazards of having a safety net, especially about the moral hazard associated with deposit insurance. Deposit insurance, which had seemed so benign and so successful in building confidence and preventing runs on banks, suddenly revealed its downside for all to see. Some insured institutions, mostly thrifts, but also savings banks, and not a few commercial banks, were taking on risks with a "heads I win, tails you lose" attitude -- sometimes collecting on high stakes bets but often leaving deposit insurance funds to pick up the pieces. At the same time, some regulators, especially the old FSLIC, which was notably strapped for funds, were compounding the problem -- and greatly increasing the ultimate cost of its resolution -- by engaging in regulatory "forbearance" when faced with technically insolvent institutions. The lessons were costly, but Americans do learn from their mistakes. The advocates of banking reform, many of them participants in this conference, saw the problems posed by moral hazard in the context of ineffectual supervision and set out to design a better system. Essentially, the reform agenda had two main components: * First, expanded powers for depository institutions that would permit them to diversify in ways that might reduce risks and improve operating efficiency; * Second, improving the effectiveness of regulation and supervision by instructing regulators, in effect, to act more like the market itself when conducting prudential regulation. FDICIA was a first step toward meeting the second challenge -- how to make regulators act more like the market. It called for a reduction in the potential for regulatory "forbearance" by laying down the conditions under which conservatorship and receivership should be initiated. It called for supervisory sanctions based on measurable performance (in particular, the Prompt Corrective Action provisions that based supervisory action on a bank's risk-based capital ratio). The Act required the FDIC and RTC to resolve failed institutions on a least-cost basis. In other words, the Act required the depository receivers to act as if the insurance funds were private insurers, rather than continue the past policy of protecting uninsured depositors and other bank creditors. Finally, FDICIA placed limitations on the doctrine of "Too Big To Fail," by requiring agency consensus and administration concurrence in order to prop up any large, failing bank. In a few places, however, FDICIA went too far. The provisions of the Act that dealt with micro management by regulators were immediately seen to be "over the top," and were later repealed. The Act provided a framework for regulators to invoke market-like discipline. It left room for them to move their own regulatory techniques in this direction -- a subject to which I will return in a minute. The other objective of reform -- diversification of bank activities through an expansion of bank powers -- has not yet resulted in legislation and is still very much an on-going debate. In part, this failure to take legislative action reflected the long-running ability of the nonbank competition to use its political muscle to forestall increased powers for banks. But the inaction on expanded powers also reflected a Congressional concern that additional powers might be used to take on additional risk, which, on the heels of the banking collapse of the late 1980s, represented poor timing, to say the least. There was also some Congressional disposition to punish "greedy bankers," who were seen as the reason for the collapse and the diversion of taxpayer funds to pay for thrift insolvencies. Whatever the reasons, not only did the 102nd Congress fail to enact expanded bank powers, but so did the next two Congresses. We are hopeful that the 105th Congress will succeed where its predecessors have failed. Meanwhile, the regulatory agencies have acted to expand bank powers within the limits of existing law. The Federal Reserve has proposed both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC has acted to liberalize banks' insurance agency powers and, most recently, to liberalize procedures for operating subsidiaries of national banks. Of course, I would have to turn in my Federal Reserve badge and give up my parking pass if I did not mention that we at the Fed believe that some activities are best carried out in a subsidiary of the holding company rather than a subsidiary of the bank. We believe that the more distance between the bank and its new, nonbank operations, the more likely that we can separate one from the other and avoid the spreading of the subsidy associated with the safety net. While the regulators can move in the right direction, it is still imperative that Congress act. Artificial barriers between and among various forms of financial activity are harmful to the best interests of the consumers of financial services, to the providers of those services, and to the general stability and well-being of our financial system, most broadly defined. Congress should consider this issue and take the next steps. Let me turn now to what I consider to be one of the most critical issues facing regulators, especially in a future in which financial markets likely will dictate significant further increases in the scope and complexity of banking activities. I am referring to the issue of how to conduct optimal supervision of banks. Fortunately, there appears actually to be an evolving consensus at least on the general principle. Regulators, including the Federal Reserve, strongly support the basic approach embodied in FDICIA; namely that regulators should place limits on depository institutions in such a way as to replicate, as closely as possible, the discipline that would be imposed by a marketplace consisting of informed participants and devoid of the moral hazard associated with the safety net. Unfortunately, as always, the devil is in the details. The difficult question is how should a regulator use "market-based" or "performance-based" measures in determining which, if any, supervisory sanctions or limits to place on a bank. FDICIA's approach was straightforward. Supervisory sanctions under Prompt Corrective Action were to be based on the bank's risk performance as measured by its levels of regulatory capital, in particular its leverage ratio and total risk-based capital ratio under the Basle capital standards. These standards now seem well-intended but rather outdated. Certainly, the Basle capital standards did the job for which they were designed, namely stopping the secular decline in bank capital levels that, by the late 1980s, threatened general safety and soundness. But the scope and complexity of banking activities has proceeded apace during the last two decades or so, and standard capital measures, at least for our very largest and most complex organizations, are no longer adequate measures on which to base supervisory action for several reasons: * The regulatory capital standards apportion capital only for credit risk and, most recently, for market risk of trading activities. Interest rate risk is dealt with subjectively, and other forms of risk, including operating risk, are not treated within the standards. * Also, the capital standards are, despite the appellation "risk-based," very much a "one-size-fits-all" rule. For example, all non-mortgage loans to corporations and households receive the same arbitrary 8 percent capital requirement. A secured loan to a triple-A rated company receives the same treatment as an unsecured loan to a junk-rated company. In other words, the capital standards don't measure credit risk although they represent a crude proxy for such risk within broad categories of banking assets. * Finally, the capital standards give insufficient consideration to hedging or mitigating risk through the use of credit derivatives or effective portfolio diversification. These shortcomings of the regulatory capital standards were beginning to be understood even as they were being implemented, but no consistent, consensus technology existed at that time for invoking a more sophisticated standard than the Basle norms. To be sure, more sophisticated standards were being used by bank supervisors, during the examination process, to determine the adequacy of capital at any individual institution. These supervisory determinations of capital adequacy on a bank-by-bank basis, reflected in the CAMEL ratings given to banks and the BOPEC ratings given to bank holding companies, are much more inclusive than the Basle standards. Research shows that CAMEL ratings are much better predictors of bank insolvency than "risk-based" capital ratios. But, a bank-by-bank supervision, of course, is not the same thing as the writing of regulations that apply to all banks. It is now evident that the simple regulatory capital standards that apply to all banks can be quite misleading. Nominally high regulatory capital ratios -- even risk-based capital ratios that are 50 or 100 percent higher than the minimums -- are no longer indicators of bank soundness. Meanwhile, however, some of our largest and most sophisticated banks have been getting ahead of the regulators and doing the two things one must do in order to properly manage risk and determine capital adequacy. First, they are statistically quantifying risk by estimating the shape of loss probability distributions associated with their risk positions. These quantitative measures of risk are calculated by asset type, by product line, and, in some cases, even down to the individual customer level. Second, the more sophisticated banks are calculating economic capital, or "risk capital," to be allocated to each asset, each line of business, and even to each customer, in order to determine risk-adjusted profitability of each type of bank activity. In making these risk capital allocations, banks are defining and meeting internal corporate standards for safety and soundness. For example, a banker might desire to achieve at least a single-A rating on his own corporate debt. He sees that, over history, single-A debt has a default probability of less than one-tenth of one percent over a one year time horizon. So the banker sets an internal corporate goal to allocate enough capital so that the probability of losses exceeding capital is less than 0.1 percent. In the language of statistics, this means that allocated capital must "cover" 99.9 percent of the estimated loss probability distribution. Once the banker estimates risk and allocates capital to that risk, the internal capital allocations can be used in a variety of ways -- for example, in so-called RAROC or risk-adjusted return on capital models that measure the relative profitability of bank activities. If a particular bank product generates a return to allocated capital that is too low, the bank can seek to cut expenses, reprice the product, or focus its efforts on other, more profitable ventures. These profitability analyses, moreover, are conducted on an "apples-to-apples" basis, since the profitability of each business line is adjusted to reflect the riskiness of the business line. What these bankers have actually done themselves, in calculating these internal capital requirements, is something regulators have never done -- defined a bank soundness target. What regulator, for example, has said that he wants capital to be high enough to reduce to 0.1 percent the probability of insolvency? Regulators have said only that capital ratios should be no lower than some number (8 percent in the case of the Basle standards). But as we should all be aware, a high capital ratio, if it is accompanied by a highly risky portfolio composition, can result in a bank with a high probability of insolvency. The question should not be how high is the bank's capital ratio, but how low is its failure probability. In sharp contrast to our 8 percent one-size-fits-all capital standard, the internal risk-capital calculations of banks result in a very wide range of capital allocations, even within a particular category of credit instrument. For example, for an unsecured commercial credit line, typical internal capital allocations might range from less than 1 percent for a triple-A or double-A rated obligor, to well over 20 percent for an obligor in one of the lowest rating categories. The range of internal capital allocations widens even more when we look at capital calculations for complex risk positions such as various forms of credit derivatives. This great diversity in economic capital allocations, as compared to regulatory capital allocations, creates at least two types of problem. * When the regulatory capital requirement is higher than the economic capital allocation, the bank must either engage in costly regulatory arbitrage to evade the regulatory requirement or change its portfolio, possibly leading to suboptimal resource allocation. * When the regulatory requirement is lower than the economic capital requirement, the bank may choose to hold capital above the regulatory requirement but below the economic requirement; in this case, the bank's nominally high capital ratio may mask the true nature of its risk position. Measuring bank soundness and overall bank performance is becoming more critical as the risk activities of banks become more complex. This condition is especially evident in the various nontraditional activities of banks. In fact, "nontraditional" is no longer a very good adjective to describe much of what goes on at our larger institutions. Take asset securitization, for example. No longer do our largest banks simply take in deposit funds and lend out the money to borrowers. Currently, well over $200 billion in assets that, in times past, have resided on the books of banks, now are owned by remote securitization conduits sponsored by banks. Sponsorship of securitization, which is now almost solely a large bank phenomenon, holds the potential for completely transforming the traditional paradigm of "banking." Now, loans are made directly by the conduits, or are made by the banks and then immediately sold to the conduits. To finance the origination or purchase of the loans, a conduit issues several classes of asset-backed securities collateralized by the loans. Most of the conduit's debt is issued to investors who require that the senior securities be highly rated, generally double-A and triple-A. In order to achieve these ratings, the conduit obtains credit enhancements insulating the senior security holders from defaults on the underlying loans. Generally, it is the bank sponsor that provides these credit enhancements, which can be in the form of standby letters of credit to the conduit, or via the purchase of the most junior/subordinated securities issued by the conduit. In return for providing the credit protection, as well as the loan origination and servicing functions, the bank lays claim to all residual spreads between the yields on the loans and the interest and non-interest cost of the conduit's securities, net of any loan losses. In other words, securitization results in banks taking on almost identically the same risks as if the loans were kept on the books of the bank the old-fashioned way. But while the credit risk of a securitized loan pool may be the same as the credit risk of holding that loan pool on the books, our capital standards do not always recognize this fact. For example, by supplying a standby letter of credit covering so-called "first-dollar" losses for the conduit, a bank might be able to reduce its regulatory capital requirement, for some of its activities, by 90 percent or more compared with what would be required if the bank held the loans directly on its own books. The question, of course, is whether the bank's internal capital allocation systems recognize the similarity in risk between, on the one hand, owning the whole loans and, on the other hand, providing a credit enhancement to a securitization conduit. If the risk measurement and management systems of the bank are faulty, then holding a nominally high capital ratio -- say, 10 percent -- is little consolation. In fact, nominally high capital ratios can be deceiving to market participants. If, for example, the bank's balance sheet is less than transparent, potential investors or creditors, seeing the nominally high 10 percent capital, but not recognizing that the economic risk capital allocation should, in percentage terms, be much higher, could direct an inappropriately high level of scarce resources toward the bank. Credit derivatives are another example of the evolution. The bottom line is that, as we move into the 21st century, traditional notions of "capital adequacy" will become less useful in determining the safety and soundness of our largest, most sophisticated, banking organizations. This growing discrepancy is important because "performance-based" solutions likely will continue to be touted as the basis for expanded bank powers or reductions in burdensome regulation. For example, the Federal Reserve's recent proposed liberalization of procedures for Regulation Y activities applies to banking companies that are "well-capitalized" and "well-managed." Similarly, the OCC's recent proposed liberalization of rules for bank operating subsidiaries applies to "well-capitalized" institutions. Also, industry participants continue to call for expanded powers and/or reduced regulatory burden based on "market tests" of good management and adequate capital. It will not be easy reaching consensus on how to measure bank soundness and overall bank performance. It cannot simply be done by observing market indicators. For example, we cannot easily use the public ratings of holding company debt. The ratings, after all, are achieved given the existence of the safety net. The ratings are biased, therefore, from the perspective of achieving our stated goal -- to impose prudential limits on banks as if there were no net. In addition, I am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings. The solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment. Regulators already have begun to move in this direction. For example, beginning in January 1998, qualifying large multinational banks will be able to use their internal Value-at-Risk models to help set capital requirements for the market risk inherent in their trading activities. The Federal Reserve is also conducting a pilot test of the pre-commitment approach to capital for market risk. In this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations. These new and innovative methods for treating the age-old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process. As the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process. For example, the banking agencies have announced programs to place an increased emphasis on banks' internal risk measurement and management processes within the assessment of overall management quality -- that is, how well a bank employs modern technology to manage risk will be reflected in the "M" portion of the bank's CAMEL rating. In a similar vein, now that VaR models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks' internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements. Regulation and supervision, like industry practices themselves, are continually evolving processes. As supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive. In conducting prudential regulation we should always remember that the optimal number of bank failures is not zero. Indeed, "market-based" performance means that some institutions, either through poor management choices, or just because of plain old bad luck, will fail. As regulators, we must carefully balance these market-like results with concerns over systemic risk. And, as regulators of banks, we must always remember that we do not operate in a vacuum -- the activities of nonbank financial institutions are also important to the general well-being of our financial system and the macro economy. Regulators, of course, can only work with the framework laid down by Congress. Let me conclude with the hope that this Congress will build on the experience of the last few years, including the experience with FDICIA, and take the next steps toward creating a structural and regulatory framework appropriate to the 21st century.	['ms. rivlin discusses the prudential regulation of banks and how to improve it remarks by the vice chairman of the board of governors of the us federal reserve system, ms. alice m. rivlin, at the the brookings institution national issues forum in washington on 19/12/96.', 'i discovered when i joined the board of governors of the federal reserve system about six months ago that most of my friends -- including my sophisticated public policy oriented friends -- had only a hazy notion what their central bank did.', 'many of them said, enthusiastically, "congratulations!"', 'then they asked with a bit of embarrassment, "is it a full-time job?"', 'or "what will you find to do between meetings?"', 'the meetings they were aware of, of course, were those of the federal open market committee.', 'they knew that the fomc meets every six weeks or so to "set interest rates."', 'that sounds like real power, so the fomc gets a lot of press attention even when, as happened again this week, we meet and decide to do absolutely nothing at all.', 'the group gathered here today, however, realizes that monetary policy, while important, is not actually very time-consuming.', 'if you cared enough to come to this conference, you also have a strong conviction that the health and vigor of the american economy depends not only on good macro-economic policy, although that certainly helps, but also on the safety, soundness and efficiency of the banking system.', 'we need a banking system that works well and one in which citizens and businesses, foreign and domestic, have high and well placed confidence.', 'so i want to talk today, as seems appropriate on the fifth anniversary of fdicia, about the subject that occupies much of our attention at the federal reserve: the prudential regulation of banks and how to improve it.', 'indeed, i want to focus today, not so much on what congress needs to do to ensure the safety and soundness of the bank system in this rapidly changing world -- there are others on the program to take on that task -- but more narrowly on how bank regulators should go about their jobs of supervising bank risk-taking.', 'the evolving search for policies that would guarantee a safe, sound and efficient banking system has featured learning from experience.', 'in the 1930s, americans learned, expensively, about the hazards of not having a safety net in a crisis that almost wiped out the banking system.', 'in the 1980s, they learned a lot about the hazards of having a safety net, especially about the moral hazard associated with deposit insurance.', 'deposit insurance, which had seemed so benign and so successful in building confidence and preventing runs on banks, suddenly revealed its downside for all to see.', 'some insured institutions, mostly thrifts, but also savings banks, and not a few commercial banks, were taking on risks with a "heads i win, tails you lose" attitude -- sometimes collecting on high stakes bets but often leaving deposit insurance funds to pick up the pieces.', 'at the same time, some regulators, especially the old fslic, which was notably strapped for funds, were compounding the problem -- and greatly increasing the ultimate cost of its resolution -- by engaging in regulatory "forbearance" when faced with technically insolvent institutions.', 'the lessons were costly, but americans do learn from their mistakes.', 'the advocates of banking reform, many of them participants in this conference, saw the problems posed by moral hazard in the context of ineffectual supervision and set out to design a better system.', 'essentially, the reform agenda had two main components: * first, expanded powers for depository institutions that would permit them to diversify in ways that might reduce risks and improve operating efficiency; * second, improving the effectiveness of regulation and supervision by instructing regulators, in effect, to act more like the market itself when conducting prudential regulation.', 'fdicia was a first step toward meeting the second challenge -- how to make regulators act more like the market.', 'it called for a reduction in the potential for regulatory "forbearance" by laying down the conditions under which conservatorship and receivership should be initiated.', "it called for supervisory sanctions based on measurable performance (in particular, the prompt corrective action provisions that based supervisory action on a bank's risk-based capital ratio).", 'the act required the fdic and rtc to resolve failed institutions on a least-cost basis.', 'in other words, the act required the depository receivers to act as if the insurance funds were private insurers, rather than continue the past policy of protecting uninsured depositors and other bank creditors.', 'finally, fdicia placed limitations on the doctrine of "too big to fail," by requiring agency consensus and administration concurrence in order to prop up any large, failing bank.', 'in a few places, however, fdicia went too far.', 'the provisions of the act that dealt with micro management by regulators were immediately seen to be "over the top," and were later repealed.', 'the act provided a framework for regulators to invoke market-like discipline.', 'it left room for them to move their own regulatory techniques in this direction -- a subject to which i will return in a minute.', 'the other objective of reform -- diversification of bank activities through an expansion of bank powers -- has not yet resulted in legislation and is still very much an on-going debate.', 'in part, this failure to take legislative action reflected the long-running ability of the nonbank competition to use its political muscle to forestall increased powers for banks.', 'but the inaction on expanded powers also reflected a congressional concern that additional powers might be used to take on additional risk, which, on the heels of the banking collapse of the late 1980s, represented poor timing, to say the least.', 'there was also some congressional disposition to punish "greedy bankers," who were seen as the reason for the collapse and the diversion of taxpayer funds to pay for thrift insolvencies.', 'whatever the reasons, not only did the 102nd congress fail to enact expanded bank powers, but so did the next two congresses.', 'we are hopeful that the 105th congress will succeed where its predecessors have failed.', 'meanwhile, the regulatory agencies have acted to expand bank powers within the limits of existing law.', "the federal reserve has proposed both liberalization of section 20 activities and expedited procedures for processing applications under regulation y. the occ has acted to liberalize banks' insurance agency powers and, most recently, to liberalize procedures for operating subsidiaries of national banks.", 'of course, i would have to turn in my federal reserve badge and give up my parking pass if i did not mention that we at the fed believe that some activities are best carried out in a subsidiary of the holding company rather than a subsidiary of the bank.', 'we believe that the more distance between the bank and its new, nonbank operations, the more likely that we can separate one from the other and avoid the spreading of the subsidy associated with the safety net.', 'while the regulators can move in the right direction, it is still imperative that congress act.', 'artificial barriers between and among various forms of financial activity are harmful to the best interests of the consumers of financial services, to the providers of those services, and to the general stability and well-being of our financial system, most broadly defined.', 'congress should consider this issue and take the next steps.', 'let me turn now to what i consider to be one of the most critical issues facing regulators, especially in a future in which financial markets likely will dictate significant further increases in the scope and complexity of banking activities.', 'i am referring to the issue of how to conduct optimal supervision of banks.', 'fortunately, there appears actually to be an evolving consensus at least on the general principle.', 'regulators, including the federal reserve, strongly support the basic approach embodied in fdicia; namely that regulators should place limits on depository institutions in such a way as to replicate, as closely as possible, the discipline that would be imposed by a marketplace consisting of informed participants and devoid of the moral hazard associated with the safety net.', 'unfortunately, as always, the devil is in the details.', 'the difficult question is how should a regulator use "market-based" or "performance-based" measures in determining which, if any, supervisory sanctions or limits to place on a bank.', "fdicia's approach was straightforward.", "supervisory sanctions under prompt corrective action were to be based on the bank's risk performance as measured by its levels of regulatory capital, in particular its leverage ratio and total risk-based capital ratio under the basle capital standards.", 'these standards now seem well-intended but rather outdated.', 'certainly, the basle capital standards did the job for which they were designed, namely stopping the secular decline in bank capital levels that, by the late 1980s, threatened general safety and soundness.', 'but the scope and complexity of banking activities has proceeded apace during the last two decades or so, and standard capital measures, at least for our very largest and most complex organizations, are no longer adequate measures on which to base supervisory action for several reasons: * the regulatory capital standards apportion capital only for credit risk and, most recently, for market risk of trading activities.', 'interest rate risk is dealt with subjectively, and other forms of risk, including operating risk, are not treated within the standards.', '* also, the capital standards are, despite the appellation "risk-based," very much a "one-size-fits-all" rule.', 'for example, all non-mortgage loans to corporations and households receive the same arbitrary 8 percent capital requirement.', 'a secured loan to a triple-a rated company receives the same treatment as an unsecured loan to a junk-rated company.', "in other words, the capital standards don't measure credit risk although they represent a crude proxy for such risk within broad categories of banking assets.", '* finally, the capital standards give insufficient consideration to hedging or mitigating risk through the use of credit derivatives or effective portfolio diversification.', 'these shortcomings of the regulatory capital standards were beginning to be understood even as they were being implemented, but no consistent, consensus technology existed at that time for invoking a more sophisticated standard than the basle norms.', 'to be sure, more sophisticated standards were being used by bank supervisors, during the examination process, to determine the adequacy of capital at any individual institution.', 'these supervisory determinations of capital adequacy on a bank-by-bank basis, reflected in the camel ratings given to banks and the bopec ratings given to bank holding companies, are much more inclusive than the basle standards.', 'research shows that camel ratings are much better predictors of bank insolvency than "risk-based" capital ratios.', 'but, a bank-by-bank supervision, of course, is not the same thing as the writing of regulations that apply to all banks.', 'it is now evident that the simple regulatory capital standards that apply to all banks can be quite misleading.', 'nominally high regulatory capital ratios -- even risk-based capital ratios that are 50 or 100 percent higher than the minimums -- are no longer indicators of bank soundness.', 'meanwhile, however, some of our largest and most sophisticated banks have been getting ahead of the regulators and doing the two things one must do in order to properly manage risk and determine capital adequacy.', 'first, they are statistically quantifying risk by estimating the shape of loss probability distributions associated with their risk positions.', 'these quantitative measures of risk are calculated by asset type, by product line, and, in some cases, even down to the individual customer level.', 'second, the more sophisticated banks are calculating economic capital, or "risk capital," to be allocated to each asset, each line of business, and even to each customer, in order to determine risk-adjusted profitability of each type of bank activity.', 'in making these risk capital allocations, banks are defining and meeting internal corporate standards for safety and soundness.', 'for example, a banker might desire to achieve at least a single-a rating on his own corporate debt.', 'he sees that, over history, single-a debt has a default probability of less than one-tenth of one percent over a one year time horizon.', 'so the banker sets an internal corporate goal to allocate enough capital so that the probability of losses exceeding capital is less than 0.1 percent.', 'in the language of statistics, this means that allocated capital must "cover" 99.9 percent of the estimated loss probability distribution.', 'once the banker estimates risk and allocates capital to that risk, the internal capital allocations can be used in a variety of ways -- for example, in so-called raroc or risk-adjusted return on capital models that measure the relative profitability of bank activities.', 'if a particular bank product generates a return to allocated capital that is too low, the bank can seek to cut expenses, reprice the product, or focus its efforts on other, more profitable ventures.', 'these profitability analyses, moreover, are conducted on an "apples-to-apples" basis, since the profitability of each business line is adjusted to reflect the riskiness of the business line.', 'what these bankers have actually done themselves, in calculating these internal capital requirements, is something regulators have never done -- defined a bank soundness target.', 'what regulator, for example, has said that he wants capital to be high enough to reduce to 0.1 percent the probability of insolvency?', 'regulators have said only that capital ratios should be no lower than some number (8 percent in the case of the basle standards).', 'but as we should all be aware, a high capital ratio, if it is accompanied by a highly risky portfolio composition, can result in a bank with a high probability of insolvency.', "the question should not be how high is the bank's capital ratio, but how low is its failure probability.", 'in sharp contrast to our 8 percent one-size-fits-all capital standard, the internal risk-capital calculations of banks result in a very wide range of capital allocations, even within a particular category of credit instrument.', 'for example, for an unsecured commercial credit line, typical internal capital allocations might range from less than 1 percent for a triple-a or double-a rated obligor, to well over 20 percent for an obligor in one of the lowest rating categories.', 'the range of internal capital allocations widens even more when we look at capital calculations for complex risk positions such as various forms of credit derivatives.', 'this great diversity in economic capital allocations, as compared to regulatory capital allocations, creates at least two types of problem.', '* when the regulatory capital requirement is higher than the economic capital allocation, the bank must either engage in costly regulatory arbitrage to evade the regulatory requirement or change its portfolio, possibly leading to suboptimal resource allocation.', "* when the regulatory requirement is lower than the economic capital requirement, the bank may choose to hold capital above the regulatory requirement but below the economic requirement; in this case, the bank's nominally high capital ratio may mask the true nature of its risk position.", 'measuring bank soundness and overall bank performance is becoming more critical as the risk activities of banks become more complex.', 'this condition is especially evident in the various nontraditional activities of banks.', 'in fact, "nontraditional" is no longer a very good adjective to describe much of what goes on at our larger institutions.', 'take asset securitization, for example.', 'no longer do our largest banks simply take in deposit funds and lend out the money to borrowers.', 'currently, well over $200 billion in assets that, in times past, have resided on the books of banks, now are owned by remote securitization conduits sponsored by banks.', 'sponsorship of securitization, which is now almost solely a large bank phenomenon, holds the potential for completely transforming the traditional paradigm of "banking."', 'now, loans are made directly by the conduits, or are made by the banks and then immediately sold to the conduits.', 'to finance the origination or purchase of the loans, a conduit issues several classes of asset-backed securities collateralized by the loans.', "most of the conduit's debt is issued to investors who require that the senior securities be highly rated, generally double-a and triple-a.", 'in order to achieve these ratings, the conduit obtains credit enhancements insulating the senior security holders from defaults on the underlying loans.', 'generally, it is the bank sponsor that provides these credit enhancements, which can be in the form of standby letters of credit to the conduit, or via the purchase of the most junior/subordinated securities issued by the conduit.', "in return for providing the credit protection, as well as the loan origination and servicing functions, the bank lays claim to all residual spreads between the yields on the loans and the interest and non-interest cost of the conduit's securities, net of any loan losses.", 'in other words, securitization results in banks taking on almost identically the same risks as if the loans were kept on the books of the bank the old-fashioned way.', 'but while the credit risk of a securitized loan pool may be the same as the credit risk of holding that loan pool on the books, our capital standards do not always recognize this fact.', 'for example, by supplying a standby letter of credit covering so-called "first-dollar" losses for the conduit, a bank might be able to reduce its regulatory capital requirement, for some of its activities, by 90 percent or more compared with what would be required if the bank held the loans directly on its own books.', "the question, of course, is whether the bank's internal capital allocation systems recognize the similarity in risk between, on the one hand, owning the whole loans and, on the other hand, providing a credit enhancement to a securitization conduit.", 'if the risk measurement and management systems of the bank are faulty, then holding a nominally high capital ratio -- say, 10 percent -- is little consolation.', 'in fact, nominally high capital ratios can be deceiving to market participants.', "if, for example, the bank's balance sheet is less than transparent, potential investors or creditors, seeing the nominally high 10 percent capital, but not recognizing that the economic risk capital allocation should, in percentage terms, be much higher, could direct an inappropriately high level of scarce resources toward the bank.", 'credit derivatives are another example of the evolution.', 'the bottom line is that, as we move into the 21st century, traditional notions of "capital adequacy" will become less useful in determining the safety and soundness of our largest, most sophisticated, banking organizations.', 'this growing discrepancy is important because "performance-based" solutions likely will continue to be touted as the basis for expanded bank powers or reductions in burdensome regulation.', 'for example, the federal reserve\'s recent proposed liberalization of procedures for regulation y activities applies to banking companies that are "well-capitalized" and "well-managed."', 'similarly, the occ\'s recent proposed liberalization of rules for bank operating subsidiaries applies to "well-capitalized" institutions.', 'also, industry participants continue to call for expanded powers and/or reduced regulatory burden based on "market tests" of good management and adequate capital.', 'it will not be easy reaching consensus on how to measure bank soundness and overall bank performance.', 'it cannot simply be done by observing market indicators.', 'for example, we cannot easily use the public ratings of holding company debt.', 'the ratings, after all, are achieved given the existence of the safety net.', 'the ratings are biased, therefore, from the perspective of achieving our stated goal -- to impose prudential limits on banks as if there were no net.', 'in addition, i am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings.', 'the solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment.', 'regulators already have begun to move in this direction.', 'for example, beginning in january 1998, qualifying large multinational banks will be able to use their internal value-at-risk models to help set capital requirements for the market risk inherent in their trading activities.', 'the federal reserve is also conducting a pilot test of the pre-commitment approach to capital for market risk.', 'in this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations.', 'these new and innovative methods for treating the age-old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process.', 'as the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process.', 'for example, the banking agencies have announced programs to place an increased emphasis on banks\' internal risk measurement and management processes within the assessment of overall management quality -- that is, how well a bank employs modern technology to manage risk will be reflected in the "m" portion of the bank\'s camel rating.', "in a similar vein, now that var models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks' internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements.", 'regulation and supervision, like industry practices themselves, are continually evolving processes.', 'as supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive.', 'in conducting prudential regulation we should always remember that the optimal number of bank failures is not zero.', 'indeed, "market-based" performance means that some institutions, either through poor management choices, or just because of plain old bad luck, will fail.', 'as regulators, we must carefully balance these market-like results with concerns over systemic risk.', 'and, as regulators of banks, we must always remember that we do not operate in a vacuum -- the activities of nonbank financial institutions are also important to the general well-being of our financial system and the macro economy.', 'regulators, of course, can only work with the framework laid down by congress.', 'let me conclude with the hope that this congress will build on the experience of the last few years, including the experience with fdicia, and take the next steps toward creating a structural and regulatory framework appropriate to the 21st century.']	Alice M Rivlin	Board of Governors of the US Federal Reserve System	Vice Chairman of the Board of Governors	US
https://www.bis.org/review/r970107b.pdf	Bank of Japan's December review of monetary and economic trends in Japan (Central Bank Articles and Speeches, 20 Dec 96)	BANK OF JAPAN, MONTHLY ECONOMIC REVIEW, 20/12/96.	1996-12-20 00:00:00	Bank of Japan's December review of monetary and economic trends in Japan BANK OF JAPAN, MONTHLY ECONOMIC REVIEW, 20/12/96. A moderate economic recovery continues in Japan, as private demand shows increasing firmness. With respect to final demand, public sector investment has peaked, but housing investment has remained at a high level because of low interest rates. The decline in net exports has paused. Business fixed investment is increasing steadily and a moderate increase also continues in personal consumption. Meanwhile, inventories on the whole are at appropriate levels. In these circumstances, industrial production growth is somewhat accelerating and corporate sentiment is improving gradually. Labor market conditions have improved on the whole, although the unemployment rate has remained at a high level. Meanwhile, the decline in prices is slowing gradually and monetary aggregates continue to grow at 3.0 - 4.0 per cent. With regard to personal consumption, growth in sales of electrical appliances has been high, particularly in personal computers and cellular phones, and passenger car sales (excluding compact cars) have recently increased significantly. Outlays for travel have remained firm and sales at department stores and supermarkets are increasing at a moderate pace. Among leading indicators of business fixed investment, machinery orders are increasing steadily albeit with some quarterly fluctuations. After the decline in the third quarter 1996, they are expected to increase significantly in the fourth quarter. Construction floor area has also picked up moderately. According to the Bank of Japan's Tankan -- Short-Term Economic Survey of Enterprises in Japan of November 1996, business fixed investment plans of principal manufacturing firms for fiscal 1996 continued to increase at the same pace as those for fiscal 1995, while those of non-manufacturing firms turned to increase for the first time in five years. As a result, business fixed investment of principal firms overall is expected to expand at a faster pace than in fiscal 1995. Business fixed investment plans of small firms (all industries) were revised upwards substantially from the August Tankan, marginally exceeding the level of the previous year for the first time in five years. This shows that the recovery in business fixed investment is spreading across a wider spectrum of industries and corporate sizes. With respect to housing investment, housing starts have continued to grow reflecting low interest rates and reasonable housing prices. It recorded a seasonally-adjusted annual rate of 1.82 million starts in October 1996, the highest level since November 1973, partly reflecting the increase in orders in September 1996 before the expected rise in the consumption tax. Regarding public-sector investment, the volume of public works contracted has, since spring 1996, stayed virtually unchanged from the level of the previous year as orders included in the economic policy package of September 1995 subsided. Public works activities such as shipments of related goods increased until summer 1996, reflecting time lags between the order and actual implementation of public works. Recently, however, they have also peaked out. Real exports have shown a moderate increase as the effects of the yen's depreciation since summer 1995 have gradually become apparent after a time lag. Meanwhile, real imports have continued to rise, in part supported by structural elements, e.g., the increased supply capacity of Asian economies. However, the tempo of increase has somewhat slowed, which also reflects the depreciation of the yen. Thus, both the real trade surplus and the nominal current account surplus declined rapidly until the first half of 1996 but have been rising since summer 1996. Industrial production increased steadily in the third quarter 1996 by an annual rate of about 6 per cent and also rose significantly in October. These increases reflect the progress in inventory adjustments and the continued increase in shipments of capital goods, which is closely related to business fixed investment. They also reflect higher growth in domestic sales and exports of passenger cars which have a large influence on production activities. Industrial production is expected to increase by an annual rate of about 10 per cent in the fourth quarter 1996 on the whole. The Tankan of November 1996 shows that the corporate profits of principal firms in both the manufacturing (excluding petroleum refining) and non-manufacturing sectors are forecast to continue increasing in fiscal 1996. Profit levels have risen particularly for manufacturing firms; the current profit-to-sales ratio is expected to reach over 4 per cent for the first time in five years. In these circumstances, business confidence of principal manufacturing firms improved moderately and is forecast to continue its upward trend. In the assembly industry in particular, the percentage differential between firms responding "favorable" and "unfavorable" has turned positive for the first time since February 1992. For non-manufacturing firms, business confidence has strengthened but it is forecast to weaken somewhat in the near future. On average, business confidence of non-manufacturing firms is on an upward trend. Small firms in both the manufacturing and non-manufacturing sectors are expected to show continuing growth in profits in fiscal 1996. However, while business confidence of manufacturing firms continues to improve moderately, that of non-manufacturing firms remains virtually unchanged partly as a result of uncertainties about the outlook for public-sector investment. Labor market conditions have improved somewhat on the whole. Although the unemployment rate remains at a high level and employment growth is weak, overtime working hours have increased, and the ratio of job offers to job applications has continued its gradual rise. With respect to price developments, domestic wholesale prices (adjusted for seasonal electricity rates) seem to have stopped declining although downward pressures from competition with imports remain strong. This development was supported by the yen's depreciation to date, the rise in crude oil prices and the improvement in domestic supply and demand conditions, particularly in construction-related goods. Corporate service prices have declined, particularly in rents and leasing charges, but the year-to-year decrease has become smaller. Consumer prices (nationwide, excluding perishables) have stayed slightly above the previous year's level as commodity prices have continued to fall gradually and service prices have risen somewhat. Growth in monetary aggregates, measured in terms of the year-to-year growth rate of M2 +CDs average outstanding, has remained at 3.0 - 4.0 per cent, albeit with some fluctuations. Regarding money market rates, the overnight call rate (uncollateralized) on the whole has stayed below the official discount rate of 0.5 per cent. The 3-month CD rate has moved at around 0.5 per cent. Meanwhile, with regard to the market's interest rate expectations, 3-month Euro-yen futures declined at a somewhat brisk pace between the second half of July and autumn 1996, and have moved at around 0.7 - 0.9 per cent since September 1996. As the market's expectations of higher interest rates receded, the long-term government bond yield has declined since mid-July 1996, and recorded a historical low of 2.34 per cent in early December. Recently, it has been moving at around 2.4 per cent. With respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since September 1995. The long-term prime lending rate was lowered by a total of 0.8 percentage points in September, October, and December to reach a record low of 2.5 per cent, reflecting developments in long-term market rates. In these circumstances, short-term and long-term average contracted interest rates on new loans and discounts have moved at record low levels. On the stock exchange, the Nikkei 225 Stock Average had remained virtually unchanged since summer 1996 at around ¥20,000 - 21,000, varying across firms. Recently, however, it has weakened somewhat. In the foreign exchange market, the yen's appreciation reversed its course and depreciated against the U.S. dollar between summer 1995 and autumn 1996. Since early 1996, the yen has continued to depreciate and has recently moved at around ¥114. Meanwhile, the yen depreciated temporarily against the deutsche mark in October and November 1996, and has recently moved at around ¥72 - 73.	["bank of japan's december review of monetary and economic trends in japan bank of japan, monthly economic review, 20/12/96.", 'a moderate economic recovery continues in japan, as private demand shows increasing firmness.', 'with respect to final demand, public sector investment has peaked, but housing investment has remained at a high level because of low interest rates.', 'the decline in net exports has paused.', 'business fixed investment is increasing steadily and a moderate increase also continues in personal consumption.', 'meanwhile, inventories on the whole are at appropriate levels.', 'in these circumstances, industrial production growth is somewhat accelerating and corporate sentiment is improving gradually.', 'labor market conditions have improved on the whole, although the unemployment rate has remained at a high level.', 'meanwhile, the decline in prices is slowing gradually and monetary aggregates continue to grow at 3.0 - 4.0 per cent.', 'with regard to personal consumption, growth in sales of electrical appliances has been high, particularly in personal computers and cellular phones, and passenger car sales (excluding compact cars) have recently increased significantly.', 'outlays for travel have remained firm and sales at department stores and supermarkets are increasing at a moderate pace.', 'among leading indicators of business fixed investment, machinery orders are increasing steadily albeit with some quarterly fluctuations.', 'after the decline in the third quarter 1996, they are expected to increase significantly in the fourth quarter.', 'construction floor area has also picked up moderately.', "according to the bank of japan's tankan -- short-term economic survey of enterprises in japan of november 1996, business fixed investment plans of principal manufacturing firms for fiscal 1996 continued to increase at the same pace as those for fiscal 1995, while those of non-manufacturing firms turned to increase for the first time in five years.", 'as a result, business fixed investment of principal firms overall is expected to expand at a faster pace than in fiscal 1995. business fixed investment plans of small firms (all industries) were revised upwards substantially from the august tankan, marginally exceeding the level of the previous year for the first time in five years.', 'this shows that the recovery in business fixed investment is spreading across a wider spectrum of industries and corporate sizes.', 'with respect to housing investment, housing starts have continued to grow reflecting low interest rates and reasonable housing prices.', 'it recorded a seasonally-adjusted annual rate of 1.82 million starts in october 1996, the highest level since november 1973, partly reflecting the increase in orders in september 1996 before the expected rise in the consumption tax.', 'regarding public-sector investment, the volume of public works contracted has, since spring 1996, stayed virtually unchanged from the level of the previous year as orders included in the economic policy package of september 1995 subsided.', 'public works activities such as shipments of related goods increased until summer 1996, reflecting time lags between the order and actual implementation of public works.', 'recently, however, they have also peaked out.', "real exports have shown a moderate increase as the effects of the yen's depreciation since summer 1995 have gradually become apparent after a time lag.", 'meanwhile, real imports have continued to rise, in part supported by structural elements, e.g., the increased supply capacity of asian economies.', 'however, the tempo of increase has somewhat slowed, which also reflects the depreciation of the yen.', 'thus, both the real trade surplus and the nominal current account surplus declined rapidly until the first half of 1996 but have been rising since summer 1996. industrial production increased steadily in the third quarter 1996 by an annual rate of about 6 per cent and also rose significantly in october.', 'these increases reflect the progress in inventory adjustments and the continued increase in shipments of capital goods, which is closely related to business fixed investment.', 'they also reflect higher growth in domestic sales and exports of passenger cars which have a large influence on production activities.', 'industrial production is expected to increase by an annual rate of about 10 per cent in the fourth quarter 1996 on the whole.', 'the tankan of november 1996 shows that the corporate profits of principal firms in both the manufacturing (excluding petroleum refining) and non-manufacturing sectors are forecast to continue increasing in fiscal 1996. profit levels have risen particularly for manufacturing firms; the current profit-to-sales ratio is expected to reach over 4 per cent for the first time in five years.', 'in these circumstances, business confidence of principal manufacturing firms improved moderately and is forecast to continue its upward trend.', 'in the assembly industry in particular, the percentage differential between firms responding "favorable" and "unfavorable" has turned positive for the first time since february 1992. for non-manufacturing firms, business confidence has strengthened but it is forecast to weaken somewhat in the near future.', 'on average, business confidence of non-manufacturing firms is on an upward trend.', 'small firms in both the manufacturing and non-manufacturing sectors are expected to show continuing growth in profits in fiscal 1996. however, while business confidence of manufacturing firms continues to improve moderately, that of non-manufacturing firms remains virtually unchanged partly as a result of uncertainties about the outlook for public-sector investment.', 'labor market conditions have improved somewhat on the whole.', 'although the unemployment rate remains at a high level and employment growth is weak, overtime working hours have increased, and the ratio of job offers to job applications has continued its gradual rise.', 'with respect to price developments, domestic wholesale prices (adjusted for seasonal electricity rates) seem to have stopped declining although downward pressures from competition with imports remain strong.', "this development was supported by the yen's depreciation to date, the rise in crude oil prices and the improvement in domestic supply and demand conditions, particularly in construction-related goods.", 'corporate service prices have declined, particularly in rents and leasing charges, but the year-to-year decrease has become smaller.', "consumer prices (nationwide, excluding perishables) have stayed slightly above the previous year's level as commodity prices have continued to fall gradually and service prices have risen somewhat.", 'growth in monetary aggregates, measured in terms of the year-to-year growth rate of m2 +cds average outstanding, has remained at 3.0 - 4.0 per cent, albeit with some fluctuations.', 'regarding money market rates, the overnight call rate (uncollateralized) on the whole has stayed below the official discount rate of 0.5 per cent.', 'the 3-month cd rate has moved at around 0.5 per cent.', "meanwhile, with regard to the market's interest rate expectations, 3-month euro-yen futures declined at a somewhat brisk pace between the second half of july and autumn 1996, and have moved at around 0.7 - 0.9 per cent since september 1996. as the market's expectations of higher interest rates receded, the long-term government bond yield has declined since mid-july 1996, and recorded a historical low of 2.34 per cent in early december.", 'recently, it has been moving at around 2.4 per cent.', 'with respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since september 1995. the long-term prime lending rate was lowered by a total of 0.8 percentage points in september, october, and december to reach a record low of 2.5 per cent, reflecting developments in long-term market rates.', 'in these circumstances, short-term and long-term average contracted interest rates on new loans and discounts have moved at record low levels.', 'on the stock exchange, the nikkei 225 stock average had remained virtually unchanged since summer 1996 at around ¥20,000 - 21,000, varying across firms.', 'recently, however, it has weakened somewhat.', "in the foreign exchange market, the yen's appreciation reversed its course and depreciated against the u.s. dollar between summer 1995 and autumn 1996. since early 1996, the yen has continued to depreciate and has recently moved at around ¥114.", 'meanwhile, the yen depreciated temporarily against the deutsche mark in october and november 1996, and has recently moved at around ¥72 - 73.']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r970107a.pdf	Mr. Matsushita considers the role of monetary policy in Japan (Central Bank Articles and Speeches, 6 Nov 96)	Translated excerpts of a speech given by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, at the Research Institute of Japan in Tokyo on 06/11/96.	1996-11-06 00:00:00	Mr. Matsushita considers the role of monetary policy in Japan Translated excerpts of a speech given by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, at the Research Institute of Japan in Tokyo on 06/11/96. I. Introduction I am greatly honored to have been invited by the Research Institute of Japan to address this distinguished audience. Today, I would first like to discuss the Bank of Japan's views on recent economic developments in Japan and the thinking behind the Bank's current monetary policy. Then, I would like to review some of the basic issues related to monetary policy management, such as the significance of price stability, which is the objective of monetary policy, and the points for consideration in achieving it. There has been much debate since the beginning of this year about Japan's central bank system, and the Central Bank Study Group, an advisory panel to the Prime Minister, is planning to publish a report in the near future. I myself have, on several occasions, addressed the basic issues involved, such as the status of the central bank within the framework of a democratic society, and the role of the central bank in maintaining financial system stability.1 As my previous speeches focused on the institutional framework of central banking, there has not been an opportunity to discuss the Bank of Japan's views on the central bank's policy management. I have thus selected monetary policy as the theme of today's speech. However, there is another reason. Over the past decade, it seems that a new thinking has been developing among the industrialized countries regarding monetary and fiscal policy management, or more broadly, the economic policy management of a country. This has prompted heated discussions in various countries in recent years on monetary policy and central banking, and this new thinking will be of great significance in contemplating the future framework of the Japanese economy. I would therefore like to examine the role of monetary policy, bearing in mind this new thinking on economic policy management. II. Domestic Economic Conditions and Current Monetary Policy A. Domestic Economic Conditions I would like to begin by reviewing domestic economic conditions. In spring 1995, the recovery of the Japanese economy came to a pause and, at one time, there were even concerns about a deflationary spiral. In view of these economic developments, substantial monetary easing and large-scale fiscal policy measures were implemented. Since the beginning of this year, the economy has once again been on a recovery path, owing to the permeation of policy effects and the depreciation of the yen. The Bank currently judges that a moderate economic recovery continues, but there are concerns as to why the economy has not shown a recovery that is any stronger than "moderate" for nearly a year. This slow recovery can be explained by the tug-of-war between the forces encouraging recovery and the structural adjustment pressures constraining recovery. Therefore, to predict future economic developments, we must first understand how these two factors are at work in the economy. One of the forces encouraging recovery is the permeation of policy effects. For example, there is no doubt that the decline in interest rates has been contributing significantly to the recovery in housing and business fixed investments. At the same time, fiscal expenditures have underpinned domestic aggregate demand. However, forces encouraging economic recovery are not limited to the supporting policy measures. As the economy follows a recovery path supported by policy effects, a larger number of firms with improving profits have begun to show a more positive stance toward business fixed investment and employment. As a result, the risk of a deflationary spiral, which was an issue of concern last year, has been practically eliminated. It can thus be said that the cyclical forces of the economy based on domestic private demand have been slowly but steadily at work for the past year. However, the factors that constrain economic recovery have also been persistent. For example, while business fixed investment continues to recover owing to progress in capital stock adjustment, it has not yet gained the full momentum seen in past economic recoveries. This is because firms, in spite of improved profits, have given priority to repaying debts in order to improve their balance sheets, or have limited their gross fixed investment to the amount of cash flow generated from depreciation of existing facilities. Intensified competition with other Asian countries, which has brought changes to the international environment, is also affecting the Japanese economy in various ways. The inflow of low-priced goods from other Asian countries, for example, seriously affects firms producing competing products. Furthermore, the relocation of production bases overseas by Japanese manufacturers not only decreases domestic business fixed investment by those manufacturers, but also restrains the investment by their domestic subcontractors, due to decrease in orders. It seems that management of firms have not been able to dispel uncertainties over the future, as the path toward a new industrial structure remains obscure under the current circumstances. B. Structural Adjustment Pressures The Japanese economy is thus faced with two types of adjustment pressures: pressures for balance-sheet adjustment in the corporate sector; and pressures for structural adjustment of the industries created by the intensifying competition with other Asian countries. These are the factors that have caused the pace of economic recovery to remain moderate. These two adjustment pressures are, however, significantly different in nature. Adjustment of balance sheets is about reducing debts which accumulated during the "bubble" period, in other words, disposing of the burdens from the past. To that extent, this adjustment is regrettably of a negative nature. In order to reduce the burdens, it will be necessary to enhance the functions of the capital markets to strengthen firms' capital bases, and to revitalize the real estate market to facilitate the liquidation of firms' real estate holdings. Ultimately, however, it is only increase in profits that provides the funds necessary to write off latent losses on real estate and repay accumulated loans. In other words, the burdens from the past need to be reduced gradually with each year's income arising from economic activity. In this regard, although it may sound paradoxical, revitalizing economic activity and boosting corporate profits, or more fundamentally, supporting the recovery of the economy will be important preconditions for the smooth progress of balance-sheet adjustment. Realizing a recovery of the economy encumbered with impaired balance sheets, therefore, requires a stronger policy support than otherwise. This is one of the reasons why the Bank has implemented substantial monetary easing measures to date. As a result, the economy has resumed recovery, although moderate, and corporate profits have been increasing. Accordingly, balance sheets have also been improving gradually. Regarding debt servicing ability, the ratio of firms' long-term debts to cash flow has been declining slowly for the past two years, after rising rapidly during the "bubble" period. It can be said that firms' balance sheets have, in general, begun to show steady improvement, although differences remain between individual sectors and firms. While the balance-sheet adjustment is an attempt to recover from a negative situation, structural adjustment of the industries in response to a new global economic environment is essentially a positive challenge in that the restructuring process itself introduces the possibility of creating renewed economic development. The increasing supply capacity of other East Asian economies and their transition to market economies have intensified competition facing Japan's labor-intensive sectors. At the same time, however, these factors have expanded markets and business opportunities for the Japanese economy. Therefore, if the Japanese economy can adapt itself successfully to this new international division of labor, these developments should bring significant benefits to the Japanese economy in the long run. In fact, a careful look at the Japanese economy will reveal indications of such positive industrial restructuring. The change in Japan's trade structure is one example. Until a decade ago, the top five imports were mostly fuels and raw materials, usually crude oil, wood, petroleum products, coal, and natural gas, although the order varied from year to year. In 1995, however, while crude oil maintained its top position, the other four major imports were office machinery, electronic parts, automobiles, and wood. The share of manufactured goods in Japan's total imports has doubled from 30 to 60 percent over the decade. This change by itself would merely suggest that the manufacturing sector, which had long been Japan's mainstay, now faces severer competition with imported goods. What is notable is that the composition of exports has also changed significantly during the same period. Automobiles, ships, and household electric appliances such as television sets and radios used to appear at the top of the list of export items. In 1995, however, while automobiles stayed as the number one import, electronic parts, office machinery, automobile parts, and scientific and optical apparatus ranked second to fifth, indicating that capital goods and parts have replaced consumer durables. As labor-intensive sectors such as the consumer durables industry grow in other East Asian economies, exports of labor-intensive products from Japan have been declining, while those of capital-intensive products with higher value added, such as capital goods and related parts, have been increasing. This is a typical illustration of the Japanese economy's strong ability to adapt to changes in the global environment. The emergence and expansion of new leading industries in Japan are also indications of industrial restructuring. The mobile telecommunications market, for example, has grown rapidly to a ¥3.5 trillion market and the business fixed investment of this industry has expanded to almost ¥2 trillion, which is equivalent to the sum of business fixed investment by the automobile and iron-and-steel industries. Furthermore, in these three years when economic recovery has been unable to obtain a firm footing, some industries achieved earnings growth comparable to or even exceeding that attained in the three years during the economic boom of the latter half of the 1980s: namely, the electrical and precision machinery industries, which have succeeded in adjusting to the new international division of labor; and the pulp and paper industry in the raw materials sector, which has been able to benefit from the increased volume of information processed and distributed in today's technological age. I have so far emphasized the brighter side of the domestic economy with the hope of further encouraging the efforts of domestic industries, but reality is obviously not so simple. During periods of transition of industrial structure, the contrast between the bright and dark sides tends to become stronger. Focusing on the dark side, the mismatch between labor supply and demand has become greater, and restructuring burdens have been particularly heavy on small and medium-sized firms. Looking back at the postwar period, the Japanese economy successfully underwent several major changes in the industrial structure and shifts in leading industries. There is no doubt that during the periods of transition, management of firms faced great uncertainties about the future, and that it was extremely difficult to accurately predict which would be the growth industries in the coming years. However, during the era of high economic growth, the rapid expansion of the economy absorbed the negative impact arising from the structural adjustment of the industries. The main difficulty that the current economy faces seems to lie not in the industrial restructuring itself, but in the fact that the current economic growth is not strong enough to provide a similar "shock absorber" effect. For this reason the implementation of structural policy, such as deregulation, has become an urgent issue. In order to promote industrial restructuring, it is necessary to create new investment opportunities and to encourage unrestricted and creative business activity through deregulation. It is also important to increase labor mobility and facilitate land transactions. C. Economic Outlook and Monetary Policy Management In order for the Japanese economy to be put firmly on a self-sustaining recovery path in the face of reduced fiscal support, it will be necessary for the structural adjustment to continue to progress and for the virtuous circle between production, income, and expenditure to gain further strength. In this respect, firms have been responding steadily to the structural adjustment pressures. The decline in net exports, which had been a drag on economic recovery, has been slowing recently. In addition, inventory adjustment, which has been under way in certain sectors since this spring, has virtually been completed in the iron-and steel-industry. In light of these facts, it is most likely that production will be further revitalized, strengthening the virtuous circle of the economy led by expanded private demand. However, this remains to be seen. In view of this economic situation, the Bank will continue, in the management of current monetary policy, to monitor monetary and economic developments closely, placing emphasis on further strengthening the foundation for an economic recovery. And to repeat my earlier point, it is also important to carry out structural reforms including drastic deregulation. In this respect, I hope that the new administration will continue to exercise strong leadership. III. New Thinking on Economic Policy Management The industrialized countries today attach more importance to structural policies, such as the strengthening of the competitiveness of domestic industries and the improvement of market infrastructure. In addition, these countries are making steady efforts to promote fiscal consolidation, to reform their central bank systems, and more broadly, to review national economic policy management and its framework. This common trend among the industrialized countries is closely related to the recent changes in the global economy. The collapse of the former socialist bloc, for example, demonstrated the superiority of a market economy over a government-controlled economy: that is, the superiority of a decentralized economy over a centrally-planned economy. In addition, the transition to a market economy and the progress of industrialization of these former socialist countries and the developing Asian countries have stimulated the industrialized countries to strengthen the competitiveness of their economies. Furthermore, past experiences of economic fluctuations, such as inflation and the asset-price "bubble", and the concurrent accumulation of budget deficits have prompted countries to closely re-examine fundamental thinking on economic policy and the underlying economic theories. This year happens to be the 50th year since the death of John Maynard Keynes. There have recently been renewed discussions on the evaluating of Keynes' theories and Keynesian economics, which in many respects formed the basis of postwar economic policies. The approaches currently adopted by various countries in addressing economic policies have several points in common. The first point is the growing emphasis placed on improving the supply side of the economy. The conventional approach to economic policy emphasizes the control of aggregate demand through monetary and fiscal policies, and this remains dominant when seeking short-term adjustments of the economy. At the same time, however, there is a growing perception that the driving force of long-term economic growth owes much to firms' efforts to improve their productivity. It is thus necessary to strengthen the supply side of the economy by promoting the introduction of new technology and by improving infrastructures such as transportation and telecommunications. In fiscal policy management, greater importance is being attached to the details of fiscal expenditures from the viewpoint of evaluating the contribution of each portion to the improvement of economic infrastructures, rather than to their effects in generating additional demand. There is also a stronger awareness that, in the medium to long term, it is more desirable to curtail inefficient fiscal expenditures thereby reducing budget deficits and to utilize economic resources more efficiently in the private sector. All this reflects the growing emphasis on the supply side of the economy. The second point in common in the approaches to addressing economic policies is the emphasis placed on the utilization of the market mechanism. Related to the first point, it can be said that this emphasis calls for fully utilizing the inherent forces of the market mechanism of promoting greater economic efficiency and of inducing technological innovation, in order to achieve higher productivity. The global trend toward deregulation and promotion of market competition obviously originates in this common thinking. The effectiveness of the market mechanism is not limited to revitalization of industries and improvement of financial markets. For example, in Europe, there is a growing understanding that the main cause of the high unemployment rate, which has persisted for some time, is the lack of mobility in the labor markets. The solution to the problem, therefore, is considered to lie in facilitating the mobility in the labor markets so as to efficiently adjust labor market conditions. The third common element is the growing emphasis placed on the public's expectations regarding future developments and its confidence in economic policies. For example, the effectiveness of fiscal policy depends significantly on the public's views on the controllability of the fiscal deficits in the future. In the European countries and the United States, there is a growing perception that doubts about a government's ability to control budget deficits could bring about an unfavorable rise in long-term interest rates. This is one of the major reasons why fiscal consolidation is considered to be an important task. It has also become clear that changes in expectations regarding price and interest rate developments significantly influence the effectiveness of monetary policy. There is a theory which even suggests that discretionary economic policy would not have any effect if people always had rational expectations about the future. While this may be an extreme example, in general it has come to be considered that the efficacy of economic policy cannot be discussed without taking into account its effects on people's expectations. These recent changes in the thinking on economic policy naturally have a close bearing on the fundamental thinking about central banking and monetary policy management. For example, even when implementing short-term demand management policy, it is necessary to ensure that the policy is compatible with the objective of price stability -- the medium to long-term objective of monetary policy and a precondition for the smooth functioning of the market mechanism. It is also necessary to ensure that the public's confidence in monetary policy be strengthened by clearly establishing the independence and accountability of the central bank. Bearing these points in mind, I would now like to move on to the other theme of today's speech, the fundamental issues concerning monetary policy management. IV. The Basic Thinking on Monetary Policy Management A. Price Stability and the Central Bank Most people agree that the objective of monetary policy is the maintenance of price stability. I would like to explain why it is that this particular economic policy objective, among others, is assigned to monetary policy. Price stability, in this context, is not necessarily the stability of prices of individual goods and services, in other words, the stability of relative prices of individual items. In fact, fluctuation of relative prices in response to changes in the supply and demand conditions reflects the most basic principle of the market mechanism. Central banks aim at achieving the stability of prices in general by taking the prices of individual items in their totality. If prices in general increase, that is, if inflation occurs, the amount of goods that can be purchased for ¥10,000 will decrease, which means that the value of ¥10,000 will decline. It can thus be said that "prices in general" is another way of expressing "currency value". The maintenance of price stability naturally becomes one of the most important missions of the central bank as the issuer of the currency, together with the mission of maintaining the stability of the financial system. Moreover, in the long run, it is the monetary policy of the central bank that is able to most effectively achieve stability of prices in general. It is true that prices, in the short term, fluctuate due to various factors: overseas market prices, such as crude oil prices; or the supply and demand conditions of particular goods. However, from a longer-term perspective, prices in general are determined by the amount of money relative to the amount of traded goods and services. For this reason inflation is often said to be a monetary phenomenon, and the task of achieving price stability is necessarily assigned to monetary policy. This then explains why the monetary policy of the central bank is so vital and why the central bank is called the guardian of the currency. There is a question of how asset prices, such as land prices and stock prices, may be considered in the management of monetary policy. The Bank believes that it is unsuitable to consider asset prices in the same way as it does the prices of ordinary goods and services. For example, land is not produced by everyday economic activity. In addition, land prices are determined in part by the perception of earnings that will be generated from the land, in other words, by the projection of economic activity and prices. Asset prices are therefore different in nature from the prices of goods and services that are produced daily through economic activity and consumed. It is also apparent, however, from the bitter experiences of the "bubble" economy that major fluctuations in asset prices are related to large swings in the economy. Therefore, the Bank believes that in order to ensure price stability in the medium to long term, due attention must be paid to asset-price developments. Later, I would like to discuss in more detail the meaning of price stability in the medium to long term. B. The Significance of Price Stability Let me now consider the significance of price stability. It seems self-evident that inflation and deflation are not desirable. As large fluctuations in prices are usually accompanied by economic overheating or recession, the stabilization of prices will lead to a stable economy. Furthermore, price fluctuations lead to an uneven distribution of income and assets, thereby threatening the stability of people's everyday lives. In addition to the above, I would like to stress that the stability of prices in general is the most important precondition for the smooth functioning of the market mechanism. The market mechanism adjusts production and demand according to the signals sent by the changes in relative prices. Once inflation or deflation occurs, it becomes extremely difficult to read the signals received from the changes in individual prices, and as a result, the price mechanism ceases to function properly. This is because it becomes impossible to distinguish whether changes in individual prices reflect shifts in relative prices or in prices in general. It is as if there is no reliable yardstick for economic activity. Under such circumstances, firms trying to formulate future business plans based on their estimation of profitability of investments, and households making plans for savings and consumption face growing uncertainties, and this impedes economic development. In the past, some argued that inflation is desirable to a certain extent in order to further stimulate economic growth, or that firms' activities would become more vigorous under inflation. The 50 years of postwar experience and the evolution of economic theories, however, have forced serious reconsideration of this argument. There is every likelihood that a mild inflation will eventually lead to full-scale inflation. In addition, once inflation takes root, the achievements of business activity are masked by nominal increases in profits, and accordingly, technological innovation and improvement in productivity are likely to be discouraged. Actual examples demonstrate that, from a longer-term perspective, countries with stable prices tend to enjoy higher economic growth. For these reasons, the current emphasis is on the significance of price stability, which is in line with the global trend in economic policy management placing stronger emphasis on the supply side of the economy and on the utilization of the market mechanism. C. The Meaning of Price Stability and Assessment Criteria How can price stability be defined? This remains a difficult question as it is not easy to draw a line between acceptable and an unacceptable rate of price increase. In theory, zero inflation would be desirable. If prices are to be the yardstick for economic activity, zero inflation allows the yardstick to be reliable and unchanging, and in addition avoids the adverse effects of price fluctuations on income distribution. I said that this is true "in theory" for several reasons. First, there are limitations to the accuracy of price statistics in that it is difficult to exclude price increases arising from improvements in product quality or to reflect changes in the market share of products. As the statistics become biased due to such technical limitations, some argue that it is undesirable to aim at zero inflation based on a specific price indicator. In addition, if there is a downward rigidity in certain prices and wages due to business practices and contractual constraints, the cost of achieving zero inflation could become substantial. In view of the significance of price stability as discussed earlier, a more practical criterion would be the sustainability of price stability in the medium to long term. This is because prices serve as a yardstick not only for deciding current production and consumption, but also for deciding the activities that lead to future economic developments, such as business fixed investment and savings. The perception that prices influence future developments has led to an increasing tendency to view price stability as being the state in which firms and households need not consider prospective price fluctuations in their economic decision-making. Even when price indexes remain stable during a certain period, price stability in the medium to long term could be at risk if the economy is overheating and creating potential upward pressures on prices. Monetary policy must thus be managed not only to minimize current fluctuations in prices, but also to contain the potential risk of price fluctuations in the future. This is why price stability is said to be a medium to long-term objective of monetary policy. The maintenance of price stability does not conflict with the achievement of stable economic growth and employment conditions. For example, measures to prevent overheating (or recession) of the economy can at the same time contain inflation (or avoid deflation), and provide medium to long-term price stability; and this price stability, in turn, is a prerequisite for achieving sustainable growth of the economy, as I mentioned earlier. D. Features of Monetary Policy I would now like to examine the important elements in managing monetary policy. There are two features of monetary policy that differentiate it from other economic policies. The first feature is that monetary policy uses market-oriented measures to transmit policy effects to market participants and therefore the efficacy of monetary policy depends on the market's reaction to the measures taken by the central bank. In this respect, monetary policy differs significantly in nature from the government's economic policy, which aims to achieve its objectives through administrative means such as laws and regulations. Specifically, monetary policy affects the supply and demand of funds in the financial markets through the implementation of the Bank's daily operations, such as bill and bond transactions. The mechanism is initiated in changes made to the money market interest rates, or in technical terms, changes to the overnight rates in the interbank market, which can be referred to as the wholesale market for cash and reserves. Changes in these rates affect other short-term interest rates and longer-term rates through arbitrage in the markets, which in turn influence changes in the deposit and lending rates offered by banks. These changes in interest rates as a whole then influence the economic activities of the corporate and household sectors. With the completion of the deregulation of interest rates, use of the market mechanism is currently the most effective way of transmitting policy effects throughout the financial markets and the economy. However, in order to effectively utilize this mechanism, public and market confidence in monetary policy is of decisive importance. Unless the policy intentions of the central bank are fully understood and considered to be credible, the effects of interest rate policies will not permeate adequately, and market interest rates may fluctuate independently of the intentions of the central bank, affected by unnecessary conjecture and rumors. The second distinct feature of monetary policy is that considerable time is required before its effects materialize, in other words, there is a long time lag before policy effects permeate throughout the economy. The mechanism through which changes in interest rates are transmitted to economic activity is complicated. Interest rate changes may have a relatively rapid influence on firms planning to make an investment in the near future. Theoretically, the effect of interest rate changes should be swiftly transmitted to fluctuations in asset prices. On the other hand, it takes a considerable time for the effects of interest rate changes to appear in actual corporate profits and household income levels. One reason is that there are various types of borrowing and investment with short and long maturities. As new interest rates are applied to these instruments only at the time of maturity, considerable time is required before the overall interest rate level changes and before the new level takes effect throughout the economy. In addition, changes in corporate profits and income levels will only bring about a gradual change in the confidence of firms and households in their investment and consumption, and after some delay in time, new decisions will be made on investment and consumption. Further time is then needed before these decisions materialize as actual spending. It has been said that pre-emptive policy responses are necessary to ensure price stability. This is because, as mentioned earlier, price stability must be achieved in the medium to long term, and because there will always be a considerable time lag before policy effects permeate throughout the economy. As this time lag in permeation of policy effects has become more widely recognized, greater emphasis has come to be placed in the management of monetary policy on assessing the potential risks in the economy, to enable pre-emptive policy responses. E. Considerations in Monetary Policy Management The requirements for monetary policy are thus "maintenance of market confidence" and "pre-emptive response". It is, however, extremely difficult to achieve these two requirements simultaneously. Let me explain how the two requirements conflict. In order to make timely policy responses, it will be necessary for the central bank to act based on its projections of the economic and price situations one or two years ahead. However, considering the difficulty of accurately predicting economic deve	['mr. matsushita considers the role of monetary policy in japan translated excerpts of a speech given by the governor of the bank of japan, mr. yasuo matsushita, at the research institute of japan in tokyo on 06/11/96.', 'i. introduction i am greatly honored to have been invited by the research institute of japan to address this distinguished audience.', "today, i would first like to discuss the bank of japan's views on recent economic developments in japan and the thinking behind the bank's current monetary policy.", 'then, i would like to review some of the basic issues related to monetary policy management, such as the significance of price stability, which is the objective of monetary policy, and the points for consideration in achieving it.', "there has been much debate since the beginning of this year about japan's central bank system, and the central bank study group, an advisory panel to the prime minister, is planning to publish a report in the near future.", "i myself have, on several occasions, addressed the basic issues involved, such as the status of the central bank within the framework of a democratic society, and the role of the central bank in maintaining financial system stability.1 as my previous speeches focused on the institutional framework of central banking, there has not been an opportunity to discuss the bank of japan's views on the central bank's policy management.", "i have thus selected monetary policy as the theme of today's speech.", 'however, there is another reason.', 'over the past decade, it seems that a new thinking has been developing among the industrialized countries regarding monetary and fiscal policy management, or more broadly, the economic policy management of a country.', 'this has prompted heated discussions in various countries in recent years on monetary policy and central banking, and this new thinking will be of great significance in contemplating the future framework of the japanese economy.', 'i would therefore like to examine the role of monetary policy, bearing in mind this new thinking on economic policy management.', 'domestic economic conditions and current monetary policy a. domestic economic conditions i would like to begin by reviewing domestic economic conditions.', 'in spring 1995, the recovery of the japanese economy came to a pause and, at one time, there were even concerns about a deflationary spiral.', 'in view of these economic developments, substantial monetary easing and large-scale fiscal policy measures were implemented.', 'since the beginning of this year, the economy has once again been on a recovery path, owing to the permeation of policy effects and the depreciation of the yen.', 'the bank currently judges that a moderate economic recovery continues, but there are concerns as to why the economy has not shown a recovery that is any stronger than "moderate" for nearly a year.', 'this slow recovery can be explained by the tug-of-war between the forces encouraging recovery and the structural adjustment pressures constraining recovery.', 'therefore, to predict future economic developments, we must first understand how these two factors are at work in the economy.', 'one of the forces encouraging recovery is the permeation of policy effects.', 'for example, there is no doubt that the decline in interest rates has been contributing significantly to the recovery in housing and business fixed investments.', 'at the same time, fiscal expenditures have underpinned domestic aggregate demand.', 'however, forces encouraging economic recovery are not limited to the supporting policy measures.', 'as the economy follows a recovery path supported by policy effects, a larger number of firms with improving profits have begun to show a more positive stance toward business fixed investment and employment.', 'as a result, the risk of a deflationary spiral, which was an issue of concern last year, has been practically eliminated.', 'it can thus be said that the cyclical forces of the economy based on domestic private demand have been slowly but steadily at work for the past year.', 'however, the factors that constrain economic recovery have also been persistent.', 'for example, while business fixed investment continues to recover owing to progress in capital stock adjustment, it has not yet gained the full momentum seen in past economic recoveries.', 'this is because firms, in spite of improved profits, have given priority to repaying debts in order to improve their balance sheets, or have limited their gross fixed investment to the amount of cash flow generated from depreciation of existing facilities.', 'intensified competition with other asian countries, which has brought changes to the international environment, is also affecting the japanese economy in various ways.', 'the inflow of low-priced goods from other asian countries, for example, seriously affects firms producing competing products.', 'furthermore, the relocation of production bases overseas by japanese manufacturers not only decreases domestic business fixed investment by those manufacturers, but also restrains the investment by their domestic subcontractors, due to decrease in orders.', 'it seems that management of firms have not been able to dispel uncertainties over the future, as the path toward a new industrial structure remains obscure under the current circumstances.', 'b. structural adjustment pressures the japanese economy is thus faced with two types of adjustment pressures: pressures for balance-sheet adjustment in the corporate sector; and pressures for structural adjustment of the industries created by the intensifying competition with other asian countries.', 'these are the factors that have caused the pace of economic recovery to remain moderate.', 'these two adjustment pressures are, however, significantly different in nature.', 'adjustment of balance sheets is about reducing debts which accumulated during the "bubble" period, in other words, disposing of the burdens from the past.', 'to that extent, this adjustment is regrettably of a negative nature.', "in order to reduce the burdens, it will be necessary to enhance the functions of the capital markets to strengthen firms' capital bases, and to revitalize the real estate market to facilitate the liquidation of firms' real estate holdings.", 'ultimately, however, it is only increase in profits that provides the funds necessary to write off latent losses on real estate and repay accumulated loans.', "in other words, the burdens from the past need to be reduced gradually with each year's income arising from economic activity.", 'in this regard, although it may sound paradoxical, revitalizing economic activity and boosting corporate profits, or more fundamentally, supporting the recovery of the economy will be important preconditions for the smooth progress of balance-sheet adjustment.', 'realizing a recovery of the economy encumbered with impaired balance sheets, therefore, requires a stronger policy support than otherwise.', 'this is one of the reasons why the bank has implemented substantial monetary easing measures to date.', 'as a result, the economy has resumed recovery, although moderate, and corporate profits have been increasing.', 'accordingly, balance sheets have also been improving gradually.', 'regarding debt servicing ability, the ratio of firms\' long-term debts to cash flow has been declining slowly for the past two years, after rising rapidly during the "bubble" period.', "it can be said that firms' balance sheets have, in general, begun to show steady improvement, although differences remain between individual sectors and firms.", 'while the balance-sheet adjustment is an attempt to recover from a negative situation, structural adjustment of the industries in response to a new global economic environment is essentially a positive challenge in that the restructuring process itself introduces the possibility of creating renewed economic development.', "the increasing supply capacity of other east asian economies and their transition to market economies have intensified competition facing japan's labor-intensive sectors.", 'at the same time, however, these factors have expanded markets and business opportunities for the japanese economy.', 'therefore, if the japanese economy can adapt itself successfully to this new international division of labor, these developments should bring significant benefits to the japanese economy in the long run.', 'in fact, a careful look at the japanese economy will reveal indications of such positive industrial restructuring.', "the change in japan's trade structure is one example.", 'until a decade ago, the top five imports were mostly fuels and raw materials, usually crude oil, wood, petroleum products, coal, and natural gas, although the order varied from year to year.', 'in 1995, however, while crude oil maintained its top position, the other four major imports were office machinery, electronic parts, automobiles, and wood.', "the share of manufactured goods in japan's total imports has doubled from 30 to 60 percent over the decade.", "this change by itself would merely suggest that the manufacturing sector, which had long been japan's mainstay, now faces severer competition with imported goods.", 'what is notable is that the composition of exports has also changed significantly during the same period.', 'automobiles, ships, and household electric appliances such as television sets and radios used to appear at the top of the list of export items.', 'in 1995, however, while automobiles stayed as the number one import, electronic parts, office machinery, automobile parts, and scientific and optical apparatus ranked second to fifth, indicating that capital goods and parts have replaced consumer durables.', 'as labor-intensive sectors such as the consumer durables industry grow in other east asian economies, exports of labor-intensive products from japan have been declining, while those of capital-intensive products with higher value added, such as capital goods and related parts, have been increasing.', "this is a typical illustration of the japanese economy's strong ability to adapt to changes in the global environment.", 'the emergence and expansion of new leading industries in japan are also indications of industrial restructuring.', 'the mobile telecommunications market, for example, has grown rapidly to a ¥3.5 trillion market and the business fixed investment of this industry has expanded to almost ¥2 trillion, which is equivalent to the sum of business fixed investment by the automobile and iron-and-steel industries.', "furthermore, in these three years when economic recovery has been unable to obtain a firm footing, some industries achieved earnings growth comparable to or even exceeding that attained in the three years during the economic boom of the latter half of the 1980s: namely, the electrical and precision machinery industries, which have succeeded in adjusting to the new international division of labor; and the pulp and paper industry in the raw materials sector, which has been able to benefit from the increased volume of information processed and distributed in today's technological age.", 'i have so far emphasized the brighter side of the domestic economy with the hope of further encouraging the efforts of domestic industries, but reality is obviously not so simple.', 'during periods of transition of industrial structure, the contrast between the bright and dark sides tends to become stronger.', 'focusing on the dark side, the mismatch between labor supply and demand has become greater, and restructuring burdens have been particularly heavy on small and medium-sized firms.', 'looking back at the postwar period, the japanese economy successfully underwent several major changes in the industrial structure and shifts in leading industries.', 'there is no doubt that during the periods of transition, management of firms faced great uncertainties about the future, and that it was extremely difficult to accurately predict which would be the growth industries in the coming years.', 'however, during the era of high economic growth, the rapid expansion of the economy absorbed the negative impact arising from the structural adjustment of the industries.', 'the main difficulty that the current economy faces seems to lie not in the industrial restructuring itself, but in the fact that the current economic growth is not strong enough to provide a similar "shock absorber" effect.', 'for this reason the implementation of structural policy, such as deregulation, has become an urgent issue.', 'in order to promote industrial restructuring, it is necessary to create new investment opportunities and to encourage unrestricted and creative business activity through deregulation.', 'it is also important to increase labor mobility and facilitate land transactions.', 'c. economic outlook and monetary policy management in order for the japanese economy to be put firmly on a self-sustaining recovery path in the face of reduced fiscal support, it will be necessary for the structural adjustment to continue to progress and for the virtuous circle between production, income, and expenditure to gain further strength.', 'in this respect, firms have been responding steadily to the structural adjustment pressures.', 'the decline in net exports, which had been a drag on economic recovery, has been slowing recently.', 'in addition, inventory adjustment, which has been under way in certain sectors since this spring, has virtually been completed in the iron-and steel-industry.', 'in light of these facts, it is most likely that production will be further revitalized, strengthening the virtuous circle of the economy led by expanded private demand.', 'however, this remains to be seen.', 'in view of this economic situation, the bank will continue, in the management of current monetary policy, to monitor monetary and economic developments closely, placing emphasis on further strengthening the foundation for an economic recovery.', 'and to repeat my earlier point, it is also important to carry out structural reforms including drastic deregulation.', 'in this respect, i hope that the new administration will continue to exercise strong leadership.', 'new thinking on economic policy management the industrialized countries today attach more importance to structural policies, such as the strengthening of the competitiveness of domestic industries and the improvement of market infrastructure.', 'in addition, these countries are making steady efforts to promote fiscal consolidation, to reform their central bank systems, and more broadly, to review national economic policy management and its framework.', 'this common trend among the industrialized countries is closely related to the recent changes in the global economy.', 'the collapse of the former socialist bloc, for example, demonstrated the superiority of a market economy over a government-controlled economy: that is, the superiority of a decentralized economy over a centrally-planned economy.', 'in addition, the transition to a market economy and the progress of industrialization of these former socialist countries and the developing asian countries have stimulated the industrialized countries to strengthen the competitiveness of their economies.', 'furthermore, past experiences of economic fluctuations, such as inflation and the asset-price "bubble", and the concurrent accumulation of budget deficits have prompted countries to closely re-examine fundamental thinking on economic policy and the underlying economic theories.', 'this year happens to be the 50th year since the death of john maynard keynes.', "there have recently been renewed discussions on the evaluating of keynes' theories and keynesian economics, which in many respects formed the basis of postwar economic policies.", 'the approaches currently adopted by various countries in addressing economic policies have several points in common.', 'the first point is the growing emphasis placed on improving the supply side of the economy.', 'the conventional approach to economic policy emphasizes the control of aggregate demand through monetary and fiscal policies, and this remains dominant when seeking short-term adjustments of the economy.', "at the same time, however, there is a growing perception that the driving force of long-term economic growth owes much to firms' efforts to improve their productivity.", 'it is thus necessary to strengthen the supply side of the economy by promoting the introduction of new technology and by improving infrastructures such as transportation and telecommunications.', 'in fiscal policy management, greater importance is being attached to the details of fiscal expenditures from the viewpoint of evaluating the contribution of each portion to the improvement of economic infrastructures, rather than to their effects in generating additional demand.', 'there is also a stronger awareness that, in the medium to long term, it is more desirable to curtail inefficient fiscal expenditures thereby reducing budget deficits and to utilize economic resources more efficiently in the private sector.', 'all this reflects the growing emphasis on the supply side of the economy.', 'the second point in common in the approaches to addressing economic policies is the emphasis placed on the utilization of the market mechanism.', 'related to the first point, it can be said that this emphasis calls for fully utilizing the inherent forces of the market mechanism of promoting greater economic efficiency and of inducing technological innovation, in order to achieve higher productivity.', 'the global trend toward deregulation and promotion of market competition obviously originates in this common thinking.', 'the effectiveness of the market mechanism is not limited to revitalization of industries and improvement of financial markets.', 'for example, in europe, there is a growing understanding that the main cause of the high unemployment rate, which has persisted for some time, is the lack of mobility in the labor markets.', 'the solution to the problem, therefore, is considered to lie in facilitating the mobility in the labor markets so as to efficiently adjust labor market conditions.', "the third common element is the growing emphasis placed on the public's expectations regarding future developments and its confidence in economic policies.", "for example, the effectiveness of fiscal policy depends significantly on the public's views on the controllability of the fiscal deficits in the future.", "in the european countries and the united states, there is a growing perception that doubts about a government's ability to control budget deficits could bring about an unfavorable rise in long-term interest rates.", 'this is one of the major reasons why fiscal consolidation is considered to be an important task.', 'it has also become clear that changes in expectations regarding price and interest rate developments significantly influence the effectiveness of monetary policy.', 'there is a theory which even suggests that discretionary economic policy would not have any effect if people always had rational expectations about the future.', "while this may be an extreme example, in general it has come to be considered that the efficacy of economic policy cannot be discussed without taking into account its effects on people's expectations.", 'these recent changes in the thinking on economic policy naturally have a close bearing on the fundamental thinking about central banking and monetary policy management.', 'for example, even when implementing short-term demand management policy, it is necessary to ensure that the policy is compatible with the objective of price stability -- the medium to long-term objective of monetary policy and a precondition for the smooth functioning of the market mechanism.', "it is also necessary to ensure that the public's confidence in monetary policy be strengthened by clearly establishing the independence and accountability of the central bank.", "bearing these points in mind, i would now like to move on to the other theme of today's speech, the fundamental issues concerning monetary policy management.", 'the basic thinking on monetary policy management a. price stability and the central bank most people agree that the objective of monetary policy is the maintenance of price stability.', 'i would like to explain why it is that this particular economic policy objective, among others, is assigned to monetary policy.', 'price stability, in this context, is not necessarily the stability of prices of individual goods and services, in other words, the stability of relative prices of individual items.', 'in fact, fluctuation of relative prices in response to changes in the supply and demand conditions reflects the most basic principle of the market mechanism.', 'central banks aim at achieving the stability of prices in general by taking the prices of individual items in their totality.', 'if prices in general increase, that is, if inflation occurs, the amount of goods that can be purchased for ¥10,000 will decrease, which means that the value of ¥10,000 will decline.', 'it can thus be said that "prices in general" is another way of expressing "currency value".', 'the maintenance of price stability naturally becomes one of the most important missions of the central bank as the issuer of the currency, together with the mission of maintaining the stability of the financial system.', 'moreover, in the long run, it is the monetary policy of the central bank that is able to most effectively achieve stability of prices in general.', 'it is true that prices, in the short term, fluctuate due to various factors: overseas market prices, such as crude oil prices; or the supply and demand conditions of particular goods.', 'however, from a longer-term perspective, prices in general are determined by the amount of money relative to the amount of traded goods and services.', 'for this reason inflation is often said to be a monetary phenomenon, and the task of achieving price stability is necessarily assigned to monetary policy.', 'this then explains why the monetary policy of the central bank is so vital and why the central bank is called the guardian of the currency.', 'there is a question of how asset prices, such as land prices and stock prices, may be considered in the management of monetary policy.', 'the bank believes that it is unsuitable to consider asset prices in the same way as it does the prices of ordinary goods and services.', 'for example, land is not produced by everyday economic activity.', 'in addition, land prices are determined in part by the perception of earnings that will be generated from the land, in other words, by the projection of economic activity and prices.', 'asset prices are therefore different in nature from the prices of goods and services that are produced daily through economic activity and consumed.', 'it is also apparent, however, from the bitter experiences of the "bubble" economy that major fluctuations in asset prices are related to large swings in the economy.', 'therefore, the bank believes that in order to ensure price stability in the medium to long term, due attention must be paid to asset-price developments.', 'later, i would like to discuss in more detail the meaning of price stability in the medium to long term.', 'b. the significance of price stability let me now consider the significance of price stability.', 'it seems self-evident that inflation and deflation are not desirable.', 'as large fluctuations in prices are usually accompanied by economic overheating or recession, the stabilization of prices will lead to a stable economy.', "furthermore, price fluctuations lead to an uneven distribution of income and assets, thereby threatening the stability of people's everyday lives.", 'in addition to the above, i would like to stress that the stability of prices in general is the most important precondition for the smooth functioning of the market mechanism.', 'the market mechanism adjusts production and demand according to the signals sent by the changes in relative prices.', 'once inflation or deflation occurs, it becomes extremely difficult to read the signals received from the changes in individual prices, and as a result, the price mechanism ceases to function properly.', 'this is because it becomes impossible to distinguish whether changes in individual prices reflect shifts in relative prices or in prices in general.', 'it is as if there is no reliable yardstick for economic activity.', 'under such circumstances, firms trying to formulate future business plans based on their estimation of profitability of investments, and households making plans for savings and consumption face growing uncertainties, and this impedes economic development.', "in the past, some argued that inflation is desirable to a certain extent in order to further stimulate economic growth, or that firms' activities would become more vigorous under inflation.", 'the 50 years of postwar experience and the evolution of economic theories, however, have forced serious reconsideration of this argument.', 'there is every likelihood that a mild inflation will eventually lead to full-scale inflation.', 'in addition, once inflation takes root, the achievements of business activity are masked by nominal increases in profits, and accordingly, technological innovation and improvement in productivity are likely to be discouraged.', 'actual examples demonstrate that, from a longer-term perspective, countries with stable prices tend to enjoy higher economic growth.', 'for these reasons, the current emphasis is on the significance of price stability, which is in line with the global trend in economic policy management placing stronger emphasis on the supply side of the economy and on the utilization of the market mechanism.', 'c. the meaning of price stability and assessment criteria how can price stability be defined?', 'this remains a difficult question as it is not easy to draw a line between acceptable and an unacceptable rate of price increase.', 'in theory, zero inflation would be desirable.', 'if prices are to be the yardstick for economic activity, zero inflation allows the yardstick to be reliable and unchanging, and in addition avoids the adverse effects of price fluctuations on income distribution.', 'i said that this is true "in theory" for several reasons.', 'first, there are limitations to the accuracy of price statistics in that it is difficult to exclude price increases arising from improvements in product quality or to reflect changes in the market share of products.', 'as the statistics become biased due to such technical limitations, some argue that it is undesirable to aim at zero inflation based on a specific price indicator.', 'in addition, if there is a downward rigidity in certain prices and wages due to business practices and contractual constraints, the cost of achieving zero inflation could become substantial.', 'in view of the significance of price stability as discussed earlier, a more practical criterion would be the sustainability of price stability in the medium to long term.', 'this is because prices serve as a yardstick not only for deciding current production and consumption, but also for deciding the activities that lead to future economic developments, such as business fixed investment and savings.', 'the perception that prices influence future developments has led to an increasing tendency to view price stability as being the state in which firms and households need not consider prospective price fluctuations in their economic decision-making.', 'even when price indexes remain stable during a certain period, price stability in the medium to long term could be at risk if the economy is overheating and creating potential upward pressures on prices.', 'monetary policy must thus be managed not only to minimize current fluctuations in prices, but also to contain the potential risk of price fluctuations in the future.', 'this is why price stability is said to be a medium to long-term objective of monetary policy.', 'the maintenance of price stability does not conflict with the achievement of stable economic growth and employment conditions.', 'for example, measures to prevent overheating (or recession) of the economy can at the same time contain inflation (or avoid deflation), and provide medium to long-term price stability; and this price stability, in turn, is a prerequisite for achieving sustainable growth of the economy, as i mentioned earlier.', 'd. features of monetary policy i would now like to examine the important elements in managing monetary policy.', 'there are two features of monetary policy that differentiate it from other economic policies.', "the first feature is that monetary policy uses market-oriented measures to transmit policy effects to market participants and therefore the efficacy of monetary policy depends on the market's reaction to the measures taken by the central bank.", "in this respect, monetary policy differs significantly in nature from the government's economic policy, which aims to achieve its objectives through administrative means such as laws and regulations.", "specifically, monetary policy affects the supply and demand of funds in the financial markets through the implementation of the bank's daily operations, such as bill and bond transactions.", 'the mechanism is initiated in changes made to the money market interest rates, or in technical terms, changes to the overnight rates in the interbank market, which can be referred to as the wholesale market for cash and reserves.', 'changes in these rates affect other short-term interest rates and longer-term rates through arbitrage in the markets, which in turn influence changes in the deposit and lending rates offered by banks.', 'these changes in interest rates as a whole then influence the economic activities of the corporate and household sectors.', 'with the completion of the deregulation of interest rates, use of the market mechanism is currently the most effective way of transmitting policy effects throughout the financial markets and the economy.', 'however, in order to effectively utilize this mechanism, public and market confidence in monetary policy is of decisive importance.', 'unless the policy intentions of the central bank are fully understood and considered to be credible, the effects of interest rate policies will not permeate adequately, and market interest rates may fluctuate independently of the intentions of the central bank, affected by unnecessary conjecture and rumors.', 'the second distinct feature of monetary policy is that considerable time is required before its effects materialize, in other words, there is a long time lag before policy effects permeate throughout the economy.', 'the mechanism through which changes in interest rates are transmitted to economic activity is complicated.', 'interest rate changes may have a relatively rapid influence on firms planning to make an investment in the near future.', 'theoretically, the effect of interest rate changes should be swiftly transmitted to fluctuations in asset prices.', 'on the other hand, it takes a considerable time for the effects of interest rate changes to appear in actual corporate profits and household income levels.', 'one reason is that there are various types of borrowing and investment with short and long maturities.', 'as new interest rates are applied to these instruments only at the time of maturity, considerable time is required before the overall interest rate level changes and before the new level takes effect throughout the economy.', 'in addition, changes in corporate profits and income levels will only bring about a gradual change in the confidence of firms and households in their investment and consumption, and after some delay in time, new decisions will be made on investment and consumption.', 'further time is then needed before these decisions materialize as actual spending.', 'it has been said that pre-emptive policy responses are necessary to ensure price stability.', 'this is because, as mentioned earlier, price stability must be achieved in the medium to long term, and because there will always be a considerable time lag before policy effects permeate throughout the economy.', 'as this time lag in permeation of policy effects has become more widely recognized, greater emphasis has come to be placed in the management of monetary policy on assessing the potential risks in the economy, to enable pre-emptive policy responses.', 'e. considerations in monetary policy management the requirements for monetary policy are thus "maintenance of market confidence" and "pre-emptive response".', 'it is, however, extremely difficult to achieve these two requirements simultaneously.', 'let me explain how the two requirements conflict.', 'in order to make timely policy responses, it will be necessary for the central bank to act based on its projections of the economic and price situations one or two years ahead.', 'however, considering the difficulty of accurately predicting economic deve']	Yasuo Matsushita	Bank of Japan	Governor	Japan
https://www.bis.org/review/r970106.pdf	Prof. Tietmeyer discusses the Bundesbank's commitment to stability (Central Bank Articles and Speeches, 28 Dec 96)	Translation of an article by the President of the Deutsche Bundesbank, Prof. Hans Tietmeyer, published in the Frankfurter Allgemeine Zeitung on 28/12/96.	1996-12-28 00:00:00	Prof. Tietmeyer discusses the Bundesbank's commitment to stability Translation of an article by President of the Deutsche Bundesbank, Prof. Hans Tietmeyer, published in the Frankfurter Allgemeine Zeitung on 28/12/96. In post-war Germany, there has been a broad consensus about the importance of a stable currency across all political groupings. The bitter consequences of two previous hyperinflations as well as the positive experience gained with the D-Mark and its strength played a major role in this. In the recent past, however, the public debate has sometimes caused doubts to be raised concerning how far this consensus still goes. Admittedly, there have often been similar disputes in post-war history. One has only to remember the controversy surrounding the D-Mark appreciations in the sixties, when the relationship between internal monetary stability and external exchange rate stability first became an issue. Or the arguments in the seventies about the spurious alternative of more inflation or more unemployment. Ultimately, however, all these controversies did not seriously jeopardise the consensus on stability; if anything, they tended to strengthen it, in fact. New discussion on stability In the run-up to the introduction of European monetary union and against the backdrop of very sharp exchange rate changes in the first half of the nineties, the debate about the importance of monetary stability -- at least in some of its forms -- seems to have gained a new quality. For example, it is not only the trade-off between inflation and unemployment -- that had been thought to have been overcome -- which has been revived recently in a number of comments made by industry, the trade unions and politicians. In view of the degree of price stability achieved, adherence to a policy of non-inflationary growth is occasionally even brought into discredit as a deflationary policy. Perhaps even more frequently one hears the proposition that foreign exchange rate stability must purportedly assume priority over internal price stability -- exchange rate stability evidently meaning the nominal and not the real (price level-adjusted) stability of exchange rates. A sustained low external value of the D-Mark has not infrequently even been regarded as necessary (or at least beneficial) for the German economy, regardless of its implications for internal monetary stability. In the recent past, this debate has also increasingly become part of the wider discussion about monetary integration in Europe. It is thus acquiring a new dimension, even going as far as postulating European monetary union at all costs; in other words, a monetary union which would tend to result in a soft rather than a strong euro. At any rate, there are a number of participants in the current discussion (in Germany, too) who -- without saying it so explicitly, of course -- evidently regard the changeover to the euro as a welcome opportunity of lessening the D-Mark's former external strength. The open or covert advocates of a weakening of the currency on competitive grounds obviously fail to recognise the interrelationship between internal and external stability. They overlook the fact that, in the past, Germany was regularly among those countries with the lowest interest rate level world-wide -- precisely because of the stability of its currency. That was and continues to provide a strong competitive edge which cannot be rated too highly, quite apart from the generally cost-curbing effects of monetary stability. The fact that such depreciation strategies are at variance with the aim of the Maastricht Treaty and even more so with its interpretation by the Bundestag, the Bundesrat and the Federal Constitutional Court seems either not to be taken into consideration or to be deliberately accepted. The Bundesbank's adherence to internal monetary stability has led to it being accused of an undue stability policy bias, or even of being obsessed with stability. Bundesbank in favour of a stability union To avoid any misunderstanding: the Bundesbank is committed to the road to European monetary union laid down in the Maastricht Treaty. In the relevant bodies at national and European level it is collaborating intensively in solving the complex and by no means easy technical tasks involved -- these range from harmonising the hitherto very different monetary policy instruments in Europe, putting in place the organisational and legal framework for the European Central Bank and the euro, to a fundamentally new and modernised payment system. All this work should not be underestimated. The preparations have to be advanced to a stage which enables the European Central Bank Council to take decisions immediately after it has been established. The European Central Bank System has to be fully operational and functionally viable right from the very first day of monetary union. And the set of instruments then in force must not put individual banking groups at a disadvantage or jeopardise the benefits of the decentralised banking structure which obtains, particularly in Germany, and the dominant long-term orientation of the markets. As important as this intensive collaboration in the technical preparation of monetary union may be, what is of even greater importance is the Bundesbank's public advocacy of monetary union actually becoming a permanent stability union, as is provided for in the Maastricht Treaty and is quite obviously desired by the majority of the population. Although there are occasionally slight differences of emphasis on individual points, there is complete unanimity within the Central Bank Council concerning the goal itself. Monetary union must become a permanent stability union with a strong currency, not least in order to prevent political conflict which might otherwise pose a risk at a later date. The Bundesbank is at one in favouring the creation of the economic and political preconditions which will ensure that the monetary stability gained through the D-Mark is likewise permanently maintained following the changeover to the euro. It has the authority to do this not only by virtue of the consensus on non-inflationary growth prevailing in Germany, it is also under a statutory obligation to do so. In accordance with article 3 of the Bundesbank Act it has the legal mandate of "safeguarding the currency". Moreover, in accordance with article 12 it "is required to support the general economic policy of the Federal Cabinet", but only without prejudice to the performance of its primary duty to "safeguard the currency". The Act explicitly states that the Bundesbank is independent of instructions from the Federal Cabinet in exercising its powers. Priority of internal stability However, the legal wording "to safeguard the currency" does not seem to be totally unambiguous with regard to the question of internal monetary stability having priority over exchange rate stability. At the time this law was drafted in 1957, when the Bretton Woods system of fixed exchange rates was still in force worldwide, internal and external exchange rate stability was virtually free of conflict. It was not until tensions emerged between the major industrial countries, as a result of domestic policy decisions and priorities drifting apart, that the subject of protecting internal stability policy against external constraints (as it was later called by Karl Schiller) became a matter of key importance. As the sixties progressed, the Bundesbank in Germany, with the vigorous support of the Federal Economics Ministers Ludwig Erhard and Karl Schiller, committed itself more and more unequivocally to the priority of internal monetary stability. And that has remained the case to the present day, with far-reaching agreement between the Federal Government and the Bundesbank. The Maastricht Treaty even adopted the priority of internal stability expressis verbis, in fact. Maintaining price stability has been enshrined in article 105 as the primary objective of the European System of Central Banks. The Bundesbank's primary orientation towards internal price stability is hence fully consistent with the regulations which will apply one day to the European Central Bank. The Bundesbank has to fulfil its stability mandate, as defined above, in several ways. Its first and most crucial task is to conduct its own monetary policy in line with its anti-inflationary stance. It does have to play its part in achieving the other targets of the Stability and Growth Act (high level of employment, external equilibrium and stable and adequate economic growth), but only to the extent that this does not jeopardise its primary goal of price stability. Since there is a large measure of consensus among economists that price stability is not -- at least in the medium term -- inconsistent with the other targets of the so-called uneasy quadrangle, but is, instead, a prerequisite for continued growth, high employment and external equilibrium, there should not actually be any conflict in this respect. An anti-inflationary monetary policy also serves other macroeconomic goals, the example of Germany providing ample evidence of this. Although a stable currency alone cannot automatically bring about and safeguard sustained growth and increased employment, it is an indispensable precondition for them. Furthermore, experience has shown that monetary stability also makes a major contribution to social equity. Given the demographic trends, not only in Germany but also in other European countries, this will be all the more the case in the future, since private provisioning by the "ordinary citizens" will become increasingly important. Role as a guardian of monetary stability In the final analysis, however, monetary stability cannot be safeguarded by an anti-inflationary monetary policy alone. It will always be influenced by the prevailing behavioural patterns in society and by developments in other policy areas. This applies, in particular, to those decisions taken in fiscal policy, labour market policy, social policy and wage policy which affect the viability of the economic and social system. Long-term undesirable trends in those areas also tend to jeopardise monetary stability in the short or long run, and then often require monetary policy countermeasures. For that reason, the Bundesbank's role as a guardian of monetary stability must of necessity extend beyond its decision-making powers in monetary policy. It has to draw attention -- at as early a stage as possible -- to potential risks to stability in other areas and parallel behavioural patterns in the economy or in society. The Bundesbank has always made every possible effort to do this, without interfering in the political discussion of specific details. The Bundesbank is also especially suited to this more far-reaching function as a guardian of stability on account of the fact that the legislature has kept it largely free of day-to-day political influence and special party and lobby interests by virtue of its being independent of political instructions and by the long-term appointment of the members of its governing bodies. Being free of short-term party and special interests, the Bundesbank is hence able to raise its warning voice -- which it has always done in the almost forty years of its existence -- if it perceives the emergence of national or international risks to monetary stability. However, the political independence of the Bundesbank by no means implies that it is free of responsibilities. In contrast to many other countries, it is not -- for well considered reasons -- accountable to the government or to parliament. Nevertheless, from the very beginning it has placed itself under the obligation publicly to explain and justify its policy as well as its assessment of developments that are relevant to monetary policy. Its target group is the general public which it addresses through the speeches of the members of its governing bodies and its diverse publications, especially its Monthly and Annual Reports. The Bundesbank uses all these opportunities to explain its policy and the reasons behind its decisions. It hence puts itself before the forum of public discussion. Role of a monetary policy adviser ... Furthermore, the Bundesbank has been assigned a specific advisory role vis-à-vis the Federal Cabinet by the legislature. In accordance with article 13, the Bundesbank has to "advise the Federal Cabinet on monetary policy matters of major importance". This advisory role has often been quite significant in the history of the Bundesbank. It not only played a considerable part in all the discussions on the design and application of the international and European monetary system. At the request of the Federal Cabinet, the Bundesbank also advised it in connection with preparing for German monetary union. Naturally, the political bodies were and remain free to follow the advice given by the Bundesbank or not. In fulfilling its political responsibilities, the Federal Cabinet departed from the Bundesbank's recommendations on individual points (e.g. in the selection of the conversion rate for current payments). ... in the Maastricht negotiations ... The Bundesbank also performed its advisory function in connection with the negotiations on the Maastricht Treaty. As long ago as September 1990, the Central Bank Council drew attention to what it deemed to be the key issues in a memorandum. It said, among other things, "... the participating economies (i.e. in the monetary union) will be inextricably linked to one another in the monetary field, come what may. The implications of this -- especially for the value of money -- will depend crucially on economic and fiscal policy and on the stance of management and labour in all member states." And then the indispensable benchmarks of a successful stability union are spelled out in detail: from an independent central banking system, with a priority commitment to the target of price stability, via the regulations for lasting budgetary discipline, to the requirements for sufficient and durable policy convergence among the participating countries prior to entry into the final stage. In addition, Bundesbank representatives, through their work on the EU Monetary Committee in Brussels and on the erstwhile Committee of Central Bank Governors in Basle, contributed to the wording of the Maastricht Treaty in numerous instances. For example, the statute of the European Central Bank was drafted largely by representatives of European central banks in Basle and then adopted, virtually unchanged, by government representatives in the Treaty negotiations. Parallel to the negotiations in Brussels and Maastricht, there were of course also repeated bilateral talks between the Bundesbank and the Federal Government on major aspects of the Treaty. These intensive and close contacts were and are fully in line with the Bundesbank's statutory mandate to proffer advice. Equally, attention should be drawn to the fact that this does not affect the Government's political accountability. It was not and is not the Bundesbank that conducted or conducts negotiations itself on these subjects. Incidentally, neither was it the Bundesbank that was responsible for the numerical fixing of the so-called fiscal criteria at 3 % of GDP for the current budget deficit and at 60 % of GDP for the fiscal debt level. To my knowledge, both figures, which in the eyes of the Bundesbank tend to be too generous, rather than too strict, for most countries, were put forward by delegations other than the German one. In the joint estimation of the Central Bank Council, however, it is imperative that, prior to entry into monetary union, "the budget deficits in all the participating countries should be reduced to a level which is sustainable in the long run and unproblematic in terms of anti-inflation policy requirements". After the conclusion of the Treaty negotiations, the Central Bank Council published the following evaluation of the Treaty early in 1992: "The question of whether EMU is to be established is a political decision. ... The planned institutional design of the final stage is largely in line with the Bundesbank's recommendations. In particular, the statute of the future European System of Central Banks ... It will be of paramount importance for the overall success of the envisaged economic and monetary union that the Community decisions to be taken in ... 1998 on the selection of the countries eligible for participation should be geared solely to their stability policy performance." ... in the preparations for EMU In line with its statutory mandate, the Bundesbank is also advising the Federal Government in the current negotiations on the preparation of monetary union. That applies particularly to the consultations on the legal texts for what is known as the "secondary legislation" now taking shape in Brussels. And it also applies to the proposal for a European stability pact (which was put forward by the Federal Government and backed by the Bundesbank) to concretise the surveillance process for budgetary and debt trends in the participating countries envisaged in article 104c of the Treaty. That stability pact has nothing to do with any German desire for hegemony. Instead, it is intended to prevent potential conflicts from arising between the future single stability-oriented monetary policy and fiscal policy (especially the fiscal policies of the major member states), thus protecting the smaller member states, in particular, from hardships imposed by the potential misconduct of the larger ones. Urging "strict" compliance with the contractual convergence criteria in the selection decision by the European Council on the member states participating in the monetary union beginning in 1999 -- as reflected in the evaluation of the Treaty published early in 1992 -is, after all, part of the Bundesbank's function of being a guardian of price stability and advisor. The calls made by the Bundesbank -- incidentally, in complete agreement with the Federal Government -- for a "strict" interpretation of the criteria laid down in the Treaty are by no means merely legalistic. Just like the Bundestag and the Bundesrat, the Bundesbank regards strict and lasting compliance with the convergence criteria as an essential precondition for the smooth inception and, as far as possible, conflict-free continuation of monetary union. Lasting convergence indispensable References to the fact that today there is not infrequently divergence, rather than convergence, within existing monetary areas disregard the fundamental difference that obtains between a monetary area that is identical to the borders of a nation state and a monetary union, which comprises several nation states with a different regulatory and social systems. After all, in a monetary union extending beyond the frontiers of a single nation state, the common features and compensatory systems which regularly exist within a nation state (such as a common legal and tax system, a dominant central government budget, common social security systems and fiscal adjustment mechanisms) are missing. Hence in a monetary union composed of several member states without superordinate national ties, the potentially diverging forces are far greater than in a nation state. It would be a fallacy to suppose that a common central banking system alone can prevent potential divergencies in a union comprising several major member states. This is why a monetary union encompassing several nation states entails from the outset a high level of common "stability culture", in the sense of joint preferences and tried-and-tested capabilities. The degree of lasting convergence achieved and the readiness to maintain lasting financial discipline are intended to document precisely that. Disregarding the significance of the selection criteria and lastingly failing to acknowledge it would imply a lack of strategic perceptiveness, and not vice versa. A monetary union which later turned out to be particularly conflict-prone, let alone fragile, would not only pose economic problems, it might even turn out to be a serious threat to the European integration process. Drawing attention to these far-reaching political dangers, and thus to the crucial importance of selecting countries in keeping with the criteria, is undoubtedly part and parcel of the Bundesbank's advisory mandate. After all, the monetary union must not be allowed to fail, let alone to become a source of political conflict in Europe. Not a "state within the state" All in all, the Bundesbank has constantly endeavoured to perform its role of being a guardian and advisor in keeping with its stability target, as laid down by Parliament -- and it will continue to do so. In the basic orientation of its policy it knows at the same time that it enjoys a consensus with the vast majority of the population. The performance of these duties by the Bundesbank, like its monetary policy, which is geared primarily to domestic price stability, has nothing to do with any stance as a "state within the state". Nor does it have anything to do with a desire for German hegemony in Europe. Quite the contrary, a lastingly sustainable foundation and an anti-inflationary orientation of the monetary union are without any doubt in the best interests of Europe, too. It may well be that such a stability-oriented guardian and advisor function does not always fit in with the political and tactical aspirations of the political decision-makers. That may even be true at times of our trading partners. But Chancellor Kohl rightly said publicly not long ago: "As the Federal Chancellor, I sometimes have problems with individual measures or statements by the Bundesbank. But as a citizen of this country, I am happy that the Bundesbank exists and that it acts in this way. Of course, neither the Bundesbank nor its President can claim always to take the right action in all circumstances". On taking office in 1993 I said: "Even the Bundesbank is not faultless". Needless to say, that is just as true today, and will remain so in future. But the fact that the Bundesbank is attested a substantial measure of "credibility in anti-inflation policy" in Germany, in Europe and in international circles alike has certainly done Germany and Europe as a whole more good than harm. That verdict has been confirmed time and again by impartial observers. Hence the Bundesbank will also continue to feel itself committed to stability in the period ahead.	["prof. tietmeyer discusses the bundesbank's commitment to stability translation of an article by president of the deutsche bundesbank, prof. hans tietmeyer, published in the frankfurter allgemeine zeitung on 28/12/96.", 'in post-war germany, there has been a broad consensus about the importance of a stable currency across all political groupings.', 'the bitter consequences of two previous hyperinflations as well as the positive experience gained with the d-mark and its strength played a major role in this.', 'in the recent past, however, the public debate has sometimes caused doubts to be raised concerning how far this consensus still goes.', 'admittedly, there have often been similar disputes in post-war history.', 'one has only to remember the controversy surrounding the d-mark appreciations in the sixties, when the relationship between internal monetary stability and external exchange rate stability first became an issue.', 'or the arguments in the seventies about the spurious alternative of more inflation or more unemployment.', 'ultimately, however, all these controversies did not seriously jeopardise the consensus on stability; if anything, they tended to strengthen it, in fact.', 'new discussion on stability in the run-up to the introduction of european monetary union and against the backdrop of very sharp exchange rate changes in the first half of the nineties, the debate about the importance of monetary stability -- at least in some of its forms -- seems to have gained a new quality.', 'for example, it is not only the trade-off between inflation and unemployment -- that had been thought to have been overcome -- which has been revived recently in a number of comments made by industry, the trade unions and politicians.', 'in view of the degree of price stability achieved, adherence to a policy of non-inflationary growth is occasionally even brought into discredit as a deflationary policy.', 'perhaps even more frequently one hears the proposition that foreign exchange rate stability must purportedly assume priority over internal price stability -- exchange rate stability evidently meaning the nominal and not the real (price level-adjusted) stability of exchange rates.', 'a sustained low external value of the d-mark has not infrequently even been regarded as necessary (or at least beneficial) for the german economy, regardless of its implications for internal monetary stability.', 'in the recent past, this debate has also increasingly become part of the wider discussion about monetary integration in europe.', 'it is thus acquiring a new dimension, even going as far as postulating european monetary union at all costs; in other words, a monetary union which would tend to result in a soft rather than a strong euro.', "at any rate, there are a number of participants in the current discussion (in germany, too) who -- without saying it so explicitly, of course -- evidently regard the changeover to the euro as a welcome opportunity of lessening the d-mark's former external strength.", 'the open or covert advocates of a weakening of the currency on competitive grounds obviously fail to recognise the interrelationship between internal and external stability.', 'they overlook the fact that, in the past, germany was regularly among those countries with the lowest interest rate level world-wide -- precisely because of the stability of its currency.', 'that was and continues to provide a strong competitive edge which cannot be rated too highly, quite apart from the generally cost-curbing effects of monetary stability.', 'the fact that such depreciation strategies are at variance with the aim of the maastricht treaty and even more so with its interpretation by the bundestag, the bundesrat and the federal constitutional court seems either not to be taken into consideration or to be deliberately accepted.', "the bundesbank's adherence to internal monetary stability has led to it being accused of an undue stability policy bias, or even of being obsessed with stability.", 'bundesbank in favour of a stability union to avoid any misunderstanding: the bundesbank is committed to the road to european monetary union laid down in the maastricht treaty.', 'in the relevant bodies at national and european level it is collaborating intensively in solving the complex and by no means easy technical tasks involved -- these range from harmonising the hitherto very different monetary policy instruments in europe, putting in place the organisational and legal framework for the european central bank and the euro, to a fundamentally new and modernised payment system.', 'all this work should not be underestimated.', 'the preparations have to be advanced to a stage which enables the european central bank council to take decisions immediately after it has been established.', 'the european central bank system has to be fully operational and functionally viable right from the very first day of monetary union.', 'and the set of instruments then in force must not put individual banking groups at a disadvantage or jeopardise the benefits of the decentralised banking structure which obtains, particularly in germany, and the dominant long-term orientation of the markets.', "as important as this intensive collaboration in the technical preparation of monetary union may be, what is of even greater importance is the bundesbank's public advocacy of monetary union actually becoming a permanent stability union, as is provided for in the maastricht treaty and is quite obviously desired by the majority of the population.", 'although there are occasionally slight differences of emphasis on individual points, there is complete unanimity within the central bank council concerning the goal itself.', 'monetary union must become a permanent stability union with a strong currency, not least in order to prevent political conflict which might otherwise pose a risk at a later date.', 'the bundesbank is at one in favouring the creation of the economic and political preconditions which will ensure that the monetary stability gained through the d-mark is likewise permanently maintained following the changeover to the euro.', 'it has the authority to do this not only by virtue of the consensus on non-inflationary growth prevailing in germany, it is also under a statutory obligation to do so.', 'in accordance with article 3 of the bundesbank act it has the legal mandate of "safeguarding the currency".', 'moreover, in accordance with article 12 it "is required to support the general economic policy of the federal cabinet", but only without prejudice to the performance of its primary duty to "safeguard the currency".', 'the act explicitly states that the bundesbank is independent of instructions from the federal cabinet in exercising its powers.', 'priority of internal stability however, the legal wording "to safeguard the currency" does not seem to be totally unambiguous with regard to the question of internal monetary stability having priority over exchange rate stability.', 'at the time this law was drafted in 1957, when the bretton woods system of fixed exchange rates was still in force worldwide, internal and external exchange rate stability was virtually free of conflict.', 'it was not until tensions emerged between the major industrial countries, as a result of domestic policy decisions and priorities drifting apart, that the subject of protecting internal stability policy against external constraints (as it was later called by karl schiller) became a matter of key importance.', 'as the sixties progressed, the bundesbank in germany, with the vigorous support of the federal economics ministers ludwig erhard and karl schiller, committed itself more and more unequivocally to the priority of internal monetary stability.', 'and that has remained the case to the present day, with far-reaching agreement between the federal government and the bundesbank.', 'the maastricht treaty even adopted the priority of internal stability expressis verbis, in fact.', 'maintaining price stability has been enshrined in article 105 as the primary objective of the european system of central banks.', "the bundesbank's primary orientation towards internal price stability is hence fully consistent with the regulations which will apply one day to the european central bank.", 'the bundesbank has to fulfil its stability mandate, as defined above, in several ways.', 'its first and most crucial task is to conduct its own monetary policy in line with its anti-inflationary stance.', 'it does have to play its part in achieving the other targets of the stability and growth act (high level of employment, external equilibrium and stable and adequate economic growth), but only to the extent that this does not jeopardise its primary goal of price stability.', 'since there is a large measure of consensus among economists that price stability is not -- at least in the medium term -- inconsistent with the other targets of the so-called uneasy quadrangle, but is, instead, a prerequisite for continued growth, high employment and external equilibrium, there should not actually be any conflict in this respect.', 'an anti-inflationary monetary policy also serves other macroeconomic goals, the example of germany providing ample evidence of this.', 'although a stable currency alone cannot automatically bring about and safeguard sustained growth and increased employment, it is an indispensable precondition for them.', 'furthermore, experience has shown that monetary stability also makes a major contribution to social equity.', 'given the demographic trends, not only in germany but also in other european countries, this will be all the more the case in the future, since private provisioning by the "ordinary citizens" will become increasingly important.', 'role as a guardian of monetary stability in the final analysis, however, monetary stability cannot be safeguarded by an anti-inflationary monetary policy alone.', 'it will always be influenced by the prevailing behavioural patterns in society and by developments in other policy areas.', 'this applies, in particular, to those decisions taken in fiscal policy, labour market policy, social policy and wage policy which affect the viability of the economic and social system.', 'long-term undesirable trends in those areas also tend to jeopardise monetary stability in the short or long run, and then often require monetary policy countermeasures.', "for that reason, the bundesbank's role as a guardian of monetary stability must of necessity extend beyond its decision-making powers in monetary policy.", 'it has to draw attention -- at as early a stage as possible -- to potential risks to stability in other areas and parallel behavioural patterns in the economy or in society.', 'the bundesbank has always made every possible effort to do this, without interfering in the political discussion of specific details.', 'the bundesbank is also especially suited to this more far-reaching function as a guardian of stability on account of the fact that the legislature has kept it largely free of day-to-day political influence and special party and lobby interests by virtue of its being independent of political instructions and by the long-term appointment of the members of its governing bodies.', 'being free of short-term party and special interests, the bundesbank is hence able to raise its warning voice -- which it has always done in the almost forty years of its existence -- if it perceives the emergence of national or international risks to monetary stability.', 'however, the political independence of the bundesbank by no means implies that it is free of responsibilities.', 'in contrast to many other countries, it is not -- for well considered reasons -- accountable to the government or to parliament.', 'nevertheless, from the very beginning it has placed itself under the obligation publicly to explain and justify its policy as well as its assessment of developments that are relevant to monetary policy.', 'its target group is the general public which it addresses through the speeches of the members of its governing bodies and its diverse publications, especially its monthly and annual reports.', 'the bundesbank uses all these opportunities to explain its policy and the reasons behind its decisions.', 'it hence puts itself before the forum of public discussion.', 'role of a monetary policy adviser ... furthermore, the bundesbank has been assigned a specific advisory role vis-à-vis the federal cabinet by the legislature.', 'in accordance with article 13, the bundesbank has to "advise the federal cabinet on monetary policy matters of major importance".', 'this advisory role has often been quite significant in the history of the bundesbank.', 'it not only played a considerable part in all the discussions on the design and application of the international and european monetary system.', 'at the request of the federal cabinet, the bundesbank also advised it in connection with preparing for german monetary union.', 'naturally, the political bodies were and remain free to follow the advice given by the bundesbank or not.', "in fulfilling its political responsibilities, the federal cabinet departed from the bundesbank's recommendations on individual points (e.g.", 'in the selection of the conversion rate for current payments).', '... in the maastricht negotiations ... the bundesbank also performed its advisory function in connection with the negotiations on the maastricht treaty.', 'as long ago as september 1990, the central bank council drew attention to what it deemed to be the key issues in a memorandum.', 'it said, among other things, "... the participating economies (i.e.', 'in the monetary union) will be inextricably linked to one another in the monetary field, come what may.', 'the implications of this -- especially for the value of money -- will depend crucially on economic and fiscal policy and on the stance of management and labour in all member states."', 'and then the indispensable benchmarks of a successful stability union are spelled out in detail: from an independent central banking system, with a priority commitment to the target of price stability, via the regulations for lasting budgetary discipline, to the requirements for sufficient and durable policy convergence among the participating countries prior to entry into the final stage.', 'in addition, bundesbank representatives, through their work on the eu monetary committee in brussels and on the erstwhile committee of central bank governors in basle, contributed to the wording of the maastricht treaty in numerous instances.', 'for example, the statute of the european central bank was drafted largely by representatives of european central banks in basle and then adopted, virtually unchanged, by government representatives in the treaty negotiations.', 'parallel to the negotiations in brussels and maastricht, there were of course also repeated bilateral talks between the bundesbank and the federal government on major aspects of the treaty.', "these intensive and close contacts were and are fully in line with the bundesbank's statutory mandate to proffer advice.", "equally, attention should be drawn to the fact that this does not affect the government's political accountability.", 'it was not and is not the bundesbank that conducted or conducts negotiations itself on these subjects.', 'incidentally, neither was it the bundesbank that was responsible for the numerical fixing of the so-called fiscal criteria at 3 % of gdp for the current budget deficit and at 60 % of gdp for the fiscal debt level.', 'to my knowledge, both figures, which in the eyes of the bundesbank tend to be too generous, rather than too strict, for most countries, were put forward by delegations other than the german one.', 'in the joint estimation of the central bank council, however, it is imperative that, prior to entry into monetary union, "the budget deficits in all the participating countries should be reduced to a level which is sustainable in the long run and unproblematic in terms of anti-inflation policy requirements".', 'after the conclusion of the treaty negotiations, the central bank council published the following evaluation of the treaty early in 1992: "the question of whether emu is to be established is a political decision.', "... the planned institutional design of the final stage is largely in line with the bundesbank's recommendations.", 'in particular, the statute of the future european system of central banks ... it will be of paramount importance for the overall success of the envisaged economic and monetary union that the community decisions to be taken in ... 1998 on the selection of the countries eligible for participation should be geared solely to their stability policy performance."', '... in the preparations for emu in line with its statutory mandate, the bundesbank is also advising the federal government in the current negotiations on the preparation of monetary union.', 'that applies particularly to the consultations on the legal texts for what is known as the "secondary legislation" now taking shape in brussels.', 'and it also applies to the proposal for a european stability pact (which was put forward by the federal government and backed by the bundesbank) to concretise the surveillance process for budgetary and debt trends in the participating countries envisaged in article 104c of the treaty.', 'that stability pact has nothing to do with any german desire for hegemony.', 'instead, it is intended to prevent potential conflicts from arising between the future single stability-oriented monetary policy and fiscal policy (especially the fiscal policies of the major member states), thus protecting the smaller member states, in particular, from hardships imposed by the potential misconduct of the larger ones.', 'urging "strict" compliance with the contractual convergence criteria in the selection decision by the european council on the member states participating in the monetary union beginning in 1999 -- as reflected in the evaluation of the treaty published early in 1992 -is, after all, part of the bundesbank\'s function of being a guardian of price stability and advisor.', 'the calls made by the bundesbank -- incidentally, in complete agreement with the federal government -- for a "strict" interpretation of the criteria laid down in the treaty are by no means merely legalistic.', 'just like the bundestag and the bundesrat, the bundesbank regards strict and lasting compliance with the convergence criteria as an essential precondition for the smooth inception and, as far as possible, conflict-free continuation of monetary union.', 'lasting convergence indispensable references to the fact that today there is not infrequently divergence, rather than convergence, within existing monetary areas disregard the fundamental difference that obtains between a monetary area that is identical to the borders of a nation state and a monetary union, which comprises several nation states with a different regulatory and social systems.', 'after all, in a monetary union extending beyond the frontiers of a single nation state, the common features and compensatory systems which regularly exist within a nation state (such as a common legal and tax system, a dominant central government budget, common social security systems and fiscal adjustment mechanisms) are missing.', 'hence in a monetary union composed of several member states without superordinate national ties, the potentially diverging forces are far greater than in a nation state.', 'it would be a fallacy to suppose that a common central banking system alone can prevent potential divergencies in a union comprising several major member states.', 'this is why a monetary union encompassing several nation states entails from the outset a high level of common "stability culture", in the sense of joint preferences and tried-and-tested capabilities.', 'the degree of lasting convergence achieved and the readiness to maintain lasting financial discipline are intended to document precisely that.', 'disregarding the significance of the selection criteria and lastingly failing to acknowledge it would imply a lack of strategic perceptiveness, and not vice versa.', 'a monetary union which later turned out to be particularly conflict-prone, let alone fragile, would not only pose economic problems, it might even turn out to be a serious threat to the european integration process.', "drawing attention to these far-reaching political dangers, and thus to the crucial importance of selecting countries in keeping with the criteria, is undoubtedly part and parcel of the bundesbank's advisory mandate.", 'after all, the monetary union must not be allowed to fail, let alone to become a source of political conflict in europe.', 'not a "state within the state" all in all, the bundesbank has constantly endeavoured to perform its role of being a guardian and advisor in keeping with its stability target, as laid down by parliament -- and it will continue to do so.', 'in the basic orientation of its policy it knows at the same time that it enjoys a consensus with the vast majority of the population.', 'the performance of these duties by the bundesbank, like its monetary policy, which is geared primarily to domestic price stability, has nothing to do with any stance as a "state within the state".', 'nor does it have anything to do with a desire for german hegemony in europe.', 'quite the contrary, a lastingly sustainable foundation and an anti-inflationary orientation of the monetary union are without any doubt in the best interests of europe, too.', 'it may well be that such a stability-oriented guardian and advisor function does not always fit in with the political and tactical aspirations of the political decision-makers.', 'that may even be true at times of our trading partners.', 'but chancellor kohl rightly said publicly not long ago: "as the federal chancellor, i sometimes have problems with individual measures or statements by the bundesbank.', 'but as a citizen of this country, i am happy that the bundesbank exists and that it acts in this way.', 'of course, neither the bundesbank nor its president can claim always to take the right action in all circumstances".', 'on taking office in 1993 i said: "even the bundesbank is not faultless".', 'needless to say, that is just as true today, and will remain so in future.', 'but the fact that the bundesbank is attested a substantial measure of "credibility in anti-inflation policy" in germany, in europe and in international circles alike has certainly done germany and europe as a whole more good than harm.', 'that verdict has been confirmed time and again by impartial observers.', 'hence the bundesbank will also continue to feel itself committed to stability in the period ahead.']	Hans Tietmeyer	Deutsche Bundesbank	President	Germany
https://www.bis.org/review/r970512a.pdf	Mr. Meyer discusses the economic outlook and the challenges facing monetary policy in the United States (Central Bank Articles and Speeches, 24 Apr 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Forecasters Club of New York on 24/4/97.	1997-04-24 00:00:00	Mr. Meyer discusses the economic outlook and the challenges facing monetary policy in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Forecasters Club of New York on 24/4/97. It is a pleasure to be here and discuss the economic outlook and monetary policy with fellow forecasters. I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change. Before proceeding, let me emphasize that the views on the economic outlook and monetary policy strategy I present this afternoon are my own. I am not speaking for either the FOMC or the Board of Governors or for any other individual members. If you want to know the views of the FOMC, you will have to do your homework--for example, read the announcement issued at the end of the last FOMC meeting, the Humphrey Hawkins testimony of the Chairman, the speeches and other comments by the full complement of participants in the FOMC, and the minutes of the last meeting when they become available. First, I shall discuss some aspects of the analytical framework or model that underlies my forecast, which in turn underpins my reasoning for the recent policy action. Second, I'll discuss the outlook context of the policy decision. Third, I'll describe the evolution of policy from a period of steady policy and asymmetric directives to the recent preemptive action. Fourth, I'll offer several interpretations of the policy action in relation to what I believe are important aspects of the strategy of monetary policy. Finally, I'll discuss some of the factors that will influence my views of the appropriate course of policy in the months ahead. The Analytical Framework Let me remind you at the outset of the framework I have been using to explain the challenge facing monetary policy in the current environment of healthy growth and high levels of resource utilization. The risk of higher inflation in this environment has two dimensions. First, there is the risk that current utilization rates are already so high that inflation will gradually increase over time. Second, there is the risk that the growth in output will be above trend going forward, implying that utilization rates will rise from their already high level, compounding the risk of higher inflation. Some apparently believe there are no speed limits, and no utilization rate can be so elevated that it threatens higher inflation. The reality is that above-trend growth raises utilization rates and, after some point, excessively high utilization rates result in higher inflation. But it is also true that threshold utilization rates and trend growth can change, that the current threshold levels for both utilization and growth rates are uncertain, that inflation can be affected by factors other than excess demand, and that policy is not infallible. Such uncertainty is a fact of life for both forecasters and policymakers. Just as forecasters do not stop forecasting because the job is difficult, policymakers have to adjust to uncertainty and not be paralyzed by it. The recent Federal Reserve policy action was clearly a preemptive one. This means that it was undertaken not in response to where the economy and inflation were at the time of the policy change, but in response to where the economy and inflation were projected to be in the future, absent a policy change. Such policy action necessarily involves a forecast and such a forecast typically is grounded in some model that relates growth, unemployment, wage change and inflation, among other variables. So let me be specific about the causal structure of the model that underpins my judgment with respect to appropriate monetary policy action. I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process. There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets. It is important to understand that the Phillips Curve is a model of inflation dynamics, not a model that determines the equilibrium inflation rate. For this reason, the Phillips Curve paradigm is not at all inconsistent with the view that inflation is, in the long run, exclusively a monetary phenomenon. Perhaps the easiest way to appreciate this is to recall that the long-run Phillips Curve is widely understood to be vertical. In other words, NAIRU is consistent with any constant rate of inflation, including zero. The Phillips Curve therefore cannot determine inflation in the long run because it is consistent with any constant rate of inflation. What does determine the rate of inflation in the long run? The rate of money growth, of course, though one needs to assume a stable money demand function to get a stable relationship between money growth and inflation. What does the Phillips Curve explain, if not the long-run level of inflation? The answer is that it explains the dynamics of the inflation process, how the economy evolves from one inflation rate to another, for example, in response to an increase in the rate of money growth. The dynamics of changes in inflation operate through excess demand in labor and/or product markets. Thus the Phillips Curve indicates that, if the unemployment rate is maintained at a level below NAIRU, inflation increases over time, progressively and indefinitely. The initial source of an increase in inflation can be anything which produces excess demand in labor and output markets. It could also be a supply shock, but I am ignoring this possibility so I can focus exclusively on the implications of the current strength in aggregate demand. Under an interest rate operating procedure, an increase in aggregate demand which increases output, utilization rates, and, ultimately, inflation will itself generate an increase in the money supply to support the higher nominal income. Money is not pinned down in such a regime, but passively adjusts to changes in nominal income. Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists' tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate. But, it should also be noted that monetary policy has responded appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by Robert Gordon and others. In the short run, there are many factors, in addition to aggregate demand, that influence inflation - including changes in the minimum wage, shocks to food and oil prices unrelated to the balance between aggregate demand and supply in the U.S., changes in the exchange rate, and exogenous effects on health care costs, etc. Some of these can be and have been effectively incorporated into the Phillips Curve model, but some of these factors have generally been outside the model. One explanation for the better than expected performance of core inflation in relation to the unemployment rate focuses, for example, on a series of favorable supply shocks - including the slowdown in benefit costs and the decline in import prices - that traditionally are not incorporated in estimated Phillips Curves. In addition, even adjusting for the above factors, NAIRU is not a constant, but can and has changed over time. For example, the evidence suggests that changes in the demographic composition of the labor force affect NAIRU and it is also likely that government programs, including unemployment compensation and welfare, also affect NAIRU. Further, the evidence suggests that, even accounting for demographics, government programs, and supply shocks, NAIRU may have edged lower over the last couple of years. The consensus in the profession is that NAIRU may have declined from around 6 percent in the decade ending in the early 1990s to perhaps 51⁄2 percent today, though some believe that the decline is even larger, while others believe that any appearance of decline is due to temporary factors so that NAIRU will ultimately settle back to close to the earlier estimate. Clearly, one of the challenges of monetary policy is to set policy in the context of uncertainty about the precise value of NAIRU. The second element in the analytical framework is the link from output growth to the level of excess demand. The economy has a capacity to grow over time that is limited by the sum of the trend rate of growth in the labor force and the trend rate of growth in labor productivity. While both components can change over time and labor force and productivity growth are subject to both cyclical variation as well as secular shift, the historical record suggests that the trend rate of output growth changes very slowly over time. Currently, the trend rate of labor force growth is near 1 percent per year (based on population growth and leaving, for later, the interpretation of the recent rise in the participation rate) and the trend rate of productivity growth is slightly above 1 percent per year (though there is more than the usual uncertainty about this estimate, in part due to conflicting indications in measures of productivity derived from the product and income sides of the national accounts), resulting in trend output growth in the 2-21⁄2 percent range. A key relationship is that when actual growth in output equals trend growth, utilization rates are constant; and when actual growth exceeds trend growth, utilization rates increase. Now we can put the causal structure of the inflation process together, connecting up growth, unemployment rates, and inflation. Growth above trend raises utilization rates. Rising labor force utilization rates raise wage change relative to productivity growth. An increase in wage change relative to productivity growth raises labor costs and an increase in labor costs results in higher price inflation. Quiz time! Does growth cause inflation? Not exactly. Certainly, higher trend growth does not raise inflation. Indeed, an unexpected increase in trend productivity and hence trend growth in output would likely result in lower inflation for a while; if the rate of money growth were held constant, a permanent increase in productivity growth would result in a permanent decline in inflation. Although above-trend growth in output does not directly cause inflation, to the extent it results in increases in utilization rates, after some point, sustained above-trend growth will result in higher inflation. There are, to be sure, a number of uncertainties in this causal structure that are highly relevant to the current circumstances. First, we have to worry about whether there may have been a change in trend growth, for example, due to a rise in trend productivity growth or a change in the trend in labor force participation. If trend growth has increased, whether because of higher labor force growth or higher productivity growth, then we would observe that rapid growth does not raise utilization rates. Second, we have to worry about whether NAIRU may be declining or, at least, may be lower than currently estimated. If NAIRU is lower than we expect, then the current unemployment rate is less likely to be associated with excess demand in the labor market and therefore poses less risk of higher inflation. Checks and balances are essential here. For example, it is important to confirm that utilization rates are rising before continuing very long to tighten policy to damp presumed above-trend growth. This will prevent a persistent mistake in the face of an unexpected shift in the economy's trend rate of growth. Monetary policy usually avoids this mistake by focusing on utilization rates and not growth. The second check is to confirm that, following a decline in the unemployment rate, wage change is moving higher, consistent with increased excess demand in the labor market. In addition, we have to take into account temporary forces related to, for example, minimum wage, health care costs, and exchange rates. Finally, we have to make allowances for the dynamics of the process, including the tendency for inertia to result in only a very small initial increase in inflation once excess demand has developed and the tendency of the initial rise in wages in excess of productivity to be tempered by a decline in profit margins before leading to higher prices. The Outlook Context Now let me summarize the key features of recent macroeconomic performance. The economy advanced at a 3.1 percent rate over 1996, including a 3.8 percent rate in the fourth quarter. Growth in the first quarter appears to have been at least as strong as the pace in the fourth quarter, and the economy seems to have solid momentum in the current quarter. In short, the economy appears to be growing at an unsustainable above-trend rate. By the way, is the prevailing trend rate of growth both historically low and disappointing? Yes. Would it be desirable, therefore, to raise the trend rate of growth? Yes. Can monetary policy accomplish this worthy task? No. Can the Congress and the Administration, through judicious combination of deficit reduction and saving and investment incentives, raise trend growth (at least for a while)? Yes. Are there opportunities for monetary policy to contribute to steady growth? Yes. First, to the extent that policy can avoid a cyclical rise in inflation, it can avoid the subsequent monetary policy response to limit and then reverse the rise in inflation; the result of avoiding the boom is avoiding the bust. Disciplined monetary policy therefore encourages steady growth, with the emphasis on the steady. Second, to the extent that price stability encourages saving and investment and a more efficient allocation of resources, as is widely believed, a monetary policy that promotes price stability is the one that best encourages steady growth, now with the emphasis on growth. Now back to the economic outlook. The unemployment rate which has fluctuated in a rather narrow band over the last year and a half has recently been inching lower and is now equal to its cyclical and 7-year low. I suspect that the unemployment rate is now below NAIRU, though the steady rise in wage change over the last year suggests that the unemployment rate may have been somewhat below NAIRU for a while. Another aside. Don't I like wage growth? Yes, but only to the extent it is real; that is, only to the extent that it does not yield increases in inflation that in turn prevent the purchasing power of wages from advancing. Shouldn't workers share in the bounty of a healthy economy? Of course. But workers will best share in the bounty when there is sustainable growth and will pay a high price for unsustainable growth in the cyclical instability that would surely follow such excess. Let me add one more complication. It is possible for wages to increase faster than productivity for a while to allow a rebound in real wages, for example, if real wages had earlier in the expansion advanced at a rate less than allowed by trend productivity. In this case, a rebound in real wages could be unwinding a temporary increase in profit margins and could therefore be accommodated without an increase in inflation. Wage change, as I just noted, has been rising. The 12-month increase in average hourly earnings is now 4.1 percent, a percentage point higher than a year ago. Compensation per hour, as measured by the ECI, has to date accelerated more modestly, with the slowing rise in benefit costs tempering the effect of a sharper rise in wage costs. The first quarter ECI bears watching for signs of a further rise in wage change and possibly a bottoming out of the recent slowing in the pace of increase in benefit costs. Core inflation remains at a cyclical and 30-year low, with the 12-month increase in the core CPI at 2.5 percent. Note, however, to correctly measure the change in inflation, a comparison of core inflation over the last couple of years has to be adjusted to account for the methodological revisions to the CPI. To date, BLS revisions have lowered inflation cumulatively by around a quarter point over the past two years. The point of the policy action, of course, is to try to prevent any significant increase in core inflation. Clearly the recent performance has been extraordinary. I have noted previously that it is not only better than virtually anyone had forecast, it is better than historical regularities would have suggested was possible. The explanations for the continuing decline in core inflation, despite an unemployment rate that in earlier periods would have been associated with rising inflation, include some combination of temporary coincidences and longer-lasting structural changes. First, the labor force has been growing about twice as rapidly as a trend rate based on population growth. It is as if demand is calling forth its own supply. Part of the explanation is a rebound from a sharp decline in participation rates over 1995. Part reflects a normal cyclical rise in participation rates, delayed in this expansion. A small part could be the early effects of changes in welfare laws and previous state efforts to trim welfare roles. As a result, the recent strength of output growth has not resulted in much of an increase in resource utilization rates. I do not expect labor force growth to continue at its recent rapid rate, though the underlying trend over the next several years may well be augmented by an upward trend in participation rates. The net result is that output growth must slow from recent levels to prevent further increases in utilization rates. Second, increased job insecurity appears to have moderated the pace of wage change, relative to what we would have expected at current levels of labor force utilization. It is important to note here that the effects on inflation of an increase in worker insecurity may be only temporary. Even with the higher worker insecurity, wages are clearly on a rising trend. Third, a slowing in the rise in benefit costs (primarily via slower increase in health care costs) has moderated the rise in labor compensation associated with wage pressures. As a result, the rise in compensation and hence labor costs has been muted, compared to the faster pace of wage gains. Fourth, declining import prices - directly and indirectly--have restrained price inflation. Some judgment has to be made in any forecast about the persistence of the special forces that have contributed to restrained wage and price change over recent quarters. The least likely to continue to act as a restraining influence, in my judgment, is health care and therefore benefit costs, based on surveys of prospective health care insurance premiums. Given the recent further appreciation of the dollar, import prices may decline further, though the restraining effect on inflation may be less important going forward than it has been over the past year. From an Asymmetric Directive to Preemptive Policy: Why Now? During the period from July of 1996 through February of 1997, monetary policy remained unchanged but operated with an asymmetric directive. Utilization rates were high -high enough to suggest some risk of rising inflation, but wage gains -- while trending higher, remained modest and core inflation remained on a downward trend, perhaps due to declining import prices and the slowing of the rise in health care costs. The anxiety associated with high utilization rates was clearly tempered by the excellent performance of core inflation, resulting in a posture of "watchful waiting." The Federal Reserve remained alert during this period, but on the sidelines. While growth was at times well above my estimate of trend, various factors made it reasonable to expect a slowdown in growth toward trend immediately ahead, suggesting that utilization rates would likely remain within their recent ranges. The asymmetric directive reflected a view that the risks in this environment were asymmetric, that there was a greater risk that inflation would rise in response to the prevailing high utilization rate (and to still higher utilization rates if growth continued above-trend growth) than that the economy would slow to below trend growth. The asymmetric policy posture was, therefore, a reflection of concern that our forecast might be wrong and that if it were wrong it was more likely to underestimate inflation going forward. What was different in March, compared to this earlier period? Not utilization rates. They were still within the narrow range that had prevailed during this period, though admittedly close to the bottom of that range. Not core inflation. If anything, core inflation was lower. No, the difference, from my perspective, was not in the data for utilization rates, wage change, and inflation, but in my forecast of the future path of these variables. The change in the forecast, to be sure, was prompted by incoming data suggesting persistent strength in aggregate demand. Instead of projecting a slowing to trend immediately ahead, it now appeared to me that we were in a period of sustained above-trend growth that would push utilization rates higher and, in particular, would push the unemployment rate below its recent range. A tightening of monetary policy was motivated, from my perspective, not by the prevailing data on unemployment rates, wage change, and inflation, but rather by a forecast of where I expected utilization rates and inflation to be six months and a year from now, if monetary policy remained unchanged. Whereas I supported the earlier asymmetric directive based on concern that my forecast might be wrong, the preemptive policy action was motivated for me by concern that my (new) forecast might be correct! The case for a preemptive approach is that it alone holds the promise of sustaining a durable expansion with continued healthy, balanced growth. The greatest threat to expansions does not come from a spontaneous weakening of demand, from lethargy, but rather from over-exuberance and overheating. Once overheating unleashes an increase in inflation, the attempt to first control and then reverse the higher inflation often results in recession. This gives substance to the well-known worth of "an ounce of prevention." Interpreting the Policy Action as Part of a Strategy for Monetary Policy Let me now interpret the tightening in relation to several descriptions of monetary policy strategy. The first three really are alternative perspectives on a single essential principle of prudent monetary policy, the importance of leaning against the wind by enforcing pro-cyclical movements in short-term interest rates. The fourth reflects one way in which monetary policy might take into account the uncertainty in the outlook. A Taylor Rule perspective I have noted in a number of previous speeches that I view the Taylor Rule as highlighting a couple of important requirements for prudent monetary policy. First, the Taylor Rule links Federal Reserve policy to a long-run inflation target and thus ensures that, in the long run, policy will force the actual inflation rate to converge to the long-run target. The Taylor Rule thus imposes a powerful nominal anchor on monetary policy. Second, the Taylor Rule generally imposes a pro-cyclical pattern on real short-term interest rates, so that monetary policy leans against the cyclical winds and thereby stabilizes the economy, in much the same way that automatic stabilizers in our fiscal institutions, via cyclical swings in government budget deficits, damp business cycles. Nevertheless, the traditional specification of the Taylor Rule does not provide a justification for tightening in March, relative to the earlier decisions to hold policy unchanged. According to the Taylor Rule, the federal funds rate should adjust over time to changes in utilization rates (the gap between actual and potential output or between the unemployment rate and NAIRU) and to changes in inflation. Because utilization rates had not increased (at least had not increased outside the range of the last year) and core inflation was actually lower in March compared with earlier, the Taylor Rule did not dictate a tightening. The Rule did suggest, however, that monetary policy would have had to tighten over time if the forecast of rising utilization rates and higher inflation proved correct. But it did not dictate immediate action. There is however an alternative specification of the Taylor Rule that does motivate an immediate tightening. I call this a forward looking version of the Taylor Rule. The traditional specification is forward looking to a degree in relation to inflation, in that it sets the funds rate in relation to both the utilization rate (an advance warning of future increases in inflation) and to inflation. But the forward-looking specification I have in mind replaces actual inflation and utilization rates in the rule with forecasts of future inflation and utilization rates. This approach to policy reaction functions was pioneered by Steve McNees of the Federal Reserve Bank of Boston in the mid 1980s and there has been a renewed interest in such an approach, in the context of the Taylor Rule, during the last couple of years. Such a forward-looking specification would rationalize and justify an increase in the funds rate in response to the forecast of rising utilization rates in the future. This leaves an interesting question. Does following a Taylor Rule based on an uncertain forecast outperform a Taylor Rule based on actual data? That, of course, depends on the quality of the forecasts. This is an interesting question, one that deserves scrutiny. But it is really the same as the question: Should policy be preemptive or reactive? As a forecaster, I am inclined to believe in the forward-looking approach and therefore in preemptive policy. But I recognize that further work should be done on this subject. An IS-LM perspective on leaning against the wind I would interpret the recent strength in demand, from the perspective of an IS-LM model, as a shift in the IS curve. Such an interpretation of cyclical swings is, of course, in the Keynesian tradition: output is demand determined in the short run (reflecting price stickiness) and swings in output are dominated by autonomous changes in aggregate demand. How should monetary policy respond to cyclical swings in demand? Should monetary policy hold short-term interest rates constant, in effect imposing a horizontal LM curve? In order to do so, it would, in general, have to respond to rightward shifts in the IS curve by adding reserves and facilitating faster money growth, so as to prevent interest rates from rising. This might be appropriate very early in an expansion, when the unemployment rate is high and inflation is declining, but it is not, in my judgment, prudent in the mature stage of an expansion, and it is most surely imprudent once utilization rates have increased toward or beyond their capacity levels. The alternative is to maintain an upward sloping LM curve. In the static model, this is the case when the money supply is fixed; allowing for trend growth and inflation, it would be equivalent to holding money growth constant, assuming a stable money demand function. In this case, a shift in the IS curve would raise interest rates as the IS curve moved along the upward sloping LM curve. This is an example of monetary policy "leaning against the wind." The resulting pro-cyclical movement in interest rates increases the stability of the economy in much the same way as cyclical swings in the federal budget deficit. Some might argue, however, that even if short-term interest rates do not rise, long-term interest rates, equity prices, and the dollar may change in ways that damp the cyclical swing in demand and thereby lessen the necessity of a direct response of monetary policy. This is sometimes referred to as the "gyroscope" theory (the bond market is the economy's gyroscope) and the active part of management of the cycle is in the hands of so-called "bond market vigilantes," some of whom are undoubtedly in the audience this afternoon. When long-term rates rise in response to a cyclical strengthening, it reflects, in large part, the expectation of higher short-term interest rates. Specifically, it reflects expectations about monetary policy. While monetary policy cannot be a slave to the bond market, when the cyclical state of the economy suggests the desirability of a pro-cyclical response in interest rates, the Federal Reserve should pat the bond market on the back and appreciate its help, but not expect the bond market to carry the entire burden. Monetary policy in this case needs to validate the movement in the bond market, rather than resist it. If it does not, surely real long-term interest rates and the dollar will decrease, eroding the market restraint, and in the future markets will be less likely to perform this stabilizing function. Of course, there will be times when the bond market is, in our view, misreading the strength of the economy and hence also misjudging the future course of our policy. In this case, we should ignore the bond market and provide an anchor for long-term interest rates to adjust back toward. Implications of a money growth rule As I have just noted, a pro-cyclical path for short-term interest rates would result from following a money growth rule. For an extended period, money demand has been insufficiently stable to allow the monetary aggregates to play a constructive role in the monetary policy process. More recently, the relationship between M2 and its determinants has stabilized, but the period of a more stable relationship has been relatively brief and has coincided with a relatively stable economy. As a result, there is not yet much inclination to place increased weight on M2 in the policy process. What I am offering here is therefore only a thought experiment. Assume that the money demand function for M2 has stabilized and that we could conduct policy by enforcing a constant rate of M2 growth. Assuming policy maintained a fixed rate of money growth (perhaps the better way to define an unchanged policy), what would be the effect of a cyclical strengthening of the economy (an increase in nominal income growth)? The answer, of course, is that short-term interest rates would rise. This is of course just another way of telling the IS-LM story. What would it take to prevent i	['mr. meyer discusses the economic outlook and the challenges facing monetary policy in the united states remarks by mr. laurence h. meyer, a member of the board of governors of the us federal reserve system, at the forecasters club of new york on 24/4/97.', 'it is a pleasure to be here and discuss the economic outlook and monetary policy with fellow forecasters.', 'i am going to offer some interpretations of the outlook as a context for the recent policy action by the federal reserve and explain how i view this action as part of a prudent and systematic strategy for monetary policy.', 'the forecasters club of new york is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change.', 'before proceeding, let me emphasize that the views on the economic outlook and monetary policy strategy i present this afternoon are my own.', 'i am not speaking for either the fomc or the board of governors or for any other individual members.', 'if you want to know the views of the fomc, you will have to do your homework--for example, read the announcement issued at the end of the last fomc meeting, the humphrey hawkins testimony of the chairman, the speeches and other comments by the full complement of participants in the fomc, and the minutes of the last meeting when they become available.', 'first, i shall discuss some aspects of the analytical framework or model that underlies my forecast, which in turn underpins my reasoning for the recent policy action.', "second, i'll discuss the outlook context of the policy decision.", "third, i'll describe the evolution of policy from a period of steady policy and asymmetric directives to the recent preemptive action.", "fourth, i'll offer several interpretations of the policy action in relation to what i believe are important aspects of the strategy of monetary policy.", "finally, i'll discuss some of the factors that will influence my views of the appropriate course of policy in the months ahead.", 'the analytical framework let me remind you at the outset of the framework i have been using to explain the challenge facing monetary policy in the current environment of healthy growth and high levels of resource utilization.', 'the risk of higher inflation in this environment has two dimensions.', 'first, there is the risk that current utilization rates are already so high that inflation will gradually increase over time.', 'second, there is the risk that the growth in output will be above trend going forward, implying that utilization rates will rise from their already high level, compounding the risk of higher inflation.', 'some apparently believe there are no speed limits, and no utilization rate can be so elevated that it threatens higher inflation.', 'the reality is that above-trend growth raises utilization rates and, after some point, excessively high utilization rates result in higher inflation.', 'but it is also true that threshold utilization rates and trend growth can change, that the current threshold levels for both utilization and growth rates are uncertain, that inflation can be affected by factors other than excess demand, and that policy is not infallible.', 'such uncertainty is a fact of life for both forecasters and policymakers.', 'just as forecasters do not stop forecasting because the job is difficult, policymakers have to adjust to uncertainty and not be paralyzed by it.', 'the recent federal reserve policy action was clearly a preemptive one.', 'this means that it was undertaken not in response to where the economy and inflation were at the time of the policy change, but in response to where the economy and inflation were projected to be in the future, absent a policy change.', 'such policy action necessarily involves a forecast and such a forecast typically is grounded in some model that relates growth, unemployment, wage change and inflation, among other variables.', 'so let me be specific about the causal structure of the model that underpins my judgment with respect to appropriate monetary policy action.', 'i am a strong and unapologetic proponent of the phillips curve and the nairu concept.', 'fundamentally, the nairu framework involves two principles.', 'first, the proximate source of an increase in inflation is excess demand in labor and/or product markets.', 'in the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and nairu, the non-accelerating inflation rate of unemployment.', 'second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process.', 'there is a third principle that i subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today.', 'utilization rates in the labor market play a special role in the inflation process.', 'that is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change.', 'this third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets.', 'it is important to understand that the phillips curve is a model of inflation dynamics, not a model that determines the equilibrium inflation rate.', 'for this reason, the phillips curve paradigm is not at all inconsistent with the view that inflation is, in the long run, exclusively a monetary phenomenon.', 'perhaps the easiest way to appreciate this is to recall that the long-run phillips curve is widely understood to be vertical.', 'in other words, nairu is consistent with any constant rate of inflation, including zero.', 'the phillips curve therefore cannot determine inflation in the long run because it is consistent with any constant rate of inflation.', 'what does determine the rate of inflation in the long run?', 'the rate of money growth, of course, though one needs to assume a stable money demand function to get a stable relationship between money growth and inflation.', 'what does the phillips curve explain, if not the long-run level of inflation?', 'the answer is that it explains the dynamics of the inflation process, how the economy evolves from one inflation rate to another, for example, in response to an increase in the rate of money growth.', 'the dynamics of changes in inflation operate through excess demand in labor and/or product markets.', 'thus the phillips curve indicates that, if the unemployment rate is maintained at a level below nairu, inflation increases over time, progressively and indefinitely.', 'the initial source of an increase in inflation can be anything which produces excess demand in labor and output markets.', 'it could also be a supply shock, but i am ignoring this possibility so i can focus exclusively on the implications of the current strength in aggregate demand.', 'under an interest rate operating procedure, an increase in aggregate demand which increases output, utilization rates, and, ultimately, inflation will itself generate an increase in the money supply to support the higher nominal income.', 'money is not pinned down in such a regime, but passively adjusts to changes in nominal income.', 'despite the sharpness and force of the phillips curve/nairu model, it can be difficult to implement in practice.', "still, this relationship was about the most stable tool in the macroeconomists' tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score.", 'nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework.', 'the challenge is to understand why we have been so fortunate.', 'but, it should also be noted that monetary policy has responded appropriately to this surprise.', 'that is, monetary policy has been careful not to be tied rigidly to a constant estimate of nairu.', 'instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of nairu to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by robert gordon and others.', 'in the short run, there are many factors, in addition to aggregate demand, that influence inflation - including changes in the minimum wage, shocks to food and oil prices unrelated to the balance between aggregate demand and supply in the u.s., changes in the exchange rate, and exogenous effects on health care costs, etc.', 'some of these can be and have been effectively incorporated into the phillips curve model, but some of these factors have generally been outside the model.', 'one explanation for the better than expected performance of core inflation in relation to the unemployment rate focuses, for example, on a series of favorable supply shocks - including the slowdown in benefit costs and the decline in import prices - that traditionally are not incorporated in estimated phillips curves.', 'in addition, even adjusting for the above factors, nairu is not a constant, but can and has changed over time.', 'for example, the evidence suggests that changes in the demographic composition of the labor force affect nairu and it is also likely that government programs, including unemployment compensation and welfare, also affect nairu.', 'further, the evidence suggests that, even accounting for demographics, government programs, and supply shocks, nairu may have edged lower over the last couple of years.', 'the consensus in the profession is that nairu may have declined from around 6 percent in the decade ending in the early 1990s to perhaps 51⁄2 percent today, though some believe that the decline is even larger, while others believe that any appearance of decline is due to temporary factors so that nairu will ultimately settle back to close to the earlier estimate.', 'clearly, one of the challenges of monetary policy is to set policy in the context of uncertainty about the precise value of nairu.', 'the second element in the analytical framework is the link from output growth to the level of excess demand.', 'the economy has a capacity to grow over time that is limited by the sum of the trend rate of growth in the labor force and the trend rate of growth in labor productivity.', 'while both components can change over time and labor force and productivity growth are subject to both cyclical variation as well as secular shift, the historical record suggests that the trend rate of output growth changes very slowly over time.', 'currently, the trend rate of labor force growth is near 1 percent per year (based on population growth and leaving, for later, the interpretation of the recent rise in the participation rate) and the trend rate of productivity growth is slightly above 1 percent per year (though there is more than the usual uncertainty about this estimate, in part due to conflicting indications in measures of productivity derived from the product and income sides of the national accounts), resulting in trend output growth in the 2-21⁄2 percent range.', 'a key relationship is that when actual growth in output equals trend growth, utilization rates are constant; and when actual growth exceeds trend growth, utilization rates increase.', 'now we can put the causal structure of the inflation process together, connecting up growth, unemployment rates, and inflation.', 'growth above trend raises utilization rates.', 'rising labor force utilization rates raise wage change relative to productivity growth.', 'an increase in wage change relative to productivity growth raises labor costs and an increase in labor costs results in higher price inflation.', 'does growth cause inflation?', 'certainly, higher trend growth does not raise inflation.', 'indeed, an unexpected increase in trend productivity and hence trend growth in output would likely result in lower inflation for a while; if the rate of money growth were held constant, a permanent increase in productivity growth would result in a permanent decline in inflation.', 'although above-trend growth in output does not directly cause inflation, to the extent it results in increases in utilization rates, after some point, sustained above-trend growth will result in higher inflation.', 'there are, to be sure, a number of uncertainties in this causal structure that are highly relevant to the current circumstances.', 'first, we have to worry about whether there may have been a change in trend growth, for example, due to a rise in trend productivity growth or a change in the trend in labor force participation.', 'if trend growth has increased, whether because of higher labor force growth or higher productivity growth, then we would observe that rapid growth does not raise utilization rates.', 'second, we have to worry about whether nairu may be declining or, at least, may be lower than currently estimated.', 'if nairu is lower than we expect, then the current unemployment rate is less likely to be associated with excess demand in the labor market and therefore poses less risk of higher inflation.', 'checks and balances are essential here.', 'for example, it is important to confirm that utilization rates are rising before continuing very long to tighten policy to damp presumed above-trend growth.', "this will prevent a persistent mistake in the face of an unexpected shift in the economy's trend rate of growth.", 'monetary policy usually avoids this mistake by focusing on utilization rates and not growth.', 'the second check is to confirm that, following a decline in the unemployment rate, wage change is moving higher, consistent with increased excess demand in the labor market.', 'in addition, we have to take into account temporary forces related to, for example, minimum wage, health care costs, and exchange rates.', 'finally, we have to make allowances for the dynamics of the process, including the tendency for inertia to result in only a very small initial increase in inflation once excess demand has developed and the tendency of the initial rise in wages in excess of productivity to be tempered by a decline in profit margins before leading to higher prices.', 'the outlook context now let me summarize the key features of recent macroeconomic performance.', 'the economy advanced at a 3.1 percent rate over 1996, including a 3.8 percent rate in the fourth quarter.', 'growth in the first quarter appears to have been at least as strong as the pace in the fourth quarter, and the economy seems to have solid momentum in the current quarter.', 'in short, the economy appears to be growing at an unsustainable above-trend rate.', 'by the way, is the prevailing trend rate of growth both historically low and disappointing?', 'would it be desirable, therefore, to raise the trend rate of growth?', 'can monetary policy accomplish this worthy task?', 'can the congress and the administration, through judicious combination of deficit reduction and saving and investment incentives, raise trend growth (at least for a while)?', 'are there opportunities for monetary policy to contribute to steady growth?', 'first, to the extent that policy can avoid a cyclical rise in inflation, it can avoid the subsequent monetary policy response to limit and then reverse the rise in inflation; the result of avoiding the boom is avoiding the bust.', 'disciplined monetary policy therefore encourages steady growth, with the emphasis on the steady.', 'second, to the extent that price stability encourages saving and investment and a more efficient allocation of resources, as is widely believed, a monetary policy that promotes price stability is the one that best encourages steady growth, now with the emphasis on growth.', 'now back to the economic outlook.', 'the unemployment rate which has fluctuated in a rather narrow band over the last year and a half has recently been inching lower and is now equal to its cyclical and 7-year low.', 'i suspect that the unemployment rate is now below nairu, though the steady rise in wage change over the last year suggests that the unemployment rate may have been somewhat below nairu for a while.', "don't i like wage growth?", 'yes, but only to the extent it is real; that is, only to the extent that it does not yield increases in inflation that in turn prevent the purchasing power of wages from advancing.', "shouldn't workers share in the bounty of a healthy economy?", 'but workers will best share in the bounty when there is sustainable growth and will pay a high price for unsustainable growth in the cyclical instability that would surely follow such excess.', 'let me add one more complication.', 'it is possible for wages to increase faster than productivity for a while to allow a rebound in real wages, for example, if real wages had earlier in the expansion advanced at a rate less than allowed by trend productivity.', 'in this case, a rebound in real wages could be unwinding a temporary increase in profit margins and could therefore be accommodated without an increase in inflation.', 'wage change, as i just noted, has been rising.', 'the 12-month increase in average hourly earnings is now 4.1 percent, a percentage point higher than a year ago.', 'compensation per hour, as measured by the eci, has to date accelerated more modestly, with the slowing rise in benefit costs tempering the effect of a sharper rise in wage costs.', 'the first quarter eci bears watching for signs of a further rise in wage change and possibly a bottoming out of the recent slowing in the pace of increase in benefit costs.', 'core inflation remains at a cyclical and 30-year low, with the 12-month increase in the core cpi at 2.5 percent.', 'note, however, to correctly measure the change in inflation, a comparison of core inflation over the last couple of years has to be adjusted to account for the methodological revisions to the cpi.', 'to date, bls revisions have lowered inflation cumulatively by around a quarter point over the past two years.', 'the point of the policy action, of course, is to try to prevent any significant increase in core inflation.', 'clearly the recent performance has been extraordinary.', 'i have noted previously that it is not only better than virtually anyone had forecast, it is better than historical regularities would have suggested was possible.', 'the explanations for the continuing decline in core inflation, despite an unemployment rate that in earlier periods would have been associated with rising inflation, include some combination of temporary coincidences and longer-lasting structural changes.', 'first, the labor force has been growing about twice as rapidly as a trend rate based on population growth.', 'it is as if demand is calling forth its own supply.', 'part of the explanation is a rebound from a sharp decline in participation rates over 1995. part reflects a normal cyclical rise in participation rates, delayed in this expansion.', 'a small part could be the early effects of changes in welfare laws and previous state efforts to trim welfare roles.', 'as a result, the recent strength of output growth has not resulted in much of an increase in resource utilization rates.', 'i do not expect labor force growth to continue at its recent rapid rate, though the underlying trend over the next several years may well be augmented by an upward trend in participation rates.', 'the net result is that output growth must slow from recent levels to prevent further increases in utilization rates.', 'second, increased job insecurity appears to have moderated the pace of wage change, relative to what we would have expected at current levels of labor force utilization.', 'it is important to note here that the effects on inflation of an increase in worker insecurity may be only temporary.', 'even with the higher worker insecurity, wages are clearly on a rising trend.', 'third, a slowing in the rise in benefit costs (primarily via slower increase in health care costs) has moderated the rise in labor compensation associated with wage pressures.', 'as a result, the rise in compensation and hence labor costs has been muted, compared to the faster pace of wage gains.', 'fourth, declining import prices - directly and indirectly--have restrained price inflation.', 'some judgment has to be made in any forecast about the persistence of the special forces that have contributed to restrained wage and price change over recent quarters.', 'the least likely to continue to act as a restraining influence, in my judgment, is health care and therefore benefit costs, based on surveys of prospective health care insurance premiums.', 'given the recent further appreciation of the dollar, import prices may decline further, though the restraining effect on inflation may be less important going forward than it has been over the past year.', 'from an asymmetric directive to preemptive policy: why now?', 'during the period from july of 1996 through february of 1997, monetary policy remained unchanged but operated with an asymmetric directive.', 'utilization rates were high -high enough to suggest some risk of rising inflation, but wage gains -- while trending higher, remained modest and core inflation remained on a downward trend, perhaps due to declining import prices and the slowing of the rise in health care costs.', 'the anxiety associated with high utilization rates was clearly tempered by the excellent performance of core inflation, resulting in a posture of "watchful waiting."', 'the federal reserve remained alert during this period, but on the sidelines.', 'while growth was at times well above my estimate of trend, various factors made it reasonable to expect a slowdown in growth toward trend immediately ahead, suggesting that utilization rates would likely remain within their recent ranges.', 'the asymmetric directive reflected a view that the risks in this environment were asymmetric, that there was a greater risk that inflation would rise in response to the prevailing high utilization rate (and to still higher utilization rates if growth continued above-trend growth) than that the economy would slow to below trend growth.', 'the asymmetric policy posture was, therefore, a reflection of concern that our forecast might be wrong and that if it were wrong it was more likely to underestimate inflation going forward.', 'what was different in march, compared to this earlier period?', 'they were still within the narrow range that had prevailed during this period, though admittedly close to the bottom of that range.', 'if anything, core inflation was lower.', 'no, the difference, from my perspective, was not in the data for utilization rates, wage change, and inflation, but in my forecast of the future path of these variables.', 'the change in the forecast, to be sure, was prompted by incoming data suggesting persistent strength in aggregate demand.', 'instead of projecting a slowing to trend immediately ahead, it now appeared to me that we were in a period of sustained above-trend growth that would push utilization rates higher and, in particular, would push the unemployment rate below its recent range.', 'a tightening of monetary policy was motivated, from my perspective, not by the prevailing data on unemployment rates, wage change, and inflation, but rather by a forecast of where i expected utilization rates and inflation to be six months and a year from now, if monetary policy remained unchanged.', 'whereas i supported the earlier asymmetric directive based on concern that my forecast might be wrong, the preemptive policy action was motivated for me by concern that my (new) forecast might be correct!', 'the case for a preemptive approach is that it alone holds the promise of sustaining a durable expansion with continued healthy, balanced growth.', 'the greatest threat to expansions does not come from a spontaneous weakening of demand, from lethargy, but rather from over-exuberance and overheating.', 'once overheating unleashes an increase in inflation, the attempt to first control and then reverse the higher inflation often results in recession.', 'this gives substance to the well-known worth of "an ounce of prevention."', 'interpreting the policy action as part of a strategy for monetary policy let me now interpret the tightening in relation to several descriptions of monetary policy strategy.', 'the first three really are alternative perspectives on a single essential principle of prudent monetary policy, the importance of leaning against the wind by enforcing pro-cyclical movements in short-term interest rates.', 'the fourth reflects one way in which monetary policy might take into account the uncertainty in the outlook.', 'a taylor rule perspective i have noted in a number of previous speeches that i view the taylor rule as highlighting a couple of important requirements for prudent monetary policy.', 'first, the taylor rule links federal reserve policy to a long-run inflation target and thus ensures that, in the long run, policy will force the actual inflation rate to converge to the long-run target.', 'the taylor rule thus imposes a powerful nominal anchor on monetary policy.', 'second, the taylor rule generally imposes a pro-cyclical pattern on real short-term interest rates, so that monetary policy leans against the cyclical winds and thereby stabilizes the economy, in much the same way that automatic stabilizers in our fiscal institutions, via cyclical swings in government budget deficits, damp business cycles.', 'nevertheless, the traditional specification of the taylor rule does not provide a justification for tightening in march, relative to the earlier decisions to hold policy unchanged.', 'according to the taylor rule, the federal funds rate should adjust over time to changes in utilization rates (the gap between actual and potential output or between the unemployment rate and nairu) and to changes in inflation.', 'because utilization rates had not increased (at least had not increased outside the range of the last year) and core inflation was actually lower in march compared with earlier, the taylor rule did not dictate a tightening.', 'the rule did suggest, however, that monetary policy would have had to tighten over time if the forecast of rising utilization rates and higher inflation proved correct.', 'but it did not dictate immediate action.', 'there is however an alternative specification of the taylor rule that does motivate an immediate tightening.', 'i call this a forward looking version of the taylor rule.', 'the traditional specification is forward looking to a degree in relation to inflation, in that it sets the funds rate in relation to both the utilization rate (an advance warning of future increases in inflation) and to inflation.', 'but the forward-looking specification i have in mind replaces actual inflation and utilization rates in the rule with forecasts of future inflation and utilization rates.', 'this approach to policy reaction functions was pioneered by steve mcnees of the federal reserve bank of boston in the mid 1980s and there has been a renewed interest in such an approach, in the context of the taylor rule, during the last couple of years.', 'such a forward-looking specification would rationalize and justify an increase in the funds rate in response to the forecast of rising utilization rates in the future.', 'this leaves an interesting question.', 'does following a taylor rule based on an uncertain forecast outperform a taylor rule based on actual data?', 'that, of course, depends on the quality of the forecasts.', 'this is an interesting question, one that deserves scrutiny.', 'but it is really the same as the question: should policy be preemptive or reactive?', 'as a forecaster, i am inclined to believe in the forward-looking approach and therefore in preemptive policy.', 'but i recognize that further work should be done on this subject.', 'an is-lm perspective on leaning against the wind i would interpret the recent strength in demand, from the perspective of an is-lm model, as a shift in the is curve.', 'such an interpretation of cyclical swings is, of course, in the keynesian tradition: output is demand determined in the short run (reflecting price stickiness) and swings in output are dominated by autonomous changes in aggregate demand.', 'how should monetary policy respond to cyclical swings in demand?', 'should monetary policy hold short-term interest rates constant, in effect imposing a horizontal lm curve?', 'in order to do so, it would, in general, have to respond to rightward shifts in the is curve by adding reserves and facilitating faster money growth, so as to prevent interest rates from rising.', 'this might be appropriate very early in an expansion, when the unemployment rate is high and inflation is declining, but it is not, in my judgment, prudent in the mature stage of an expansion, and it is most surely imprudent once utilization rates have increased toward or beyond their capacity levels.', 'the alternative is to maintain an upward sloping lm curve.', 'in the static model, this is the case when the money supply is fixed; allowing for trend growth and inflation, it would be equivalent to holding money growth constant, assuming a stable money demand function.', 'in this case, a shift in the is curve would raise interest rates as the is curve moved along the upward sloping lm curve.', 'this is an example of monetary policy "leaning against the wind."', 'the resulting pro-cyclical movement in interest rates increases the stability of the economy in much the same way as cyclical swings in the federal budget deficit.', 'some might argue, however, that even if short-term interest rates do not rise, long-term interest rates, equity prices, and the dollar may change in ways that damp the cyclical swing in demand and thereby lessen the necessity of a direct response of monetary policy.', 'this is sometimes referred to as the "gyroscope" theory (the bond market is the economy\'s gyroscope) and the active part of management of the cycle is in the hands of so-called "bond market vigilantes," some of whom are undoubtedly in the audience this afternoon.', 'when long-term rates rise in response to a cyclical strengthening, it reflects, in large part, the expectation of higher short-term interest rates.', 'specifically, it reflects expectations about monetary policy.', 'while monetary policy cannot be a slave to the bond market, when the cyclical state of the economy suggests the desirability of a pro-cyclical response in interest rates, the federal reserve should pat the bond market on the back and appreciate its help, but not expect the bond market to carry the entire burden.', 'monetary policy in this case needs to validate the movement in the bond market, rather than resist it.', 'if it does not, surely real long-term interest rates and the dollar will decrease, eroding the market restraint, and in the future markets will be less likely to perform this stabilizing function.', 'of course, there will be times when the bond market is, in our view, misreading the strength of the economy and hence also misjudging the future course of our policy.', 'in this case, we should ignore the bond market and provide an anchor for long-term interest rates to adjust back toward.', 'implications of a money growth rule as i have just noted, a pro-cyclical path for short-term interest rates would result from following a money growth rule.', 'for an extended period, money demand has been insufficiently stable to allow the monetary aggregates to play a constructive role in the monetary policy process.', 'more recently, the relationship between m2 and its determinants has stabilized, but the period of a more stable relationship has been relatively brief and has coincided with a relatively stable economy.', 'as a result, there is not yet much inclination to place increased weight on m2 in the policy process.', 'what i am offering here is therefore only a thought experiment.', 'assume that the money demand function for m2 has stabilized and that we could conduct policy by enforcing a constant rate of m2 growth.', 'assuming policy maintained a fixed rate of money growth (perhaps the better way to define an unchanged policy), what would be the effect of a cyclical strengthening of the economy (an increase in nominal income growth)?', 'the answer, of course, is that short-term interest rates would rise.', 'this is of course just another way of telling the is-lm story.', 'what would it take to prevent i']	Laurence H Meyer	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r970605b.pdf	Mr. Heikensten looks at the intellectual framework for monetary policy in Sweden (Central Bank Articles and Speeches, 26 May 97)	Address by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at the Monetary Policy Forum held in Stockholm on 26/5/97.	1997-05-26 00:00:00	Mr. Heikensten looks at the intellectual framework for monetary policy in Sweden Address by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at the Monetary Policy Forum held in Stockholm on 26/5/97. Economic policy developments during the early 1990s were marked by the after-effects of the overheating in the 1980s. At the beginning of 1993--after the krona had fallen--the Riksbank made clear its intention to meet an inflation target. An important task since then has been the firm establishment of a policy of low inflation in Swedish society and the clarification of the principles that guide monetary policy. We think that we have now come a long way in the effort to secure low inflation. At the same time, support for the policy of low inflation has increased. The Government and the Riksdag have positioned themselves behind the policy and recently proposals have been put forward to, among other things, make price stability an objective of the Riksbank prescribed by law. Against this background it may now be appropriate to try to clarify the intellectual framework within which the Riksbank is working. To contribute to such a more fundamental discussion on the principles of monetary policy formulation, I will today consider four related issues: view the connection between price stability First I intend to comment on how I and growth for different time perspectives. One issue that I will dwell on somewhat is how the balance between the two appears in the short term. Next, I shall discuss how uncertainty and the degree of credibility with which monetary policy is associated influence policy formulation. These two factors play an important role in practice. The third issue concerns the exchange rate. For small open economies this issue is one of the most important determinants of inflation at the same time as it is also an important measure of how stable economic policy is seen to be. How changes in the exchange rate ought to be handled when monetary policy decisions are taken has been an important monetary policy issue in Sweden in recent years. how the monetary policy goal has been defined Finally I shall discuss the issue of and should be interpreted. The Inflation/Growth Connection The Riksbank's chief task is the achievement and preservation of price stability, which should be interpreted as keeping the rate of inflation at a low and stable level. Behind this view of the role of monetary policy lies the understanding that growth and employment cannot in the long run be achieved via an inflationary policy. There are other factors that determine growth: technological development, the way in which the economy functions, human resources development, etc. Attempts to stimulate the economy in the short run by allowing higher inflation tend to rebound in the long run. Swedish experience in the last decade, and also experiences in other countries, demonstrate this. Participants in the economy see through the policy, revise wage demands upwards and raise prices. When inflation expectations are taken into account, the outcome of an inflationary policy is normally worse rather than better economic development . The best contribution that monetary policy can make to good growth in the long term is to see to it that an environment with stable prices is created and maintained. Within these bounds a central bank can support economic development in general. In the short term the possibility may exist to influence the economy's activity level with monetary policy instruments. For that to be possible, monetary policy objectives would need to be completely credible. A central bank should have as its primary objective price stability. Given the time lags that exist in monetary policy, it takes from one to two years before the effects of an interest rate change make themselves fully felt on inflation. Therefore policy must be be guided by the forecasted inflation, not by the inflation existing in the present situation. If an inflation forecast for the coming two years shows that there is a risk that the inflation target may be missed, the instrumental rate should be changed so that inflation is driven back in line with the target. If inflation is expected to be lower than the target, there is room in practice for monetary policy to take the activity level into consideration. The Riksbank can then lower the interest rate and in such a manner stimulate production and employment temporarily. In the same manner, interest rates will normally need to be raised in situations in which future inflation tends to get excessive as a consequence of a too high resource utilization. Consequently, when an inflation forecast shows that future inflation does not appear to be in line with the target, policy must be altered. In these situations there is a balancing problem. The question is how forceful the interest rate change should be. If it is dramatic, the adjustment in the rate of inflation to the established target may be faster, but the repercussions in the short term in the form of fluctuations in production and employment will probably be bigger also. Figure 1 Price Stabilization : Altern ative Path s π t 2% t t+4 t+8 The reasoning can be made clear with a simple diagram (Figure 1). By choosing interest rate path 2 rather than path 1, the adjustment to the inflation target will be somewhat slower; however, the development in the economy will also be less spasmodic. The fact that the Riksbank--when the price stability objective was introduced in 1993--chose to postpone its application for about 2 years (the decision that evaluation would only be made when the direct effects of the krona's weakening had died away in 1995) can be said to have been a way of taking into consideration the above reasoning. In recent years, however, this sort of consideration has not played such a prominent role. There are several interrelated explanations for this. Monetary policy thus far has been aimed to a great extent at establishing a regime of low inflation and engendering understanding for it. In practice, the scope is also limited for monetary policy decisions of a fine-tuning character by the uncertainty that prevails, inter alia, about future developments and by the degree of credibility for the low inflation policy. 2. Uncertainty and Credibility There are various kinds of uncertainty that in practice play an important part in monetary policy and are also important for the speed and scale with which changes in interest rates are made: - One type of uncertainty has to do with the economy's basic mechanisms.. Which model of the economy shall we use for our analysis? A major problem here in recent years has been that the shift to low inflation and a flexible exchange rate by itself can change the relationships in the model. - A second type of uncertainty concerns the interpretation of new information that is constantly coming in. It is important in this connection to assess what effects an interference or a shock have, which, inter alia, is linked with whether it is permanent or temporary. - Finally there is uncertainty about the effect of the measures that the Riksbank can take--in practice, changes in the instrumental interest rates. The question is how the so-called transmission mechanism looks and in what time frame interest rate changes affect inflation. If a central bank overestimates the deviation from the inflation target or underestimates the effect of a change in its interest rate policy, there is a risk that it will raise or lower interest rates too much. In such a situation, the policy in the end will become excessively restrictive or expansive and it may become necessary for the central bank to shift its policy in the opposite direction. Such a change may create instability and reinforce cyclical swings. Therefore it would appear that there is reason to proceed with some caution when the policy is changed. Central banks also tend to adjust interest rates in relatively small steps. Nevertheless, the conclusion that a central bank should proceed carefully is not self-evident. The question is how the markets players interpret a certain behaviour. Ever so small changes in the instrumental interest rates, which may be interpreted as the first step in policy change, can have a big impact. (cf. the Federal Reserve's increase in February 1994). There is probably no obvious and simple rule for action. Most likely, the central bank's task is to account for, as clearly as possible, both its long-term plans and the uncertainty that is inherent in its assessment. Figure 2 M o n e y M arke t Age n ts' In flatio n Exp e ctatio n s P e r ce n t 5 5 O ct. . '94 94 4 4 O ct. . '95 95 C P I 3 3 M ay y '96 96 N o v . . ' '96 96 2 2 F eb. . ' '97 1 1 0 0 -1 -1 94 94 95 95 96 96 97 97 98 98 99 99 00 00 01 01 S ources: S ta tistics S weden and P rospe ra R ese arch The way in which the instrumental interest rates are changed also has to do with credibility and tactics. If complete credibility in monetary policy and a low-inflation regime have not been achieved , it will naturally influence the pace with which interest rates are lowered or raised. In situations of this kind, the result may be that the central bank has its instrumental rates set at either a too high or a too low level compared with what would have been warranted in an environment of high credibility. Developments during 1996 can illustrate the effects on policy of both uncertainty and insufficient credibility. At the beginning of the year, the Riksbank estimated that activity in the economy was declining and that inflationary pressure was falling. Both the demand situation and the indicators that exist for inflation expectations pointed in the same direction. (Figure 2). However, the forecasts of inflation, which were made by private players, were still not wholly in line with the Riksbank's target. Nevertheless, the Riksbank's assessment was that in this situation there was room to begin lowering interest rates without threatening the inflation target. Initially, the Riksbank chose to lower the repo rate in equal intervals of 25 basis points (Figure 3). Prudence was warranted by our wish to receive further information which could confirm our picture of falling inflationary pressures. Moreover, we estimated that it was urgent that the decreases not be interpreted by the market as an indication that the Riksbank had begun to tinker with the inflation target, with possible negative effects primarily on long-term interest rates and the krona. The series of small decreases in the repo rate continued to the end of the year, when the rate had been lowered to 4.10 per cent, that is to say, a total decrease of 4.81 per centage points. In the spring, new information came that supported the brighter picture. Inflation and budget figures were improving gradually at the same time as the policy generally appeared to be stabilising. This supported monetary policy. These events give an example of how difficulties in interpreting the information received can be handled. The Riksbank's policy is based on forecasts, which are necesssarily uncertain, and it also has to be designed so that it is perceived as consistent in the long term and credible. Figure 3 Actu al an d Exp ected Rep o Rate Per cen t 10 10 10 10 R ep o o r ate 9 9 8 8 5 5 Mar .'96 96 7 7 5 5 J u u n n e'96 96 6 6 24 24 S ept.'.'96 96 5 5 10 10 Ma r.'.'97 97 4 4 13 13 Ma y '97 3 3 jan -96 m ar-96 ju u n n -96 s ep-96 96 dec ec-96 96 m ar-97 ju u n n -97 S ource: T he R iksbank The conclusion is that there may be reason and scope for the Riksbank, within the framework of a policy with price stability as its objective, to pay attention to real economic developments. In fact, this possibility is inherent in a monetary policy based on an inflation target. In practice, however, the possibilities of an active stabilisation policy are limited by the general uncertainty that prevails. The Exchange Rate In small, open economies, the exchange rate has an important influence on inflation. At the same time, it is a variable that has fluctuated considerably in recent years for reasons which have not always been easy to foresee and interpret. How changes in the exchange rate should be handled in practical policy depends above all on how lasting a change in the exchange rate is judged to be. More enduring changes that have an effect on inflation forecasts obviously have to be taken into account In order to decide on the duration and what is a reasonable reaction, one normally has to know what brought about the change. Several different cases can be discerned: A nominal change in the exchange rate can be a result of a change in the real equilibrium exchange rate. This case is in principle simple to manage since it normally does not lead to a changed picture of inflation and thereby does not occasion any specific policy measures. Changes in the real equilibrium exchange rate have not been an especially common reason for changes in the exchange rate in recent years, at any rate since the krona fell in connection with the changeover to a flexible exchange rate in 1992. A change in the nominal exchange rate may also have to do with a change in the long-term view of the steadfastness in economic policy, or what is termed credibility. In practice it is not always so easy to distinguish between what is important for credibility and various factors can interact in a complicated manner. Two cases can, however, be discerned: - In the first case, the problem of credibility is primarily based on a lack of confidence in the central bank as such and in monetary policy. In the long-term perspective, the task is then the establishment of a trackrecord. Laws that guarantee independence can be an important support in this process. In the short term, there is probably most often not much that can be done other than to show by action--increases in interest rates--that one is sticking to one's objectives. - More difficult to assess and manage are situations in which the currency's depreciation is a consequence of weakening credibility in the general direction of economic policy. Investors in the financial market may, for example, think that the risk has increased for a change of regimes in the future, when the target for price stability may be abandoned at least temporarily as a result, for example, of government financial problems. In Sweden this was probably the most common explanation for the recurrent periods of exchange rate turbulence during the 1990s. In situations of this type, monetary policy itself cannot do the job, and what is worse, in the short term the costs of monetary policy measures may be considerable. Yet there is hardly any other alternative for a central bank than to respond by raising interest rates and in such a way demonstrate its intention to counter inflationary tendencies. At the same time there is reason to try to influence developments in other ways by clarifying the nature of the problems, so that financial policy is turned in the right direction. Figure 4 Th e Swed ish Exch an ge Rate versus USD an d DEM 5,0 8,0 7,8 SEK /USD right t axis s 4,8 7,6 7,4 4,6 7,2 7,0 4,4 6,8 SEK /DE M 6,6 left t axis 4,2 6,4 6,2 4,0 6,0 jun un-96 jul-96 sep-96 nov-96 jan-97 mar-97 maj-97 Source: The Riksbank Another, often complementary, reason for fluctuations in the nominal exchange rate may be unrest or disturbances in the international currency and capital markets. If such disturbances can be deemed to be pure market phenomena and thus of short duration, they should make hardly any difference to the bank's behaviour. However, this is not the most common case. What we saw in the international financial markets-after the bond markets' crash in 1994 or the Mexico/Barings unrest in 1995-is an interaction between market tendencies in a more limited sense and weak public finances or other credibility problems. High international interest rates and currency unrest have aggravated the problem of public finances, so that on these occasions economies such as Sweden's have moved from a virtuous to a vicious circle. Examples of how one could analyse exchange rate developments in the above terms can also be found in events of the last half-year. An explanation of developments with respect to the krona has to do with the position of the Swedish and continental economies in the business cycle. In recent months the dollar and the pound especially have appreciated relative to continental currencies. Monetary policy in the USA and Great Britain has been relatively tight. (Figure 4). This is still not the entire explanation. The krona has also fallen somewhat against continental currencies, especially during the winter and spring. In part, this has coincided with concerns with respect to the EMU process, possibly strengthened in Sweden's case because Sweden's position on the EMU issue is unclear. In addition there has been some uncertainty about the steadfastness of long-term economic policy connected with, inter alia, continued high unemployment. The studies that have been done by the Riksbank indicate that there is room for an appreciation of the krona. Not only are government finances in considerably better condition than they were earlier (in fact, Sweden is one of the relatively few EU countries, which, according to the EU Commission can be expected to have a budget deficit in 1997 that complies with Maastricht targets with a margin), but also Sweden has a large current account surplus and the inflation forecasts are positive. Despite that, the krona has depreciated by 6 to 7 per cent in effective terms since October last year. How should monetary policy handle such a situation? We can use 'open-mouth operations' and inform the markets and other players of our assessment of what has been happening. Maybe this can influence developments in some measure. If the krona's downward trend cannot be stopped, it will eventually have an effect on demand -- something the Riksbank has to take into account when the instrumental rates are decided. Accordingly, a depreciating exchange rate is an important factor that can affect the estimate of future inflation and thus the direction of monetary policy. Target Variable To conclude, I intend to discuss a few issues that have to do with the design and interpretation of the price stability objective. The line of argument I am going to take can hardly be perceived as controversial. Even with the general support for a price stability objective that has been achieved, a number of questions of a more practical nature concerning how monetary policy should be implemented remain. Price stability, as everyone realizes, may be defined in many ways, with somewhat different consequences for the execution of monetary policy. When the index for measuring inflation is chosen, a number of different considerations have to be taken into account. The index has to be reasonably broad and give a picture of price developments in the economy as a whole. It is an advantage if it is also well established and regularly published with a short time lag. In addition, it is desirable that the index is seldom revised. All these factors bear out the suitability of the consumer price index (CPI) . Thus, the Riksbank's inflation target has been expressed in terms of a change in the official consumer price index. Figure 5 CPI an d Un derlyin g In flation Percen tage 12-m on th ch an ge 6.0 6.0 5.0 5.0 CPI 4.0 Underly ing g 4.0 dom estic c 3.0 3.0 in flation 2.0 2.0 1.0 1.0 0.0 0.0 92 92 93 93 94 94 95 95 96 96 97 97 -1.0 -1.0 Sources: Statistics Sweden and the Riksbank One problem with the CPI is that it is affected by temporary influences on inflation. Such influences can be changes in indirect taxes and subsidies or the price of oil. To the extent that such changes only have an initial direct effect on the price level but are not deemed to influence the future rate of inflation, they should not precipitate interest rate adjustments. A special case of the temporary effects is what happens when the Riksbank changes its policy and raises or lowers the instrumental rates. This affects the interest costs of housing, thereby influencing the CPI. Hence, interest rate changes can make it more difficult to reach the price stability objective in the short run. The CPI has varied significantly more than the various measures of underlying inflation that the Riksbank produces (Figure 5). One example is 1996, when interest rates were reduced rapidly. The CPI then fell much more than the underlying inflation, which was due to a reduction of the interest costs for housing. In this way, annual inflation ended up somewhat below the one per cent lower limit of the tolerance interval. At the same time, all indicators of underlying inflation show that it has edged downwards and has recently kept relatively stable in the interval of 1-1.5 per cent. The problem of temporary influences can be managed in different ways: 1. One possibility is to clearly specify in advance which deviations from the CPI are acceptable. This is the method used in New Zealand. It could lead to greater transparency. On the other hand, it would be less clear exactly how the valid objective is defined. In addition, it is difficult to foresee all the corrections warranted and to quantify their exact price effects. Finally, it is a problem that corrections of this kind are so highly dependent on the central bank's own asessments, which can influence credibility negatively. 2. A closely related alternative is to use a measure of underlying inflation as target. Compared to the first alternative, it has the advantage of giving a clear definition of the objective. It would, however, lead to difficulties similar to those of alternative 1 with respect to problems of defining and quantifying the effects of various disturbances. 3. Another possibility is to supplement the CPI by one or several measures of underlying inflation. In Canada the objective is expressed in terms of the CPI whereas a measure of the underlying inflation--which descibes the process of inflation better--is the operative target. In the long run, the final goal is reached since there is a clear link between it and the operative target. A "softer" variety on the same theme is to clarify how practical policy is influenced by underlying inflation, since it can often give a clearer picture of the process of inflation. It is important to note that the big changes which occurred in the repo rate and thus in the interest costs of housing in recent years were linked to the transition from the high inflation regime of the seventies and eighties to a regime of price stability. A continued confidence in the low inflation regime would imply that such large changes in the interest rate component are less likely in the future. It is evident from what the Riksbank has said earlier in various contexts that there are price effects, which will not be caught within the tolerance interval and which we do not need to counteract fully by monetary policy measures. Attempts to do so could destabilise the economy further, partly due to time lags in the effects of monetary policy. Consequently, if unexpected disturbances were to occur, or if taxes and subsidies were to be changed, for example in connection with a major change in the tax system, we would have to accept that this would have an immediate effect on the price level. Temporary deviations from the targeted inflation rate may therefore happen. What is important with respect to such deviations is to drive inflation back to the target within the horizon where monetary policy has its biggest effect on price developments. The possibility to achieve the inflation target is accordingly affected not only by how the target variables are defined, but also by what time perspective is used when the policy is evaluated and how wide the applied tolerance level is. The Riksbank has emphasized that one should see the price stability objective in an annual perspective-nothing more precise than that. As to the width of the band, we have started from an interval of +1 per cent, which is fairly normal among countries with an inflation target. Summary The policy with an inflation target has functioned well in Sweden and in other countries that have chosen to work with an inflation target. Inflation has become low. In addition an increased understanding of a policy directed at price stability has been created in Sweden as well as in other countries with an inflation target. This is especially notew orthy because many of the countries which now work with an inflation target are the very same countries that earlier had problems with inflation. When monetary policy is conducted with an inflation target, production and employment are normally stabilised too. For example, increased demand usually implies an increased rate of inflation. When inflation forecasts indicate that a risk for inflation will exceed the target, raising the instrumental rate is warranted, thereby also slowing down demand growth. In practice the room for an active stabilisation policy is circumscribed by the uncertainty about future inflation. Another important complication relates to how credible the policy is. Increased credibility of monetary policy creates more room for both rapidly shifting policy in a more expansionary direction in situations of weakening demand and deferring interest rate hikes. Measures to strengthen central bank independence should inter alia be seen in this light. How the exchange rate is to be managed within the framework of a policy with an inflation target is an important matter. The countries with inflation targets have different approaches. In all circumstances, it is important to assess how durable an exchange rate change is likely to be. This normally implies a picture of what caused the change. Durable changes influencing the inflation forecast have to be taken into account when the instrumental rates are set. Increased credibility of economic policy in general makes this problem easier to handle. The higher the credibility, the smaller the exchange-rate fluctuations are likely to be. The question of how the target is formulated and interpreted (for example, in relation to the measures describing the underlying inflation process) is worth discussing. Several factors have to be taken into account when the target variable is chosen. First, the capacity of monetary policy exactly to forecast and control inflation in the very short run is small. Second, the economy may be hit by disturbances that could create a conflict between a short-term inflation target and an ambition to stabilise the real development. Third, the outcome of the CPI is not a perfect indicator of the underlying inflation trend. This problem is handled in different ways in countries having a price stabilization objective. The Swedish monetary policy with a price stability objective has been successful and seems well balanced in view of present inflation forecasts. However, this should not prevent us from deepening the discussion about how monetary policy is conducted against the background of the experiences in Sweden and other countries.	['mr. heikensten looks at the intellectual framework for monetary policy in sweden address by the deputy governor of the bank of sweden, mr. lars heikensten, at the monetary policy forum held in stockholm on 26/5/97.', 'economic policy developments during the early 1990s were marked by the after-effects of the overheating in the 1980s.', 'at the beginning of 1993--after the krona had fallen--the riksbank made clear its intention to meet an inflation target.', 'an important task since then has been the firm establishment of a policy of low inflation in swedish society and the clarification of the principles that guide monetary policy.', 'we think that we have now come a long way in the effort to secure low inflation.', 'at the same time, support for the policy of low inflation has increased.', 'the government and the riksdag have positioned themselves behind the policy and recently proposals have been put forward to, among other things, make price stability an objective of the riksbank prescribed by law.', 'against this background it may now be appropriate to try to clarify the intellectual framework within which the riksbank is working.', 'to contribute to such a more fundamental discussion on the principles of monetary policy formulation, i will today consider four related issues: view the connection between price stability first i intend to comment on how i and growth for different time perspectives.', 'one issue that i will dwell on somewhat is how the balance between the two appears in the short term.', 'next, i shall discuss how uncertainty and the degree of credibility with which monetary policy is associated influence policy formulation.', 'these two factors play an important role in practice.', 'the third issue concerns the exchange rate.', 'for small open economies this issue is one of the most important determinants of inflation at the same time as it is also an important measure of how stable economic policy is seen to be.', 'how changes in the exchange rate ought to be handled when monetary policy decisions are taken has been an important monetary policy issue in sweden in recent years.', 'how the monetary policy goal has been defined finally i shall discuss the issue of and should be interpreted.', "the inflation/growth connection the riksbank's chief task is the achievement and preservation of price stability, which should be interpreted as keeping the rate of inflation at a low and stable level.", 'behind this view of the role of monetary policy lies the understanding that growth and employment cannot in the long run be achieved via an inflationary policy.', 'there are other factors that determine growth: technological development, the way in which the economy functions, human resources development, etc.', 'attempts to stimulate the economy in the short run by allowing higher inflation tend to rebound in the long run.', 'swedish experience in the last decade, and also experiences in other countries, demonstrate this.', 'participants in the economy see through the policy, revise wage demands upwards and raise prices.', 'when inflation expectations are taken into account, the outcome of an inflationary policy is normally worse rather than better economic development .', 'the best contribution that monetary policy can make to good growth in the long term is to see to it that an environment with stable prices is created and maintained.', 'within these bounds a central bank can support economic development in general.', "in the short term the possibility may exist to influence the economy's activity level with monetary policy instruments.", 'for that to be possible, monetary policy objectives would need to be completely credible.', 'a central bank should have as its primary objective price stability.', 'given the time lags that exist in monetary policy, it takes from one to two years before the effects of an interest rate change make themselves fully felt on inflation.', 'therefore policy must be be guided by the forecasted inflation, not by the inflation existing in the present situation.', 'if an inflation forecast for the coming two years shows that there is a risk that the inflation target may be missed, the instrumental rate should be changed so that inflation is driven back in line with the target.', 'if inflation is expected to be lower than the target, there is room in practice for monetary policy to take the activity level into consideration.', 'the riksbank can then lower the interest rate and in such a manner stimulate production and employment temporarily.', 'in the same manner, interest rates will normally need to be raised in situations in which future inflation tends to get excessive as a consequence of a too high resource utilization.', 'consequently, when an inflation forecast shows that future inflation does not appear to be in line with the target, policy must be altered.', 'in these situations there is a balancing problem.', 'the question is how forceful the interest rate change should be.', 'if it is dramatic, the adjustment in the rate of inflation to the established target may be faster, but the repercussions in the short term in the form of fluctuations in production and employment will probably be bigger also.', 'figure 1 price stabilization : altern ative path s π t 2% t t+4 t+8 the reasoning can be made clear with a simple diagram (figure 1).', 'by choosing interest rate path 2 rather than path 1, the adjustment to the inflation target will be somewhat slower; however, the development in the economy will also be less spasmodic.', "the fact that the riksbank--when the price stability objective was introduced in 1993--chose to postpone its application for about 2 years (the decision that evaluation would only be made when the direct effects of the krona's weakening had died away in 1995) can be said to have been a way of taking into consideration the above reasoning.", 'in recent years, however, this sort of consideration has not played such a prominent role.', 'there are several interrelated explanations for this.', 'monetary policy thus far has been aimed to a great extent at establishing a regime of low inflation and engendering understanding for it.', 'in practice, the scope is also limited for monetary policy decisions of a fine-tuning character by the uncertainty that prevails, inter alia, about future developments and by the degree of credibility for the low inflation policy.', "2. uncertainty and credibility there are various kinds of uncertainty that in practice play an important part in monetary policy and are also important for the speed and scale with which changes in interest rates are made: - one type of uncertainty has to do with the economy's basic mechanisms.. which model of the economy shall we use for our analysis?", 'a major problem here in recent years has been that the shift to low inflation and a flexible exchange rate by itself can change the relationships in the model.', '- a second type of uncertainty concerns the interpretation of new information that is constantly coming in.', 'it is important in this connection to assess what effects an interference or a shock have, which, inter alia, is linked with whether it is permanent or temporary.', '- finally there is uncertainty about the effect of the measures that the riksbank can take--in practice, changes in the instrumental interest rates.', 'the question is how the so-called transmission mechanism looks and in what time frame interest rate changes affect inflation.', 'if a central bank overestimates the deviation from the inflation target or underestimates the effect of a change in its interest rate policy, there is a risk that it will raise or lower interest rates too much.', 'in such a situation, the policy in the end will become excessively restrictive or expansive and it may become necessary for the central bank to shift its policy in the opposite direction.', 'such a change may create instability and reinforce cyclical swings.', 'therefore it would appear that there is reason to proceed with some caution when the policy is changed.', 'central banks also tend to adjust interest rates in relatively small steps.', 'nevertheless, the conclusion that a central bank should proceed carefully is not self-evident.', 'the question is how the markets players interpret a certain behaviour.', 'ever so small changes in the instrumental interest rates, which may be interpreted as the first step in policy change, can have a big impact.', "the federal reserve's increase in february 1994).", 'there is probably no obvious and simple rule for action.', "most likely, the central bank's task is to account for, as clearly as possible, both its long-term plans and the uncertainty that is inherent in its assessment.", "figure 2 m o n e y m arke t age n ts' in flatio n exp e ctatio n s p e r ce n t 5 5 o ct. .", "'94 94 4 4 o ct. .", "'95 95 c p i 3 3 m ay y '96 96 n o v .", "'96 96 2 2 f eb.", "'97 1 1 0 0 -1 -1 94 94 95 95 96 96 97 97 98 98 99 99 00 00 01 01 s ources: s ta tistics s weden and p rospe ra r ese arch the way in which the instrumental interest rates are changed also has to do with credibility and tactics.", 'if complete credibility in monetary policy and a low-inflation regime have not been achieved , it will naturally influence the pace with which interest rates are lowered or raised.', 'in situations of this kind, the result may be that the central bank has its instrumental rates set at either a too high or a too low level compared with what would have been warranted in an environment of high credibility.', 'developments during 1996 can illustrate the effects on policy of both uncertainty and insufficient credibility.', 'at the beginning of the year, the riksbank estimated that activity in the economy was declining and that inflationary pressure was falling.', 'both the demand situation and the indicators that exist for inflation expectations pointed in the same direction.', "however, the forecasts of inflation, which were made by private players, were still not wholly in line with the riksbank's target.", "nevertheless, the riksbank's assessment was that in this situation there was room to begin lowering interest rates without threatening the inflation target.", 'initially, the riksbank chose to lower the repo rate in equal intervals of 25 basis points (figure 3).', 'prudence was warranted by our wish to receive further information which could confirm our picture of falling inflationary pressures.', 'moreover, we estimated that it was urgent that the decreases not be interpreted by the market as an indication that the riksbank had begun to tinker with the inflation target, with possible negative effects primarily on long-term interest rates and the krona.', 'the series of small decreases in the repo rate continued to the end of the year, when the rate had been lowered to 4.10 per cent, that is to say, a total decrease of 4.81 per centage points.', 'in the spring, new information came that supported the brighter picture.', 'inflation and budget figures were improving gradually at the same time as the policy generally appeared to be stabilising.', 'this supported monetary policy.', 'these events give an example of how difficulties in interpreting the information received can be handled.', "the riksbank's policy is based on forecasts, which are necesssarily uncertain, and it also has to be designed so that it is perceived as consistent in the long term and credible.", 'figure 3 actu al an d exp ected rep o rate per cen t 10 10 10 10 r ep o o r ate 9 9 8 8 5 5 mar .', "'96 96 7 7 5 5 j u u n n e'96 96 6 6 24 24 s ept.'.", "'96 96 5 5 10 10 ma r.'.", "'97 97 4 4 13 13 ma y '97 3 3 jan -96 m ar-96 ju u n n -96 s ep-96 96 dec ec-96 96 m ar-97 ju u n n -97 s ource: t he r iksbank the conclusion is that there may be reason and scope for the riksbank, within the framework of a policy with price stability as its objective, to pay attention to real economic developments.", 'in fact, this possibility is inherent in a monetary policy based on an inflation target.', 'in practice, however, the possibilities of an active stabilisation policy are limited by the general uncertainty that prevails.', 'the exchange rate in small, open economies, the exchange rate has an important influence on inflation.', 'at the same time, it is a variable that has fluctuated considerably in recent years for reasons which have not always been easy to foresee and interpret.', 'how changes in the exchange rate should be handled in practical policy depends above all on how lasting a change in the exchange rate is judged to be.', 'more enduring changes that have an effect on inflation forecasts obviously have to be taken into account in order to decide on the duration and what is a reasonable reaction, one normally has to know what brought about the change.', 'several different cases can be discerned: a nominal change in the exchange rate can be a result of a change in the real equilibrium exchange rate.', 'this case is in principle simple to manage since it normally does not lead to a changed picture of inflation and thereby does not occasion any specific policy measures.', 'changes in the real equilibrium exchange rate have not been an especially common reason for changes in the exchange rate in recent years, at any rate since the krona fell in connection with the changeover to a flexible exchange rate in 1992. a change in the nominal exchange rate may also have to do with a change in the long-term view of the steadfastness in economic policy, or what is termed credibility.', 'in practice it is not always so easy to distinguish between what is important for credibility and various factors can interact in a complicated manner.', 'two cases can, however, be discerned: - in the first case, the problem of credibility is primarily based on a lack of confidence in the central bank as such and in monetary policy.', 'in the long-term perspective, the task is then the establishment of a trackrecord.', 'laws that guarantee independence can be an important support in this process.', "in the short term, there is probably most often not much that can be done other than to show by action--increases in interest rates--that one is sticking to one's objectives.", "- more difficult to assess and manage are situations in which the currency's depreciation is a consequence of weakening credibility in the general direction of economic policy.", 'investors in the financial market may, for example, think that the risk has increased for a change of regimes in the future, when the target for price stability may be abandoned at least temporarily as a result, for example, of government financial problems.', 'in sweden this was probably the most common explanation for the recurrent periods of exchange rate turbulence during the 1990s.', 'in situations of this type, monetary policy itself cannot do the job, and what is worse, in the short term the costs of monetary policy measures may be considerable.', 'yet there is hardly any other alternative for a central bank than to respond by raising interest rates and in such a way demonstrate its intention to counter inflationary tendencies.', 'at the same time there is reason to try to influence developments in other ways by clarifying the nature of the problems, so that financial policy is turned in the right direction.', 'figure 4 th e swed ish exch an ge rate versus usd an d dem 5,0 8,0 7,8 sek /usd right t axis s 4,8 7,6 7,4 4,6 7,2 7,0 4,4 6,8 sek /de m 6,6 left t axis 4,2 6,4 6,2 4,0 6,0 jun un-96 jul-96 sep-96 nov-96 jan-97 mar-97 maj-97 source: the riksbank another, often complementary, reason for fluctuations in the nominal exchange rate may be unrest or disturbances in the international currency and capital markets.', "if such disturbances can be deemed to be pure market phenomena and thus of short duration, they should make hardly any difference to the bank's behaviour.", 'however, this is not the most common case.', "what we saw in the international financial markets-after the bond markets' crash in 1994 or the mexico/barings unrest in 1995-is an interaction between market tendencies in a more limited sense and weak public finances or other credibility problems.", "high international interest rates and currency unrest have aggravated the problem of public finances, so that on these occasions economies such as sweden's have moved from a virtuous to a vicious circle.", 'examples of how one could analyse exchange rate developments in the above terms can also be found in events of the last half-year.', 'an explanation of developments with respect to the krona has to do with the position of the swedish and continental economies in the business cycle.', 'in recent months the dollar and the pound especially have appreciated relative to continental currencies.', 'monetary policy in the usa and great britain has been relatively tight.', 'this is still not the entire explanation.', 'the krona has also fallen somewhat against continental currencies, especially during the winter and spring.', "in part, this has coincided with concerns with respect to the emu process, possibly strengthened in sweden's case because sweden's position on the emu issue is unclear.", 'in addition there has been some uncertainty about the steadfastness of long-term economic policy connected with, inter alia, continued high unemployment.', 'the studies that have been done by the riksbank indicate that there is room for an appreciation of the krona.', 'not only are government finances in considerably better condition than they were earlier (in fact, sweden is one of the relatively few eu countries, which, according to the eu commission can be expected to have a budget deficit in 1997 that complies with maastricht targets with a margin), but also sweden has a large current account surplus and the inflation forecasts are positive.', 'despite that, the krona has depreciated by 6 to 7 per cent in effective terms since october last year.', 'how should monetary policy handle such a situation?', "we can use 'open-mouth operations' and inform the markets and other players of our assessment of what has been happening.", 'maybe this can influence developments in some measure.', "if the krona's downward trend cannot be stopped, it will eventually have an effect on demand -- something the riksbank has to take into account when the instrumental rates are decided.", 'accordingly, a depreciating exchange rate is an important factor that can affect the estimate of future inflation and thus the direction of monetary policy.', 'target variable to conclude, i intend to discuss a few issues that have to do with the design and interpretation of the price stability objective.', 'the line of argument i am going to take can hardly be perceived as controversial.', 'even with the general support for a price stability objective that has been achieved, a number of questions of a more practical nature concerning how monetary policy should be implemented remain.', 'price stability, as everyone realizes, may be defined in many ways, with somewhat different consequences for the execution of monetary policy.', 'when the index for measuring inflation is chosen, a number of different considerations have to be taken into account.', 'the index has to be reasonably broad and give a picture of price developments in the economy as a whole.', 'it is an advantage if it is also well established and regularly published with a short time lag.', 'in addition, it is desirable that the index is seldom revised.', 'all these factors bear out the suitability of the consumer price index (cpi) .', "thus, the riksbank's inflation target has been expressed in terms of a change in the official consumer price index.", 'figure 5 cpi an d un derlyin g in flation percen tage 12-m on th ch an ge 6.0 6.0 5.0 5.0 cpi 4.0 underly ing g 4.0 dom estic c 3.0 3.0 in flation 2.0 2.0 1.0 1.0 0.0 0.0 92 92 93 93 94 94 95 95 96 96 97 97 -1.0 -1.0 sources: statistics sweden and the riksbank one problem with the cpi is that it is affected by temporary influences on inflation.', 'such influences can be changes in indirect taxes and subsidies or the price of oil.', 'to the extent that such changes only have an initial direct effect on the price level but are not deemed to influence the future rate of inflation, they should not precipitate interest rate adjustments.', 'a special case of the temporary effects is what happens when the riksbank changes its policy and raises or lowers the instrumental rates.', 'this affects the interest costs of housing, thereby influencing the cpi.', 'hence, interest rate changes can make it more difficult to reach the price stability objective in the short run.', 'the cpi has varied significantly more than the various measures of underlying inflation that the riksbank produces (figure 5).', 'one example is 1996, when interest rates were reduced rapidly.', 'the cpi then fell much more than the underlying inflation, which was due to a reduction of the interest costs for housing.', 'in this way, annual inflation ended up somewhat below the one per cent lower limit of the tolerance interval.', 'at the same time, all indicators of underlying inflation show that it has edged downwards and has recently kept relatively stable in the interval of 1-1.5 per cent.', 'the problem of temporary influences can be managed in different ways: 1. one possibility is to clearly specify in advance which deviations from the cpi are acceptable.', 'this is the method used in new zealand.', 'it could lead to greater transparency.', 'on the other hand, it would be less clear exactly how the valid objective is defined.', 'in addition, it is difficult to foresee all the corrections warranted and to quantify their exact price effects.', "finally, it is a problem that corrections of this kind are so highly dependent on the central bank's own asessments, which can influence credibility negatively.", '2. a closely related alternative is to use a measure of underlying inflation as target.', 'compared to the first alternative, it has the advantage of giving a clear definition of the objective.', 'it would, however, lead to difficulties similar to those of alternative 1 with respect to problems of defining and quantifying the effects of various disturbances.', '3. another possibility is to supplement the cpi by one or several measures of underlying inflation.', 'in canada the objective is expressed in terms of the cpi whereas a measure of the underlying inflation--which descibes the process of inflation better--is the operative target.', 'in the long run, the final goal is reached since there is a clear link between it and the operative target.', 'a "softer" variety on the same theme is to clarify how practical policy is influenced by underlying inflation, since it can often give a clearer picture of the process of inflation.', 'it is important to note that the big changes which occurred in the repo rate and thus in the interest costs of housing in recent years were linked to the transition from the high inflation regime of the seventies and eighties to a regime of price stability.', 'a continued confidence in the low inflation regime would imply that such large changes in the interest rate component are less likely in the future.', 'it is evident from what the riksbank has said earlier in various contexts that there are price effects, which will not be caught within the tolerance interval and which we do not need to counteract fully by monetary policy measures.', 'attempts to do so could destabilise the economy further, partly due to time lags in the effects of monetary policy.', 'consequently, if unexpected disturbances were to occur, or if taxes and subsidies were to be changed, for example in connection with a major change in the tax system, we would have to accept that this would have an immediate effect on the price level.', 'temporary deviations from the targeted inflation rate may therefore happen.', 'what is important with respect to such deviations is to drive inflation back to the target within the horizon where monetary policy has its biggest effect on price developments.', 'the possibility to achieve the inflation target is accordingly affected not only by how the target variables are defined, but also by what time perspective is used when the policy is evaluated and how wide the applied tolerance level is.', 'the riksbank has emphasized that one should see the price stability objective in an annual perspective-nothing more precise than that.', 'as to the width of the band, we have started from an interval of +1 per cent, which is fairly normal among countries with an inflation target.', 'summary the policy with an inflation target has functioned well in sweden and in other countries that have chosen to work with an inflation target.', 'inflation has become low.', 'in addition an increased understanding of a policy directed at price stability has been created in sweden as well as in other countries with an inflation target.', 'this is especially notew orthy because many of the countries which now work with an inflation target are the very same countries that earlier had problems with inflation.', 'when monetary policy is conducted with an inflation target, production and employment are normally stabilised too.', 'for example, increased demand usually implies an increased rate of inflation.', 'when inflation forecasts indicate that a risk for inflation will exceed the target, raising the instrumental rate is warranted, thereby also slowing down demand growth.', 'in practice the room for an active stabilisation policy is circumscribed by the uncertainty about future inflation.', 'another important complication relates to how credible the policy is.', 'increased credibility of monetary policy creates more room for both rapidly shifting policy in a more expansionary direction in situations of weakening demand and deferring interest rate hikes.', 'measures to strengthen central bank independence should inter alia be seen in this light.', 'how the exchange rate is to be managed within the framework of a policy with an inflation target is an important matter.', 'the countries with inflation targets have different approaches.', 'in all circumstances, it is important to assess how durable an exchange rate change is likely to be.', 'this normally implies a picture of what caused the change.', 'durable changes influencing the inflation forecast have to be taken into account when the instrumental rates are set.', 'increased credibility of economic policy in general makes this problem easier to handle.', 'the higher the credibility, the smaller the exchange-rate fluctuations are likely to be.', 'the question of how the target is formulated and interpreted (for example, in relation to the measures describing the underlying inflation process) is worth discussing.', 'several factors have to be taken into account when the target variable is chosen.', 'first, the capacity of monetary policy exactly to forecast and control inflation in the very short run is small.', 'second, the economy may be hit by disturbances that could create a conflict between a short-term inflation target and an ambition to stabilise the real development.', 'third, the outcome of the cpi is not a perfect indicator of the underlying inflation trend.', 'this problem is handled in different ways in countries having a price stabilization objective.', 'the swedish monetary policy with a price stability objective has been successful and seems well balanced in view of present inflation forecasts.', 'however, this should not prevent us from deepening the discussion about how monetary policy is conducted against the background of the experiences in sweden and other countries.']	Lars Heikensten	Sveriges Riksbank	Deputy Governor	Sweden
https://www.bis.org/review/r971104a.pdf	Mr. Thompson considers the topic of risks in banking (Central Bank Articles and Speeches, 28 Oct 97)	Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the Australian Institute of Banking and Finance Inc., New South Wales State Committee, in Sydney on 28/10/97.	1997-10-28 00:00:00	Mr. Thompson considers the topic of risks in banking Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the Australian Institute of Banking and Finance Inc., New South Wales State Committee, in Sydney on 28/10/97. Introduction I spoke in June in Canberra to a joint luncheon meeting of the AIBF and two other local organisations. My theme was the many faces of risk in banking. Today I would like to expand on a couple of the risks I touched on then, namely: the Year 2000 problem; payments system risk, particularly in relation to settlement of foreign exchange transactions. This also gives me the opportunity to talk about the results from two surveys recently conducted by the RBA. Year 2000 I think almost everyone is now aware that the Year 2000 will bring not only the euphoria which accompanies the arrival of a new millennium - or the approach of it, for those holding on to the view that the third millennium starts in 2001. It also brings potentially major disruption to finance, commerce and almost every aspect of daily life if computers are not able properly to comprehend the move from the year programmed as '99' to the one shown as '00'. Financial institutions are almost totally dependent on computer systems for their continuing day-to-day operations and getting dates correct is a critical element in this. They are, therefore, heavily at risk from the Year 2000 problem. The RBA is taking a close interest in how this problem is being addressed, both as supervisor of banks (for the time being) and with our broader interest in the smooth running of the financial system. The Basle Committee on Banking Supervision recently turned its attention to Year 2000 risk, and has issued a paper which includes a recommended program of remedial action for all banks. The main phases of this are: (i) developing a strategic approach to solving the problem; (ii) creating organisational awareness of its importance; (iii) assessing necessary actions and developing detailed plans; (iv) renovating systems, applications and equipment; (v) validating this renovation through testing; and (vi) implementing tested, compliant systems. The well-prepared financial institution will have completed steps (i) to (iii). It will now be engaged in step (iv) -- renovating systems and applications. The recommended completion date for this work, to allow sufficient time for testing, is the end of 1998. The renovation of critical systems should be finished by the middle of 1998. - 2 - To assess the preparation of Australian banks for Year 2000, we asked them in May to complete a comprehensive survey. Some of the results from this can be summarised usefully under the first four headings of the Basle Committee's recommended program. (i) Developing a strategy to tackle the problem: Some banks have been rather slow to do this, and several had not completed their strategies when our survey arrived. Some banks have placed the CEO or a director in charge of their project, while in others an IT staffer has responsibility. There are dangers in the latter course, because Year 2000 is big enough and threatening enough to be treated as a business issue and not simply a technical problem. (ii) Creating organisational awareness: Awareness appears to be strong in IT areas, but it varies dramatically elsewhere. Some banks have (or will soon have) arranged training for all staff, incorporated Year 2000 into credit review procedures and made relationship managers responsible for compliance by customers. In contrast, others had not even arranged formal briefing of people in their non-IT areas who might be developing spreadsheets and small databases in blissful ignorance of the issue. (iii) Assessing actions and developing detailed plans: Nearly half the banks had not completed their assessments at the time of our survey. This might reflect their adoption of an iterative approach, where key systems were identified early and compliance work begun, with minor systems the subject of later investigation. It also indicates, however, that a few banks are having trouble grappling with the problem. (iv) Renovating systems, applications and equipment: Most banks are currently in this stage, but they have made only modest progress. At mid-year less than 10 per cent of the expected total cost of Year 2000 compliance -- of around $600 million -- had been spent. (Although substantial, this figure is itself about 10 per cent of total expected IT expenditures between now and the end of the decade.) The remaining two steps -- validation through testing and the implementing of tested, compliant systems -- are, of course, still ahead. A few other observations are worth making from our survey results. Most banks have adopted the end-1998 target for achieving Year 2000 compliance. Along with the Basle Committee, we regard this as highly desirable. A few banks have acknowledged that full compliance will not be achieved until some time in 1999. Some of these have structured their projects so that non-critical systems will be dealt with last. Banks collectively have assigned over 1,000 in-house IT staff to fixing the problem, although this includes staff doing concurrent redevelopment work. There has been speculation about serious shortages of experienced staff, but nearly half of the banks in our survey did not plan to hire additional people for their projects, and only four expect to increase staffing by more than 10 per cent. Staff resources do not, therefore, appear to be a major issue in Australia, but there is no room for complacency because shortages could well be a bigger problem in other countries and we are part of a global labour market. Furthermore, the resources required for testing could be under-estimated. Year 2000 testing will be more complex, and on a larger scale, than anything attempted previously. Many banks have not yet developed formal contingency plans in the event that systems cannot be made Year 2000 compliant. Only one-third of them have designed business resumption plans -- others are leaving that until closer to the day, in part because they expect that their systems may have altered substantially by then. - 3 - The overall picture on Australian banks' current state of preparation is, then, rather mixed. At this stage, they all appear capable of addressing their own Year 2000 problems in time. But most of the work is still to be done, and system developments of the scale required are notorious for running over budget and over time -- a luxury which is not available in this case. Moreover, the testing phase could well be the most resource-intensive. Compliance work could also be complicated by other distractions, such as preparing for the euro or managing mergers. (On the latter, the Basle Committee noted that the need to prepare for Year 2000 will greatly complicate mergers and acquisitions among financial institutions, and that the risks in trying to manage projects in more than one institution in the time available could be sufficient reason to defer such mergers.) We will be monitoring the progress of the banks closely, and giving special attention to the laggards. (Although the lack of contingency and business resumption plans is not of current concern, we will also need to revisit this issue.) Most of banks' compliance work to date has been focused internally, which is where our survey concentrated. This is only part of the challenge. Successful renovation of its internal systems will not necessarily protect a bank from serious problems which may be imported from elsewhere, for instance through payments and trading linkages. Banks will need to co-operate closely to ensure that such cross-institutional links are fully tested. The new RTGS system for high-value payments -- on which I will say more in a moment -- was built with Year 2000 in mind. Even so, a comprehensive test plan has been developed for RTGS and its suitability is being confirmed with a number of system participants. This plan allows for full testing in conjunction with participants' interface systems, and aims to confirm that the RTGS system is Year 2000 compliant by the end of 1998. Meanwhile, the Australian Payments Clearing Association has formed a special Consultative Group to address issues relating to the other clearing systems. Banks must also prepare for problems affecting their customers (as well as trading counterparties in wholesale markets) and should be inquiring into the Year 2000 readiness of their borrowers and potential borrowers. The effects of Year 2000 could severely interfere with the conduct of borrowers' businesses and reduce their capacity to meet loan obligations. Customers could also find themselves unable to use electronic links to their banks, and try to revert to manual processing. This would put considerable strain on banks' resources. If not well-prepared, banks could also be drawn into extensive legal actions flowing from Year 2000 breakdowns. The RBA will continue to disseminate information about Year 2000 issues, and will help to co-ordinate renovation and testing where we can. We are participating in an Inter-bank Working Group which will aim to ensure that core banking systems and other shared infrastructure are fully tested, and that exposure to telecommunications problems are limited; to work with key vendors to ensure that their products conform to agreed compliance guidelines; and to develop contingency measures for critical areas. This Group will also be playing an education role with banks' business partners and customers. Let me now describe briefly what the RBA is doing about its own house. Our target is to have our systems fully Year 2000 compliant by the end of next year. Our project is overseen by a Steering Group of senior officers. While the scale of the challenge is not as great for us as for many other financial institutions, our technology platform is complex, involving a mix of hardware and software developed inhouse and also provided by third-party suppliers. It encompasses the exchange of data and services with the Commonwealth Government, some State governments and the financial community at large -- banks, non-bank financial institutions, Austraclear and so on. We also have international linkages through SWIFT to our overseas offices and trading counterparties. Our key internal systems run on the mainframe platform. So, this is where we focused our initial efforts. We began assessing and converting our mainframe application systems last year, with - 4 - the aim of flushing out and fixing date-related problems by end 1997. With one exception, which is now planned for completion in mid-1998, we are on target and have renovated, tested and re-implemented more than half of our systems. To prove total compliance, these systems need to be tested on fully compliant platforms where the dates can be rolled forward into 2000. We aim to have compliant platforms by April next year, and to begin testing with financial institutions and our other counterparties and customers from July 1998. We have also begun assessing our less critical PC and spreadsheet applications which have been developed and supported by various user areas. Each business/policy area has "ownership" of the renovation required for these systems, with support from the IT group. We plan to have these fully tested and proven clean by September 1998. Another area of concern for all of us is the potential problems with embedded chips which control the operation of everything from lifts to air conditioning to fax machines. Our Facilities Management people began tackling this last year. Having assessed key equipment, they are now identifying the hidden components of building infrastructure which may have chips and so need to be assessed. Since many of these items cannot easily be tested internally, we will be seeking certification and proven test results from the vendors. Settlement risk -- RTGS Let me turn briefly to the RTGS project which, as you know, will allow high-value interbank payments to be settled on a "real time", pay-as-you-go basis from the first half of next year. This will eliminate a large proportion of the interbank settlement risk which currently arises because final settlement is deferred to the day after payments are processed. Over the past six months, several major milestones have been achieved in the RTGS project, and now all of the basic infrastructure is in place: The necessary enhancements to RITS (the Reserve Bank Information and Transfer System), which will form the core of RTGS, were completed early in July. The SWIFT Payment Delivery System, which will send customer and foreign exchange payments for real-time settlement, went "live" at the end of August. Last week, this system carried an average daily volume of around 1,100 payments, with average daily value around $13 billion. By the end of this month, we expect 16 banks will be using the system. Austraclear commenced operations as a feeder system at the end of September, with settlement details of all interbank transactions through Austraclear now sent automatically to RITS. Most transactions across these various systems continue to be settled on a next-day basis, but banks are now able to monitor continuously their exchange settlement account (ESA) balances and their net obligations to each other. Prior to full implementation, they will be able to test the queuing, repo and offset functions which will smooth liquidity management in the RTGS world. This project, which represents a major advance in the sophistication of the Australian financial system, is now entering its final stages. Between November and January, payments between the major banks, which are now carried across RITS, will migrate to the SWIFT Payment Delivery System. Then, in February next year, the RBA will set a limit on each bank's consolidated ESA and "net interbank obligation" position. These limits will be reduced progressively to allow us all to adjust to the new environment. When they reach zero in April 1998, full RTGS will be operative. Foreign exchange settlement - 5 - RTGS will eliminate settlement risk for high-value payments between domestic banks. Banks will remain exposed to foreign exchange settlement risk because the currencies in a foreign exchange transaction are each settled in a different "domestic" market. That makes synchronised payment-versus-payment extremely difficult because the respective payment systems are often in different time zones. Also, it is unlikely that both parties to the transaction are direct participants (with final settlement capacity) in each market. So correspondent banks were invented. The time taken for correspondent banks to carry out instructions and to notify their principals adds to settlement risk. The exposure -- or amount at risk -- in a foreign exchange trade lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally by a bank until the time the currency purchased is received with finality. And it equals the full amount of the currency purchased. Although foreign exchange settlement risk first became a major concern with the failure of Bankhaus Herstatt in 1974, only in the past few years has a serious attack been made on the problem. The ball was set rolling by the New York Foreign Exchange Committee and the Committee on Payment and Settlement Systems of the Group of Ten Countries. (The most recent report by the latter is known as "the Allsopp Report"). Their work has done much to improve knowledge of the various components of foreign exchange settlement risk and to promote ways of reducing it. Significantly, these bodies have expressed a preference for the private sector to develop solutions, but have made it clear that central banks should encourage and monitor progress with this. One finding of the Allsopp Report was that the magnitude of foreign exchange risk can be very large. To quote: "Given current practices, a bank's maximum FX settlement exposure could equal, or even surpass, the amount receivable for three days' worth of trades, so that at any point in time -- including weekends and public holidays -- the amount at risk to even a single counterparty could exceed a bank's capital." Another finding was that banks can often reduce settlement risk through relatively simple changes in procedures -- for instance, by renegotiating arrangements with correspondent banks, and by making their own back offices more efficient. More fundamental attacks on settlement risk have been through netting arrangements, both bilateral and multilateral, in which gross obligations are replaced with much smaller, netted amounts. The most ambitious scheme is that developed by the "Group of Twenty" banks, which is known as Continuous Linked Settlement. Many of the details are still to be sorted out, but at the centre of this proposal is having a special-purpose bank as a member of the payment system of each of the currencies included in the scheme. Participating banks would hold individual currency accounts at this special bank, with settlement between them transacted across these accounts. Collateralising arrangements would avoid the creation of credit risk. With extended operating hours in some countries and access to domestic payments systems being on a real-time gross basis, payments by banks in different currencies into and out of the special purpose bank would be made with finality on a continuous basis. FX settlement risk would be eliminated. Unfortunately, groups such as the G10 countries and the G20 banks do not have Australian representation, and their work has not encompassed either the Australian dollar or our market, despite their importance in global foreign exchange trading. Consequently, the RBA set out to replicate some of the international studies to get an idea of the dimensions of the FX risks incurred in Australia, and to identify any special features of the Australian dollar market. We surveyed 24 bank and non-bank foreign exchange dealers during April this year, asking about their settlement practices and the volumes of transactions handled in different ways. It has taken longer than we had expected to analyse the results, but the reasons for the delay -- identifying and - 6 - rectifying errors in a large number of the completed questionnaires -- have been instructive in themselves. Our analysis is still not complete, but we do have some preliminary observations. These impressions from the survey are not particularly comforting. On the other hand, they are also not out of line with overseas findings. The first point is that many banks had considerable difficulty in even completing the survey -- surprisingly including some who had helped us design it. Second, in many banks it took quite some time for our survey to find a "home", suggesting that they may not have one person (or group) charged with responsibility for FX settlement risk. Giving someone such "ownership" is considered best practice. Many banks seem not to have a good feel for the size of their settlement risk. But it is clear that the magnitudes are huge. Aggregate daily trades of all currencies on the Australian market are probably at least as large as the $90 billion exchanged each day through the domestic payments system. Some banks seem to have a poor understanding of exactly when receipts become final in those countries which do not settle foreign exchange transactions in real time. There is some evidence of a "no news is good news" policy in respect of assuming settlements have occurred. Finally, for even the major currency pairs traded out of Australia, the period of foreign exchange settlement risk (leaving aside weekends and holidays) frequently lasts for more than 24 hours. In some instances, it extends into a third day. For minor currency pairings, and taking into account the period for which a bank might not know whether a trade has been settled or not, it can be as long as 31 days! And remember that settlement risk which is not extinguished during the day it arises, cumulates with the risk incurred the following day. It goes without saying that, in consultation with banks, we will be looking for considerable improvement in the management of FX settlement risk after the full results of our survey are compiled and published in the next month or so. On the positive side, we have seen some evidence of improvement already, as the survey has encouraged senior management to pay more attention to the subject. This is essential, because FX is clearly the next frontier of risk reduction in the payments system. We also believe that it is of utmost importance to our banks, and to our financial system generally, that Australia's interests are fully represented in any proposed global solutions. We will be working with the Australian banks to achieve this.	['mr. thompson considers the topic of risks in banking speech by the deputy governor of the reserve bank of australia, mr. g.j.', 'thompson, at the australian institute of banking and finance inc., new south wales state committee, in sydney on 28/10/97.', 'introduction i spoke in june in canberra to a joint luncheon meeting of the aibf and two other local organisations.', 'my theme was the many faces of risk in banking.', 'today i would like to expand on a couple of the risks i touched on then, namely: the year 2000 problem; payments system risk, particularly in relation to settlement of foreign exchange transactions.', 'this also gives me the opportunity to talk about the results from two surveys recently conducted by the rba.', "year 2000 i think almost everyone is now aware that the year 2000 will bring not only the euphoria which accompanies the arrival of a new millennium - or the approach of it, for those holding on to the view that the third millennium starts in 2001. it also brings potentially major disruption to finance, commerce and almost every aspect of daily life if computers are not able properly to comprehend the move from the year programmed as '99' to the one shown as '00'.", 'financial institutions are almost totally dependent on computer systems for their continuing day-to-day operations and getting dates correct is a critical element in this.', 'they are, therefore, heavily at risk from the year 2000 problem.', 'the rba is taking a close interest in how this problem is being addressed, both as supervisor of banks (for the time being) and with our broader interest in the smooth running of the financial system.', 'the basle committee on banking supervision recently turned its attention to year 2000 risk, and has issued a paper which includes a recommended program of remedial action for all banks.', 'the main phases of this are: (i) developing a strategic approach to solving the problem; (ii) creating organisational awareness of its importance; (iii) assessing necessary actions and developing detailed plans; (iv) renovating systems, applications and equipment; (v) validating this renovation through testing; and (vi) implementing tested, compliant systems.', 'the well-prepared financial institution will have completed steps (i) to (iii).', 'it will now be engaged in step (iv) -- renovating systems and applications.', 'the recommended completion date for this work, to allow sufficient time for testing, is the end of 1998. the renovation of critical systems should be finished by the middle of 1998.', '- 2 - to assess the preparation of australian banks for year 2000, we asked them in may to complete a comprehensive survey.', "some of the results from this can be summarised usefully under the first four headings of the basle committee's recommended program.", '(i) developing a strategy to tackle the problem: some banks have been rather slow to do this, and several had not completed their strategies when our survey arrived.', 'some banks have placed the ceo or a director in charge of their project, while in others an it staffer has responsibility.', 'there are dangers in the latter course, because year 2000 is big enough and threatening enough to be treated as a business issue and not simply a technical problem.', '(ii) creating organisational awareness: awareness appears to be strong in it areas, but it varies dramatically elsewhere.', 'some banks have (or will soon have) arranged training for all staff, incorporated year 2000 into credit review procedures and made relationship managers responsible for compliance by customers.', 'in contrast, others had not even arranged formal briefing of people in their non-it areas who might be developing spreadsheets and small databases in blissful ignorance of the issue.', '(iii) assessing actions and developing detailed plans: nearly half the banks had not completed their assessments at the time of our survey.', 'this might reflect their adoption of an iterative approach, where key systems were identified early and compliance work begun, with minor systems the subject of later investigation.', 'it also indicates, however, that a few banks are having trouble grappling with the problem.', '(iv) renovating systems, applications and equipment: most banks are currently in this stage, but they have made only modest progress.', 'at mid-year less than 10 per cent of the expected total cost of year 2000 compliance -- of around $600 million -- had been spent.', '(although substantial, this figure is itself about 10 per cent of total expected it expenditures between now and the end of the decade.)', 'the remaining two steps -- validation through testing and the implementing of tested, compliant systems -- are, of course, still ahead.', 'a few other observations are worth making from our survey results.', 'most banks have adopted the end-1998 target for achieving year 2000 compliance.', 'along with the basle committee, we regard this as highly desirable.', 'a few banks have acknowledged that full compliance will not be achieved until some time in 1999. some of these have structured their projects so that non-critical systems will be dealt with last.', 'banks collectively have assigned over 1,000 in-house it staff to fixing the problem, although this includes staff doing concurrent redevelopment work.', 'there has been speculation about serious shortages of experienced staff, but nearly half of the banks in our survey did not plan to hire additional people for their projects, and only four expect to increase staffing by more than 10 per cent.', 'staff resources do not, therefore, appear to be a major issue in australia, but there is no room for complacency because shortages could well be a bigger problem in other countries and we are part of a global labour market.', 'furthermore, the resources required for testing could be under-estimated.', 'year 2000 testing will be more complex, and on a larger scale, than anything attempted previously.', 'many banks have not yet developed formal contingency plans in the event that systems cannot be made year 2000 compliant.', 'only one-third of them have designed business resumption plans -- others are leaving that until closer to the day, in part because they expect that their systems may have altered substantially by then.', "- 3 - the overall picture on australian banks' current state of preparation is, then, rather mixed.", 'at this stage, they all appear capable of addressing their own year 2000 problems in time.', 'but most of the work is still to be done, and system developments of the scale required are notorious for running over budget and over time -- a luxury which is not available in this case.', 'moreover, the testing phase could well be the most resource-intensive.', 'compliance work could also be complicated by other distractions, such as preparing for the euro or managing mergers.', '(on the latter, the basle committee noted that the need to prepare for year 2000 will greatly complicate mergers and acquisitions among financial institutions, and that the risks in trying to manage projects in more than one institution in the time available could be sufficient reason to defer such mergers.)', 'we will be monitoring the progress of the banks closely, and giving special attention to the laggards.', '(although the lack of contingency and business resumption plans is not of current concern, we will also need to revisit this issue.)', "most of banks' compliance work to date has been focused internally, which is where our survey concentrated.", 'this is only part of the challenge.', 'successful renovation of its internal systems will not necessarily protect a bank from serious problems which may be imported from elsewhere, for instance through payments and trading linkages.', 'banks will need to co-operate closely to ensure that such cross-institutional links are fully tested.', 'the new rtgs system for high-value payments -- on which i will say more in a moment -- was built with year 2000 in mind.', 'even so, a comprehensive test plan has been developed for rtgs and its suitability is being confirmed with a number of system participants.', "this plan allows for full testing in conjunction with participants' interface systems, and aims to confirm that the rtgs system is year 2000 compliant by the end of 1998. meanwhile, the australian payments clearing association has formed a special consultative group to address issues relating to the other clearing systems.", 'banks must also prepare for problems affecting their customers (as well as trading counterparties in wholesale markets) and should be inquiring into the year 2000 readiness of their borrowers and potential borrowers.', "the effects of year 2000 could severely interfere with the conduct of borrowers' businesses and reduce their capacity to meet loan obligations.", 'customers could also find themselves unable to use electronic links to their banks, and try to revert to manual processing.', "this would put considerable strain on banks' resources.", 'if not well-prepared, banks could also be drawn into extensive legal actions flowing from year 2000 breakdowns.', 'the rba will continue to disseminate information about year 2000 issues, and will help to co-ordinate renovation and testing where we can.', 'we are participating in an inter-bank working group which will aim to ensure that core banking systems and other shared infrastructure are fully tested, and that exposure to telecommunications problems are limited; to work with key vendors to ensure that their products conform to agreed compliance guidelines; and to develop contingency measures for critical areas.', "this group will also be playing an education role with banks' business partners and customers.", 'let me now describe briefly what the rba is doing about its own house.', 'our target is to have our systems fully year 2000 compliant by the end of next year.', 'our project is overseen by a steering group of senior officers.', 'while the scale of the challenge is not as great for us as for many other financial institutions, our technology platform is complex, involving a mix of hardware and software developed inhouse and also provided by third-party suppliers.', 'it encompasses the exchange of data and services with the commonwealth government, some state governments and the financial community at large -- banks, non-bank financial institutions, austraclear and so on.', 'we also have international linkages through swift to our overseas offices and trading counterparties.', 'our key internal systems run on the mainframe platform.', 'so, this is where we focused our initial efforts.', 'we began assessing and converting our mainframe application systems last year, with - 4 - the aim of flushing out and fixing date-related problems by end 1997. with one exception, which is now planned for completion in mid-1998, we are on target and have renovated, tested and re-implemented more than half of our systems.', 'to prove total compliance, these systems need to be tested on fully compliant platforms where the dates can be rolled forward into 2000. we aim to have compliant platforms by april next year, and to begin testing with financial institutions and our other counterparties and customers from july 1998. we have also begun assessing our less critical pc and spreadsheet applications which have been developed and supported by various user areas.', 'each business/policy area has "ownership" of the renovation required for these systems, with support from the it group.', 'we plan to have these fully tested and proven clean by september 1998. another area of concern for all of us is the potential problems with embedded chips which control the operation of everything from lifts to air conditioning to fax machines.', 'our facilities management people began tackling this last year.', 'having assessed key equipment, they are now identifying the hidden components of building infrastructure which may have chips and so need to be assessed.', 'since many of these items cannot easily be tested internally, we will be seeking certification and proven test results from the vendors.', 'settlement risk -- rtgs let me turn briefly to the rtgs project which, as you know, will allow high-value interbank payments to be settled on a "real time", pay-as-you-go basis from the first half of next year.', 'this will eliminate a large proportion of the interbank settlement risk which currently arises because final settlement is deferred to the day after payments are processed.', 'over the past six months, several major milestones have been achieved in the rtgs project, and now all of the basic infrastructure is in place: the necessary enhancements to rits (the reserve bank information and transfer system), which will form the core of rtgs, were completed early in july.', 'the swift payment delivery system, which will send customer and foreign exchange payments for real-time settlement, went "live" at the end of august.', 'last week, this system carried an average daily volume of around 1,100 payments, with average daily value around $13 billion.', 'by the end of this month, we expect 16 banks will be using the system.', 'austraclear commenced operations as a feeder system at the end of september, with settlement details of all interbank transactions through austraclear now sent automatically to rits.', 'most transactions across these various systems continue to be settled on a next-day basis, but banks are now able to monitor continuously their exchange settlement account (esa) balances and their net obligations to each other.', 'prior to full implementation, they will be able to test the queuing, repo and offset functions which will smooth liquidity management in the rtgs world.', 'this project, which represents a major advance in the sophistication of the australian financial system, is now entering its final stages.', 'between november and january, payments between the major banks, which are now carried across rits, will migrate to the swift payment delivery system.', 'then, in february next year, the rba will set a limit on each bank\'s consolidated esa and "net interbank obligation" position.', 'these limits will be reduced progressively to allow us all to adjust to the new environment.', 'when they reach zero in april 1998, full rtgs will be operative.', 'foreign exchange settlement - 5 - rtgs will eliminate settlement risk for high-value payments between domestic banks.', 'banks will remain exposed to foreign exchange settlement risk because the currencies in a foreign exchange transaction are each settled in a different "domestic" market.', 'that makes synchronised payment-versus-payment extremely difficult because the respective payment systems are often in different time zones.', 'also, it is unlikely that both parties to the transaction are direct participants (with final settlement capacity) in each market.', 'so correspondent banks were invented.', 'the time taken for correspondent banks to carry out instructions and to notify their principals adds to settlement risk.', 'the exposure -- or amount at risk -- in a foreign exchange trade lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally by a bank until the time the currency purchased is received with finality.', 'and it equals the full amount of the currency purchased.', 'although foreign exchange settlement risk first became a major concern with the failure of bankhaus herstatt in 1974, only in the past few years has a serious attack been made on the problem.', 'the ball was set rolling by the new york foreign exchange committee and the committee on payment and settlement systems of the group of ten countries.', '(the most recent report by the latter is known as "the allsopp report").', 'their work has done much to improve knowledge of the various components of foreign exchange settlement risk and to promote ways of reducing it.', 'significantly, these bodies have expressed a preference for the private sector to develop solutions, but have made it clear that central banks should encourage and monitor progress with this.', 'one finding of the allsopp report was that the magnitude of foreign exchange risk can be very large.', 'to quote: "given current practices, a bank\'s maximum fx settlement exposure could equal, or even surpass, the amount receivable for three days\' worth of trades, so that at any point in time -- including weekends and public holidays -- the amount at risk to even a single counterparty could exceed a bank\'s capital."', 'another finding was that banks can often reduce settlement risk through relatively simple changes in procedures -- for instance, by renegotiating arrangements with correspondent banks, and by making their own back offices more efficient.', 'more fundamental attacks on settlement risk have been through netting arrangements, both bilateral and multilateral, in which gross obligations are replaced with much smaller, netted amounts.', 'the most ambitious scheme is that developed by the "group of twenty" banks, which is known as continuous linked settlement.', 'many of the details are still to be sorted out, but at the centre of this proposal is having a special-purpose bank as a member of the payment system of each of the currencies included in the scheme.', 'participating banks would hold individual currency accounts at this special bank, with settlement between them transacted across these accounts.', 'collateralising arrangements would avoid the creation of credit risk.', 'with extended operating hours in some countries and access to domestic payments systems being on a real-time gross basis, payments by banks in different currencies into and out of the special purpose bank would be made with finality on a continuous basis.', 'fx settlement risk would be eliminated.', 'unfortunately, groups such as the g10 countries and the g20 banks do not have australian representation, and their work has not encompassed either the australian dollar or our market, despite their importance in global foreign exchange trading.', 'consequently, the rba set out to replicate some of the international studies to get an idea of the dimensions of the fx risks incurred in australia, and to identify any special features of the australian dollar market.', 'we surveyed 24 bank and non-bank foreign exchange dealers during april this year, asking about their settlement practices and the volumes of transactions handled in different ways.', 'it has taken longer than we had expected to analyse the results, but the reasons for the delay -- identifying and - 6 - rectifying errors in a large number of the completed questionnaires -- have been instructive in themselves.', 'our analysis is still not complete, but we do have some preliminary observations.', 'these impressions from the survey are not particularly comforting.', 'on the other hand, they are also not out of line with overseas findings.', 'the first point is that many banks had considerable difficulty in even completing the survey -- surprisingly including some who had helped us design it.', 'second, in many banks it took quite some time for our survey to find a "home", suggesting that they may not have one person (or group) charged with responsibility for fx settlement risk.', 'giving someone such "ownership" is considered best practice.', 'many banks seem not to have a good feel for the size of their settlement risk.', 'but it is clear that the magnitudes are huge.', 'aggregate daily trades of all currencies on the australian market are probably at least as large as the $90 billion exchanged each day through the domestic payments system.', 'some banks seem to have a poor understanding of exactly when receipts become final in those countries which do not settle foreign exchange transactions in real time.', 'there is some evidence of a "no news is good news" policy in respect of assuming settlements have occurred.', 'finally, for even the major currency pairs traded out of australia, the period of foreign exchange settlement risk (leaving aside weekends and holidays) frequently lasts for more than 24 hours.', 'in some instances, it extends into a third day.', 'for minor currency pairings, and taking into account the period for which a bank might not know whether a trade has been settled or not, it can be as long as 31 days!', 'and remember that settlement risk which is not extinguished during the day it arises, cumulates with the risk incurred the following day.', 'it goes without saying that, in consultation with banks, we will be looking for considerable improvement in the management of fx settlement risk after the full results of our survey are compiled and published in the next month or so.', 'on the positive side, we have seen some evidence of improvement already, as the survey has encouraged senior management to pay more attention to the subject.', 'this is essential, because fx is clearly the next frontier of risk reduction in the payments system.', "we also believe that it is of utmost importance to our banks, and to our financial system generally, that australia's interests are fully represented in any proposed global solutions.", 'we will be working with the australian banks to achieve this.']	Graeme J. Thompson	Reserve Bank of Australia	Deputy Governor	Australia
https://www.bis.org/review/r980309a.pdf	Mr. O'Connell reports on the Irish economy and different aspects of the Central Bank of Ireland's activities (Central Bank Articles and Speeches, 18 Feb 97)	Statement by the Governor of the Central Bank of Ireland, Mr. Maurice O'Connell, to the Joint Committee of the Oireachtas (Parliament) on Finance and the Public Service in Dublin on 18/2/97.	1997-02-18 00:00:00	Mr. O'Connell reports on the Irish economy and different aspects of the Central Bank of Ireland's activities Statement by the Governor of the Central Bank of Ireland, Mr. Maurice O'Connell, to the Joint Committee of the Oireachtas (Parliament) on Finance and the Public Service in Dublin on 18/2/97. I thank you for your invitation and I welcome the opportunity to appear before this Committee. Internationally, the economic outlook remains generally good. While the crisis in Asia has reduced forecasts, there is still optimism that reasonable growth with low inflation will continue. Worldwide, there is a strong consensus on the merits of price stability and reduced budget deficits as the best platform for growth and employment. In Europe, the picture is mixed. In general, there has been some improvement in the past half year and a growth rate not far off 3 per cent on average is predicted for 1998. The prospects for substantial reductions in unemployment in the short term remain disappointing. Unemployment in Europe is seen largely as a structural problem that can only be resolved over an extended period. On the positive side inflation has been subdued and interest rates are relatively low. As we move towards the deadline for decision on membership of EMU, there is a great awareness everywhere, in shaping policy, of the requirements to satisfy the entry conditions. The Irish economy Ireland's position is unique at the moment by European standards. Economic growth has continued to exceed expectations. The Central Bank expects that growth this year will be of the order of 7 to 8 per cent. Others might put the figure higher. While growth will probably slow down in the years ahead, it should remain well above the European average. The Central Bank estimates that a long-term growth pattern of the order of 4-5 per cent is within our capability, if the international environment remains benign. This will depend on a number of factors, not least continuing low inflation. The current national wage arrangements provide a solid basis for cost competitiveness and it is most important that these terms are not diluted. Unemployment is below the European average. The progress on job creation in recent years is impressive and the outlook is good. In its quarterly report published in December the Central Bank forecasted an average inflation rate for this year of 21⁄2 per cent, which is relatively low in absolute terms and is within the threshold for qualification for EMU. The subsequent decline in the Irish pound has increased the prospect of a somewhat higher figure. There are other factors such as asset price increases and tightening conditions in the labour market, which also carry the potential for overheating of the economy and higher inflation. These are a source of concern because they could ultimately damage the economy. One feature of the strong performance of the economy is the growth in private sector credit. The cumulative growth in the past three years was over 50 per cent and it is now increasing at an annual rate above 20 per cent. As we started from a level of indebtedness relatively low by international standards, growth on this scale may not be a cause of immediate alarm. On all previous experience, however, it would be unsustainable in the longer term without inflationary consequences. The ready availability of credit at relatively low interest rate levels has been a contributory factor to the excessive rises last year in house prices which are now at historically high levels in real terms and by reference to average earnings. House prices have risen by 40-50 per cent since 1994. There are predictions that a further substantial rise in prices this year is likely. We may not be far from a situation where home ownership will be beyond the reach of persons on average incomes. There seems to be a perception that the Central Bank can exercise some legal authority in restricting credit. It has no such authority. Any restriction would be inconsistent with European Union practice. Besides, it would be unworkable as demand would probably be met by overseas lenders. The introduction of the single currency will facilitate access by overseas lenders. The Bank continues to monitor the conditions applied by the credit institutions in lending for house purchase. It has warned these institutions repeatedly of the dangers inherent in high rates of credit growth and any relaxation of lending standards. Insofar as the Bank can establish, 100 per cent mortgages have been issued only in exceptional cases where properties were being purchased for investment. The Bank would not encourage this practice and the credit institutions have been so advised. Economic and monetary union Preparation for EMU is a dominant feature of the work of the Central Bank at the moment. Our duty is to ensure, as best we can, that Ireland continues to fulfil the entry requirements, in particular the requirement on inflation, and that the banking and financial system in general is well prepared for the single currency. It now seems virtually assured that EMU will start on schedule on 1st January 1999 and that a substantial majority of European Union countries will participate from the outset. Control of monetary policy will pass immediately to the Governing Council of the European Central Bank and decisions will be made on the basis of European requirements. We will no longer be able to adjust the exchange rate or interest rates to correct domestic problems. The priority of the European Central Bank will be price stability. Besides, the conditions of the Stability and Growth Pact effectively require that member countries run a balanced budget over a complete economic cycle. The preparations for monetary union at operational level are well advanced, under the aegis of the European Monetary Institute. Much of this work is of a detailed technical nature relating to business between the individual central banks. The EMI has recommended two possible monetary policy strategies for the European Central Bank - monetary targeting and direct inflation targeting. Among the other important strategic issues are the extent of decentralisation, management of reserves, pooling of reserves and monetary income and linking of payment systems. There are some awkward issues yet to be resolved. The definition of monetary income for instance is a problem. In the single currency regime there will be a deliberate policy of decentralisation and the day-to-day activities of the Central Bank will be conducted within this framework. We will continue to manage reserves and to provide liquidity to the banks. We will, however, work to guidelines or benchmarks determined by the Governing Council of the European Central Bank. In certain areas of the Bank the working day will be extended. Our preliminary arrangements for production and stockpiling of euro banknotes and coin are well under way. While the deadline of 1st January 2002 may seem distant, we must begin production far in advance. There have been reports to the effect that the Central Bank will have a large surplus of reserves when we join EMU. This is misleading. At the end of 1997 the Bank had total assets of £61⁄2 billion. These assets were matched by corresponding liabilities of £5 billion, leaving net assets, or internal reserves, of nearly £11⁄2 billion. The Bank will continue to need internal reserves. I would not speculate on an appropriate level. We may not need the present level of reserves in due course but it is too early to make a judgement on this until we have experience of the new system. All of the other national central banks participating in EMU will be in a similar position. Our internal reserves as a proportion of total assets are about average by European Union standards. I might add that any transfer of internal reserves would reduce future earnings and profit transfers to the Exchequer. From 1st January next onwards, all Central Bank business will be conducted in the new currency, the euro. All accounts with the Bank, whether held by credit institutions, the Government or international institutions, will be in euro. Existing notes and coin will become constituent parts of the euro. The banks generally must be ready to make any banking service required in Ireland available in euro. From January next, they will process lodgements and payments in Irish pounds or euro, as required. It would be reasonable to anticipate that Irish business in general will move to the euro faster than the official timetable requires. The National Changeover Plan, published some weeks ago, draws attention to arrangements for the period of transition pending the introduction of euro banknotes and coin. During this period banknotes of the member States participating in EMU must be exchanged at par value. From January the Central Bank will provide an inward exchange service free of charge. Exchange rate/interest rate I am under the usual constraints in regard to comment on current exchange rates and interest rates for the Irish pound. These issues are highly sensitive. Determination of exchange rate policy is the prerogative of the Minister for Finance. It has been decided that the method for arriving at the conversion rates for the different currencies, including the Irish pound, will be settled and announced at the time of decision on EMU membership. This decision, it now appears, will be taken on 3rd May. Nothing further has been decided at this stage in relation to fixing of exchange rates. The intention to pre-announce bilateral rates in May is driven by the general concern throughout Europe to avoid market speculation as we move closer to the January 1999 deadline. While national authorities will continue to be responsible for the exchange rate of their respective currencies up to this deadline, the May agreement should have a decisive influence and should diminish the possibility of considerable fluctuations. There has been substantial convergence of interest rates in Europe in recent months. Irish interest rates, at the short end of the scale, though low by historic standards, remain substantially above levels across much of Europe. There has been a good reason for this. It reflects domestic conditions here as the economy has continued to be exceptionally buoyant and the threat of overheating remains. If we were not on the doorstep of EMU, our interest rates would now be higher. Wholesale interest rates must converge, among the countries participating in EMU, by January 1999. This points to the expectation of reductions in Irish rates, even if European rates were to move upwards further in the meantime. I cannot quantify reductions precisely nor can I outline a timepath. It is evident, however, that some reductions of significance are likely. In the meantime, Irish interest rate policy will be influenced by the requirements of the domestic economy. The Central Bank will retain the discretion to adjust rates for as long as possible. I might also draw the attention of members to the impact on savings. In a lower interest rate regime some deposit rates must inevitably come down. The returns on call deposits in particular are already at very low levels. It would be unwise to assume that interest rates will remain permanently low once the euro area is established. As with the US dollar, successful management of the euro will require periodic interest rate adjustments to secure the objective of price stability. In the context of EMU, the relationship with sterling is of obvious concern to us. We now know that the UK will not join EMU for some time ahead. It would be better for us, if it joined at the outset. I cannot predict future movements of sterling relative to the euro. I would, however, point to the Treaty requirements that all member States should treat exchange rate policy as a matter of common interest. This applies as much to the UK as to anybody else. The Bank of England will participate in the General Council of the European System of Central Banks and will be subject to the obligations that this imposes. I would further suggest that the decision last year to give operational independence to the Bank of England is significant in this context. It is working to an inflation target and this arrangement should reduce the likelihood of large-scale fluctuations of sterling vis-à-vis the euro. It is vitally important that the credibility of the euro is established immediately. To achieve this the new currency must be supported by a solid economic background and political consensus. There is considerable speculation about the merits of a hard or a soft currency. The critical factor is that the currency be stable in terms of European prices so that its international role will be secure and that, in time, it will challenge the dominance of the US dollar. The external value of the euro will be largely determined by the monetary policy implemented by the European Central Bank and by developments in the foreign exchange markets for the major industrial currencies. Supervision May I now turn to a different aspect of our activities. The Central Bank's approach to supervision reflects European legal requirements and is in line with best international practice. The basic objectives of supervision of banks and building societies are to protect depositors and investors and to ensure as far as possible that risks to the financial system as a whole are minimised. Insofar as the Bank examines individual customer accounts, its focus is always on the solvency of the institution. Our main attention is focused on the quality of loans and other assets and good management. We frequently come across breaches of the rules. Many of these would be of a minor nature. Most are dealt with by administrative action. We discourage applications for banking licences unless we are fully satisfied as to the status of the applicant. No system of supervision, however comprehensive, can give a one hundred per cent guarantee against abuse. Effective supervision requires the co-operation of the entity that is being supervised. Despite the improvements in controls, and international co-operation, bank failures continue. The ultimate objective worldwide is to avoid systemic problems. Arising from the Tribunals of Inquiry and other recent developments, there has been some confusion about the confidentiality exercised by the Central Bank in relation to its functions. May I say at the outset that we are co-operating to the fullest extent possible with Tribunal investigations. Members are aware that the Central Bank is conducting an investigation following recent allegations against National Irish Bank. I am precluded from discussing individual cases. The Bank is bound under law, to observe strict rules of confidentiality. It may not disclose information about individual entities or persons to any third parties, other than in exceptional circumstances. These include criminal proceedings in court, providing information to the Gardai on money laundering and other criminal activity, including tax evasion, and transfer of information to other regulatory authorities. The Bank is prohibited from communicating information to the Revenue Commissioners. We are not tax investigators. It is the duty of individual financial institutions to report to the Gardai suspicions of criminal activity (including tax evasion) by their customers. I understand that such reports to the Gardai are not infrequent. If we become aware of tax abuse, by an institution that we supervise, it is our duty to notify the Gardai. These requirements derive from and are consistent with European Union laws. Other banking supervisors in the European Union are subject to similar confidentiality requirements. Our situation is in no sense unique. If the Irish authorities attempted to abandon these requirements, not only would we be in breach of EU law but we would forfeit the co-operation of other supervisors in exchanging information. This exchange of information is vital. Without it, we simply could not operate as a competent supervisory authority and operations by Irish banks abroad would be called into question. The supervisory duties of the Central Bank have been extended considerably in recent years. The International Financial Services Centre continues to expand. Last year responsibility for all investment intermediaries was assigned to the Bank. In response, we have contacted more than one thousand intermediaries in order to compile a register and to develop a code of conduct. The supervision of small retail operations is a new departure for the Bank and it may take some time yet to settle on a definite pattern of operation. A further complication is that a majority of intermediaries are also engaged in insurance and other activities which are not the responsibility of the Central Bank. It makes little sense to examine investment operations without taking some overview of the total business of an intermediary. Exchange controls have also been in the news. In operating these controls up to their abolition in 1992, the Central Bank acted as agent for the Minister for Finance. The Bank may give information on these matters to the Minister only. Irish financial institutions Irish banks and financial institutions generally have been returning consistently strong profits. This is unsurprising in view of the favourable conditions for lending and minimising bad debts. At the same time, operating margins have been reducing significantly in the face of sharper competition. All indications suggest that competition will intensify further in the years ahead. There will be expensive technological developments and competition from outside will be facilitated by the single currency in EMU. It would be reasonable to predict that there may be significant rationalisation within our financial system in the period ahead. It would be disappointing if this resulted in a situation where the great proportion of Irish banking was controlled from outside. I should also mention the impressive overseas expansion by a number of Irish financial institutions in recent years. We live in a world of large-scale movement of funds across borders and Ireland is no exception. Given the open nature of the Irish economy, it is no surprise that cross-border holdings of funds in our case are relatively high. The total volume of deposits, excluding interbank deposits, with banks and building societies in Ireland is estimated to be in the region of £60 billion. Roughly one third of these deposits are held by non-resident companies and individuals. This proportion is quite high by international standards. On the other hand deposits held abroad by Irish residents - again excluding interbank figures - are in the region of £11 billion. This figure is high by international comparison. The figure has quadrupled in the past ten years, reflecting the growth in Irish trade, the removal of exchange controls in the context of the single European market and the development of the International Financial Services Centre. This covers only the deposit side of the picture. Borrowing by Irish residents from overseas banks has also grown rapidly in the past decade. It is now estimated to be of a similar order of magnitude to overseas deposits. Access to credit abroad at competitive interest rates, growth in the multinational sector and the IFSC have contributed to this development. This is by no means a comprehensive picture. It does not incorporate cross-border flows in securities and other investments such as equities, for which we do not have specific information. The Central Bank is aware throughout every day of the broad quantities of funds moving in and out of Irish pounds across the foreign exchange market. It does not have knowledge of the movement of funds on behalf of individual bank customers. Conclusions Before I conclude, may I refer again briefly to monetary policy. In the implementation of monetary policy the first objective of the Central Bank at all times is price stability. This will also be the first objective of the European Central Bank and this is made abundantly clear in the Maastricht Treaty. Price stability is the best foundation for a growing economy and for continuing improvements in employment. This has been demonstrated consistently, not just in the Irish situation but worldwide.	["mr. o'connell reports on the irish economy and different aspects of the central bank of ireland's activities statement by the governor of the central bank of ireland, mr. maurice o'connell, to the joint committee of the oireachtas (parliament) on finance and the public service in dublin on 18/2/97.", 'i thank you for your invitation and i welcome the opportunity to appear before this committee.', 'internationally, the economic outlook remains generally good.', 'while the crisis in asia has reduced forecasts, there is still optimism that reasonable growth with low inflation will continue.', 'worldwide, there is a strong consensus on the merits of price stability and reduced budget deficits as the best platform for growth and employment.', 'in europe, the picture is mixed.', 'in general, there has been some improvement in the past half year and a growth rate not far off 3 per cent on average is predicted for 1998. the prospects for substantial reductions in unemployment in the short term remain disappointing.', 'unemployment in europe is seen largely as a structural problem that can only be resolved over an extended period.', 'on the positive side inflation has been subdued and interest rates are relatively low.', 'as we move towards the deadline for decision on membership of emu, there is a great awareness everywhere, in shaping policy, of the requirements to satisfy the entry conditions.', "the irish economy ireland's position is unique at the moment by european standards.", 'economic growth has continued to exceed expectations.', 'the central bank expects that growth this year will be of the order of 7 to 8 per cent.', 'others might put the figure higher.', 'while growth will probably slow down in the years ahead, it should remain well above the european average.', 'the central bank estimates that a long-term growth pattern of the order of 4-5 per cent is within our capability, if the international environment remains benign.', 'this will depend on a number of factors, not least continuing low inflation.', 'the current national wage arrangements provide a solid basis for cost competitiveness and it is most important that these terms are not diluted.', 'unemployment is below the european average.', 'the progress on job creation in recent years is impressive and the outlook is good.', 'in its quarterly report published in december the central bank forecasted an average inflation rate for this year of 21⁄2 per cent, which is relatively low in absolute terms and is within the threshold for qualification for emu.', 'the subsequent decline in the irish pound has increased the prospect of a somewhat higher figure.', 'there are other factors such as asset price increases and tightening conditions in the labour market, which also carry the potential for overheating of the economy and higher inflation.', 'these are a source of concern because they could ultimately damage the economy.', 'one feature of the strong performance of the economy is the growth in private sector credit.', 'the cumulative growth in the past three years was over 50 per cent and it is now increasing at an annual rate above 20 per cent.', 'as we started from a level of indebtedness relatively low by international standards, growth on this scale may not be a cause of immediate alarm.', 'on all previous experience, however, it would be unsustainable in the longer term without inflationary consequences.', 'the ready availability of credit at relatively low interest rate levels has been a contributory factor to the excessive rises last year in house prices which are now at historically high levels in real terms and by reference to average earnings.', 'house prices have risen by 40-50 per cent since 1994. there are predictions that a further substantial rise in prices this year is likely.', 'we may not be far from a situation where home ownership will be beyond the reach of persons on average incomes.', 'there seems to be a perception that the central bank can exercise some legal authority in restricting credit.', 'it has no such authority.', 'any restriction would be inconsistent with european union practice.', 'besides, it would be unworkable as demand would probably be met by overseas lenders.', 'the introduction of the single currency will facilitate access by overseas lenders.', 'the bank continues to monitor the conditions applied by the credit institutions in lending for house purchase.', 'it has warned these institutions repeatedly of the dangers inherent in high rates of credit growth and any relaxation of lending standards.', 'insofar as the bank can establish, 100 per cent mortgages have been issued only in exceptional cases where properties were being purchased for investment.', 'the bank would not encourage this practice and the credit institutions have been so advised.', 'economic and monetary union preparation for emu is a dominant feature of the work of the central bank at the moment.', 'our duty is to ensure, as best we can, that ireland continues to fulfil the entry requirements, in particular the requirement on inflation, and that the banking and financial system in general is well prepared for the single currency.', 'it now seems virtually assured that emu will start on schedule on 1st january 1999 and that a substantial majority of european union countries will participate from the outset.', 'control of monetary policy will pass immediately to the governing council of the european central bank and decisions will be made on the basis of european requirements.', 'we will no longer be able to adjust the exchange rate or interest rates to correct domestic problems.', 'the priority of the european central bank will be price stability.', 'besides, the conditions of the stability and growth pact effectively require that member countries run a balanced budget over a complete economic cycle.', 'the preparations for monetary union at operational level are well advanced, under the aegis of the european monetary institute.', 'much of this work is of a detailed technical nature relating to business between the individual central banks.', 'the emi has recommended two possible monetary policy strategies for the european central bank - monetary targeting and direct inflation targeting.', 'among the other important strategic issues are the extent of decentralisation, management of reserves, pooling of reserves and monetary income and linking of payment systems.', 'there are some awkward issues yet to be resolved.', 'the definition of monetary income for instance is a problem.', 'in the single currency regime there will be a deliberate policy of decentralisation and the day-to-day activities of the central bank will be conducted within this framework.', 'we will continue to manage reserves and to provide liquidity to the banks.', 'we will, however, work to guidelines or benchmarks determined by the governing council of the european central bank.', 'in certain areas of the bank the working day will be extended.', 'our preliminary arrangements for production and stockpiling of euro banknotes and coin are well under way.', 'while the deadline of 1st january 2002 may seem distant, we must begin production far in advance.', 'there have been reports to the effect that the central bank will have a large surplus of reserves when we join emu.', 'at the end of 1997 the bank had total assets of £61⁄2 billion.', 'these assets were matched by corresponding liabilities of £5 billion, leaving net assets, or internal reserves, of nearly £11⁄2 billion.', 'the bank will continue to need internal reserves.', 'i would not speculate on an appropriate level.', 'we may not need the present level of reserves in due course but it is too early to make a judgement on this until we have experience of the new system.', 'all of the other national central banks participating in emu will be in a similar position.', 'our internal reserves as a proportion of total assets are about average by european union standards.', 'i might add that any transfer of internal reserves would reduce future earnings and profit transfers to the exchequer.', 'from 1st january next onwards, all central bank business will be conducted in the new currency, the euro.', 'all accounts with the bank, whether held by credit institutions, the government or international institutions, will be in euro.', 'existing notes and coin will become constituent parts of the euro.', 'the banks generally must be ready to make any banking service required in ireland available in euro.', 'from january next, they will process lodgements and payments in irish pounds or euro, as required.', 'it would be reasonable to anticipate that irish business in general will move to the euro faster than the official timetable requires.', 'the national changeover plan, published some weeks ago, draws attention to arrangements for the period of transition pending the introduction of euro banknotes and coin.', 'during this period banknotes of the member states participating in emu must be exchanged at par value.', 'from january the central bank will provide an inward exchange service free of charge.', 'exchange rate/interest rate i am under the usual constraints in regard to comment on current exchange rates and interest rates for the irish pound.', 'these issues are highly sensitive.', 'determination of exchange rate policy is the prerogative of the minister for finance.', 'it has been decided that the method for arriving at the conversion rates for the different currencies, including the irish pound, will be settled and announced at the time of decision on emu membership.', 'this decision, it now appears, will be taken on 3rd may.', 'nothing further has been decided at this stage in relation to fixing of exchange rates.', 'the intention to pre-announce bilateral rates in may is driven by the general concern throughout europe to avoid market speculation as we move closer to the january 1999 deadline.', 'while national authorities will continue to be responsible for the exchange rate of their respective currencies up to this deadline, the may agreement should have a decisive influence and should diminish the possibility of considerable fluctuations.', 'there has been substantial convergence of interest rates in europe in recent months.', 'irish interest rates, at the short end of the scale, though low by historic standards, remain substantially above levels across much of europe.', 'there has been a good reason for this.', 'it reflects domestic conditions here as the economy has continued to be exceptionally buoyant and the threat of overheating remains.', 'if we were not on the doorstep of emu, our interest rates would now be higher.', 'wholesale interest rates must converge, among the countries participating in emu, by january 1999. this points to the expectation of reductions in irish rates, even if european rates were to move upwards further in the meantime.', 'i cannot quantify reductions precisely nor can i outline a timepath.', 'it is evident, however, that some reductions of significance are likely.', 'in the meantime, irish interest rate policy will be influenced by the requirements of the domestic economy.', 'the central bank will retain the discretion to adjust rates for as long as possible.', 'i might also draw the attention of members to the impact on savings.', 'in a lower interest rate regime some deposit rates must inevitably come down.', 'the returns on call deposits in particular are already at very low levels.', 'it would be unwise to assume that interest rates will remain permanently low once the euro area is established.', 'as with the us dollar, successful management of the euro will require periodic interest rate adjustments to secure the objective of price stability.', 'in the context of emu, the relationship with sterling is of obvious concern to us.', 'we now know that the uk will not join emu for some time ahead.', 'it would be better for us, if it joined at the outset.', 'i cannot predict future movements of sterling relative to the euro.', 'i would, however, point to the treaty requirements that all member states should treat exchange rate policy as a matter of common interest.', 'this applies as much to the uk as to anybody else.', 'the bank of england will participate in the general council of the european system of central banks and will be subject to the obligations that this imposes.', 'i would further suggest that the decision last year to give operational independence to the bank of england is significant in this context.', 'it is working to an inflation target and this arrangement should reduce the likelihood of large-scale fluctuations of sterling vis-à-vis the euro.', 'it is vitally important that the credibility of the euro is established immediately.', 'to achieve this the new currency must be supported by a solid economic background and political consensus.', 'there is considerable speculation about the merits of a hard or a soft currency.', 'the critical factor is that the currency be stable in terms of european prices so that its international role will be secure and that, in time, it will challenge the dominance of the us dollar.', 'the external value of the euro will be largely determined by the monetary policy implemented by the european central bank and by developments in the foreign exchange markets for the major industrial currencies.', 'supervision may i now turn to a different aspect of our activities.', "the central bank's approach to supervision reflects european legal requirements and is in line with best international practice.", 'the basic objectives of supervision of banks and building societies are to protect depositors and investors and to ensure as far as possible that risks to the financial system as a whole are minimised.', 'insofar as the bank examines individual customer accounts, its focus is always on the solvency of the institution.', 'our main attention is focused on the quality of loans and other assets and good management.', 'we frequently come across breaches of the rules.', 'many of these would be of a minor nature.', 'most are dealt with by administrative action.', 'we discourage applications for banking licences unless we are fully satisfied as to the status of the applicant.', 'no system of supervision, however comprehensive, can give a one hundred per cent guarantee against abuse.', 'effective supervision requires the co-operation of the entity that is being supervised.', 'despite the improvements in controls, and international co-operation, bank failures continue.', 'the ultimate objective worldwide is to avoid systemic problems.', 'arising from the tribunals of inquiry and other recent developments, there has been some confusion about the confidentiality exercised by the central bank in relation to its functions.', 'may i say at the outset that we are co-operating to the fullest extent possible with tribunal investigations.', 'members are aware that the central bank is conducting an investigation following recent allegations against national irish bank.', 'i am precluded from discussing individual cases.', 'the bank is bound under law, to observe strict rules of confidentiality.', 'it may not disclose information about individual entities or persons to any third parties, other than in exceptional circumstances.', 'these include criminal proceedings in court, providing information to the gardai on money laundering and other criminal activity, including tax evasion, and transfer of information to other regulatory authorities.', 'the bank is prohibited from communicating information to the revenue commissioners.', 'we are not tax investigators.', 'it is the duty of individual financial institutions to report to the gardai suspicions of criminal activity (including tax evasion) by their customers.', 'i understand that such reports to the gardai are not infrequent.', 'if we become aware of tax abuse, by an institution that we supervise, it is our duty to notify the gardai.', 'these requirements derive from and are consistent with european union laws.', 'other banking supervisors in the european union are subject to similar confidentiality requirements.', 'our situation is in no sense unique.', 'if the irish authorities attempted to abandon these requirements, not only would we be in breach of eu law but we would forfeit the co-operation of other supervisors in exchanging information.', 'this exchange of information is vital.', 'without it, we simply could not operate as a competent supervisory authority and operations by irish banks abroad would be called into question.', 'the supervisory duties of the central bank have been extended considerably in recent years.', 'the international financial services centre continues to expand.', 'last year responsibility for all investment intermediaries was assigned to the bank.', 'in response, we have contacted more than one thousand intermediaries in order to compile a register and to develop a code of conduct.', 'the supervision of small retail operations is a new departure for the bank and it may take some time yet to settle on a definite pattern of operation.', 'a further complication is that a majority of intermediaries are also engaged in insurance and other activities which are not the responsibility of the central bank.', 'it makes little sense to examine investment operations without taking some overview of the total business of an intermediary.', 'exchange controls have also been in the news.', 'in operating these controls up to their abolition in 1992, the central bank acted as agent for the minister for finance.', 'the bank may give information on these matters to the minister only.', 'irish financial institutions irish banks and financial institutions generally have been returning consistently strong profits.', 'this is unsurprising in view of the favourable conditions for lending and minimising bad debts.', 'at the same time, operating margins have been reducing significantly in the face of sharper competition.', 'all indications suggest that competition will intensify further in the years ahead.', 'there will be expensive technological developments and competition from outside will be facilitated by the single currency in emu.', 'it would be reasonable to predict that there may be significant rationalisation within our financial system in the period ahead.', 'it would be disappointing if this resulted in a situation where the great proportion of irish banking was controlled from outside.', 'i should also mention the impressive overseas expansion by a number of irish financial institutions in recent years.', 'we live in a world of large-scale movement of funds across borders and ireland is no exception.', 'given the open nature of the irish economy, it is no surprise that cross-border holdings of funds in our case are relatively high.', 'the total volume of deposits, excluding interbank deposits, with banks and building societies in ireland is estimated to be in the region of £60 billion.', 'roughly one third of these deposits are held by non-resident companies and individuals.', 'this proportion is quite high by international standards.', 'on the other hand deposits held abroad by irish residents - again excluding interbank figures - are in the region of £11 billion.', 'this figure is high by international comparison.', 'the figure has quadrupled in the past ten years, reflecting the growth in irish trade, the removal of exchange controls in the context of the single european market and the development of the international financial services centre.', 'this covers only the deposit side of the picture.', 'borrowing by irish residents from overseas banks has also grown rapidly in the past decade.', 'it is now estimated to be of a similar order of magnitude to overseas deposits.', 'access to credit abroad at competitive interest rates, growth in the multinational sector and the ifsc have contributed to this development.', 'this is by no means a comprehensive picture.', 'it does not incorporate cross-border flows in securities and other investments such as equities, for which we do not have specific information.', 'the central bank is aware throughout every day of the broad quantities of funds moving in and out of irish pounds across the foreign exchange market.', 'it does not have knowledge of the movement of funds on behalf of individual bank customers.', 'conclusions before i conclude, may i refer again briefly to monetary policy.', 'in the implementation of monetary policy the first objective of the central bank at all times is price stability.', 'this will also be the first objective of the european central bank and this is made abundantly clear in the maastricht treaty.', 'price stability is the best foundation for a growing economy and for continuing improvements in employment.', 'this has been demonstrated consistently, not just in the irish situation but worldwide.']	Maurice O'Connell	Central Bank of Ireland	Governor	Ireland
https://www.bis.org/review/r980227d.pdf	Mr. Matsushita reports on recent financial and economic conditions in Japan (Central Bank Articles and Speeches, 12 Dec 97)	Speech by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, to the Japan National Press Club in Tokyo on 12/12/97.	1997-12-12 00:00:00	Mr. Matsushita reports on recent financial and economic conditions in Japan Speech by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, to the Japan National Press Club in Tokyo on 12/12/97. I. Introduction I truly appreciate this opportunity to address this distinguished audience at the Japan National Press Club. The circumstances of the Japanese economy and financial system have increased in severity in the past six months. The economy has not shown any definite signs of recovery since its reaction to the rise in the consumption tax rate in April 1997. Rather, economic recovery appears to be decelerating. The currencies and financial markets of South-East Asian countries, which have been the high-growth area, have been in turmoil since summer of 1997, and an adverse impact on the Japanese economy has been anticipated. In addition, recent successive failures of large Japanese financial institutions have once again aroused concern about the stability of Japan's financial system in Japan and abroad. Thus, it is not easy to judge where the Japanese economy is headed and to draw up a prescription for each problem. In such a situation, it is important that the circumstances be analyzed carefully so as to perceive the underlying mechanism. This is because developments in the economy and the markets -even, or particularly, when they suggest confusion or disruption -- often provide important indications or warnings that lead to a better solution of the problem. Today, I would like to discuss and explain the Bank's thinking on three topics: issues concerning Japan's financial system, the turmoil in the Asian currencies and financial markets, and the domestic economic situation. These are three independent issues that in a way are closely correlated. I would like to explain them with a view to clarifying the underlying mechanism. II. Issues Regarding Japan's Financial System A. Resolution of Failed Financial Institutions I would like to start with issues regarding Japan's financial system. The successive failures of Japanese financial institutions since the fall of 1997 have once again emphasized domestically and internationally the severity of the situation facing the Japanese financial system, temporarily increasing the tension in the financial markets. First, I would like to explain the measures the Bank has taken to deal with this situation and the thinking behind them. When a financial institution fails, the most important task is to contain systemic risk. In other words, it is crucial to prevent the failure from affecting other financial institutions or the markets as a whole, disrupting the entire financial system, through widespread anxiety of depositors and market participants or through a chain reaction of defaults. In order to contain systemic risk, two requirements must be satisfied. First, it must be ensured that smooth repayment of deposits be made by the failed financial institution. Second, it is important to avert liquidity contraction to ensure the stability of the entire financial system. Failure of financial institutions causes market participants to become overly cautious, making it difficult for transactions to come to terms. As a result, upward pressures tend to be placed on interest rates. Therefore, - 2 - in order for these two requirements to be satisfied, the Bank took decisive measures in response to the financial institution failures. To meet the first requirement, the Bank extended special loans as necessary to several failed institutions -- for example, Hokkaido Takushoku Bank and Yamaichi Securities -- under Article 25 of the Bank of Japan Law, without requiring the usual collateral. The Bank has committed itself to providing funds for the purpose of ensuring the stability of the financial system only in cases where all of the following four conditions are met: (1) there is a strong possibility that systemic risk -- a risk that failure of one financial institution to settle transactions with another may trigger a chain reaction of defaults -- will materialize, and that as a result, confidence in other sound financial institutions will be undermined, or that runs on deposits will occur; (2) credit extension by the Bank is indispensable, as there are no other sources of funds; (3) measures are taken to prevent moral hazard; and (4) the financial soundness of the Bank will not be threatened. In the cases of the recent financial institution failures, the Bank judged it appropriate to extend special loans after thoroughly examining these four points. While the Bank had previously extended special loans to depository institutions, the loan extension to Yamaichi Securities should be regarded as an extraordinary measure. This is because the failure of a non-depository financial institution such as a securities company differs in several ways from the failure of a depository institution. Customers of a securities company conduct stock and bond transactions through the securities company, and are not in a creditor-debtor relationship with the company. They do deposit money and securities with a securities company, but unlike bank deposits, these are not means of payment. Accordingly, it is usually unlikely that the failure of a securities company would directly give rise to systemic risk. Yamaichi Securities' decision to close down its business, however, is significant in that the company is one of Japan's four largest securities companies. Furthermore, considering the fact that the Japanese financial system is being viewed more critically and that Yamaichi conducted a wide range of business in domestic and overseas markets and had a large number of customers, any difficulties in returning customers' assets or in settling outstanding transactions in the process of closing down the company were quite likely to lead to withdrawal of customer assets from other securities companies or disrupt market transactions. If no measures had been taken to prevent such a situation, the credibility of the Japanese financial system could have been seriously eroded and disruptions could have been caused in domestic and overseas financial markets, in the end seriously affecting overall economic activity in Japan. Against this backdrop, the Bank decided to provide Yamaichi with necessary liquidity under Article 25 of the Bank of Japan Law in order to minimize the adverse impact of the closing down of the company's business on the domestic and overseas financial markets as well as the Japanese economy. The Bank's measures had their intended effect: payment and settlement were executed smoothly by the failed institutions, and thus the materialization of systemic risk was avoided. However, the failures of large depository institutions and a securities company made the behavior of market participants very cautious, and as a result, it became difficult for transactions to come to terms, placing upward pressures on market interest rates. Therefore, to fulfil the second requirement in containing systemic risk, the Bank exerted itself to its utmost to avoid declines in market liquidity through market operations. The Bank utilized various market operations means to provide sufficient liquidity in the markets, to thereby support smooth market transactions and stable formation of market interest rates. - 3 - Since September 1995, the Bank has conducted market operations in order to maintain the uncollateralized overnight call money rate at a level on average slightly below the official discount rate. However, demand for funds in the market heightened following the series of financial institution failures, and at the end of November 1997, the call money rate rose far above this targeted level. The Bank therefore made continuous efforts to supply sufficient liquidity to the market, and as a result the rate has recently declined to the targeted level. Rates on longer-term money market instruments, however, especially 1-month rates on end-of-year funds, remain high due to a rise in the "Japan premium" -- the extra funding cost that Japanese banks have to pay compared to leading U.S. and European banks due to a decline in their creditworthiness in international markets. The Bank would like to emphasize that it will continue to take a firm stance in its market operations toward the end of the year to ensure the stability of money market rates. The Bank, in cooperation with the government, will continue to commit itself to maintaining the stability of the financial system, and strongly hopes that the public and market participants will act calmly. B. The Implications of Recent Financial Institution Failures Significant progress has been made toward the solution of the nonperforming-loan problem, and it can be said that the recent failures of financial institutions occurred amid this notable progress. Therefore, these failures can be considered to have important implications for the strengthening of Japan's financial system and for the restoring of domestic and international confidence in the system. The disclosed amount of total nonperforming loans held by the Japanese depository institutions decreased from ¥38 trillion as of the end of March 1995 to ¥28 trillion as of the end of March 1997. Of this, the amount that needs to be disposed of, or those not covered by collateral or loan loss reserves, has been reduced from the ¥18 trillion in 1993 to ¥4.5 trillion. While this amount is still substantial, it is fair to say that there has been steady progress in the disposal of nonperforming loans. A matter of concern is that the pace of disposal differs among financial institutions. For example, some financial institutions have completed removal of nonperforming loans from their balance sheets. Many other institutions seem to be planning to record net losses for the accounting term ending in March 1998 to dispose of a considerable amount of nonperforming loans. The overall progress in solving the nonperforming-loan problem, together with enhanced disclosure practices, has sharpened the contrast between institutions that are being prompt in dealing with their problem and those that lag behind. Under such circumstances, there seem to be two requirements in restoring confidence in Japan's financial system at home and abroad. First, it is necessary for financial institutions to further improve disclosure and thereby enhance the transparency of their management. Depositors, creditors, and other market participants are scrutinizing the financial conditions of Japanese financial institutions with increasing severity, and the scheduled introduction of Prompt Corrective Action in April 1998 and the implementation of the Japanese "Big Bang" deregulation measures are likely to encourage such tendency. Therefore, it is vital that individual financial institutions accelerate the disposal of nonperforming loans and the implementation of restructuring measures to ensure the market's confidence. As for the disclosure of nonperforming loans held by financial institutions, a uniform standard has been established based on a recommendation by the Financial System Research Council to allow comparison between financial institutions, and the range of disclosure has been expanded in line - 4 - with this standard. To increase the transparency of financial institution management and to thereby strengthen the market's confidence, however, it is essential that institutions expand the range of disclosure on their own initiative, not only with respect to nonperforming loans but also to the implementation of their restructuring measures, and thereby provide the market with a convincing explanation of how they intend to improve, or how they have improved, their financial strength. Second, the recent series of financial institution failures has highlighted the importance of preventing the surfacing of systemic risk and of thereby ensuring the stability of the entire financial system. It must be remembered that in the financial system, an appropriate balance must be struck between the need to draw out the dynamism of the market mechanism and the need to ensure the stability of the system. As I stated earlier, the financial strength of financial institutions is being more severely examined in anticipation of the implementation of the Japanese "Big Bang". To maintain the stability of the financial system under these circumstances, it is extremely important to ensure that even if the market were to pass a hard judgment on an institution, this would not shake the entire financial system. In this regard, the provision of emergency liquidity for preventing any serious disturbance from occurring in the system, which I mentioned earlier, is the responsibility of the central bank as the "lender of last resort". When the failed institution has a negative net worth, there is the problem of how to dispose of the ultimate losses. However, credit extension by the Bank is aimed solely at providing temporary liquidity, and not at making up for losses. Therefore, it is required that a loss-covering scheme be in place before swift repayment of deposits can be made and resolution of the failed institution be carried out smoothly. The deposit insurance system is one of the frameworks made available for such schemes, and various measures have been taken to enhance the functions of the Deposit Insurance Corporation. There could be cases, however, where losses are too large for this system to bear. In such cases overseas, public funds have been used subject to certain conditions to solve the problem. In view of those examples abroad and the current situation of Japan's financial system, an argument has been put forward that public funds should be utilized for the early and fundamental solution of the nonperforming loan problem, triggering serious debate in the Government and Diet. The Bank considers the argument to carry great significance for the domestic financial system, and therefore hopes that a national consensus on the matter will be reached through wide discussions. The global and domestic conditions facing Japan's financial system are becoming increasingly harsh, as represented by the expansion of the "Japan premium" in international financial markets. Thus, Japan's financial system is at a critical juncture that will determine whether it can restore domestic and international confidence, with financial institutions further enhancing disclosure and accelerating the disposal of nonperforming loans, and the authorities ensuring the stability of the financial system. III. Financial Conditions in Asia and Their Impact on the Japanese Economy A. The Background of the Turmoil in Asian Financial Markets Let me next discuss the recent developments in other Asian economies. In this section, I will refer to Asian economies on the basis of excluding that of Japan. To confront the turmoil in the Asian financial markets which started in summer 1997, various measures have been taken -- each country - 5 - has been adjusting its macroeconomic policy and setting out measures to stabilize the financial system, and international assistance has been provided under the leadership of the International Monetary Fund (IMF). However, instability remains in the financial and foreign exchange markets of these countries, and uncertainty prevails as to how their economies will evolve under the various economic measures. Today, therefore, I would like to examine the background of the Asian turmoil and its possible impact on the Japanese economy. First, I would like to emphasize that it is not appropriate to perceive the currency turbulence in Asian countries as having been caused by speculative attacks by global investors on specific currencies and financial markets, and to emphasize the instability of international financial markets. Turmoil in the international financial and foreign exchange markets has occurred several times in the past: the demise of the postwar fixed exchange-rate system, established by the IMF in the 1970s; and the currency crises in the European Monetary System in 1992 and in Mexico in 1994. In all the above cases, before the turbulence arose in the markets, there had been for some time a gap between the exchange rate of the country's currency and the real economic condition of the country, with that gap expanding gradually preceding the turbulence. Immediate adjustment of the foreign exchange rate is inevitable once market participants detect the situation. In the adjustment process, the exchange rate may overshoot, giving the impression that the market is in disruption. However, it is important that the grounds for such large fluctuations be clearly identified, or otherwise, the warning signals sent out by the market, which are pointing to the expanding gap in this case, will be overlooked. With the emergence of the Asian currency turmoil, some have questioned the previous achievements of East Asian economies. This view also seems to be rather extreme. It appears that the potential growth rate of East Asia remains high, supported by its high-quality labor, high savings rate, and solid market and industry infrastructures. Although East Asian economies will face adjustment pressures in the short term, they can be expected to establish a foundation for further growth by carrying out various structural reforms based on their recent experiences. What, then, can be considered to be the background of the recent turmoil in Asian currencies? While Asian countries differ from each other in many ways, one common factor is that most Asian currencies were pegged to the U.S. dollar, and under the peg, large amounts of foreign funds flowed in during the 1990s. This in turn led to excessive financial and investment activities, overheating of the economy, and accordingly, deterioration in the external balance. It cannot be denied that there was a sense of euphoria, or an overexpectation of economic growth, in East Asia. When there is an influx of abundant funds based on such expectations, upward pressure is exerted on the foreign exchange rate of the country's currency. To maintain the pegged exchange rates, countries were under pressure to ease money to lower domestic interest rates or at least avoid monetary tightening. Such policy response fuelled financial and investment activities, and this may have upheld the euphoria for a certain period of time. Inflation rates in Asian countries rose due to overheated economic activity, and under their fixed exchange rate system, their currencies became overvalued. Consequently, the international competitiveness of these economies declined gradually and current account deficits expanded. The deficits in the current accounts were not a problem as long as they were financed by foreign capital. However, as soon as market participants began to doubt the sustainability of the external imbalance and the economic boom in the area, foreign funds were abruptly withdrawn from the countries, putting severe pressures on foreign exchange rates and stock prices. Against this backdrop, many countries were compelled to abandon their exchange rate pegs to the U.S. dollar and adopt a floating rate system. - 6 - Several important lessons can be drawn from this experience with regard to ensuring the stability of international financial markets. Obviously, preventing an overheating of economic and financial activities through proper macroeconomic policies is the most important prerequisite for securing the stability of one's own economy as well as the international financial markets. It is equally important to ensure flexible foreign exchange developments, promote information disclosure to allow the market mechanism to check the appropriateness of economic policies, and establish a sound financial system by, for example, reviewing the framework of financial institution supervision. Based on these lessons, East Asian countries have embarked on the restoration of their economies and financial systems with international support. The Bank of Japan, too, continues to play an appropriate role in the framework in which the IMF takes the initiative. In terms of cooperation among Asian central banks, the Executives' Meeting of East Asia and Pacific Central Banks (EMEAP) was established in 1991. The governors' meeting has taken place annually since 1996; the first being held in Tokyo and the second in Shanghai. Taking the opportunity of such meetings, the Bank intends to strengthen its ties with other Asian central banks by exchanging views and extending technical assistance in various fields. B. Impact on the Japanese Economy Next, I would like to discuss the impact of developments in the Asian economies on that of Japan. The economic relations between Japan and other Asian countries have been intensifying, and the region is now the largest trade partner of Japan. Of Japan's total exports, those to Asia's Newly Industrializing Economies (Asian NIEs) and the member countries of the Association of South East Asian Nations (ASEAN) account for about 35 percent, exceeding the share of exports to the United States and to the European Union, 30 percent and 15 percent respectively. As for Japan's imports, the share of imports from Asian NIEs and ASEAN countries has grown to almost 20 percent, approaching the 22 percent from the United States, which holds the largest share. Accordingly, it is inevitable that the depreciation of the currencies and the economic slowdown due to the implementation of adjustment measures in these countries will affect the real economy of Japan. At present, demand in other regions such as China, the United States, and Europe is firm, and the average exchange rate of the yen (weighted by the value of trade with each country) remains stable. Thus, the export environment is not significantly deteriorating as a whole. However, exports to Asia, especially to Thailand and the Republic of Korea, have started decreasing. Furthermore, slowdown of economic growth in East Asian countries is bringing about a fall in international commodities prices, especially those of raw materials. This is beginning to affect the profits of materials manufacturers in Japan, and as a result, some of these firms are planning to curtail production. Thus, careful observation of economic trends including these kinds of indirect impact is necessary. In addition to developments in the real economy, the problem of nonperforming loans is surfacing in the Asian countries, although the degree differs from country to country. According to statistics compiled by the Bank for International Settlements (BIS), the total credit exposure of Japanese banks to Asian countries amounts to US $270 billion, which accounts for about 30 percent of the total exposure of world's financial institutions to Asia. However, these figures include Japanese banks' credits to Asian branches and affiliates of Japanese, U.S., and European financial institutions. Furthermore, a large portion of business credits of - 7 - Japanese banks are extended to Japanese affiliates with a guarantee given by their parent companies. According to the Bank's survey, Japanese banks' credit exposure to non-Japanese firms and local banks in Asia appears to be around 30 to 40 percent of the total credit exposure reported in the BIS statistics. Moreover, most of such credit is loans to sound major banks and firms and project finances, which are unlikely to turn into nonperforming loans. As discussed above, the impact of the currency and financial turmoil in Asia on the real economy and financial market of Japan has been limited to date. However, the economic situation in this region remains unstable. Therefore, the degree of economic slowdown and developments in the nonperforming-loan problem in these countries must continue to be monitored. IV. Recent Financial and Economic Conditions and Monetary Policy Management in Japan A. Domestic Financial and Economic Conditions I would now like to move on to today's last topic -- the recent economic situation in Japan. The decelerating trend of Japan's economic growth since April 1997 has been intensifying recently. In final demand, exports and business fixed investment continue to be on an upward trend, supporting economic activity. However, household spending such as personal consumption and housing investment, which fell substantially following the rise in the consumption tax rate in April 1997, is recovering only at a very slow pace. In personal consumption, outlays on services such as travel services have shown a moderate increase, while outlays on goods, as indicated by sales of automobiles and household electric appliances as well as department store sales, have remained sluggish. In addition, housing starts have declined more recently to 1.3 million from the 1.5 million per annum level prevailing until spring 1997. With such weakness in final demand, inventory adjustment pressures remain in the consumer durables- and construction-related industries, and thus industrial production has been declining slightly. Such developments seem to be gradually affecting employment and income. However, this year's temporary economic slowdown is inevitable in that the economy is at a phase in which the downward pressures of fiscal tightening appear most strongly. The concern is how these developments will affect the momentum of the self-sustained economic recovery in 1998. At present, corporate profits and employment income, which form the basis of the self-sustained recovery, continue to be on an upward trend. Therefore, it is unlikely that the economy has entered a recession. However, there is some weakening of the virtuous circle of production, income, and expenditure, and if this trend continues, it may undermine the strength of the self-sustained recovery. The Bank will therefore continue closely to monitor the pace of recovery in consumption, progress in inventory adjustment, and developments in household and corporate sentiment. Meanwhile, prices have remained stable on the whole. Domestic wholesale prices have continued to decline slowly, particularly those of construction materials. Consumer prices, after excluding the effect of the rise in the consumption tax rate, have been at a level slightly above that of the previous year, and corporate service prices remain at the previous year's level. In view of such economic and price conditions, the Bank is determined to observe developments carefully in managing monetary policy, placing emphasis on strengthening the foundation of the economic recovery. In the conduct of market operations, the Bank intends to continue supplying sufficient liquidity to the financial market, to thereby ensure smooth transactions and stability of market interest rates. - 8 - B. Lending Attitude of Financial Institutions With regard to the recent financial situation, there have been various discussions concerning the cautious lending attitude of financial institutions. Today, financial institutions are faced with many challenging management issues, such as expeditious disposal of nonperforming loans, as well as implementation of measures to deal with the Japanese "Big Bang" financial reform and with the introduction of Prompt Corrective Action. Therefore, with a view to enhancing the soundness and efficiency of management, an increasing number of financial institutions are strengthening their risk management and attaching more importance to profitability in their extension of loans. These efforts by financial institutions are indispensable for strengthening Japan's financial system. However, it is a matter of concern whether the cautious lending attitude of financial institutions has reached the point where it hinders the recovery of the economy as a whole. To date, partly because of weak corporate demand for funds, there has been neither any significant shortage of funds in corporate financing nor an overall rise in lending rates due to a squeeze in lending. Therefore, the Bank believes that the cautious lending attitude of financial institutions is not hampering economic recovery at present. However, risk management systems of financial institutions are being further reinforced. In addition, the influence of developments in financial markets, such as low stock prices and the rise in the "Japan premium", on financial institutions' lending activity requires due attention. While the current lending activity of financial institutions is not hampering economic recovery, it is not positively contributing to the recovery as it did during past periods of monetary easing. This fact offers a significant point for discussion when considering the interaction between financial activity and real economic activity, because the expected role of financial institutions goes beyond merely responding passively to corporate demand for funds. Financial institutions are expected to actively support forward-looking business activities -- for example, by helping corporations find new business opportunities and accepting financial risks when new businesses are started. In fact, such functions of financial institutions played a significant role in promoting economic recovery in the past. While it is true that financial institutions went too far in these activities, leading to the emergence of the economic "bubble", it is also undeniable that in the present phase of economic recovery financial support for economic activity has been weak. In order to ensure economic recovery, it is important to strengthen the functions of financial institutions and the financial market, thereby restoring a strong and efficient financial system. I would like to point out that the cautious lending attitude of financial institutions, causing the so-called "credit crunch", should therefore be discussed in connection with the issue of strengthening the financial system. C. The Significance of Stronger Confidence in the Economy The Bank's primary concern regarding the economy is the fact that the confidence of firms and households in the Japanese economy and its outlook seems to be deteriorating. It is very difficult to measure accurately the level of confidence of economic entities. However, the financial and asset markets offer some important information. Asset values, for example, reflect the expectations of market participants as to the future profits which may be earned by holding such assets. How, then, should we see the recent low level of stock prices? Corporate profits are at a significantly higher level today compared with those in 1995, when there were concerns about a deflationary spiral. However, stock prices are close to the 1995 level. This suggests that confidence in the economy has weakened compared with that in 1995. Under such circumstances, firms and financial - 9 - institutions would be inclined to hold back from forward-looking activities that involve risks. Weakened confidence would also reduce the effects of monetary easing. However, it seems unnatural to assume that the potential growth rate of the Japanese economy in the medium to long term has declined significantly in the past two years. In 1995, for example, there were strong concerns over the future of Japanese industry, due to increasing competition with other Asian economies and anxiety over a hollowing-out of industry, but Japanese firms are responding by building new global networks of production and parts procurement, utilizing the new international division of labor. Also, with the depreciation of the yen, apprehension about the international competitiveness of Japanese industry seems to have receded considerably. In view of these conditions, the weakening confidence in the economy that is reflected in the low stock prices must be attributable to some other factor. A clue in finding the answer is the fact that the "outlook for the economy" does not reflect only the estimated potential growth rate, but also uncertainty regarding its realization. For example, even when similar levels of profit growth are expected, stock prices will decline when there is greater uncertainty about the realization of the expected profit growth, in other words, when the risk premium expands. The same phenomenon can be observed in the economy as a whole. Uncertainty regarding future developments significantly undermines confidence in the economy. Thus, it can be said that the present weakness of confidence in the economy is related to the fact that the Japanese economy is at a critical phase of various structural reforms, including financial system reforms. There are many uncertainties surrounding economic entities -- such as the developments in the financial system, the progress of structural	['mr. matsushita reports on recent financial and economic conditions in japan speech by the governor of the bank of japan, mr. yasuo matsushita, to the japan national press club in tokyo on 12/12/97.', 'i. introduction i truly appreciate this opportunity to address this distinguished audience at the japan national press club.', 'the circumstances of the japanese economy and financial system have increased in severity in the past six months.', 'the economy has not shown any definite signs of recovery since its reaction to the rise in the consumption tax rate in april 1997. rather, economic recovery appears to be decelerating.', 'the currencies and financial markets of south-east asian countries, which have been the high-growth area, have been in turmoil since summer of 1997, and an adverse impact on the japanese economy has been anticipated.', "in addition, recent successive failures of large japanese financial institutions have once again aroused concern about the stability of japan's financial system in japan and abroad.", 'thus, it is not easy to judge where the japanese economy is headed and to draw up a prescription for each problem.', 'in such a situation, it is important that the circumstances be analyzed carefully so as to perceive the underlying mechanism.', 'this is because developments in the economy and the markets -even, or particularly, when they suggest confusion or disruption -- often provide important indications or warnings that lead to a better solution of the problem.', "today, i would like to discuss and explain the bank's thinking on three topics: issues concerning japan's financial system, the turmoil in the asian currencies and financial markets, and the domestic economic situation.", 'these are three independent issues that in a way are closely correlated.', 'i would like to explain them with a view to clarifying the underlying mechanism.', "issues regarding japan's financial system a. resolution of failed financial institutions i would like to start with issues regarding japan's financial system.", 'the successive failures of japanese financial institutions since the fall of 1997 have once again emphasized domestically and internationally the severity of the situation facing the japanese financial system, temporarily increasing the tension in the financial markets.', 'first, i would like to explain the measures the bank has taken to deal with this situation and the thinking behind them.', 'when a financial institution fails, the most important task is to contain systemic risk.', 'in other words, it is crucial to prevent the failure from affecting other financial institutions or the markets as a whole, disrupting the entire financial system, through widespread anxiety of depositors and market participants or through a chain reaction of defaults.', 'in order to contain systemic risk, two requirements must be satisfied.', 'first, it must be ensured that smooth repayment of deposits be made by the failed financial institution.', 'second, it is important to avert liquidity contraction to ensure the stability of the entire financial system.', 'failure of financial institutions causes market participants to become overly cautious, making it difficult for transactions to come to terms.', 'as a result, upward pressures tend to be placed on interest rates.', 'therefore, - 2 - in order for these two requirements to be satisfied, the bank took decisive measures in response to the financial institution failures.', 'to meet the first requirement, the bank extended special loans as necessary to several failed institutions -- for example, hokkaido takushoku bank and yamaichi securities -- under article 25 of the bank of japan law, without requiring the usual collateral.', 'the bank has committed itself to providing funds for the purpose of ensuring the stability of the financial system only in cases where all of the following four conditions are met: (1) there is a strong possibility that systemic risk -- a risk that failure of one financial institution to settle transactions with another may trigger a chain reaction of defaults -- will materialize, and that as a result, confidence in other sound financial institutions will be undermined, or that runs on deposits will occur; (2) credit extension by the bank is indispensable, as there are no other sources of funds; (3) measures are taken to prevent moral hazard; and (4) the financial soundness of the bank will not be threatened.', 'in the cases of the recent financial institution failures, the bank judged it appropriate to extend special loans after thoroughly examining these four points.', 'while the bank had previously extended special loans to depository institutions, the loan extension to yamaichi securities should be regarded as an extraordinary measure.', 'this is because the failure of a non-depository financial institution such as a securities company differs in several ways from the failure of a depository institution.', 'customers of a securities company conduct stock and bond transactions through the securities company, and are not in a creditor-debtor relationship with the company.', 'they do deposit money and securities with a securities company, but unlike bank deposits, these are not means of payment.', 'accordingly, it is usually unlikely that the failure of a securities company would directly give rise to systemic risk.', "yamaichi securities' decision to close down its business, however, is significant in that the company is one of japan's four largest securities companies.", "furthermore, considering the fact that the japanese financial system is being viewed more critically and that yamaichi conducted a wide range of business in domestic and overseas markets and had a large number of customers, any difficulties in returning customers' assets or in settling outstanding transactions in the process of closing down the company were quite likely to lead to withdrawal of customer assets from other securities companies or disrupt market transactions.", 'if no measures had been taken to prevent such a situation, the credibility of the japanese financial system could have been seriously eroded and disruptions could have been caused in domestic and overseas financial markets, in the end seriously affecting overall economic activity in japan.', "against this backdrop, the bank decided to provide yamaichi with necessary liquidity under article 25 of the bank of japan law in order to minimize the adverse impact of the closing down of the company's business on the domestic and overseas financial markets as well as the japanese economy.", "the bank's measures had their intended effect: payment and settlement were executed smoothly by the failed institutions, and thus the materialization of systemic risk was avoided.", 'however, the failures of large depository institutions and a securities company made the behavior of market participants very cautious, and as a result, it became difficult for transactions to come to terms, placing upward pressures on market interest rates.', 'therefore, to fulfil the second requirement in containing systemic risk, the bank exerted itself to its utmost to avoid declines in market liquidity through market operations.', 'the bank utilized various market operations means to provide sufficient liquidity in the markets, to thereby support smooth market transactions and stable formation of market interest rates.', '- 3 - since september 1995, the bank has conducted market operations in order to maintain the uncollateralized overnight call money rate at a level on average slightly below the official discount rate.', 'however, demand for funds in the market heightened following the series of financial institution failures, and at the end of november 1997, the call money rate rose far above this targeted level.', 'the bank therefore made continuous efforts to supply sufficient liquidity to the market, and as a result the rate has recently declined to the targeted level.', 'rates on longer-term money market instruments, however, especially 1-month rates on end-of-year funds, remain high due to a rise in the "japan premium" -- the extra funding cost that japanese banks have to pay compared to leading u.s. and european banks due to a decline in their creditworthiness in international markets.', 'the bank would like to emphasize that it will continue to take a firm stance in its market operations toward the end of the year to ensure the stability of money market rates.', 'the bank, in cooperation with the government, will continue to commit itself to maintaining the stability of the financial system, and strongly hopes that the public and market participants will act calmly.', 'b. the implications of recent financial institution failures significant progress has been made toward the solution of the nonperforming-loan problem, and it can be said that the recent failures of financial institutions occurred amid this notable progress.', "therefore, these failures can be considered to have important implications for the strengthening of japan's financial system and for the restoring of domestic and international confidence in the system.", 'the disclosed amount of total nonperforming loans held by the japanese depository institutions decreased from ¥38 trillion as of the end of march 1995 to ¥28 trillion as of the end of march 1997. of this, the amount that needs to be disposed of, or those not covered by collateral or loan loss reserves, has been reduced from the ¥18 trillion in 1993 to ¥4.5 trillion.', 'while this amount is still substantial, it is fair to say that there has been steady progress in the disposal of nonperforming loans.', 'a matter of concern is that the pace of disposal differs among financial institutions.', 'for example, some financial institutions have completed removal of nonperforming loans from their balance sheets.', 'many other institutions seem to be planning to record net losses for the accounting term ending in march 1998 to dispose of a considerable amount of nonperforming loans.', 'the overall progress in solving the nonperforming-loan problem, together with enhanced disclosure practices, has sharpened the contrast between institutions that are being prompt in dealing with their problem and those that lag behind.', "under such circumstances, there seem to be two requirements in restoring confidence in japan's financial system at home and abroad.", 'first, it is necessary for financial institutions to further improve disclosure and thereby enhance the transparency of their management.', 'depositors, creditors, and other market participants are scrutinizing the financial conditions of japanese financial institutions with increasing severity, and the scheduled introduction of prompt corrective action in april 1998 and the implementation of the japanese "big bang" deregulation measures are likely to encourage such tendency.', "therefore, it is vital that individual financial institutions accelerate the disposal of nonperforming loans and the implementation of restructuring measures to ensure the market's confidence.", 'as for the disclosure of nonperforming loans held by financial institutions, a uniform standard has been established based on a recommendation by the financial system research council to allow comparison between financial institutions, and the range of disclosure has been expanded in line - 4 - with this standard.', "to increase the transparency of financial institution management and to thereby strengthen the market's confidence, however, it is essential that institutions expand the range of disclosure on their own initiative, not only with respect to nonperforming loans but also to the implementation of their restructuring measures, and thereby provide the market with a convincing explanation of how they intend to improve, or how they have improved, their financial strength.", 'second, the recent series of financial institution failures has highlighted the importance of preventing the surfacing of systemic risk and of thereby ensuring the stability of the entire financial system.', 'it must be remembered that in the financial system, an appropriate balance must be struck between the need to draw out the dynamism of the market mechanism and the need to ensure the stability of the system.', 'as i stated earlier, the financial strength of financial institutions is being more severely examined in anticipation of the implementation of the japanese "big bang".', 'to maintain the stability of the financial system under these circumstances, it is extremely important to ensure that even if the market were to pass a hard judgment on an institution, this would not shake the entire financial system.', 'in this regard, the provision of emergency liquidity for preventing any serious disturbance from occurring in the system, which i mentioned earlier, is the responsibility of the central bank as the "lender of last resort".', 'when the failed institution has a negative net worth, there is the problem of how to dispose of the ultimate losses.', 'however, credit extension by the bank is aimed solely at providing temporary liquidity, and not at making up for losses.', 'therefore, it is required that a loss-covering scheme be in place before swift repayment of deposits can be made and resolution of the failed institution be carried out smoothly.', 'the deposit insurance system is one of the frameworks made available for such schemes, and various measures have been taken to enhance the functions of the deposit insurance corporation.', 'there could be cases, however, where losses are too large for this system to bear.', 'in such cases overseas, public funds have been used subject to certain conditions to solve the problem.', "in view of those examples abroad and the current situation of japan's financial system, an argument has been put forward that public funds should be utilized for the early and fundamental solution of the nonperforming loan problem, triggering serious debate in the government and diet.", 'the bank considers the argument to carry great significance for the domestic financial system, and therefore hopes that a national consensus on the matter will be reached through wide discussions.', 'the global and domestic conditions facing japan\'s financial system are becoming increasingly harsh, as represented by the expansion of the "japan premium" in international financial markets.', "thus, japan's financial system is at a critical juncture that will determine whether it can restore domestic and international confidence, with financial institutions further enhancing disclosure and accelerating the disposal of nonperforming loans, and the authorities ensuring the stability of the financial system.", 'financial conditions in asia and their impact on the japanese economy a. the background of the turmoil in asian financial markets let me next discuss the recent developments in other asian economies.', 'in this section, i will refer to asian economies on the basis of excluding that of japan.', 'to confront the turmoil in the asian financial markets which started in summer 1997, various measures have been taken -- each country - 5 - has been adjusting its macroeconomic policy and setting out measures to stabilize the financial system, and international assistance has been provided under the leadership of the international monetary fund (imf).', 'however, instability remains in the financial and foreign exchange markets of these countries, and uncertainty prevails as to how their economies will evolve under the various economic measures.', 'today, therefore, i would like to examine the background of the asian turmoil and its possible impact on the japanese economy.', 'first, i would like to emphasize that it is not appropriate to perceive the currency turbulence in asian countries as having been caused by speculative attacks by global investors on specific currencies and financial markets, and to emphasize the instability of international financial markets.', "turmoil in the international financial and foreign exchange markets has occurred several times in the past: the demise of the postwar fixed exchange-rate system, established by the imf in the 1970s; and the currency crises in the european monetary system in 1992 and in mexico in 1994. in all the above cases, before the turbulence arose in the markets, there had been for some time a gap between the exchange rate of the country's currency and the real economic condition of the country, with that gap expanding gradually preceding the turbulence.", 'immediate adjustment of the foreign exchange rate is inevitable once market participants detect the situation.', 'in the adjustment process, the exchange rate may overshoot, giving the impression that the market is in disruption.', 'however, it is important that the grounds for such large fluctuations be clearly identified, or otherwise, the warning signals sent out by the market, which are pointing to the expanding gap in this case, will be overlooked.', 'with the emergence of the asian currency turmoil, some have questioned the previous achievements of east asian economies.', 'this view also seems to be rather extreme.', 'it appears that the potential growth rate of east asia remains high, supported by its high-quality labor, high savings rate, and solid market and industry infrastructures.', 'although east asian economies will face adjustment pressures in the short term, they can be expected to establish a foundation for further growth by carrying out various structural reforms based on their recent experiences.', 'what, then, can be considered to be the background of the recent turmoil in asian currencies?', 'while asian countries differ from each other in many ways, one common factor is that most asian currencies were pegged to the u.s. dollar, and under the peg, large amounts of foreign funds flowed in during the 1990s.', 'this in turn led to excessive financial and investment activities, overheating of the economy, and accordingly, deterioration in the external balance.', 'it cannot be denied that there was a sense of euphoria, or an overexpectation of economic growth, in east asia.', "when there is an influx of abundant funds based on such expectations, upward pressure is exerted on the foreign exchange rate of the country's currency.", 'to maintain the pegged exchange rates, countries were under pressure to ease money to lower domestic interest rates or at least avoid monetary tightening.', 'such policy response fuelled financial and investment activities, and this may have upheld the euphoria for a certain period of time.', 'inflation rates in asian countries rose due to overheated economic activity, and under their fixed exchange rate system, their currencies became overvalued.', 'consequently, the international competitiveness of these economies declined gradually and current account deficits expanded.', 'the deficits in the current accounts were not a problem as long as they were financed by foreign capital.', 'however, as soon as market participants began to doubt the sustainability of the external imbalance and the economic boom in the area, foreign funds were abruptly withdrawn from the countries, putting severe pressures on foreign exchange rates and stock prices.', 'against this backdrop, many countries were compelled to abandon their exchange rate pegs to the u.s. dollar and adopt a floating rate system.', '- 6 - several important lessons can be drawn from this experience with regard to ensuring the stability of international financial markets.', "obviously, preventing an overheating of economic and financial activities through proper macroeconomic policies is the most important prerequisite for securing the stability of one's own economy as well as the international financial markets.", 'it is equally important to ensure flexible foreign exchange developments, promote information disclosure to allow the market mechanism to check the appropriateness of economic policies, and establish a sound financial system by, for example, reviewing the framework of financial institution supervision.', 'based on these lessons, east asian countries have embarked on the restoration of their economies and financial systems with international support.', 'the bank of japan, too, continues to play an appropriate role in the framework in which the imf takes the initiative.', "in terms of cooperation among asian central banks, the executives' meeting of east asia and pacific central banks (emeap) was established in 1991. the governors' meeting has taken place annually since 1996; the first being held in tokyo and the second in shanghai.", 'taking the opportunity of such meetings, the bank intends to strengthen its ties with other asian central banks by exchanging views and extending technical assistance in various fields.', 'b. impact on the japanese economy next, i would like to discuss the impact of developments in the asian economies on that of japan.', 'the economic relations between japan and other asian countries have been intensifying, and the region is now the largest trade partner of japan.', "of japan's total exports, those to asia's newly industrializing economies (asian nies) and the member countries of the association of south east asian nations (asean) account for about 35 percent, exceeding the share of exports to the united states and to the european union, 30 percent and 15 percent respectively.", "as for japan's imports, the share of imports from asian nies and asean countries has grown to almost 20 percent, approaching the 22 percent from the united states, which holds the largest share.", 'accordingly, it is inevitable that the depreciation of the currencies and the economic slowdown due to the implementation of adjustment measures in these countries will affect the real economy of japan.', 'at present, demand in other regions such as china, the united states, and europe is firm, and the average exchange rate of the yen (weighted by the value of trade with each country) remains stable.', 'thus, the export environment is not significantly deteriorating as a whole.', 'however, exports to asia, especially to thailand and the republic of korea, have started decreasing.', 'furthermore, slowdown of economic growth in east asian countries is bringing about a fall in international commodities prices, especially those of raw materials.', 'this is beginning to affect the profits of materials manufacturers in japan, and as a result, some of these firms are planning to curtail production.', 'thus, careful observation of economic trends including these kinds of indirect impact is necessary.', 'in addition to developments in the real economy, the problem of nonperforming loans is surfacing in the asian countries, although the degree differs from country to country.', "according to statistics compiled by the bank for international settlements (bis), the total credit exposure of japanese banks to asian countries amounts to us $270 billion, which accounts for about 30 percent of the total exposure of world's financial institutions to asia.", "however, these figures include japanese banks' credits to asian branches and affiliates of japanese, u.s., and european financial institutions.", 'furthermore, a large portion of business credits of - 7 - japanese banks are extended to japanese affiliates with a guarantee given by their parent companies.', "according to the bank's survey, japanese banks' credit exposure to non-japanese firms and local banks in asia appears to be around 30 to 40 percent of the total credit exposure reported in the bis statistics.", 'moreover, most of such credit is loans to sound major banks and firms and project finances, which are unlikely to turn into nonperforming loans.', 'as discussed above, the impact of the currency and financial turmoil in asia on the real economy and financial market of japan has been limited to date.', 'however, the economic situation in this region remains unstable.', 'therefore, the degree of economic slowdown and developments in the nonperforming-loan problem in these countries must continue to be monitored.', "recent financial and economic conditions and monetary policy management in japan a. domestic financial and economic conditions i would now like to move on to today's last topic -- the recent economic situation in japan.", "the decelerating trend of japan's economic growth since april 1997 has been intensifying recently.", 'in final demand, exports and business fixed investment continue to be on an upward trend, supporting economic activity.', 'however, household spending such as personal consumption and housing investment, which fell substantially following the rise in the consumption tax rate in april 1997, is recovering only at a very slow pace.', 'in personal consumption, outlays on services such as travel services have shown a moderate increase, while outlays on goods, as indicated by sales of automobiles and household electric appliances as well as department store sales, have remained sluggish.', 'in addition, housing starts have declined more recently to 1.3 million from the 1.5 million per annum level prevailing until spring 1997. with such weakness in final demand, inventory adjustment pressures remain in the consumer durables- and construction-related industries, and thus industrial production has been declining slightly.', 'such developments seem to be gradually affecting employment and income.', "however, this year's temporary economic slowdown is inevitable in that the economy is at a phase in which the downward pressures of fiscal tightening appear most strongly.", 'the concern is how these developments will affect the momentum of the self-sustained economic recovery in 1998. at present, corporate profits and employment income, which form the basis of the self-sustained recovery, continue to be on an upward trend.', 'therefore, it is unlikely that the economy has entered a recession.', 'however, there is some weakening of the virtuous circle of production, income, and expenditure, and if this trend continues, it may undermine the strength of the self-sustained recovery.', 'the bank will therefore continue closely to monitor the pace of recovery in consumption, progress in inventory adjustment, and developments in household and corporate sentiment.', 'meanwhile, prices have remained stable on the whole.', 'domestic wholesale prices have continued to decline slowly, particularly those of construction materials.', "consumer prices, after excluding the effect of the rise in the consumption tax rate, have been at a level slightly above that of the previous year, and corporate service prices remain at the previous year's level.", 'in view of such economic and price conditions, the bank is determined to observe developments carefully in managing monetary policy, placing emphasis on strengthening the foundation of the economic recovery.', 'in the conduct of market operations, the bank intends to continue supplying sufficient liquidity to the financial market, to thereby ensure smooth transactions and stability of market interest rates.', '- 8 - b. lending attitude of financial institutions with regard to the recent financial situation, there have been various discussions concerning the cautious lending attitude of financial institutions.', 'today, financial institutions are faced with many challenging management issues, such as expeditious disposal of nonperforming loans, as well as implementation of measures to deal with the japanese "big bang" financial reform and with the introduction of prompt corrective action.', 'therefore, with a view to enhancing the soundness and efficiency of management, an increasing number of financial institutions are strengthening their risk management and attaching more importance to profitability in their extension of loans.', "these efforts by financial institutions are indispensable for strengthening japan's financial system.", 'however, it is a matter of concern whether the cautious lending attitude of financial institutions has reached the point where it hinders the recovery of the economy as a whole.', 'to date, partly because of weak corporate demand for funds, there has been neither any significant shortage of funds in corporate financing nor an overall rise in lending rates due to a squeeze in lending.', 'therefore, the bank believes that the cautious lending attitude of financial institutions is not hampering economic recovery at present.', 'however, risk management systems of financial institutions are being further reinforced.', 'in addition, the influence of developments in financial markets, such as low stock prices and the rise in the "japan premium", on financial institutions\' lending activity requires due attention.', 'while the current lending activity of financial institutions is not hampering economic recovery, it is not positively contributing to the recovery as it did during past periods of monetary easing.', 'this fact offers a significant point for discussion when considering the interaction between financial activity and real economic activity, because the expected role of financial institutions goes beyond merely responding passively to corporate demand for funds.', 'financial institutions are expected to actively support forward-looking business activities -- for example, by helping corporations find new business opportunities and accepting financial risks when new businesses are started.', 'in fact, such functions of financial institutions played a significant role in promoting economic recovery in the past.', 'while it is true that financial institutions went too far in these activities, leading to the emergence of the economic "bubble", it is also undeniable that in the present phase of economic recovery financial support for economic activity has been weak.', 'in order to ensure economic recovery, it is important to strengthen the functions of financial institutions and the financial market, thereby restoring a strong and efficient financial system.', 'i would like to point out that the cautious lending attitude of financial institutions, causing the so-called "credit crunch", should therefore be discussed in connection with the issue of strengthening the financial system.', "c. the significance of stronger confidence in the economy the bank's primary concern regarding the economy is the fact that the confidence of firms and households in the japanese economy and its outlook seems to be deteriorating.", 'it is very difficult to measure accurately the level of confidence of economic entities.', 'however, the financial and asset markets offer some important information.', 'asset values, for example, reflect the expectations of market participants as to the future profits which may be earned by holding such assets.', 'how, then, should we see the recent low level of stock prices?', 'corporate profits are at a significantly higher level today compared with those in 1995, when there were concerns about a deflationary spiral.', 'however, stock prices are close to the 1995 level.', 'this suggests that confidence in the economy has weakened compared with that in 1995. under such circumstances, firms and financial - 9 - institutions would be inclined to hold back from forward-looking activities that involve risks.', 'weakened confidence would also reduce the effects of monetary easing.', 'however, it seems unnatural to assume that the potential growth rate of the japanese economy in the medium to long term has declined significantly in the past two years.', 'in 1995, for example, there were strong concerns over the future of japanese industry, due to increasing competition with other asian economies and anxiety over a hollowing-out of industry, but japanese firms are responding by building new global networks of production and parts procurement, utilizing the new international division of labor.', 'also, with the depreciation of the yen, apprehension about the international competitiveness of japanese industry seems to have receded considerably.', 'in view of these conditions, the weakening confidence in the economy that is reflected in the low stock prices must be attributable to some other factor.', 'a clue in finding the answer is the fact that the "outlook for the economy" does not reflect only the estimated potential growth rate, but also uncertainty regarding its realization.', 'for example, even when similar levels of profit growth are expected, stock prices will decline when there is greater uncertainty about the realization of the expected profit growth, in other words, when the risk premium expands.', 'the same phenomenon can be observed in the economy as a whole.', 'uncertainty regarding future developments significantly undermines confidence in the economy.', 'thus, it can be said that the present weakness of confidence in the economy is related to the fact that the japanese economy is at a critical phase of various structural reforms, including financial system reforms.', 'there are many uncertainties surrounding economic entities -- such as the developments in the financial system, the progress of structural']	Masaru Hayami	Bank of Japan	Governor	Japan
https://www.bis.org/review/r980114a.pdf	Mr. Stals discusses the current monetary situation in South Africa and the implications for 1998 (Central Bank Articles and Speeches, 18 Nov 97)	Address by the Governor of the South African Reserve Bank, Dr. C. Stals, at an investment conference arranged by Huysamer Stals in Johannesburg on 18/11/97.	1997-11-18 00:00:00	Mr. Stals discusses the current monetary situation in South Africa and the implications for 1998 Address by the Governor of the South African Reserve Bank, Dr. C. Stals, at an investment conference arranged by Huysamer Stals in Johannesburg on 18/11/97. 1. The task and function of monetary policy Monetary policy is about money. Governments give central banks the special right to issue money, and also a mandate to manage the money system in the interest of economic development. In the final situation, monetary policy is about the quantity of money, the price of money and the value of money. In the broad context of macroeconomic policy, the central bank is normally tasked with the function of protecting the value of money. This is but an immediate objective, making an important contribution to the achievement of the ultimate goal of economic policy, which is to sustain optimum economic development that will create more jobs and lead to an improvement in the standard of living of all the people of the country. Monetary policy cannot be used to solve all the macroeconomic problems of a country. However, a stable financial environment with a low rate of inflation is regarded as an important precondition for the solution of many of the existing macroeconomic problems in any country. By focusing on the maintenance of low inflation, central banks do not distance themselves from the broader macroeconomic problems such as excessive budget shortages, untenable balance-of-payments deficits, short-term business cycle developments or uncompetitive international trade positions. It is indeed only in conditions of a stable financial environment, that is low inflation, that the real nature of the more fundamental macroeconomic deficiencies will be exposed, diagnosed, understood and rectified. In most cases, remedial action for structural economic ails will also not produce the required corrections in an inflationary environment. Pressure is often put on central banks to harness the power of money creation for purposes other than pure monetary policy objectives, for example to facilitate the financing of public sector budget deficits, or to stimulate real demand for goods and services, or to help small businesses. Pursuing all kinds of non-monetary objectives with monetary policy will, however, normally lead the country inevitably on the dead-end road of higher inflation. 2. Recent monetary developments in South Africa The main objective of monetary policy therefore is and should be to keep inflation low. In the absence of a national commitment to a predetermined and quantified target for inflation, the Reserve Bank's approach is that the rate of inflation in South Africa should be maintained more or less in line with the average rate of inflation in the economies of our major trading partners and competitors. Measured against this benchmark, South Africa did not do well in recent years. It is true that the average rate of inflation stayed around a level of about 14 per cent for more than twenty years from 1972 to 1992 and has now been kept below 10 per cent per annum for almost 5 years. At the level of 8 per cent established over the twelve months up to September 1997, the most recent available statistic, the South African rate of inflation is, however, still about three times as high as the current rates of inflation in our major international trading partners. After the depreciation of the rand last year, consumer price inflation increased from 5.5 per cent in April 1996 to 9.9 per cent in April 1997. Since then, it declined again to 8 per cent in September. Calculated at a seasonally adjusted annualised rate, consumer prices increased by only 6.6 per cent in the third quarter of 1997. Increases in the production price index followed a similar trend and declined from a peak of 9.6 per cent in March 1997 to 6.1 per cent in September. In the third quarter of 1997, the seasonally adjusted annualised rate of production price inflation indeed declined to a very low level of 2.1 per cent. The rate of increase in the total amount of domestic bank credit extension to the public and private sectors together similarly showed an encouraging slowdown in recent months. The rate of growth in total bank credit extension reached a peak of 21.6 per cent in February 1997, before declining to 15.3 per cent over the twelve months up to September 1997. The growth from quarter to quarter in the average total domestic credit extension fell from 23.6 per cent in the first quarter of 1997 to 6.2 per cent in the third quarter. The growth in total bank credit extended to the private sector also declined to a level of less than 10 per cent in the third quarter. Developments in the M3-money supply were less satisfactory. The growth rate in M3 measured over twelve months declined from 16.5 per cent in March 1997 to 12.7 per cent in June, but then accelerated again to 16.3 per cent in September 1997. On a quarterly basis, however, the rate of increase in M3 also slowed down from 18.1 per cent in the first quarter of 1997 to 12.2 per cent in the third quarter. Another monetary aggregate which is of great importance for the Reserve Bank is the amount of liquidity available in the banking sector as reflected in the amount of loans banking institutions seek from the Reserve Bank's discount window every day. This amount declined from a daily average level of R10.6 billion in March 1997 to R5.3 billion in October, indicating that the lower rate of increase in the demand for credit was no longer absorbing the increases in liquidity arising from the large net capital inflows from abroad. The banks no longer needed large amounts of Reserve Bank assistance for most of the time. These trends in monetary conditions were also reflected in interest rates which first rose quite substantially last year but then declined since the beginning of 1997. The rate on bankers' acceptances with a maturity of three months declined from 16.2 per cent at the end of January 1997 to 14.2 per cent on 25 October. Satisfactory developments also occurred in the international financial aggregates over the past twelve months. The net inflow of foreign capital gained momentum again towards the end of 1996. During the first three quarters of this year, the total net capital inflow amounted to almost R20 billion. Net purchases of bonds and equities by non-residents amounted to about R34 billion, which enabled South African residents, mainly institutional investors, to switch a further R17 billion of their South African portfolios into foreign currency denominated assets. The relatively large net capital inflows during the first three quarters of 1997 exceeded a smaller deficit on the current account of the balance of payments and enabled the Reserve Bank and the private banking sector to increase their holdings of short-term foreign assets. At the end of September 1997, the total gross gold and other foreign exchange reserves held by the combined banking sector amounted to an estimated R33.6 billion, or the equivalent of about 10 weeks' imports. These favourable overall balance of payments developments contributed to a more stable exchange rate for the rand. After depreciating by almost 22 per cent in 1996, the nominal effective exchange rate of the rand, measured against a basket of the currencies of South Africa's major trading partners, depreciated by less than one per cent from 31 December 1996 to 31 October 1997. Larger depreciations against the US dollar and the British pound were neutralised by appreciations against most of the European currencies and the Japanese yen. The average value of the rand against foreign currencies for the first ten months of the year is about 6 per cent lower compared with the average value for the first ten months of 1996. 3. Implications for monetary policy Monetary policy decisions in South Africa are guided mainly by developments in financial aggregates such as the money supply, bank credit extension, money market liquidity, market interest rates, the official foreign reserves and the exchange rate. There is, over time, obviously a relationship between developments in the financial aggregates and in real economic activity. The growth rates of most of the financial aggregates over the past few months showed a marked slowdown, particularly the rates of growth in the components of gross domestic expenditure, which already started to decline in the second half of 1996. Critics of the Reserve Bank are often of the opinion that monetary policy should be linked more directly to changes in real economic activity, and not to changes in the financial aggregates. The experience of the 1960s and 1970s, when monetary policy was still guided by Keynesian demand management principles, proved that premature relaxations of monetary policy could easily lead to "stop-go" or "boom-bust" economies, and to a persistent rise of inflation to a higher level after the completion of each successive business cycle. In the modern approach of supply side economies, monetary authorities in most countries now link policy changes with great success rather to changes in the financial aggregates. There is therefore a different and more effective timing of changes in monetary policy. Taking account of developments in real economic activity in South Africa over the past year, in the overall balance of payments and in the financial markets, the Reserve Bank adopted an easier monetary policy stance already in the middle of 1997. The Bank acquiesced in gradual increases in money market liquidity, and also in the declines of market interest rates such as the yield on long-term government bonds and Treasury bills, and on bankers' acceptances and negotiable certificates of deposit. The Reserve Bank endorsed the easier monetary conditions by reducing the Bank rate from 17 to 16 per cent on 20 October 1997. 4. Recent developments in the monetary situation Since the last week of October, turmoil in the currency and capital markets overflowed the cauldron of certain overheated East Asian economies and disrupted also the South African financial tranquillity. These developments led to some substantial selling of South African bonds and equities by non-residents, sharp declines in equity prices, volatile conditions in the foreign exchange markets, an increase in the money market shortage and upward pressure on interest rates. Understandably, the new situation created great uncertainty in the financial markets and initiated an ongoing debate on what the consequences of these developments would be for South Africa. There is no doubt that major adjustments will be necessary to restore equilibrium in the economies of the affected East Asian countries. Some of the countries, for example Thailand, are already biting the bullet and are now implementing IMF austerity programmes for painful macroeconomic adjustments that cannot be avoided. It will take time to restore confidence and to put a new tiger in the tanks of those countries that are perhaps now suffering from growth fatigue. It remains to be seen to what extent the unavoidable slow-down in real economic activity of the East Asian region will affect global economic developments over the next year. The South African economic conditions will obviously also be influenced by these developments, although our direct trade with the affected economies is relatively small. We have perhaps a greater interest in the early recovery of the ailing Japanese economy, which can now also be delayed because of adverse influences of conditions in the economies of the tired tigers of the region. South Africa has also recently been affected by the decline in the gold price, a development which is of course not completely unrelated to the developments in the foreign exchange and capital markets. There may be some disappointment that on this occasion international investors looking for value in a flight from securities opted for the US dollar, and not for gold. Once again, the possible adverse effects of the decline in the gold price on the South African balance of payments or the exchange rate of the rand should not be exaggerated. It holds a much greater social problem if one or two gold mines should be forced to close and many mine workers should be retrenched because of the low gold price. Monetary policy must obviously even in the short term be adapted to major changes in underlying conditions, and must take account of the recent dramatic movements in the foreign exchange and financial markets. The basic fundamentals in South Africa, however, remain sound and well-balanced. Should these external disruptions settle down soon, and should the events of the past few months in East Asia not have too much of a ripple effect on the overall global economic growth prospects for 1998, South Africa can look forward to a period of steady and sound economic recovery next year. 5. Implications for 1998 The macroeconomic consolidation process in the South African business cycle has been completed to an important extent: There is better equilibrium now between real total domestic production and real total demand; The overall balance of payments is in surplus and the capital inflows up to the third • quarter exceeded a relatively small current account deficit; • In the financial sector, both money supply and bank credit extension still increased at relatively high rates over the past year, but slowed down significantly over the past few months; • The total gold and foreign exchange reserves is now at a more comfortable level than at any stage last year; • The rate of inflation has declined since the first quarter of this year and the rates of increase in both consumer and producer prices will hopefully continue on a downward path; • the average nominal effective exchange rate of the rand stabilised over the past year. Not everyting is, however, favourable for an expected economic recovery in South Africa next year. In our forward planning we must take account of: the possible adverse effects on the global economy of the present problems of certain East Asian countries and Japan; • the adverse effects of the lower gold price, particularly for the official objective of increasing total formal sector employment in South Africa; and • the threatening danger of adverse climatic conditions because of the El Nino effect. On balance, South Africa can with justification look forward to a better economic performance in 1998 after the successful consolidation period of 1997.	['mr. stals discusses the current monetary situation in south africa and the implications for 1998 address by the governor of the south african reserve bank, dr. c. stals, at an investment conference arranged by huysamer stals in johannesburg on 18/11/97.', '1. the task and function of monetary policy monetary policy is about money.', 'governments give central banks the special right to issue money, and also a mandate to manage the money system in the interest of economic development.', 'in the final situation, monetary policy is about the quantity of money, the price of money and the value of money.', 'in the broad context of macroeconomic policy, the central bank is normally tasked with the function of protecting the value of money.', 'this is but an immediate objective, making an important contribution to the achievement of the ultimate goal of economic policy, which is to sustain optimum economic development that will create more jobs and lead to an improvement in the standard of living of all the people of the country.', 'monetary policy cannot be used to solve all the macroeconomic problems of a country.', 'however, a stable financial environment with a low rate of inflation is regarded as an important precondition for the solution of many of the existing macroeconomic problems in any country.', 'by focusing on the maintenance of low inflation, central banks do not distance themselves from the broader macroeconomic problems such as excessive budget shortages, untenable balance-of-payments deficits, short-term business cycle developments or uncompetitive international trade positions.', 'it is indeed only in conditions of a stable financial environment, that is low inflation, that the real nature of the more fundamental macroeconomic deficiencies will be exposed, diagnosed, understood and rectified.', 'in most cases, remedial action for structural economic ails will also not produce the required corrections in an inflationary environment.', 'pressure is often put on central banks to harness the power of money creation for purposes other than pure monetary policy objectives, for example to facilitate the financing of public sector budget deficits, or to stimulate real demand for goods and services, or to help small businesses.', 'pursuing all kinds of non-monetary objectives with monetary policy will, however, normally lead the country inevitably on the dead-end road of higher inflation.', '2. recent monetary developments in south africa the main objective of monetary policy therefore is and should be to keep inflation low.', "in the absence of a national commitment to a predetermined and quantified target for inflation, the reserve bank's approach is that the rate of inflation in south africa should be maintained more or less in line with the average rate of inflation in the economies of our major trading partners and competitors.", 'measured against this benchmark, south africa did not do well in recent years.', 'it is true that the average rate of inflation stayed around a level of about 14 per cent for more than twenty years from 1972 to 1992 and has now been kept below 10 per cent per annum for almost 5 years.', 'at the level of 8 per cent established over the twelve months up to september 1997, the most recent available statistic, the south african rate of inflation is, however, still about three times as high as the current rates of inflation in our major international trading partners.', 'after the depreciation of the rand last year, consumer price inflation increased from 5.5 per cent in april 1996 to 9.9 per cent in april 1997. since then, it declined again to 8 per cent in september.', 'calculated at a seasonally adjusted annualised rate, consumer prices increased by only 6.6 per cent in the third quarter of 1997. increases in the production price index followed a similar trend and declined from a peak of 9.6 per cent in march 1997 to 6.1 per cent in september.', 'in the third quarter of 1997, the seasonally adjusted annualised rate of production price inflation indeed declined to a very low level of 2.1 per cent.', 'the rate of increase in the total amount of domestic bank credit extension to the public and private sectors together similarly showed an encouraging slowdown in recent months.', 'the rate of growth in total bank credit extension reached a peak of 21.6 per cent in february 1997, before declining to 15.3 per cent over the twelve months up to september 1997. the growth from quarter to quarter in the average total domestic credit extension fell from 23.6 per cent in the first quarter of 1997 to 6.2 per cent in the third quarter.', 'the growth in total bank credit extended to the private sector also declined to a level of less than 10 per cent in the third quarter.', 'developments in the m3-money supply were less satisfactory.', 'the growth rate in m3 measured over twelve months declined from 16.5 per cent in march 1997 to 12.7 per cent in june, but then accelerated again to 16.3 per cent in september 1997. on a quarterly basis, however, the rate of increase in m3 also slowed down from 18.1 per cent in the first quarter of 1997 to 12.2 per cent in the third quarter.', "another monetary aggregate which is of great importance for the reserve bank is the amount of liquidity available in the banking sector as reflected in the amount of loans banking institutions seek from the reserve bank's discount window every day.", 'this amount declined from a daily average level of r10.6 billion in march 1997 to r5.3 billion in october, indicating that the lower rate of increase in the demand for credit was no longer absorbing the increases in liquidity arising from the large net capital inflows from abroad.', 'the banks no longer needed large amounts of reserve bank assistance for most of the time.', "these trends in monetary conditions were also reflected in interest rates which first rose quite substantially last year but then declined since the beginning of 1997. the rate on bankers' acceptances with a maturity of three months declined from 16.2 per cent at the end of january 1997 to 14.2 per cent on 25 october.", 'satisfactory developments also occurred in the international financial aggregates over the past twelve months.', 'the net inflow of foreign capital gained momentum again towards the end of 1996. during the first three quarters of this year, the total net capital inflow amounted to almost r20 billion.', 'net purchases of bonds and equities by non-residents amounted to about r34 billion, which enabled south african residents, mainly institutional investors, to switch a further r17 billion of their south african portfolios into foreign currency denominated assets.', 'the relatively large net capital inflows during the first three quarters of 1997 exceeded a smaller deficit on the current account of the balance of payments and enabled the reserve bank and the private banking sector to increase their holdings of short-term foreign assets.', "at the end of september 1997, the total gross gold and other foreign exchange reserves held by the combined banking sector amounted to an estimated r33.6 billion, or the equivalent of about 10 weeks' imports.", 'these favourable overall balance of payments developments contributed to a more stable exchange rate for the rand.', "after depreciating by almost 22 per cent in 1996, the nominal effective exchange rate of the rand, measured against a basket of the currencies of south africa's major trading partners, depreciated by less than one per cent from 31 december 1996 to 31 october 1997. larger depreciations against the us dollar and the british pound were neutralised by appreciations against most of the european currencies and the japanese yen.", 'the average value of the rand against foreign currencies for the first ten months of the year is about 6 per cent lower compared with the average value for the first ten months of 1996.', '3. implications for monetary policy monetary policy decisions in south africa are guided mainly by developments in financial aggregates such as the money supply, bank credit extension, money market liquidity, market interest rates, the official foreign reserves and the exchange rate.', 'there is, over time, obviously a relationship between developments in the financial aggregates and in real economic activity.', 'the growth rates of most of the financial aggregates over the past few months showed a marked slowdown, particularly the rates of growth in the components of gross domestic expenditure, which already started to decline in the second half of 1996. critics of the reserve bank are often of the opinion that monetary policy should be linked more directly to changes in real economic activity, and not to changes in the financial aggregates.', 'the experience of the 1960s and 1970s, when monetary policy was still guided by keynesian demand management principles, proved that premature relaxations of monetary policy could easily lead to "stop-go" or "boom-bust" economies, and to a persistent rise of inflation to a higher level after the completion of each successive business cycle.', 'in the modern approach of supply side economies, monetary authorities in most countries now link policy changes with great success rather to changes in the financial aggregates.', 'there is therefore a different and more effective timing of changes in monetary policy.', "taking account of developments in real economic activity in south africa over the past year, in the overall balance of payments and in the financial markets, the reserve bank adopted an easier monetary policy stance already in the middle of 1997. the bank acquiesced in gradual increases in money market liquidity, and also in the declines of market interest rates such as the yield on long-term government bonds and treasury bills, and on bankers' acceptances and negotiable certificates of deposit.", 'the reserve bank endorsed the easier monetary conditions by reducing the bank rate from 17 to 16 per cent on 20 october 1997.', '4. recent developments in the monetary situation since the last week of october, turmoil in the currency and capital markets overflowed the cauldron of certain overheated east asian economies and disrupted also the south african financial tranquillity.', 'these developments led to some substantial selling of south african bonds and equities by non-residents, sharp declines in equity prices, volatile conditions in the foreign exchange markets, an increase in the money market shortage and upward pressure on interest rates.', 'understandably, the new situation created great uncertainty in the financial markets and initiated an ongoing debate on what the consequences of these developments would be for south africa.', 'there is no doubt that major adjustments will be necessary to restore equilibrium in the economies of the affected east asian countries.', 'some of the countries, for example thailand, are already biting the bullet and are now implementing imf austerity programmes for painful macroeconomic adjustments that cannot be avoided.', 'it will take time to restore confidence and to put a new tiger in the tanks of those countries that are perhaps now suffering from growth fatigue.', 'it remains to be seen to what extent the unavoidable slow-down in real economic activity of the east asian region will affect global economic developments over the next year.', 'the south african economic conditions will obviously also be influenced by these developments, although our direct trade with the affected economies is relatively small.', 'we have perhaps a greater interest in the early recovery of the ailing japanese economy, which can now also be delayed because of adverse influences of conditions in the economies of the tired tigers of the region.', 'south africa has also recently been affected by the decline in the gold price, a development which is of course not completely unrelated to the developments in the foreign exchange and capital markets.', 'there may be some disappointment that on this occasion international investors looking for value in a flight from securities opted for the us dollar, and not for gold.', 'once again, the possible adverse effects of the decline in the gold price on the south african balance of payments or the exchange rate of the rand should not be exaggerated.', 'it holds a much greater social problem if one or two gold mines should be forced to close and many mine workers should be retrenched because of the low gold price.', 'monetary policy must obviously even in the short term be adapted to major changes in underlying conditions, and must take account of the recent dramatic movements in the foreign exchange and financial markets.', 'the basic fundamentals in south africa, however, remain sound and well-balanced.', 'should these external disruptions settle down soon, and should the events of the past few months in east asia not have too much of a ripple effect on the overall global economic growth prospects for 1998, south africa can look forward to a period of steady and sound economic recovery next year.', '5. implications for 1998 the macroeconomic consolidation process in the south african business cycle has been completed to an important extent: there is better equilibrium now between real total domestic production and real total demand; the overall balance of payments is in surplus and the capital inflows up to the third • quarter exceeded a relatively small current account deficit; • in the financial sector, both money supply and bank credit extension still increased at relatively high rates over the past year, but slowed down significantly over the past few months; • the total gold and foreign exchange reserves is now at a more comfortable level than at any stage last year; • the rate of inflation has declined since the first quarter of this year and the rates of increase in both consumer and producer prices will hopefully continue on a downward path; • the average nominal effective exchange rate of the rand stabilised over the past year.', 'not everyting is, however, favourable for an expected economic recovery in south africa next year.', 'in our forward planning we must take account of: the possible adverse effects on the global economy of the present problems of certain east asian countries and japan; • the adverse effects of the lower gold price, particularly for the official objective of increasing total formal sector employment in south africa; and • the threatening danger of adverse climatic conditions because of the el nino effect.', 'on balance, south africa can with justification look forward to a better economic performance in 1998 after the successful consolidation period of 1997.']	Chris Stals	South African Reserve Bank	Governor	South Africa
https://www.bis.org/review/r980109b.pdf	Bank of Japan's December review of monetary and economic trends in Japan (Central Bank Articles and Speeches, 22 Dec 97)	BANK OF JAPAN, COMMUNICATION, 22/12/97.	1997-12-22 00:00:00	Bank of Japan's December review of monetary and economic trends in Japan BANK OF JAPAN, COMMUNICATION, 22/12/97. Japan's economic growth has stalled. Weak household expenditures have gradually affected production, employment and income. Corporate sentiment is also deteriorating. With respect to final demand, net exports have continued to increase and business fixed investment has been rising moderately, particularly in the manufacturing sector. Meanwhile, public-sector investment has been decreasing, and housing investment has also continued to be weak. Personal consumption has continued to stagnate, reflecting weakening consumer confidence. Industrial production has been on a slightly declining trend because inventory adjustment pressure has spread gradually reflecting weak final demand. The pace of improvement in employment and income conditions has been slowing. Prices have remained stable on the whole, with the exception of wholesale prices which have declined somewhat. Monetary aggregates continue to grow at around 3 per cent. Personal consumption has continued to stagnate. Although outlays for travel have been increasing moderately, passenger car sales have fallen significantly below the level recorded in the second half of fiscal 1996 when sales surged, and have not even recovered the levels recorded before then. The recovery in sales of household electrical appliances has paused and sales at department stores and supermarkets have remained below the previous year's level. Among leading indicators of business fixed investment, machinery orders continued to increase since early 1997 after having surged in the second half of 1996. Recently, orders from nonmanufacturing firms have been weak, however. Construction floor area has followed a moderate recovery trend, albeit with some fluctuations. According to the Bank of Japan's Tankan -- Short-term Economic Survey of Enterprises of December, investment growth in the principal nonmanufacturing firms for fiscal 1997 is projected to be lower than that in fiscal 1996, while growth in the principal manufacturing firms is planned to be higher than that in the previous fiscal year. This makes the growth of investment plans in principal firms overall the same as the previous year. Meanwhile, overall investment plans by small firms in fiscal 1997 are lower than those for fiscal 1996. This is because investment plans of nonmanufacturing firms fell significantly below the previous year, although plans of manufacturing firms at this time of the fiscal year grew at a somewhat higher pace compared to fiscal 1996. With respect to housing investment, housing starts in terms of the seasonally-adjusted annual rate declined in July to 1.24 million, the lowest level since September 1985, following the surge in demand in the second half of 1996 ahead of the consumption tax hike. Housing starts have since remained weak at around 1.3 - 1.4 million. Regarding public-sector investment, the amount of public works contracted has followed a decreasing trend reflecting the restrained budget for fiscal 1997. Real exports have continued to rise since the second quarter 1997 against the background of steady overseas demand and the yen's depreciation to date. Real imports, on the other hand, have remained virtually unchanged, partly owing to weak domestic demand. Meanwhile, the impact of the turmoil in the East Asian economies has been limited, although some exports to Asia have declined. As a result, the real trade surplus has been increasing with some fluctuations. Reflecting these developments, the nominal current-account surplus has also been expanding significantly since April 1997. Industrial production remained virtually unchanged in the third quarter 1997. Production in the fourth quarter is expected to decrease on the whole. This is because inventory adjustment which has derived from weak domestic sales, began to spread from consumer durables and construction-related goods to materials. Meanwhile, the December Tankan shows that the increasing trend in current profits is expected to continue for the large manufacturing firms (excluding petroleum refinery) in fiscal 1997, while those in the nonmanufacturing sector (excluding electricity and gas) are projected to decline. Forecasts of current profit growth in both the manufacturing and nonmanufacturing sector have been revised downwards since the September survey. In these circumstances, the business confidence DI for current conditions and on the outlook for principal firms in the manufacturing and nonmanufacturing sectors have both deteriorated. Current profits of small firms in both the manufacturing and nonmanufacturing sector are expected to decline in fiscal 1997. The business confidence DI has also deteriorated in most industries. With respect to labor market conditions, the unemployment rate has remained at a high level, and the ratio of job offers to job applications has recently eased. In October 1997, overtime working hours fell below the previous year's level for the first time since August 1994, and the growth in employment and nominal wages has recently been slowing gradually, reflecting weak production. Thus, the pace of recovery in employment and income conditions has slowed. Prices remained stable on the whole. Domestic wholesale prices have declined to some extent, partly owing to inventory adjustments. The corporate service prices on the whole have remained virtually unchanged from the previous year's level. This is because supply and demand conditions in real estate rents and information service prices have improved, although leasing charges have continued to decline. Consumer prices (nationwide, excluding perishables) have remained stable at a level slightly above that of the previous year excluding the institutional factors, such as the medical insurance system reform. The growth in monetary aggregates, measured in terms of year-to-year growth of M2 + CDs average outstanding, was 2.9 per cent in October and 3.2 in November. Regarding money market rates, the overnight call rate (uncollateralized) had moved at a level slightly below the official discount rate, and the 3-month CD rate had stayed at around 0.50 - 0.60 per cent since summer 1997. However, as the market participants became cautious following the failures of some financial institutions in November, the overnight call rate (uncollateralized) rose to around 0.65 in late November, and the 3-month CD rate to around 0.85 per cent in early December. In reaction to this, the Bank continued to provide the market with ample liquidity. As a result, the overnight call rate has gradually recovered its stability. Longer term money market rates, on the other hand, have remained high, partly reflecting the Japan premium in overseas markets. The long-term government bond yield fluctuated at around 1.6 - 1.8 per cent during November against the background of uncertainties about future economic growth and anticipation of the economic stimulus package. In early December, it reached the record low level of 1.5 - 1.6 per cent, and has recently recovered to 1.6 - 1.8 per cent. With respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since September 1995. The long-term prime lending rate has been at a record low of 2.3 per cent since October 1997. In these circumstances, short and long-term contracted interest rates for new loans and discounts (up to October) have stayed at record low levels. According to the December Tankan, both principal and small firms started to feel that the lending attitude of financial institutions have become more severe. Among small firms in particular, the difference between the total number of those which feel that the lending attitude is easy and those which feel that it is severe (easy minus severe) has reached a negative figure. Against the background of uncertainties about economic growth and about the stability of the financial system, the Nikkei 225 stock average has declined to ¥15,000 by mid-November, with the additional impact from the precipitous decline in Hong Kong stock prices in late October. It has since shown wide fluctuations between ¥15, 000 and ¥17,000. In the foreign exchange market, the yen had moved at around ¥119 - 123 to the U.S. dollar until October. However, the yen began to depreciate in November and temporarily declined to ¥131- 132 in mid-December. It then recovered and has recently moved at around ¥127 - 130. Meanwhile, the yen started to depreciate against the Deutsche Mark after having peaked at around ¥62 in mid-August, and has recently moved at around ¥71 - 74.	["bank of japan's december review of monetary and economic trends in japan bank of japan, communication, 22/12/97.", "japan's economic growth has stalled.", 'weak household expenditures have gradually affected production, employment and income.', 'corporate sentiment is also deteriorating.', 'with respect to final demand, net exports have continued to increase and business fixed investment has been rising moderately, particularly in the manufacturing sector.', 'meanwhile, public-sector investment has been decreasing, and housing investment has also continued to be weak.', 'personal consumption has continued to stagnate, reflecting weakening consumer confidence.', 'industrial production has been on a slightly declining trend because inventory adjustment pressure has spread gradually reflecting weak final demand.', 'the pace of improvement in employment and income conditions has been slowing.', 'prices have remained stable on the whole, with the exception of wholesale prices which have declined somewhat.', 'monetary aggregates continue to grow at around 3 per cent.', 'personal consumption has continued to stagnate.', 'although outlays for travel have been increasing moderately, passenger car sales have fallen significantly below the level recorded in the second half of fiscal 1996 when sales surged, and have not even recovered the levels recorded before then.', "the recovery in sales of household electrical appliances has paused and sales at department stores and supermarkets have remained below the previous year's level.", 'among leading indicators of business fixed investment, machinery orders continued to increase since early 1997 after having surged in the second half of 1996. recently, orders from nonmanufacturing firms have been weak, however.', 'construction floor area has followed a moderate recovery trend, albeit with some fluctuations.', "according to the bank of japan's tankan -- short-term economic survey of enterprises of december, investment growth in the principal nonmanufacturing firms for fiscal 1997 is projected to be lower than that in fiscal 1996, while growth in the principal manufacturing firms is planned to be higher than that in the previous fiscal year.", 'this makes the growth of investment plans in principal firms overall the same as the previous year.', 'meanwhile, overall investment plans by small firms in fiscal 1997 are lower than those for fiscal 1996. this is because investment plans of nonmanufacturing firms fell significantly below the previous year, although plans of manufacturing firms at this time of the fiscal year grew at a somewhat higher pace compared to fiscal 1996. with respect to housing investment, housing starts in terms of the seasonally-adjusted annual rate declined in july to 1.24 million, the lowest level since september 1985, following the surge in demand in the second half of 1996 ahead of the consumption tax hike.', 'housing starts have since remained weak at around 1.3 - 1.4 million.', "regarding public-sector investment, the amount of public works contracted has followed a decreasing trend reflecting the restrained budget for fiscal 1997. real exports have continued to rise since the second quarter 1997 against the background of steady overseas demand and the yen's depreciation to date.", 'real imports, on the other hand, have remained virtually unchanged, partly owing to weak domestic demand.', 'meanwhile, the impact of the turmoil in the east asian economies has been limited, although some exports to asia have declined.', 'as a result, the real trade surplus has been increasing with some fluctuations.', 'reflecting these developments, the nominal current-account surplus has also been expanding significantly since april 1997. industrial production remained virtually unchanged in the third quarter 1997. production in the fourth quarter is expected to decrease on the whole.', 'this is because inventory adjustment which has derived from weak domestic sales, began to spread from consumer durables and construction-related goods to materials.', 'meanwhile, the december tankan shows that the increasing trend in current profits is expected to continue for the large manufacturing firms (excluding petroleum refinery) in fiscal 1997, while those in the nonmanufacturing sector (excluding electricity and gas) are projected to decline.', 'forecasts of current profit growth in both the manufacturing and nonmanufacturing sector have been revised downwards since the september survey.', 'in these circumstances, the business confidence di for current conditions and on the outlook for principal firms in the manufacturing and nonmanufacturing sectors have both deteriorated.', 'current profits of small firms in both the manufacturing and nonmanufacturing sector are expected to decline in fiscal 1997. the business confidence di has also deteriorated in most industries.', 'with respect to labor market conditions, the unemployment rate has remained at a high level, and the ratio of job offers to job applications has recently eased.', "in october 1997, overtime working hours fell below the previous year's level for the first time since august 1994, and the growth in employment and nominal wages has recently been slowing gradually, reflecting weak production.", 'thus, the pace of recovery in employment and income conditions has slowed.', 'prices remained stable on the whole.', 'domestic wholesale prices have declined to some extent, partly owing to inventory adjustments.', "the corporate service prices on the whole have remained virtually unchanged from the previous year's level.", 'this is because supply and demand conditions in real estate rents and information service prices have improved, although leasing charges have continued to decline.', 'consumer prices (nationwide, excluding perishables) have remained stable at a level slightly above that of the previous year excluding the institutional factors, such as the medical insurance system reform.', 'the growth in monetary aggregates, measured in terms of year-to-year growth of m2 + cds average outstanding, was 2.9 per cent in october and 3.2 in november.', 'regarding money market rates, the overnight call rate (uncollateralized) had moved at a level slightly below the official discount rate, and the 3-month cd rate had stayed at around 0.50 - 0.60 per cent since summer 1997. however, as the market participants became cautious following the failures of some financial institutions in november, the overnight call rate (uncollateralized) rose to around 0.65 in late november, and the 3-month cd rate to around 0.85 per cent in early december.', 'in reaction to this, the bank continued to provide the market with ample liquidity.', 'as a result, the overnight call rate has gradually recovered its stability.', 'longer term money market rates, on the other hand, have remained high, partly reflecting the japan premium in overseas markets.', 'the long-term government bond yield fluctuated at around 1.6 - 1.8 per cent during november against the background of uncertainties about future economic growth and anticipation of the economic stimulus package.', 'in early december, it reached the record low level of 1.5 - 1.6 per cent, and has recently recovered to 1.6 - 1.8 per cent.', 'with respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since september 1995. the long-term prime lending rate has been at a record low of 2.3 per cent since october 1997. in these circumstances, short and long-term contracted interest rates for new loans and discounts (up to october) have stayed at record low levels.', 'according to the december tankan, both principal and small firms started to feel that the lending attitude of financial institutions have become more severe.', 'among small firms in particular, the difference between the total number of those which feel that the lending attitude is easy and those which feel that it is severe (easy minus severe) has reached a negative figure.', 'against the background of uncertainties about economic growth and about the stability of the financial system, the nikkei 225 stock average has declined to ¥15,000 by mid-november, with the additional impact from the precipitous decline in hong kong stock prices in late october.', 'it has since shown wide fluctuations between ¥15, 000 and ¥17,000.', 'in the foreign exchange market, the yen had moved at around ¥119 - 123 to the u.s. dollar until october.', 'however, the yen began to depreciate in november and temporarily declined to ¥131- 132 in mid-december.', 'it then recovered and has recently moved at around ¥127 - 130. meanwhile, the yen started to depreciate against the deutsche mark after having peaked at around ¥62 in mid-august, and has recently moved at around ¥71 - 74.']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r980109a.pdf	Mr. Matsushita discusses recent monetary and economic conditions in Japan and comments on the Bank of Japan's monetary policy management (Central Bank Articles and Speeches, 5 Nov 97)	Speech by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, to the Research Institute of Japan in Tokyo on 5/11/97.	1997-11-05 00:00:00	Mr. Matsushita discusses recent monetary and economic conditions in Japan and comments on the Bank of Japan's monetary policy management Speech by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, to the Research Institute of Japan in Tokyo on 5/11/97. I. Introduction It is a great honor to be invited by the Research Institute of Japan to address this distinguished audience. It has been one year since I last attended this gathering in November 1996. Looking back at the economic developments in Japan over the past year, economic growth temporarily accelerated from the latter half of 1996 through the spring of 1997, helped to some extent by increased demand ahead of the rise in the consumption tax rate in fiscal 1997. Since April this year, however, economic growth has been decelerating partly reflecting the lingering effects of the rise in the consumption tax rate. During this period, business sentiment seems to have become more cautious. Today, I would like to give views of the Bank of Japan on the present condition of and on the outlook for the Japanese economy. I will also discuss the Bank's thinking behind its monetary policy management. I would then like to use the remaining time to discuss the Bank's views on some of the comments and questions the Bank has been receiving recently concerning the prolonged easy money policy, by which the official discount rate has been maintained at 0.5 percent for more than two years. Through my explanation, I hope to gain your better understanding on the Bank's aims in its monetary policy management. II. Recent Monetary and Economic Conditions and the Bank's Monetary Policy Management A. The Present Condition of and the Outlook for the Domestic Economy Let me first discuss the domestic economic condition. Japan's economic growth has been decelerating since April 1997 partly reflecting the impact of the rise in the consumption tax rate that took place that month. In addition to the continuing decrease in public investment since autumn 1996, household spending such as personal consumption and housing investment has also dropped significantly since April 1997. As regards personal consumption, outlays on services such as those provided by the travel industry have been increasing moderately. However, outlays on goods have remained sluggish, as indicated by the sales of automobiles and household electric appliances as well as department store and chain store sales, although there are signs of a slight recovery. In addition, housing investment in terms of housing starts has declined more recently to 1.3 million from the 1.6 million per annum level that existed until spring 1997. Several factors are responsible for such declines in household spending. The first is the strong and persistent reaction to the significantly increased demand ahead of the rise in the consumption tax rate. The increase in sales in the consumer goods- and housing-related industries from the latter half of 1996 had been taken as a strong indication of a sustainable recovery. In hindsight, those sales in fact included a significant amount of demand for household spending that would most likely have taken place later this year had the hike in the tax rate not been scheduled. The second factor, which to some extent had been anticipated, is the slowdown in the growth of real disposable income of households -- nominal income less tax payments and income erosion due to inflation -- following the rise in the consumption tax rate and the discontinuation of the special tax reduction. In addition, it seems undeniable that consumer confidence has weakened somewhat. This decline in household expenditure since spring 1997, which was greater than had initially been anticipated, created excess inventories in certain sectors of consumer goods- and housing-related industries. These sectors have been required to reduce excess inventories since summer 1997 and, as a result, industrial production has leveled off. These developments in household expenditure and industrial production have resulted in a more cautious business sentiment. The question is whether these developments in household expenditure and industrial production will undermine the momentum of economic recovery, or in other words, whether the declining personal consumption and housing investment will affect other demand items such as business fixed investment, thereby placing further downside pressure on the economy. The answer lies in the current strength of the self-sustained recovery in the private sector, and this is precisely what the Bank has carefully attended to over the past two years. As this is the most important factor when judging the outlook for the economy, I would like to give the Bank's views in some detail. I will start off by discussing what is meant by the momentum of a self-sustained economic recovery, and then move on to the Bank's assessment of the present force of the self-sustained recovery as compared to that in 1995, when the Bank lowered the official discount rate to 0.5 percent. Lastly, I will use these points to examine the actual developments in demand and production, and assess the outlook for the economy. The strength of self-sustained recovery of the private sector can be considered as the strength of the cyclical force inherent in the private sector. With this force, a build up of economic activity should lead to improved business sentiment, which, in turn, should lead to increased earnings and income. The rises in earnings and income should eventually encourage sustained growth in business fixed investment and personal consumption, respectively. When the strength of the self-sustained recovery, or the momentum of this cyclical force, is very weak, there is a risk that private-sector activity might begin to decline, particularly if unable to absorb the negative impact of such exogenous factors as external demand and fiscal policy. However, when there is a reasonable measure of strength in the self-sustained recovery, the inherent force can be expected to withstand the negative impact and put the economy back on the recovery path, despite being temporarily decelerated. In this case, the negative impact is contained and the private sector's economic outlook and investment attitude remain firm. As the pressures created by those exogenous factors subsequently subside, economic recovery should gradually become apparent. I will now turn to my second point, that is, assessment of the strength of Japan's self-sustained recovery. The Japanese economy began to recover in late 1993 from a recession that followed the collapse of the "bubble" economy. In early 1995, however, the recovery paused, and there were even concerns about the occurrence of a deflationary spiral. In view of these circumstances, drastic monetary and fiscal policy measures were adopted. While the halt was directly attributable to the negative effects of the rapid appreciation of the yen, it was also due to the fact that the strength of the self-sustained recovery in the private sector was yet too weak to overcome the downward pressures from outside the private sector. It is true that the economy had been on a recovery trend since late 1993. However, we at the Bank judge that because firms' profitability as well as capacity utilization had remained at a low level, the shock of a sudden appreciation of the yen applied the brakes to the economic recovery. The important issue now is how much strength there is in the recent economic recovery in Japan. Balance-sheet adjustment and adjustment of industrial structure are still in process. This being the case, we at the Bank do not believe that the self-sustained economic recovery has gained sufficient strength. This is precisely why we have maintained the official discount rate at a low level since September 1995. In the course of the gradual economic recovery over the past two years, however, the level of economic activity has doubtlessly been rising steadily, gradually adding to the strength of the self-sustained economic recovery. Specifically, there has been some progress in balance-sheet adjustment and industrial restructuring as corporate profits continued to increase. The manufacturing sector, especially large manufacturers, have achieved a higher than average level of profitability, although the profitability of the nonmanufacturing sector remains low. According to the results of the "Tankan -- Short-Term Economic Survey of Enterprises in Japan", firms feel that there have been declines in the excessiveness of production capacity and employment. This implies that while business fixed investment increased over the past two years, excessive accumulation of capital stock has been avoided. Judging from these points, the force of the self-sustained economic recovery has clearly strengthened compared to 1995, at which time there were concerns about a deflationary spiral. Thirdly, I would like to discuss the outlook for demand, production, and income based on the aforementioned assessment of the self-sustained economic recovery. As for final demand, personal consumption and housing investment continue to be sluggish in general and public investment is expected to follow a declining trend. Employment, however, continues to be on a trend of gradual recovery. Firms plan to increase the number of newly hired graduates in fiscal 1998 for the second consecutive year. Although the growth of the household sector's real disposable income is expected to slow, any substantial income erosion should be avoided owing to the increase in employment. Therefore, provided that there is no serious deterioration of consumer confidence, personal consumption should gradually move toward recovery as the initial impact of the rise in the consumption tax rate diminishes. Meanwhile, net exports and business fixed investment continue to increase. Exports have increased significantly since the latter half of 1996, reflecting the depreciation of the yen until spring 1997. Imports, after having increased rapidly until mid-1996 due partly to a growth in imports from the overseas subsidiaries of Japanese manufacturers, have leveled off recently reflecting the depreciation of the yen. Under these circumstances, the key issue for the time being is how the recent currency and financial instability in Southeast Asia will affect Japan's exports and imports and its economy as a whole. In view of the progress in the horizontal division of labor and expansion of trade and capital transactions between Japan and other Asian countries, this matter requires due attention. If we take a look at Japan's trade with Asian countries, Japan's exports to Thailand have decreased significantly. However, there have not been any notable declines in exports to other neighboring countries. In addition, Japan's other export markets such as the United States maintain solid economic growth. On the foreign exchange market, the yen has appreciated against Southeast Asian currencies following their shift to a floating exchange rate system. However, the yen has, overall, remained in a stable range reflecting a gradual depreciation against the U.S. dollar. Thus, Japan's export environment as a whole continues to be favorable, and the currency and financial instability in Southeast Asia has, so far, not affected the fundamental trend of Japan's exports in any significant way. In addition, Southeast Asian countries have been adopting various measures, some of which are internationally coordinated. On November 1, it was announced that the International Monetary Fund (IMF) and other international organizations have agreed on a financial package for Indonesia. In the foreign exchange markets, the monetary authorities of Japan, Singapore, and Indonesia have confirmed that they will cooperate to stabilize the Indonesian currency. The Bank of Japan strongly hopes that these and similar measures taken by other countries will soon restore monetary and financial stability in these countries and encourage a smooth economic adjustment. The Bank will continue to observe developments carefully. With regard to business fixed investment, this is likely to continue to expand as a whole against the backdrop of sustained growth in corporate profits. Firms' projections of earnings in fiscal 1997 indicate that smaller nonmanufacturing firms anticipate a decline in profits for the first time in four years, strongly affected by a decline in public investment and in personal consumption. In the manufacturing sector, however, both large and smaller firms expect a continued rise in earnings and profits partly supported by solid export performance. In addition, large nonmanufacturing firms project sustained growth in profits following the favorable results in the manufacturing sector. Some of these profitable firms recently revised their earnings outlook downward because of the recent deceleration in domestic demand. However, on the whole, earnings and profits remain on an upward trend. Against the backdrop of such developments in profits, overall investment plans in fiscal 1997 seem to be firm, especially in the manufacturing sector, although business fixed investment of smaller firms in the nonmanufacturing sector is expected to remain at a low level. In view of the aforementioned profit trend, the positive outlook for returns on investment, and the strong demand for information-related investment, it is fair to expect that business fixed investment will continue to increase. As I have discussed, the Bank believes that the trend of economic recovery has not been undermined on account of gradual improvements in corporate profits, employment, and income. The Bank, therefore, expects that as personal consumption recovers, inventory adjustment will progress and the economy will resume a gradual recovery. However, it is apparent that the virtuous circle in which increased production leads to larger income, which in turn stimulates spending, has weakened due in part to the effects of fiscal tightening. Should recovery in household expenditure be delayed, thus prolonging economic deceleration, the strength of the self-sustained economic recovery might be impaired. Bearing this possibility in mind, the Bank will watch cautiously economic developments in the coming days, including such points as the pace of recovery in personal consumption, progress in inventory adjustment, and developments in business and household confidence. B. Recent Monetary Condition Looking at the recent monetary condition in Japan, stock prices dropped sharply at the end of October amid a worldwide decline in stock markets triggered by the Hong Kong market. The impact on the prices seems to have subsided in the markets, however, owing to rebounds in the Southeast Asian markets. The Bank has been informed that Sanyo Securities has decided to take legal measures to liquidate its affiliated entities, and that due to losses on credits extended to these affiliates, it has become difficult for Sanyo Securities to continue ordinary business. On November 3, Sanyo Securities filed with the Tokyo District Court an application for the commencement of reorganization proceedings. In response to the application, the District Court has issued an asset preservation order halting the company's repayment activities, but has allowed for exceptions with regard to such activities as return of customer property. The Bank has been informed that customer property, including cash deposited by customers, will be protected and that the property will be returned swiftly with the support and cooperation of relevant parties, including the Securities Deposit Compensation Fund (a fund established for compensating customers' losses in the event of a failure of a member securities company) and the main banks of Sanyo Securities. While the Bank regrets the failure of Sanyo Securities, the Bank acknowledges it crucial that investors be protected and the stability of the securities market be secured through the efforts of relevant parties in order to maintain confidence in the Japanese financial system at home and abroad. If I may now turn to developments in lending by financial institutions, there have recently been views that financial institutions may have become too cautious with their lending, and this as a result may be constraining the economic activity of private businesses. I would like to briefly discuss the Bank's present views on this point. It is true that an increasing number of financial institutions are strengthening risk management and attaching more importance to profitability in order to improve the soundness and efficiency of their management and operations. More specifically, they are revising their screening systems to assess more rigorously the creditworthiness of borrowers. They are also establishing lending rate structures that adequately reflect creditworthiness. These efforts are essential to financial institutions if they are to accommodate themselves to the ongoing financial globalization and deregulation over the long run. However, it may appear to firms that financial institutions have significantly shifted their lending attitude, or have suddenly adopted a very strict lending policy. Having said that, financial institutions maintain a positive lending stance toward firms showing sound business performance. In fact, the Tankan survey indicates that while an increasing number of firms in certain sectors feel that the lending attitude has become "severe", more firms feel that the attitude remains "accommodative". The average lending rates of financial institutions have been linked to market rates at historically low levels. In view of these circumstances, it is fair to assume that the recent slow growth in lending by financial institutions is due to weak demand for funds arising against the background of decelerating domestic demand. Therefore, the Bank considers that the lending attitude of financial institutions is, at the moment, not constraining business activity, nor militating against the economy. The Bank will continue to monitor carefully the lending activity of financial institutions focusing on (1) whether the stance of financial institutions is reaching a point where even firms maintaining sound management find it difficult to borrow; and (2) whether squeezed lending is leading to a general rise in interest rates. C. Monetary Policy Management After the effects of the rise in the consumption tax rate are excluded, prices can be seen to have remained generally stable and are expected to remains so for some time. In managing monetary policy under such a monetary and economic situation, the Bank believes it appropriate to continue to watch developments carefully with an emphasis being placed on further strengthening the foundation of the economic recovery. III. Bank's Thinking Behind Its Continued Easy Stance of Monetary Policy A. The Effects of Monetary Easing I would like to use the remaining time to discuss the Bank's views on some of the comments and questions the Bank has been receiving in relation to the prolonged low level of interest rates. First, there have been questions about the effects of monetary easing -- that is, although low interest rates are conducive to improving corporate profits, it seems that businesses are simply using those earnings to repay their debts, and therefore, the desired effects of stimulating economic activity, such as increasing investment, have not been achieved. Some even say that the low interest rates are only delaying the structural adjustment of the Japanese economy. If we take a look at the actual figures of corporate profits and business fixed investment, cash flow of firms -- hat is, retained earnings plus depreciation -- increased by approximately ¥7 trillion in the two years since fiscal 1995, when the official discount rate was lowered to 0.5 percent. Business fixed investment also increased by approximately ¥7 trillion, commensurate with the growth in corporate profits. During this two-year period, the low interest rates have helped to improve the profitability of investment and to support corporate profits. Therefore, the Bank believes that low interest rates have had the effect of generating an appropriate increase in business fixed investment. It should be noted, however, that in past phases of economic recovery, firms borrowed from financial institutions to expand their business fixed investment in addition to using their cash flow. This time, however, few firms have increased bank lending or issued bonds for this purpose. Rather, in quite a few cases, firms have used the increase in profits to repay their debt. Thus, there has been no significant acceleration of business fixed investment when compared to past recovery phases. One factor behind this seems to be the various structural adjustment pressures that the Japanese economy faces today, notably persistent balance-sheet adjustment pressures. As you are aware, many firms borrowed actively from financial institutions during the economic "bubble" period to engage in large-scale real-estate investment or securities investment. Following the bursting of the economic "bubble", prices of real estate and stocks plunged. The borrowings, however, remained. Thus, on corporate balance sheets, there was a significant depreciation of assets at market value while liabilities remained unchanged. This resulted in a decrease in the net worth of firms -- that is, assets less liabilities -- and this in turn has limited the business risks that these firms can take on. Firms in this situation can rarely conduct active investment in plant and equipment that leads to the expansion of their business activity. This situation is often referred to as the "balance-sheet problem". When we look at the relationship between balance sheets and business fixed investment by sector and by the size of firm, large manufacturers are faced with only limited balance-sheet adjustment pressures since they did not take on large debts during the "bubble" period. These large manufacturing firms saw an early recovery in profits following the collapse of the economic "bubble", and in fact, have been investing significant amounts in plant and equipment since fiscal 1995. Smaller firms, however, especially those in the nonmanufacturing sector, continue to suffer heavy balance-sheet adjustment pressures, having borrowed heavily from financial institutions during the "bubble" period to invest in real estate. The ratio of financial liabilities to assets at market value of smaller nonmanufacturing firms remains at a high level. As these firms have been most strongly affected by industrial restructuring, their profits as a whole have been slow to recover. As a result, their business fixed investment has shown little signs of improvement. Yet, it cannot be said that low interest rates have proved ineffective to alleviate firms' balance-sheet problems. The only ways to alleviate the balance-sheet adjustment pressures is for firms to increase profits, and low interest rates have contributed broadly to improving firms' profits. With increased profits, firms can repay borrowings and thereby recover their net worth. Also, a forecasted rise in a firm's profits would facilitate the raising of capital by that firm. Thus, increasing profits is most effective in improving the financial strength of a firm, and the repayment of debt is an important process in allowing a firm to prepare for future business activity. Although in the current phase of economic recovery, low interest rates have not yet triggered any significant rise in business fixed investment in the smaller nonmanufacturing firms, these rates have steadily contributed to establishing the foundation of the recovery by helping to improve firms' financial strength. Including such indirect effects, the Bank believes that the low interest rates have in fact been firmly supporting the recovery of economic activity in the corporate sector. I would now like to go on to another often raised question about whether low interest rates are delaying the structural adjustment. It is true that there may be firms that are managing to survive despite a deteriorating business performance, owing to lower interest rates alleviating the burden of paying interest. My view, however, is that structural adjustment of the economy is achieved not just through natural selection of firms, where those with extremely poor business performance are weeded out. Rather, I believe that it is achieved when the large number of firms with high growth potentials enhance their activities. Therefore, in order to promote structural adjustment, it is most important to pursue effective deregulation. Monetary policy, by nature, is not aimed at promoting structural adjustment. It is to be managed in accordance with economic and price developments with the aim of achieving noninflationary, sustainable growth. However, monetary policy can realize a stable macroeconomic environment, that in turn would facilitate structural adjustment. This is because firms can confidently undergo forward-looking business transformation only when there is a stable macroeconomic environment. Also, as I have already stated, monetary easing has been contributing to the balance-sheet adjustment of firms. The Bank believes that if interest rates were to be raised before economic activity has sufficiently firmed, it may affect not only troubled firms but also growing businesses. In view of the fundamentally weak earnings structure of venture businesses, which are expected to be the driving force of the structural reform, it can easily be imagined that an untimely raising of interest rates would make the progress of industrial restructuring even more difficult. In other words, although monetary easing is not directly aimed at promoting structural adjustment, by providing a stable macroeconomic environment, it does support the management efforts of many firms with high growth potentials and thereby contributes to laying the foundation for structural adjustment. I very much hope to gain your understanding on the importance of this point. B. Monetary Easing and Income Distribution Another set of comments and questions that the Bank often receives in relation to the low level of interest rates concerns the issue of income distribution. There have been comments that low interest rates are sacrificing the household sector, or that they are aimed solely at supporting the profits of financial institutions. As I have spoken on this subject on various occasions already, I will give only a brief explanation of the Bank's views. Monetary easing would have the impact of reducing interest earning on deposits and bonds while lowering interest payments on mortgage loans and other liabilities. As the household sector holds a larger amount of financial assets than financial liabilities, lower interest rates would in fact to reduce the net interest income. It would not be appropriate, however, to judge the effects of monetary easing based simply on the interest income. Lower interest rates stimulate economic activity by improving returns on investment, increasing corporate profits, and supporting asset prices. This in turn leads to an increase in employment and in employees' income to thereby bring about a favorable impact on the household sector as a whole. In fact, in the two years since fiscal 1995, when the series of monetary easing measures was implemented, employees' income has increased steadily, and this increase has significantly exceeded the net decrease in interest income. This implies that the monetary easing, by stimulating economic activity, has had favorable effects on the entire household sector. In reality, there are various types of households, and the Bank is fully aware that the situation has been extremely difficult for those households that are heavily dependent on interest income. However, I would like to emphasize that monetary policy should be managed from a macroeconomic perspective for the purpose of achieving a self-sustained economic recovery. When a self-sustained recovery is realized, benefits will accrue broadly to all sectors, including the household sector. In relation to the profits of financial institutions, monetary easing was not implemented for the purpose of increasing financial institutions' earnings and the Bank has absolutely no intention of managing monetary policy to aid financial institutions. The misunderstanding over the Bank's intentions seems to derive from the fact that operating profits of financial institutions tend to increase when interest rates decline. For example, in fiscal 1995, when there was a sharp decline in interest rates, operating profits of financial institutions rose significantly. This is partly due to the fact that when interest rates decline, the prices of their bond-holdings rise, and therefore, their profits on sales tend to increase. It is also due to the fact that lower interest rates are reflected immediately on the liability side, whereas their effects appear more slowly on the asset side, since the average length of maturity of assets, such as loans, tends to be longer than the average length of maturity of liabilities such as deposits. However, these effects are only temporary. For example, once the effects of lower interest rates have worked their way through, sale of bonds will no longer generate new profits. Moreover, if interest rates begin to rise, the sale of bonds will start creating losses. In addition, maturity gap between assets and liabilities will cause profits to decline from the following accounting term reflecting declines in the returns on interest-earning assets, which follow the fall in the cost of financing liabilities. In fact, the operating profits of financial institutions, after rising significantly in fiscal 1995, leveled off in fiscal 1996. In fiscal 1997, they are likely to register a substantial decline as the effects of reduced interest rates will have diminished. In the meantime, the net interest margin of financial institutions -- that is, the differential between financing costs and investment returns -- remains at a level equal to the average since the latter half of the 1980s. In other words, the decline in deposit interest rates has not permanently widened the interest margin for financial institutions, which is only the intermediate stage in the permeation of monetary-easing effects. Rather, the decline has subsequently lead to lower lending rates. Through these channels, the effects of monetary easing have been permeating steadily through the entire Japanese economy. As I have explained, monetary policy is not aimed at supporting financial institutions, and it is not possible to control the earnings of financial institutions by means of monetary policy over an extended period. I would once again like to emphasize that monetary policy is to be managed in accordance with the overall economic condition for the purpose of ensuring price stability. C. Monetary Policy Management from a Medium to Long-Term Perspective I would like to turn to a third set of comments and questions received by the Bank related to its monetary policy management. It is a question of whether the official discount rate should have been raised sometime between 1996 and early 1997, when the economy was recovering. Monetary policy should, by its very nature, be monitored over a long period of time. In addition, I believe it is not appropriate for the Bank, which is in charge of monetary policy management, to give its own assessment casually. Today, therefore, I would like to explain the basic thinking underlying the Bank's monetary policy management, including that on the recent interest-rate policy. The drastic monetary easing measures the Bank implemented in September 1995 -- including the lowering of the official discount rate to 0.5 percent -- was aimed at preventing the occurrence of a deflationary spiral and was intended to place the Japanese economy on a path of self-sustained recovery by strengthening corporate and household confidence in the economy. Since the beginning of 1996, the Japanese economy has recovered moderately. In the course of the recovery, the concern for a possible deflationary spiral has been gradually dispelled, and the confidence of the corporate and household sectors has been gradually regained. Looking back, it appears that the recovery in early 1996 was supported significantly by the series of monetary easing measures and government economic packages adopted in autumn 1995. It also cannot be denied that the growth rate from the second half o	["mr. matsushita discusses recent monetary and economic conditions in japan and comments on the bank of japan's monetary policy management speech by the governor of the bank of japan, mr. yasuo matsushita, to the research institute of japan in tokyo on 5/11/97.", 'i. introduction it is a great honor to be invited by the research institute of japan to address this distinguished audience.', 'it has been one year since i last attended this gathering in november 1996. looking back at the economic developments in japan over the past year, economic growth temporarily accelerated from the latter half of 1996 through the spring of 1997, helped to some extent by increased demand ahead of the rise in the consumption tax rate in fiscal 1997. since april this year, however, economic growth has been decelerating partly reflecting the lingering effects of the rise in the consumption tax rate.', 'during this period, business sentiment seems to have become more cautious.', 'today, i would like to give views of the bank of japan on the present condition of and on the outlook for the japanese economy.', "i will also discuss the bank's thinking behind its monetary policy management.", "i would then like to use the remaining time to discuss the bank's views on some of the comments and questions the bank has been receiving recently concerning the prolonged easy money policy, by which the official discount rate has been maintained at 0.5 percent for more than two years.", "through my explanation, i hope to gain your better understanding on the bank's aims in its monetary policy management.", "recent monetary and economic conditions and the bank's monetary policy management a. the present condition of and the outlook for the domestic economy let me first discuss the domestic economic condition.", "japan's economic growth has been decelerating since april 1997 partly reflecting the impact of the rise in the consumption tax rate that took place that month.", 'in addition to the continuing decrease in public investment since autumn 1996, household spending such as personal consumption and housing investment has also dropped significantly since april 1997. as regards personal consumption, outlays on services such as those provided by the travel industry have been increasing moderately.', 'however, outlays on goods have remained sluggish, as indicated by the sales of automobiles and household electric appliances as well as department store and chain store sales, although there are signs of a slight recovery.', 'in addition, housing investment in terms of housing starts has declined more recently to 1.3 million from the 1.6 million per annum level that existed until spring 1997. several factors are responsible for such declines in household spending.', 'the first is the strong and persistent reaction to the significantly increased demand ahead of the rise in the consumption tax rate.', 'the increase in sales in the consumer goods- and housing-related industries from the latter half of 1996 had been taken as a strong indication of a sustainable recovery.', 'in hindsight, those sales in fact included a significant amount of demand for household spending that would most likely have taken place later this year had the hike in the tax rate not been scheduled.', 'the second factor, which to some extent had been anticipated, is the slowdown in the growth of real disposable income of households -- nominal income less tax payments and income erosion due to inflation -- following the rise in the consumption tax rate and the discontinuation of the special tax reduction.', 'in addition, it seems undeniable that consumer confidence has weakened somewhat.', 'this decline in household expenditure since spring 1997, which was greater than had initially been anticipated, created excess inventories in certain sectors of consumer goods- and housing-related industries.', 'these sectors have been required to reduce excess inventories since summer 1997 and, as a result, industrial production has leveled off.', 'these developments in household expenditure and industrial production have resulted in a more cautious business sentiment.', 'the question is whether these developments in household expenditure and industrial production will undermine the momentum of economic recovery, or in other words, whether the declining personal consumption and housing investment will affect other demand items such as business fixed investment, thereby placing further downside pressure on the economy.', 'the answer lies in the current strength of the self-sustained recovery in the private sector, and this is precisely what the bank has carefully attended to over the past two years.', "as this is the most important factor when judging the outlook for the economy, i would like to give the bank's views in some detail.", "i will start off by discussing what is meant by the momentum of a self-sustained economic recovery, and then move on to the bank's assessment of the present force of the self-sustained recovery as compared to that in 1995, when the bank lowered the official discount rate to 0.5 percent.", 'lastly, i will use these points to examine the actual developments in demand and production, and assess the outlook for the economy.', 'the strength of self-sustained recovery of the private sector can be considered as the strength of the cyclical force inherent in the private sector.', 'with this force, a build up of economic activity should lead to improved business sentiment, which, in turn, should lead to increased earnings and income.', 'the rises in earnings and income should eventually encourage sustained growth in business fixed investment and personal consumption, respectively.', 'when the strength of the self-sustained recovery, or the momentum of this cyclical force, is very weak, there is a risk that private-sector activity might begin to decline, particularly if unable to absorb the negative impact of such exogenous factors as external demand and fiscal policy.', 'however, when there is a reasonable measure of strength in the self-sustained recovery, the inherent force can be expected to withstand the negative impact and put the economy back on the recovery path, despite being temporarily decelerated.', "in this case, the negative impact is contained and the private sector's economic outlook and investment attitude remain firm.", 'as the pressures created by those exogenous factors subsequently subside, economic recovery should gradually become apparent.', "i will now turn to my second point, that is, assessment of the strength of japan's self-sustained recovery.", 'the japanese economy began to recover in late 1993 from a recession that followed the collapse of the "bubble" economy.', 'in early 1995, however, the recovery paused, and there were even concerns about the occurrence of a deflationary spiral.', 'in view of these circumstances, drastic monetary and fiscal policy measures were adopted.', 'while the halt was directly attributable to the negative effects of the rapid appreciation of the yen, it was also due to the fact that the strength of the self-sustained recovery in the private sector was yet too weak to overcome the downward pressures from outside the private sector.', "it is true that the economy had been on a recovery trend since late 1993. however, we at the bank judge that because firms' profitability as well as capacity utilization had remained at a low level, the shock of a sudden appreciation of the yen applied the brakes to the economic recovery.", 'the important issue now is how much strength there is in the recent economic recovery in japan.', 'balance-sheet adjustment and adjustment of industrial structure are still in process.', 'this being the case, we at the bank do not believe that the self-sustained economic recovery has gained sufficient strength.', 'this is precisely why we have maintained the official discount rate at a low level since september 1995. in the course of the gradual economic recovery over the past two years, however, the level of economic activity has doubtlessly been rising steadily, gradually adding to the strength of the self-sustained economic recovery.', 'specifically, there has been some progress in balance-sheet adjustment and industrial restructuring as corporate profits continued to increase.', 'the manufacturing sector, especially large manufacturers, have achieved a higher than average level of profitability, although the profitability of the nonmanufacturing sector remains low.', 'according to the results of the "tankan -- short-term economic survey of enterprises in japan", firms feel that there have been declines in the excessiveness of production capacity and employment.', 'this implies that while business fixed investment increased over the past two years, excessive accumulation of capital stock has been avoided.', 'judging from these points, the force of the self-sustained economic recovery has clearly strengthened compared to 1995, at which time there were concerns about a deflationary spiral.', 'thirdly, i would like to discuss the outlook for demand, production, and income based on the aforementioned assessment of the self-sustained economic recovery.', 'as for final demand, personal consumption and housing investment continue to be sluggish in general and public investment is expected to follow a declining trend.', 'employment, however, continues to be on a trend of gradual recovery.', 'firms plan to increase the number of newly hired graduates in fiscal 1998 for the second consecutive year.', "although the growth of the household sector's real disposable income is expected to slow, any substantial income erosion should be avoided owing to the increase in employment.", 'therefore, provided that there is no serious deterioration of consumer confidence, personal consumption should gradually move toward recovery as the initial impact of the rise in the consumption tax rate diminishes.', 'meanwhile, net exports and business fixed investment continue to increase.', 'exports have increased significantly since the latter half of 1996, reflecting the depreciation of the yen until spring 1997. imports, after having increased rapidly until mid-1996 due partly to a growth in imports from the overseas subsidiaries of japanese manufacturers, have leveled off recently reflecting the depreciation of the yen.', "under these circumstances, the key issue for the time being is how the recent currency and financial instability in southeast asia will affect japan's exports and imports and its economy as a whole.", 'in view of the progress in the horizontal division of labor and expansion of trade and capital transactions between japan and other asian countries, this matter requires due attention.', "if we take a look at japan's trade with asian countries, japan's exports to thailand have decreased significantly.", 'however, there have not been any notable declines in exports to other neighboring countries.', "in addition, japan's other export markets such as the united states maintain solid economic growth.", 'on the foreign exchange market, the yen has appreciated against southeast asian currencies following their shift to a floating exchange rate system.', 'however, the yen has, overall, remained in a stable range reflecting a gradual depreciation against the u.s. dollar.', "thus, japan's export environment as a whole continues to be favorable, and the currency and financial instability in southeast asia has, so far, not affected the fundamental trend of japan's exports in any significant way.", 'in addition, southeast asian countries have been adopting various measures, some of which are internationally coordinated.', 'on november 1, it was announced that the international monetary fund (imf) and other international organizations have agreed on a financial package for indonesia.', 'in the foreign exchange markets, the monetary authorities of japan, singapore, and indonesia have confirmed that they will cooperate to stabilize the indonesian currency.', 'the bank of japan strongly hopes that these and similar measures taken by other countries will soon restore monetary and financial stability in these countries and encourage a smooth economic adjustment.', 'the bank will continue to observe developments carefully.', 'with regard to business fixed investment, this is likely to continue to expand as a whole against the backdrop of sustained growth in corporate profits.', "firms' projections of earnings in fiscal 1997 indicate that smaller nonmanufacturing firms anticipate a decline in profits for the first time in four years, strongly affected by a decline in public investment and in personal consumption.", 'in the manufacturing sector, however, both large and smaller firms expect a continued rise in earnings and profits partly supported by solid export performance.', 'in addition, large nonmanufacturing firms project sustained growth in profits following the favorable results in the manufacturing sector.', 'some of these profitable firms recently revised their earnings outlook downward because of the recent deceleration in domestic demand.', 'however, on the whole, earnings and profits remain on an upward trend.', 'against the backdrop of such developments in profits, overall investment plans in fiscal 1997 seem to be firm, especially in the manufacturing sector, although business fixed investment of smaller firms in the nonmanufacturing sector is expected to remain at a low level.', 'in view of the aforementioned profit trend, the positive outlook for returns on investment, and the strong demand for information-related investment, it is fair to expect that business fixed investment will continue to increase.', 'as i have discussed, the bank believes that the trend of economic recovery has not been undermined on account of gradual improvements in corporate profits, employment, and income.', 'the bank, therefore, expects that as personal consumption recovers, inventory adjustment will progress and the economy will resume a gradual recovery.', 'however, it is apparent that the virtuous circle in which increased production leads to larger income, which in turn stimulates spending, has weakened due in part to the effects of fiscal tightening.', 'should recovery in household expenditure be delayed, thus prolonging economic deceleration, the strength of the self-sustained economic recovery might be impaired.', 'bearing this possibility in mind, the bank will watch cautiously economic developments in the coming days, including such points as the pace of recovery in personal consumption, progress in inventory adjustment, and developments in business and household confidence.', 'b. recent monetary condition looking at the recent monetary condition in japan, stock prices dropped sharply at the end of october amid a worldwide decline in stock markets triggered by the hong kong market.', 'the impact on the prices seems to have subsided in the markets, however, owing to rebounds in the southeast asian markets.', 'the bank has been informed that sanyo securities has decided to take legal measures to liquidate its affiliated entities, and that due to losses on credits extended to these affiliates, it has become difficult for sanyo securities to continue ordinary business.', 'on november 3, sanyo securities filed with the tokyo district court an application for the commencement of reorganization proceedings.', "in response to the application, the district court has issued an asset preservation order halting the company's repayment activities, but has allowed for exceptions with regard to such activities as return of customer property.", "the bank has been informed that customer property, including cash deposited by customers, will be protected and that the property will be returned swiftly with the support and cooperation of relevant parties, including the securities deposit compensation fund (a fund established for compensating customers' losses in the event of a failure of a member securities company) and the main banks of sanyo securities.", 'while the bank regrets the failure of sanyo securities, the bank acknowledges it crucial that investors be protected and the stability of the securities market be secured through the efforts of relevant parties in order to maintain confidence in the japanese financial system at home and abroad.', 'if i may now turn to developments in lending by financial institutions, there have recently been views that financial institutions may have become too cautious with their lending, and this as a result may be constraining the economic activity of private businesses.', "i would like to briefly discuss the bank's present views on this point.", 'it is true that an increasing number of financial institutions are strengthening risk management and attaching more importance to profitability in order to improve the soundness and efficiency of their management and operations.', 'more specifically, they are revising their screening systems to assess more rigorously the creditworthiness of borrowers.', 'they are also establishing lending rate structures that adequately reflect creditworthiness.', 'these efforts are essential to financial institutions if they are to accommodate themselves to the ongoing financial globalization and deregulation over the long run.', 'however, it may appear to firms that financial institutions have significantly shifted their lending attitude, or have suddenly adopted a very strict lending policy.', 'having said that, financial institutions maintain a positive lending stance toward firms showing sound business performance.', 'in fact, the tankan survey indicates that while an increasing number of firms in certain sectors feel that the lending attitude has become "severe", more firms feel that the attitude remains "accommodative".', 'the average lending rates of financial institutions have been linked to market rates at historically low levels.', 'in view of these circumstances, it is fair to assume that the recent slow growth in lending by financial institutions is due to weak demand for funds arising against the background of decelerating domestic demand.', 'therefore, the bank considers that the lending attitude of financial institutions is, at the moment, not constraining business activity, nor militating against the economy.', 'the bank will continue to monitor carefully the lending activity of financial institutions focusing on (1) whether the stance of financial institutions is reaching a point where even firms maintaining sound management find it difficult to borrow; and (2) whether squeezed lending is leading to a general rise in interest rates.', 'c. monetary policy management after the effects of the rise in the consumption tax rate are excluded, prices can be seen to have remained generally stable and are expected to remains so for some time.', 'in managing monetary policy under such a monetary and economic situation, the bank believes it appropriate to continue to watch developments carefully with an emphasis being placed on further strengthening the foundation of the economic recovery.', "bank's thinking behind its continued easy stance of monetary policy a. the effects of monetary easing i would like to use the remaining time to discuss the bank's views on some of the comments and questions the bank has been receiving in relation to the prolonged low level of interest rates.", 'first, there have been questions about the effects of monetary easing -- that is, although low interest rates are conducive to improving corporate profits, it seems that businesses are simply using those earnings to repay their debts, and therefore, the desired effects of stimulating economic activity, such as increasing investment, have not been achieved.', 'some even say that the low interest rates are only delaying the structural adjustment of the japanese economy.', 'if we take a look at the actual figures of corporate profits and business fixed investment, cash flow of firms -- hat is, retained earnings plus depreciation -- increased by approximately ¥7 trillion in the two years since fiscal 1995, when the official discount rate was lowered to 0.5 percent.', 'business fixed investment also increased by approximately ¥7 trillion, commensurate with the growth in corporate profits.', 'during this two-year period, the low interest rates have helped to improve the profitability of investment and to support corporate profits.', 'therefore, the bank believes that low interest rates have had the effect of generating an appropriate increase in business fixed investment.', 'it should be noted, however, that in past phases of economic recovery, firms borrowed from financial institutions to expand their business fixed investment in addition to using their cash flow.', 'this time, however, few firms have increased bank lending or issued bonds for this purpose.', 'rather, in quite a few cases, firms have used the increase in profits to repay their debt.', 'thus, there has been no significant acceleration of business fixed investment when compared to past recovery phases.', 'one factor behind this seems to be the various structural adjustment pressures that the japanese economy faces today, notably persistent balance-sheet adjustment pressures.', 'as you are aware, many firms borrowed actively from financial institutions during the economic "bubble" period to engage in large-scale real-estate investment or securities investment.', 'following the bursting of the economic "bubble", prices of real estate and stocks plunged.', 'the borrowings, however, remained.', 'thus, on corporate balance sheets, there was a significant depreciation of assets at market value while liabilities remained unchanged.', 'this resulted in a decrease in the net worth of firms -- that is, assets less liabilities -- and this in turn has limited the business risks that these firms can take on.', 'firms in this situation can rarely conduct active investment in plant and equipment that leads to the expansion of their business activity.', 'this situation is often referred to as the "balance-sheet problem".', 'when we look at the relationship between balance sheets and business fixed investment by sector and by the size of firm, large manufacturers are faced with only limited balance-sheet adjustment pressures since they did not take on large debts during the "bubble" period.', 'these large manufacturing firms saw an early recovery in profits following the collapse of the economic "bubble", and in fact, have been investing significant amounts in plant and equipment since fiscal 1995. smaller firms, however, especially those in the nonmanufacturing sector, continue to suffer heavy balance-sheet adjustment pressures, having borrowed heavily from financial institutions during the "bubble" period to invest in real estate.', 'the ratio of financial liabilities to assets at market value of smaller nonmanufacturing firms remains at a high level.', 'as these firms have been most strongly affected by industrial restructuring, their profits as a whole have been slow to recover.', 'as a result, their business fixed investment has shown little signs of improvement.', "yet, it cannot be said that low interest rates have proved ineffective to alleviate firms' balance-sheet problems.", "the only ways to alleviate the balance-sheet adjustment pressures is for firms to increase profits, and low interest rates have contributed broadly to improving firms' profits.", 'with increased profits, firms can repay borrowings and thereby recover their net worth.', "also, a forecasted rise in a firm's profits would facilitate the raising of capital by that firm.", 'thus, increasing profits is most effective in improving the financial strength of a firm, and the repayment of debt is an important process in allowing a firm to prepare for future business activity.', "although in the current phase of economic recovery, low interest rates have not yet triggered any significant rise in business fixed investment in the smaller nonmanufacturing firms, these rates have steadily contributed to establishing the foundation of the recovery by helping to improve firms' financial strength.", 'including such indirect effects, the bank believes that the low interest rates have in fact been firmly supporting the recovery of economic activity in the corporate sector.', 'i would now like to go on to another often raised question about whether low interest rates are delaying the structural adjustment.', 'it is true that there may be firms that are managing to survive despite a deteriorating business performance, owing to lower interest rates alleviating the burden of paying interest.', 'my view, however, is that structural adjustment of the economy is achieved not just through natural selection of firms, where those with extremely poor business performance are weeded out.', 'rather, i believe that it is achieved when the large number of firms with high growth potentials enhance their activities.', 'therefore, in order to promote structural adjustment, it is most important to pursue effective deregulation.', 'monetary policy, by nature, is not aimed at promoting structural adjustment.', 'it is to be managed in accordance with economic and price developments with the aim of achieving noninflationary, sustainable growth.', 'however, monetary policy can realize a stable macroeconomic environment, that in turn would facilitate structural adjustment.', 'this is because firms can confidently undergo forward-looking business transformation only when there is a stable macroeconomic environment.', 'also, as i have already stated, monetary easing has been contributing to the balance-sheet adjustment of firms.', 'the bank believes that if interest rates were to be raised before economic activity has sufficiently firmed, it may affect not only troubled firms but also growing businesses.', 'in view of the fundamentally weak earnings structure of venture businesses, which are expected to be the driving force of the structural reform, it can easily be imagined that an untimely raising of interest rates would make the progress of industrial restructuring even more difficult.', 'in other words, although monetary easing is not directly aimed at promoting structural adjustment, by providing a stable macroeconomic environment, it does support the management efforts of many firms with high growth potentials and thereby contributes to laying the foundation for structural adjustment.', 'i very much hope to gain your understanding on the importance of this point.', 'b. monetary easing and income distribution another set of comments and questions that the bank often receives in relation to the low level of interest rates concerns the issue of income distribution.', 'there have been comments that low interest rates are sacrificing the household sector, or that they are aimed solely at supporting the profits of financial institutions.', "as i have spoken on this subject on various occasions already, i will give only a brief explanation of the bank's views.", 'monetary easing would have the impact of reducing interest earning on deposits and bonds while lowering interest payments on mortgage loans and other liabilities.', 'as the household sector holds a larger amount of financial assets than financial liabilities, lower interest rates would in fact to reduce the net interest income.', 'it would not be appropriate, however, to judge the effects of monetary easing based simply on the interest income.', 'lower interest rates stimulate economic activity by improving returns on investment, increasing corporate profits, and supporting asset prices.', "this in turn leads to an increase in employment and in employees' income to thereby bring about a favorable impact on the household sector as a whole.", "in fact, in the two years since fiscal 1995, when the series of monetary easing measures was implemented, employees' income has increased steadily, and this increase has significantly exceeded the net decrease in interest income.", 'this implies that the monetary easing, by stimulating economic activity, has had favorable effects on the entire household sector.', 'in reality, there are various types of households, and the bank is fully aware that the situation has been extremely difficult for those households that are heavily dependent on interest income.', 'however, i would like to emphasize that monetary policy should be managed from a macroeconomic perspective for the purpose of achieving a self-sustained economic recovery.', 'when a self-sustained recovery is realized, benefits will accrue broadly to all sectors, including the household sector.', "in relation to the profits of financial institutions, monetary easing was not implemented for the purpose of increasing financial institutions' earnings and the bank has absolutely no intention of managing monetary policy to aid financial institutions.", "the misunderstanding over the bank's intentions seems to derive from the fact that operating profits of financial institutions tend to increase when interest rates decline.", 'for example, in fiscal 1995, when there was a sharp decline in interest rates, operating profits of financial institutions rose significantly.', 'this is partly due to the fact that when interest rates decline, the prices of their bond-holdings rise, and therefore, their profits on sales tend to increase.', 'it is also due to the fact that lower interest rates are reflected immediately on the liability side, whereas their effects appear more slowly on the asset side, since the average length of maturity of assets, such as loans, tends to be longer than the average length of maturity of liabilities such as deposits.', 'however, these effects are only temporary.', 'for example, once the effects of lower interest rates have worked their way through, sale of bonds will no longer generate new profits.', 'moreover, if interest rates begin to rise, the sale of bonds will start creating losses.', 'in addition, maturity gap between assets and liabilities will cause profits to decline from the following accounting term reflecting declines in the returns on interest-earning assets, which follow the fall in the cost of financing liabilities.', 'in fact, the operating profits of financial institutions, after rising significantly in fiscal 1995, leveled off in fiscal 1996. in fiscal 1997, they are likely to register a substantial decline as the effects of reduced interest rates will have diminished.', 'in the meantime, the net interest margin of financial institutions -- that is, the differential between financing costs and investment returns -- remains at a level equal to the average since the latter half of the 1980s.', 'in other words, the decline in deposit interest rates has not permanently widened the interest margin for financial institutions, which is only the intermediate stage in the permeation of monetary-easing effects.', 'rather, the decline has subsequently lead to lower lending rates.', 'through these channels, the effects of monetary easing have been permeating steadily through the entire japanese economy.', 'as i have explained, monetary policy is not aimed at supporting financial institutions, and it is not possible to control the earnings of financial institutions by means of monetary policy over an extended period.', 'i would once again like to emphasize that monetary policy is to be managed in accordance with the overall economic condition for the purpose of ensuring price stability.', 'c. monetary policy management from a medium to long-term perspective i would like to turn to a third set of comments and questions received by the bank related to its monetary policy management.', 'it is a question of whether the official discount rate should have been raised sometime between 1996 and early 1997, when the economy was recovering.', 'monetary policy should, by its very nature, be monitored over a long period of time.', 'in addition, i believe it is not appropriate for the bank, which is in charge of monetary policy management, to give its own assessment casually.', "today, therefore, i would like to explain the basic thinking underlying the bank's monetary policy management, including that on the recent interest-rate policy.", 'the drastic monetary easing measures the bank implemented in september 1995 -- including the lowering of the official discount rate to 0.5 percent -- was aimed at preventing the occurrence of a deflationary spiral and was intended to place the japanese economy on a path of self-sustained recovery by strengthening corporate and household confidence in the economy.', 'since the beginning of 1996, the japanese economy has recovered moderately.', 'in the course of the recovery, the concern for a possible deflationary spiral has been gradually dispelled, and the confidence of the corporate and household sectors has been gradually regained.', 'looking back, it appears that the recovery in early 1996 was supported significantly by the series of monetary easing measures and government economic packages adopted in autumn 1995. it also cannot be denied that the growth rate from the second half o']	Masaru Hayami	Bank of Japan	Governor	Japan
https://www.bis.org/review/r980102e.pdf	Mr. Kelley discusses the 'Millennium Bug' from a public sector perspective (Central Bank Articles and Speeches, 15 Dec 97)	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Professional Banker's Association, Washington, D.C. on 15/12/97.	1997-12-15 00:00:00	Mr. Kelley discusses the "Millennium Bug" from a public sector perspective Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Professional Banker's Association, Washington, D.C. on 15/12/97. I am pleased to appear before the Professional Banker's Association to discuss the Millennium Bug from a public sector perspective. The Millennium Bug, or Year 2000 problem, has the potential to seriously disrupt the infrastructure of computer systems and telecommunications that the world community depends upon for the free flow of funds and payments and hence, virtually all of everyday commerce. The Year 2000 problem is a business continuity issue that requires a coordinated effort by public and private business and information technology management. Although the problem itself is not technically difficult, ensuring that information systems are Year 2000 compliant is a management challenge of enormous scale and complexity. While this matter will impact every organization everywhere, my talk today will focus specifically on the key areas of public sector finance and banking. The global nature of today's financial services industry relies upon the interconnection of computer systems world-wide. My purpose today is to identify the serious nature of the problem and the urgent need for immediate action by the government of every nation. As it will impact every country with which you interact, I believe that you of the Professional Banker's Association are in a unique position to be a catalyst for promoting attention to the Year 2000, stimulating action, and promulgating best practices in developing nations. This afternoon, after sketching out the critical nature of the problem, I will focus on plans and actions being taken by the Federal Reserve System to address the Millennium Bug in its own internal operation, as a case study of what an organization like ours must do. Then on to our efforts within the U.S. financial services industry and the international financial community, and finally a few words on how you can help. The Millennium Bug What is this problem all about? Most computer operating systems and applications in use today register dates as two digits. Consequently, such computer systems, software programs, or embedded chip devices can not distinguish the year 2000 from 1900, when both dates are registered as "00". When the clock rolls over the next millennium, computations based on two digit dates will produce errors. Those relatively few systems using four digit date fields will have different problems, but they will have problems, nonetheless. While the situation can be stated simply, its scope is vast and fixing it is enormously time consuming. As this audience knows, banking systems and financial services rely heavily on computer systems to manage and deliver services electronically. With the linkage of payment systems globally, a failure of any linked system could have waterfall effects to other systems and a disastrous result to the world economy. The scope of the Millennium Bug extends far beyond financial services and beyond the traditional notion of large mainframe processing systems. Computer systems that control telecommunications, electric utilities, transportation services, and a host of other critical infrastructure systems are vulnerable. The Gartner Group estimates 50 million embedded-system devices worldwide will exhibit Year 2000 problems. Embedded chips are used to control elevators, environmental systems, navigational devices, household appliances, safes and vaults, and on and on. The pervasive reliance on computer systems is not constrained to large industrialized countries; developing countries are also vulnerable, particularly those with older computer systems and software. I think that some "what ifs" cited by the Computer Information Centre in the UK brings a practical perspective of the effect of what could happen in our everyday life as the millennium arrives. • The computers in financial services organizations, etc. cannot deliver payments to counter parties, or receive funds from them. Gridlock ensues. There's a collapse in financial markets because of the bad news coming from companies about their inability to trade normally. • The power fails, and it is mid-winter in the Northern hemisphere and mid-summer in the Southern hemisphere. The power company's production is controlled by innumerable computer chips, which were installed many years ago and no one knows what they do, how they work, nor dare they touch them, because the whole of the plant might come irreparably to a standstill. More personal possibilities: • The telephone system fails -- and you're unable to notify anyone of your pyramiding problems. • Your medical center's computer has problems and cannot trace the medicines your elderly mother has been prescribed in the past nor the conditions she has had. A doctor prescribes the wrong medicine and she becomes very ill. • You try to draw money from an ATM and it refuses, even though you know you have money in your account. Your bank's computer thinks it is January 1, 1900 -- and you weren't a customer then! As I said, fixing the Year 2000 bug is not technically difficult but it is an enormous task that will be frightfully costly. After all, one needs only to find and repair all date instances in programs. But when you consider the number of lines of code in computer programs in the aggregate, however, the scale of this task is monumental. Consider these estimates: • The Gartner Group believes that there are about 180 billion lines of COBOL code alone in the U.S. • British Telecommunications estimates it will need 1,000 staff at peak to check and correct some 300 million lines of computer code. The Federal Reserve is faced with checking some 90 million lines, and some very large financial institutions have many more than that. Clearly, solving the Year 2000 problem requires skilled staff and is time consuming. Because of so many unknowns, however, it is difficult to accurately estimate the amount of resources that will ultimately be required. Killen & Associates estimates that $280 billion will be spent worldwide between 1997 and 2002. Other responsible estimates run to over twice that. Federal Reserve Readiness Efforts Let me now turn to the approach toward Year 2000 compliance that we have taken at the Federal Reserve, as it may be a useful case study of the scope and scale of what a substantial public agency faces. Doubtless there are larger entities that will confront larger tasks internally, but there are probably not very many with more substantial external relationships requiring attention. For example: The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications, Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) are the most critical payment systems. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $280 trillion. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $160 trillion. The average total daily values of Fedwire funds and securities transfers are about $1.1 trillion and $650 billion respectively. The ACH is an electronic payment service that is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $12 trillion. About 3.3 billion of these payments were commercial transactions and the remainder were originated by the Federal government. The scope of the Federal Reserve's Year 2000 activities includes remediation and testing of all components of these processing environments, the supporting telecommunications network, and all of the many systems supporting the operations of this complex organization. That is just for payment systems; bank supervision and monetary policy management pose challenges of similar magnitude. I believe that we have developed a successful program to ensure Year 2000 readiness that is based on industry best practices. This program is receiving the highest level of executive support that emphasizes awareness and commitment throughout our organization. To date, we have completed application assessments, developed internal test plans, and we are currently renovating software. All Federal Reserve computer program changes are scheduled to be completed by year-end 1998, with the financial services systems that interface externally with the industry completed by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. Challenges ahead include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, extensive communications, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our activities. And the entire project is being closely coordinated among the twelve Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and numerous other government agencies. Federal Reserve Bank Supervision As a bank supervisor, the Federal Reserve has worked closely with the other U.S. supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise, so that we can identify and address problems that arise as early as possible. By mid-year 1998 we expect to complete a thorough compliance preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. When facing the most serious supervisory cases of lack of preparedness for the Year 2000, the Federal Reserve will use its enforcement authority as necessary to require corrective action. Recently, the Federal Reserve issued the first cease and desist order against a bank holding company for failing to provide its subsidiary banks with reliable information systems services and for not addressing the needs resulting from the approach of the century date change. Federal Reserve Contingency Planning While our main focus is on our Year 2000 readiness and the avoidance of problems, we know from experience that on occasion things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. As a result of our experience in responding to problems arising from such diverse events as natural disasters and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with Year 2000 problems that might arise. We are mindful, however, that Year 2000 failures may present many unique situations and we are developing specific contingency plans to address various operational scenarios. Our existing business resumption plans will be updated to address date-related difficulties, and key technical staff will be ready to respond quickly to problems with our computer and network systems. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counter parties, or others. The Federal Reserve is prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. And, of course, the Federal Reserve will be prepared to lend in appropriate circumstances. Federal Reserve Efforts to Promote Public Awareness We believe that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We have inaugurated a Year 2000 industry newsletter to advise our bank customers of our plans and time frames for making our software Year 2000 ready. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. It can be accessed at the following Internet address: http://www.ffiec.gov/y2k. We have also produced a ten-minute video entitled "Year 2000 Executive Awareness", intended for viewing by a bank's board of directors and senior management, which presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. The video can be ordered through the Board's Web site. International Awareness Early in 1996, the Federal Reserve began to have concerns about international progress on the Year 2000. Informal discussions within the Bank for International Settlements (BIS) Committee on Banking Supervision indicated that the Year 2000 was not then a priority in many countries. That has now changed. We are working intensively through the Committee, which is composed of many international supervisory agencies. Through formal and informal discussions, the distribution of several interagency statements, advisories, and the Federal Reserve's Year 2000 video, we have sought to elevate bank supervisors' awareness of the risks posed by the century date change. The G-10 central bank governors issued an advisory in September, that included a paper by the bank supervisors committee on the Year 2000 challenge, to ensure a higher level of awareness and activity among leading bankers. If you have not seen it, I commend it to your attention. Federal Reserve speakers have been featured in a number of Year 2000 conferences and are looking for others wherever they can be found or promoted. We also participated in a BIS meeting for G-10 and major non-G-10 central banks in September which provided a forum to share views on, and approaches to, dealing with Year 2000 issues. The majority of those present seemed confident that payment and settlement applications under their management would be ready, but the approach of many central banks toward raising industry awareness in their countries varies widely, and little is known about preparations in smaller emerging nations. These efforts within the BIS have confirmed what we had been hearing anecdotally from U.S. financial institutions and from the U.S. branches and agencies of foreign banks. Reportedly, many foreign banks continue to be less focused on the Year 2000 than prudence might suggest. Many organizations appear to be underestimating how important and difficult effective preparation is to a successful Year 2000 effort. To broaden the base of global supervisory awareness of the issue, the Basle Supervisors are working with securities and insurance authorities to sponsor additional activities, and I understand that final arrangements are now being made to hold a large meeting for financial supervisors from around the world in early April to further focus on this topic. Additionally, the banking supervisors are working to see that third-party vendors and service providers rise to the issue. Our supervisory agencies sponsored a conference for vendors in November and the New York Reserve Bank is sponsoring two half-day conferences on managing vendor relationships in early January. In areas such as telecommunications, where the financial industry is highly dependent on companies supervised by other regulators, we have also initiated contact with the FCC to help assure that federal supervisors are coordinated in their approaches. How can the Professional Bankers Association Help? You can help. Time is of the essence. As you can see, much is being done, but we fear that on a worldwide comprehensive basis we are far behind where we should be, and the days are inexorably going by. The problem is global and must be solved worldwide, or all will suffer. I believe the membership of the PBA is in a unique position to raise the awareness of developing countries to this looming problem. Your intervention might take many forms, and your assistance in stimulating action within your constituency can help bridge the readiness gap we believe now exists in international Year 2000 preparedness efforts. Each member of the PBA can help to help raise the visibility of the problem, publicize its critical nature, and ensure that a compliance commitment originates from the most senior executive level within all of the organizations you monitor. Your own senior executives could communicate the priority placed on this issue to all constituents through public policy statements such as that issued by the G-10 governors of the BIS. As the Fed case demonstrates, your awareness program should emphasize that this is not just a technical matter, but rather a comprehensive business continuity problem that requires the joint cooperation of government and industry sectors. Your organizations have access to the highest levels of government within your constituent countries that can enable you to effectively elevate concern about the danger this problem poses to the safety and soundness of each country's financial system. The PBA could also work closely with the financial community within developing countries to assist in identifying Year 2000 risks, prioritizing resources, and assessing the application and system inventories of your constituents. You can identify common third-party applications and systems and assist in coordinating efforts among these product suppliers and developing countries. The PBA can promote collaborative efforts among developing nations, and sponsor conferences and workshops on Year 2000. You can act as a clearinghouse for information and share "best practices" that could provide a valuable jump-start to those countries still behind the curve. Finally, Year 2000 assessment must also evaluate the level of financial resources available to developing countries to successfully complete a readiness program, and funding to constituents for Year 2000 initiatives should receive a high priority. Closing Remarks As I indicated at the outset, the Federal Reserve views Year 2000 preparations with great seriousness. We have placed a high priority on the remediation of date problems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress, and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. Much remains to be done. We intend to be as prepared as is humanly possible, and believe that most U.S. banking institutions will be, as well. So will the central and private banks of various other countries. But we would be greatly comforted if this were the outlook for every nation, and for every industry. At this time, that is not the prospect. Let me close by urgently requesting your concern and assistance.	['mr. kelley discusses the "millennium bug" from a public sector perspective remarks by mr. edward w. kelley, jr., a member of the board of governors of the us federal reserve system, before the professional banker\'s association, washington, d.c. on 15/12/97.', "i am pleased to appear before the professional banker's association to discuss the millennium bug from a public sector perspective.", 'the millennium bug, or year 2000 problem, has the potential to seriously disrupt the infrastructure of computer systems and telecommunications that the world community depends upon for the free flow of funds and payments and hence, virtually all of everyday commerce.', 'the year 2000 problem is a business continuity issue that requires a coordinated effort by public and private business and information technology management.', 'although the problem itself is not technically difficult, ensuring that information systems are year 2000 compliant is a management challenge of enormous scale and complexity.', 'while this matter will impact every organization everywhere, my talk today will focus specifically on the key areas of public sector finance and banking.', "the global nature of today's financial services industry relies upon the interconnection of computer systems world-wide.", 'my purpose today is to identify the serious nature of the problem and the urgent need for immediate action by the government of every nation.', "as it will impact every country with which you interact, i believe that you of the professional banker's association are in a unique position to be a catalyst for promoting attention to the year 2000, stimulating action, and promulgating best practices in developing nations.", 'this afternoon, after sketching out the critical nature of the problem, i will focus on plans and actions being taken by the federal reserve system to address the millennium bug in its own internal operation, as a case study of what an organization like ours must do.', 'then on to our efforts within the u.s. financial services industry and the international financial community, and finally a few words on how you can help.', 'the millennium bug what is this problem all about?', 'most computer operating systems and applications in use today register dates as two digits.', 'consequently, such computer systems, software programs, or embedded chip devices can not distinguish the year 2000 from 1900, when both dates are registered as "00".', 'when the clock rolls over the next millennium, computations based on two digit dates will produce errors.', 'those relatively few systems using four digit date fields will have different problems, but they will have problems, nonetheless.', 'while the situation can be stated simply, its scope is vast and fixing it is enormously time consuming.', 'as this audience knows, banking systems and financial services rely heavily on computer systems to manage and deliver services electronically.', 'with the linkage of payment systems globally, a failure of any linked system could have waterfall effects to other systems and a disastrous result to the world economy.', 'the scope of the millennium bug extends far beyond financial services and beyond the traditional notion of large mainframe processing systems.', 'computer systems that control telecommunications, electric utilities, transportation services, and a host of other critical infrastructure systems are vulnerable.', 'the gartner group estimates 50 million embedded-system devices worldwide will exhibit year 2000 problems.', 'embedded chips are used to control elevators, environmental systems, navigational devices, household appliances, safes and vaults, and on and on.', 'the pervasive reliance on computer systems is not constrained to large industrialized countries; developing countries are also vulnerable, particularly those with older computer systems and software.', 'i think that some "what ifs" cited by the computer information centre in the uk brings a practical perspective of the effect of what could happen in our everyday life as the millennium arrives.', '• the computers in financial services organizations, etc.', 'cannot deliver payments to counter parties, or receive funds from them.', "there's a collapse in financial markets because of the bad news coming from companies about their inability to trade normally.", '• the power fails, and it is mid-winter in the northern hemisphere and mid-summer in the southern hemisphere.', "the power company's production is controlled by innumerable computer chips, which were installed many years ago and no one knows what they do, how they work, nor dare they touch them, because the whole of the plant might come irreparably to a standstill.", "more personal possibilities: • the telephone system fails -- and you're unable to notify anyone of your pyramiding problems.", "• your medical center's computer has problems and cannot trace the medicines your elderly mother has been prescribed in the past nor the conditions she has had.", 'a doctor prescribes the wrong medicine and she becomes very ill. • you try to draw money from an atm and it refuses, even though you know you have money in your account.', "your bank's computer thinks it is january 1, 1900 -- and you weren't a customer then!", 'as i said, fixing the year 2000 bug is not technically difficult but it is an enormous task that will be frightfully costly.', 'after all, one needs only to find and repair all date instances in programs.', 'but when you consider the number of lines of code in computer programs in the aggregate, however, the scale of this task is monumental.', 'consider these estimates: • the gartner group believes that there are about 180 billion lines of cobol code alone in the u.s. • british telecommunications estimates it will need 1,000 staff at peak to check and correct some 300 million lines of computer code.', 'the federal reserve is faced with checking some 90 million lines, and some very large financial institutions have many more than that.', 'clearly, solving the year 2000 problem requires skilled staff and is time consuming.', 'because of so many unknowns, however, it is difficult to accurately estimate the amount of resources that will ultimately be required.', 'killen & associates estimates that $280 billion will be spent worldwide between 1997 and 2002. other responsible estimates run to over twice that.', 'federal reserve readiness efforts let me now turn to the approach toward year 2000 compliance that we have taken at the federal reserve, as it may be a useful case study of the scope and scale of what a substantial public agency faces.', 'doubtless there are larger entities that will confront larger tasks internally, but there are probably not very many with more substantial external relationships requiring attention.', 'for example: the federal reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the united states.', 'three of these applications, fedwire funds transfer, fedwire securities transfer, and automated clearing house (ach) are the most critical payment systems.', 'about 10,000 depository institutions use the fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $280 trillion.', 'about 8,000 depository institutions use the fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $160 trillion.', 'the average total daily values of fedwire funds and securities transfers are about $1.1 trillion and $650 billion respectively.', 'the ach is an electronic payment service that is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers.', 'approximately 4 billion ach transactions were processed in 1996 with a total value of approximately $12 trillion.', 'about 3.3 billion of these payments were commercial transactions and the remainder were originated by the federal government.', "the scope of the federal reserve's year 2000 activities includes remediation and testing of all components of these processing environments, the supporting telecommunications network, and all of the many systems supporting the operations of this complex organization.", 'that is just for payment systems; bank supervision and monetary policy management pose challenges of similar magnitude.', 'i believe that we have developed a successful program to ensure year 2000 readiness that is based on industry best practices.', 'this program is receiving the highest level of executive support that emphasizes awareness and commitment throughout our organization.', 'to date, we have completed application assessments, developed internal test plans, and we are currently renovating software.', 'all federal reserve computer program changes are scheduled to be completed by year-end 1998, with the financial services systems that interface externally with the industry completed by mid-1998.', 'this schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources.', 'challenges ahead include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, extensive communications, and establishing contingency plans.', 'we are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our activities.', 'and the entire project is being closely coordinated among the twelve reserve banks, the board of governors, numerous vendors and service providers, approximately 13,000 customers, and numerous other government agencies.', 'federal reserve bank supervision as a bank supervisor, the federal reserve has worked closely with the other u.s. supervisory agencies that are part of the federal financial institutions examination council (ffiec) to alert the industry to our concerns and to monitor year 2000 preparations of the institutions we supervise, so that we can identify and address problems that arise as early as possible.', 'by mid-year 1998 we expect to complete a thorough compliance preparedness examination of every bank, u.s. branch and agency of a foreign bank, and service provider that we supervise.', "our examination program includes a review of each organization's year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan.", 'when facing the most serious supervisory cases of lack of preparedness for the year 2000, the federal reserve will use its enforcement authority as necessary to require corrective action.', 'recently, the federal reserve issued the first cease and desist order against a bank holding company for failing to provide its subsidiary banks with reliable information systems services and for not addressing the needs resulting from the approach of the century date change.', 'federal reserve contingency planning while our main focus is on our year 2000 readiness and the avoidance of problems, we know from experience that on occasion things can go wrong.', "given our unique role as the nation's central bank, the federal reserve has always stressed contingency planning -- for both systemic risks as well as operational failures.", 'as a result of our experience in responding to problems arising from such diverse events as natural disasters and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with year 2000 problems that might arise.', 'we are mindful, however, that year 2000 failures may present many unique situations and we are developing specific contingency plans to address various operational scenarios.', 'our existing business resumption plans will be updated to address date-related difficulties, and key technical staff will be ready to respond quickly to problems with our computer and network systems.', 'we recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counter parties, or others.', 'the federal reserve is prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market.', 'and, of course, the federal reserve will be prepared to lend in appropriate circumstances.', 'federal reserve efforts to promote public awareness we believe that extensive communication with the industry and the public is crucial to the success of century date change efforts.', "our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness.", 'we have inaugurated a year 2000 industry newsletter to advise our bank customers of our plans and time frames for making our software year 2000 ready.', "we have also established an internet web site to provide depository institutions with information regarding the federal reserve system's cdc project.", 'this site can be accessed at the following internet address: http://www.frbsf.org/fiservices/cdc.', 'on behalf of the ffiec, the federal reserve has developed a year 2000 information distribution system, including an internet web site and a toll free fax back service (888-882-0982).', 'the web site provides easy access to policy statements, guidance to examiners, and paths to other year 2000 web sites available from numerous other sources.', 'it can be accessed at the following internet address: http://www.ffiec.gov/y2k.', 'we have also produced a ten-minute video entitled "year 2000 executive awareness", intended for viewing by a bank\'s board of directors and senior management, which presents a summary of the year 2000 five-phase project management plan outlined in the interagency policy statement.', "the video can be ordered through the board's web site.", 'international awareness early in 1996, the federal reserve began to have concerns about international progress on the year 2000. informal discussions within the bank for international settlements (bis) committee on banking supervision indicated that the year 2000 was not then a priority in many countries.', 'that has now changed.', 'we are working intensively through the committee, which is composed of many international supervisory agencies.', "through formal and informal discussions, the distribution of several interagency statements, advisories, and the federal reserve's year 2000 video, we have sought to elevate bank supervisors' awareness of the risks posed by the century date change.", 'the g-10 central bank governors issued an advisory in september, that included a paper by the bank supervisors committee on the year 2000 challenge, to ensure a higher level of awareness and activity among leading bankers.', 'if you have not seen it, i commend it to your attention.', 'federal reserve speakers have been featured in a number of year 2000 conferences and are looking for others wherever they can be found or promoted.', 'we also participated in a bis meeting for g-10 and major non-g-10 central banks in september which provided a forum to share views on, and approaches to, dealing with year 2000 issues.', 'the majority of those present seemed confident that payment and settlement applications under their management would be ready, but the approach of many central banks toward raising industry awareness in their countries varies widely, and little is known about preparations in smaller emerging nations.', 'these efforts within the bis have confirmed what we had been hearing anecdotally from u.s. financial institutions and from the u.s. branches and agencies of foreign banks.', 'reportedly, many foreign banks continue to be less focused on the year 2000 than prudence might suggest.', 'many organizations appear to be underestimating how important and difficult effective preparation is to a successful year 2000 effort.', 'to broaden the base of global supervisory awareness of the issue, the basle supervisors are working with securities and insurance authorities to sponsor additional activities, and i understand that final arrangements are now being made to hold a large meeting for financial supervisors from around the world in early april to further focus on this topic.', 'additionally, the banking supervisors are working to see that third-party vendors and service providers rise to the issue.', 'our supervisory agencies sponsored a conference for vendors in november and the new york reserve bank is sponsoring two half-day conferences on managing vendor relationships in early january.', 'in areas such as telecommunications, where the financial industry is highly dependent on companies supervised by other regulators, we have also initiated contact with the fcc to help assure that federal supervisors are coordinated in their approaches.', 'how can the professional bankers association help?', 'time is of the essence.', 'as you can see, much is being done, but we fear that on a worldwide comprehensive basis we are far behind where we should be, and the days are inexorably going by.', 'the problem is global and must be solved worldwide, or all will suffer.', 'i believe the membership of the pba is in a unique position to raise the awareness of developing countries to this looming problem.', 'your intervention might take many forms, and your assistance in stimulating action within your constituency can help bridge the readiness gap we believe now exists in international year 2000 preparedness efforts.', 'each member of the pba can help to help raise the visibility of the problem, publicize its critical nature, and ensure that a compliance commitment originates from the most senior executive level within all of the organizations you monitor.', 'your own senior executives could communicate the priority placed on this issue to all constituents through public policy statements such as that issued by the g-10 governors of the bis.', 'as the fed case demonstrates, your awareness program should emphasize that this is not just a technical matter, but rather a comprehensive business continuity problem that requires the joint cooperation of government and industry sectors.', "your organizations have access to the highest levels of government within your constituent countries that can enable you to effectively elevate concern about the danger this problem poses to the safety and soundness of each country's financial system.", 'the pba could also work closely with the financial community within developing countries to assist in identifying year 2000 risks, prioritizing resources, and assessing the application and system inventories of your constituents.', 'you can identify common third-party applications and systems and assist in coordinating efforts among these product suppliers and developing countries.', 'the pba can promote collaborative efforts among developing nations, and sponsor conferences and workshops on year 2000. you can act as a clearinghouse for information and share "best practices" that could provide a valuable jump-start to those countries still behind the curve.', 'finally, year 2000 assessment must also evaluate the level of financial resources available to developing countries to successfully complete a readiness program, and funding to constituents for year 2000 initiatives should receive a high priority.', 'closing remarks as i indicated at the outset, the federal reserve views year 2000 preparations with great seriousness.', 'we have placed a high priority on the remediation of date problems and the development of action plans that will ensure business continuity for the critical financial systems we operate.', 'while we have made significant progress, and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using federal reserve services, we must ensure that our efforts remain on schedule and that problems are addressed in a timely fashion.', 'much remains to be done.', 'we intend to be as prepared as is humanly possible, and believe that most u.s. banking institutions will be, as well.', 'so will the central and private banks of various other countries.', 'but we would be greatly comforted if this were the outlook for every nation, and for every industry.', 'at this time, that is not the prospect.', 'let me close by urgently requesting your concern and assistance.']	Edward W Kelley, Jr	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r980102d.pdf	Mr. Chan reports on the Hong Kong dollar post-July 1997 (Central Bank Articles and Speeches, 4 Dec 97)	Speech by the Deputy Chief Executive of the Hong Kong Monetary Institute, Mr. Norman T.L. Chan, at the Hong Kong Business Summit '97 organised by The Hong Kong General Chamber of Commerce on 4/12/97.	1997-12-04 00:00:00	Mr. Chan reports on the Hong Kong dollar post-July 1997 Speech by the Deputy Chief Executive of the Hong Kong Monetary Institute, Mr. Norman T.L. Chan, at the Hong Kong Business Summit '97 organised by The Hong Kong General Chamber of Commerce on 4/12/97. I am honoured to have been invited by the Hong Kong General Chamber of Commerce to attend Business Summit 1997. This year's Summit carries special significance because this is the first Summit after the return of Hong Kong's sovereignty to China. As Hong Kong enters into a new era under the framework of "one country, two systems" and "Hong Kong people ruling Hong Kong", our attention has recently been focused on the financial turmoil in the region and its effects on Hong Kong. In view of the limited time available, I do not propose to go into the background why this financial turmoil has occurred. I would instead like to take this opportunity to clarify a few points which have been the subjects of extensive debate recently. 2. Firstly, I should reiterate that the Government's resolve in maintaining the linked exchange rate system is absolute. Given Hong Kong's small and open economy, the link has been and will continue to be the most suitable arrangement for Hong Kong. Let us not forget the fact that the link has served Hong Kong well in the last 14 years by providing an anchor for monetary stability, without which it would not have been possible for Hong Kong to weather numerous shocks during this period and to develop into a leading financial, trade and services centre in the region, with a per capita income higher than many of the developed economies, including the United Kingdom. Even in the latest regional currency turmoil, the link has once again proved its resilience and the Hong Kong dollar has remained very stable against the US dollar. However, questions or doubts have emerged on whether the price for maintaining the link is too high for Hong Kong. 3. This leads me to my next point. Is the price for maintaining the link too high for Hong Kong? The higher interest rates resulting from the defence of the HK$ under the currency board arrangement are causing some pain, especially on the asset markets and on the finance costs for doing business generally. It is true that, under the currency board mechanism, when the HK$ is under speculative selling pressure, local interbank interest rates may go up sharply, as they did on 23 October. On 24 October, the major banks raised their best lending rate by 75 b.p. to 9.5% in view of the rising funding costs. Although the short-term interbank interest rates have come down to low levels very quickly, the interest rates for the 1-month maturity and beyond had stayed above 10% for a longer while. However, since mid-November the term interest rates have also eased steadily, with one month rate falling to 7.5% early this week. While some may regard the present levels of interest rates as too high and the correction in the stock market and property market too painful, they have missed a vital point when they put all the blame on the linked exchange rate system. This is because they have assumed, quite wrongly, that under a floating rate system, Hong Kong interest rates can stay constant or low compared with what they are under the linked exchange rate system. Moreover, they assume that the asset markets would have avoided the kind of sharp falls that we have experienced. This is an unrealistic assumption because the financial turmoil in our neighboring economies is a regional or even global problem from which Hong Kong cannot be immune. 4. It may be easier to explain my point by comparing Hong Kong with our neighboring economies. You are of course aware that the regional stock markets, including Hong Kong, have seen major corrections recently. If one also takes into account the depreciation of the domestic currency against US$ as at end-November, the stock market of Thailand has fallen by 71% from its peak this year, Malaysia by 69.7%, Indonesia by 64%, Korea by 61% and the Philippines by 61%. Even Singapore's stock market suffered a 35.7% drop in US$ terms, which is comparable to the 37.7% fall in the Hang Seng Index. Only Taiwan recorded a lower fall of 31%, whereas the Nikkei also lost 28%. I quoted these figures in order to illustrate the magnitude of the turmoil and its contagion effects on the asset markets in the region. Singapore, which is a strong economy and given a triple-A rating by the international rating agencies, adopts a managed floating rate regime, but such regime has not insulated its asset markets from the regional turmoil. In terms of interest rates, Singapore's one month interbank rate rose by almost 5 times to 16% on 27 October from around 3.6% on 2 July. Singapore's one month rate is now 6.25%, which is still significantly higher than the level in early July. In the case of Hong Kong, the one month rate rose also by around 5 times from 6% in early July to a high of 30% on 23 October. At present the one month rate in Hong Kong is around 7.5%. Again I quote these figures to illustrate the point that even under a floating rate regime, as in the case of Singapore, domestic interest rates can still go up sharply in the event of external shocks. It will be wrong to assume that interest rates will remain stable if Hong Kong were under a floating rate regime when external shocks occur. 5. While a floating rate regime will not insulate Hong Kong from possible interest rate hikes and asset market corrections when external shocks occur, to abandon the link now will have even more devastating results. According to the analysis conducted by one of the major banks in Hong Kong, a switch to a floating rate regime would lead to a sharp rise in inflation, to a double digit figure, and a sharp fall in GDP growth for 1998. Moreover, the uncertainty and disturbance caused by the change will undermine public confidence in Hong Kong's monetary system, which may bring irreparable damage to Hong Kong's position as the leading international financial centre in the region. In short, the price and pain for switching to a floating rate regime will be even higher. 6. Clearly I appreciate that Hong Kong's manufacturers will be facing strong competition from our neighboring economies whose currencies have depreciated sharply in recent months. However, competitive devaluation is not and cannot be our answer to the problem. While attractive superficially, competitive devaluation is a risky and counterproductive approach. As Hong Kong has to import almost all the raw materials and equipment, devaluation of the currency does not mean that the export prices would necessarily be lowered by the same extent of the devaluation. As you know better than I do, although price is always important, competitiveness does not depend on price alone, whether or not you are talking about manufactured goods or services. Competitiveness depends on a host of factors, including better cost control, innovation, entrepreneurship, marketing and constant striving to achieve productivity gains. In this context, I cannot help tell an old, but true, story involving a conversation with an American friend 6 or 7 years ago, when the US$ was depreciating and the DM and the Yen surging to new highs. He was complaining that many countries, including the Southeast Asian economies, were manipulating their exchange rates to gain trade competitiveness. As a result, American goods were having a hard time selling overseas because they were too expensive. I told him that, while it may or may not be true that some countries were deliberately keeping their exchange rates low, the apparent difficulty experienced by US manufacturers to penetrate the Asian markets was not caused by pricing alone. For example, how could the Americans expect to sell their refrigerators to Hong Kong households if most of the refrigerators they tried to sell were almost as big as the kitchen of an average flat here in Hong Kong? How could the US car manufacturers expect to compete in the motor car market in Hong Kong if the US cars were oversized and, more importantly, had virtually no post-sale service in Hong Kong, which is so crucial in the motor car market? Of course, since then the US manufacturers have gone a long way in improving the product types and quality, and have now become much more competitive than they used to be. 7. For Hong Kong to remain competitive under the linked exchange rate system, prices, including land costs and wages, will need to adjust. This adjustment process is already taking place, as we have seen in the correction in property prices and, in due course, rentals. With the slowdown in consumer spending and easing of the demand for labour, the pressure on wage increases for next year should also reduce. I am confident that the flexibility of Hong Kong's economy will enable us to cope with external shocks effectively and to regain competitiveness. In the last 13 years, Hong Kong's manufacturers have managed to keep the unit value rise of Hong Kong's exports to 3% per annum, which is marginally much lower than the inflation rate of 3.5% in industrial countries, and well below the domestic inflation rate in terms of CPI of 8%. This is achieved through the hard work, dedication and ingenuity of our manufacturers, who have seized the opportunity to exploit the synergy between Hong Kong and the Mainland China by relocating the land- and labour-intensive processes north of Hong Kong while retaining the servicing and supporting base in Hong Kong. 8. Finally, I would like to close by echoing what Mr. C.H. Tung said in Vancouver during the APEC meeting. Hong Kong, given its sound fundamentals, robust monetary and banking systems, huge foreign reserves, flexibility and resilience in coping with external shocks, would be the first economy to rebound after this episode. We should have confidence that, while in the short run the markets may become more volatile or they may overshoot from time to time and there may be pain involved during the adjustment process, economic fundamentals should prevail in the end. We should be confident that, as we have done on so many occasions in the past, we shall be able to overcome this difficult period and emerge as a stronger and more competitive financial and servicing centre in Asia. We have done it before and we can surely do it again.	['mr. chan reports on the hong kong dollar post-july 1997 speech by the deputy chief executive of the hong kong monetary institute, mr. norman t.l.', "chan, at the hong kong business summit '97 organised by the hong kong general chamber of commerce on 4/12/97.", "i am honoured to have been invited by the hong kong general chamber of commerce to attend business summit 1997. this year's summit carries special significance because this is the first summit after the return of hong kong's sovereignty to china.", 'as hong kong enters into a new era under the framework of "one country, two systems" and "hong kong people ruling hong kong", our attention has recently been focused on the financial turmoil in the region and its effects on hong kong.', 'in view of the limited time available, i do not propose to go into the background why this financial turmoil has occurred.', 'i would instead like to take this opportunity to clarify a few points which have been the subjects of extensive debate recently.', "2. firstly, i should reiterate that the government's resolve in maintaining the linked exchange rate system is absolute.", "given hong kong's small and open economy, the link has been and will continue to be the most suitable arrangement for hong kong.", 'let us not forget the fact that the link has served hong kong well in the last 14 years by providing an anchor for monetary stability, without which it would not have been possible for hong kong to weather numerous shocks during this period and to develop into a leading financial, trade and services centre in the region, with a per capita income higher than many of the developed economies, including the united kingdom.', 'even in the latest regional currency turmoil, the link has once again proved its resilience and the hong kong dollar has remained very stable against the us dollar.', 'however, questions or doubts have emerged on whether the price for maintaining the link is too high for hong kong.', '3. this leads me to my next point.', 'is the price for maintaining the link too high for hong kong?', 'the higher interest rates resulting from the defence of the hk$ under the currency board arrangement are causing some pain, especially on the asset markets and on the finance costs for doing business generally.', 'it is true that, under the currency board mechanism, when the hk$ is under speculative selling pressure, local interbank interest rates may go up sharply, as they did on 23 october.', 'on 24 october, the major banks raised their best lending rate by 75 b.p.', 'to 9.5% in view of the rising funding costs.', 'although the short-term interbank interest rates have come down to low levels very quickly, the interest rates for the 1-month maturity and beyond had stayed above 10% for a longer while.', 'however, since mid-november the term interest rates have also eased steadily, with one month rate falling to 7.5% early this week.', 'while some may regard the present levels of interest rates as too high and the correction in the stock market and property market too painful, they have missed a vital point when they put all the blame on the linked exchange rate system.', 'this is because they have assumed, quite wrongly, that under a floating rate system, hong kong interest rates can stay constant or low compared with what they are under the linked exchange rate system.', 'moreover, they assume that the asset markets would have avoided the kind of sharp falls that we have experienced.', 'this is an unrealistic assumption because the financial turmoil in our neighboring economies is a regional or even global problem from which hong kong cannot be immune.', '4. it may be easier to explain my point by comparing hong kong with our neighboring economies.', 'you are of course aware that the regional stock markets, including hong kong, have seen major corrections recently.', 'if one also takes into account the depreciation of the domestic currency against us$ as at end-november, the stock market of thailand has fallen by 71% from its peak this year, malaysia by 69.7%, indonesia by 64%, korea by 61% and the philippines by 61%.', "even singapore's stock market suffered a 35.7% drop in us$ terms, which is comparable to the 37.7% fall in the hang seng index.", 'only taiwan recorded a lower fall of 31%, whereas the nikkei also lost 28%.', 'i quoted these figures in order to illustrate the magnitude of the turmoil and its contagion effects on the asset markets in the region.', 'singapore, which is a strong economy and given a triple-a rating by the international rating agencies, adopts a managed floating rate regime, but such regime has not insulated its asset markets from the regional turmoil.', "in terms of interest rates, singapore's one month interbank rate rose by almost 5 times to 16% on 27 october from around 3.6% on 2 july.", "singapore's one month rate is now 6.25%, which is still significantly higher than the level in early july.", 'in the case of hong kong, the one month rate rose also by around 5 times from 6% in early july to a high of 30% on 23 october.', 'at present the one month rate in hong kong is around 7.5%.', 'again i quote these figures to illustrate the point that even under a floating rate regime, as in the case of singapore, domestic interest rates can still go up sharply in the event of external shocks.', 'it will be wrong to assume that interest rates will remain stable if hong kong were under a floating rate regime when external shocks occur.', '5. while a floating rate regime will not insulate hong kong from possible interest rate hikes and asset market corrections when external shocks occur, to abandon the link now will have even more devastating results.', "according to the analysis conducted by one of the major banks in hong kong, a switch to a floating rate regime would lead to a sharp rise in inflation, to a double digit figure, and a sharp fall in gdp growth for 1998. moreover, the uncertainty and disturbance caused by the change will undermine public confidence in hong kong's monetary system, which may bring irreparable damage to hong kong's position as the leading international financial centre in the region.", 'in short, the price and pain for switching to a floating rate regime will be even higher.', "6. clearly i appreciate that hong kong's manufacturers will be facing strong competition from our neighboring economies whose currencies have depreciated sharply in recent months.", 'however, competitive devaluation is not and cannot be our answer to the problem.', 'while attractive superficially, competitive devaluation is a risky and counterproductive approach.', 'as hong kong has to import almost all the raw materials and equipment, devaluation of the currency does not mean that the export prices would necessarily be lowered by the same extent of the devaluation.', 'as you know better than i do, although price is always important, competitiveness does not depend on price alone, whether or not you are talking about manufactured goods or services.', 'competitiveness depends on a host of factors, including better cost control, innovation, entrepreneurship, marketing and constant striving to achieve productivity gains.', 'in this context, i cannot help tell an old, but true, story involving a conversation with an american friend 6 or 7 years ago, when the us$ was depreciating and the dm and the yen surging to new highs.', 'he was complaining that many countries, including the southeast asian economies, were manipulating their exchange rates to gain trade competitiveness.', 'as a result, american goods were having a hard time selling overseas because they were too expensive.', 'i told him that, while it may or may not be true that some countries were deliberately keeping their exchange rates low, the apparent difficulty experienced by us manufacturers to penetrate the asian markets was not caused by pricing alone.', 'for example, how could the americans expect to sell their refrigerators to hong kong households if most of the refrigerators they tried to sell were almost as big as the kitchen of an average flat here in hong kong?', 'how could the us car manufacturers expect to compete in the motor car market in hong kong if the us cars were oversized and, more importantly, had virtually no post-sale service in hong kong, which is so crucial in the motor car market?', 'of course, since then the us manufacturers have gone a long way in improving the product types and quality, and have now become much more competitive than they used to be.', '7. for hong kong to remain competitive under the linked exchange rate system, prices, including land costs and wages, will need to adjust.', 'this adjustment process is already taking place, as we have seen in the correction in property prices and, in due course, rentals.', 'with the slowdown in consumer spending and easing of the demand for labour, the pressure on wage increases for next year should also reduce.', "i am confident that the flexibility of hong kong's economy will enable us to cope with external shocks effectively and to regain competitiveness.", "in the last 13 years, hong kong's manufacturers have managed to keep the unit value rise of hong kong's exports to 3% per annum, which is marginally much lower than the inflation rate of 3.5% in industrial countries, and well below the domestic inflation rate in terms of cpi of 8%.", 'this is achieved through the hard work, dedication and ingenuity of our manufacturers, who have seized the opportunity to exploit the synergy between hong kong and the mainland china by relocating the land- and labour-intensive processes north of hong kong while retaining the servicing and supporting base in hong kong.', '8. finally, i would like to close by echoing what mr. c.h.', 'tung said in vancouver during the apec meeting.', 'hong kong, given its sound fundamentals, robust monetary and banking systems, huge foreign reserves, flexibility and resilience in coping with external shocks, would be the first economy to rebound after this episode.', 'we should have confidence that, while in the short run the markets may become more volatile or they may overshoot from time to time and there may be pain involved during the adjustment process, economic fundamentals should prevail in the end.', 'we should be confident that, as we have done on so many occasions in the past, we shall be able to overcome this difficult period and emerge as a stronger and more competitive financial and servicing centre in asia.', 'we have done it before and we can surely do it again.']	Deputy Chief Executive of the Hong Kong Monetary Institute	Hong Kong Monetary Authority	Deputy Chief Executive	Hong Kong
https://www.bis.org/review/r980102b.pdf	Mr. Yam comments on the financial turmoil in Asia (Central Bank Articles and Speeches, 2 Dec 97)	Address by the Chief Executive of the Hong Kong Monetary Institute, Mr. Joseph Yam, JP, at the Euromoney Asia Pacific Issuers and Investors Forum on 2/12/97.	1997-12-02 00:00:00	Address by the Chief Mr. Yam comments on the financial turmoil in Asia Executive of the Hong Kong Monetary Institute, Mr. Joseph Yam, JP, at the Euromoney Asia Pacific Issuers and Investors Forum on 2/12/97. 1. Ladies and gentlemen, I am honoured to have been invited this year to deliver the opening address for Euromoney's Asia Pacific Issuers and Investors Forum. 2. The year 1997 has been an unusual year for Asia, particularly for Hong Kong. Amidst financial turmoil of the worst kind in the history of Asia, Hong Kong went through political transition to become a Special Administrative Region of the People's Republic of China. This was achieved in the smoothest manner one could imagine. And as the currencies of Asia tumbled one after another in a process of competitive devaluation, involving sharp depletions of foreign reserves and requiring financial assistance from the International Monetary Fund and others, and sending shock waves to financial markets throughout the region and beyond, our currency, the Hong Kong dollar, remained very stable and our already very substantial foreign reserves increased. Although our asset markets have been affected by the contagion, some consolidation was in any case overdue; and in the event, for the year to date, the downward adjustment has been significantly less severe than those of many others in the region. 3. Hong Kong has thus held up extremely well under the circumstances. This has perhaps surprised many, just as they have been surprised that the financial turmoil of the region could so suddenly erupt with such severity and contagion. 4. Indeed, not long ago, stories about the Asian miracle abounded. Asia had been the fastest growing region in the world and the economic numbers had been generally sound. Asian economies had low inflation rates and exchange rates had been stable, at least until recently. Current account for the region as a whole had been broadly in balance, although understandably the situation for individual economies varied. The fiscal account excluding Japan had been in surplus. Asia also had exceptionally high savings rates of over 30% of GDP and investment rates were equally high. Official sector savings of the Asian economies, in terms of their foreign currency reserves, were very substantial, accounting for about 40% of the world's foreign exchange reserves. Now five of the top six foreign reserves holders in the world are in Asia. The work force in Asia was young, educated and flexible. The political situation was stable. Policies were outward-looking with a commitment to open markets and free trade. 5. So what went wrong in Asia? What turned the Asian miracle into what is now referred to, quite unkindly in my opinion, as the Asian myth or the Asian mirage? A few months into this fall out, there have been many explanations offered. The most talked about was the rapid growth and volatility of international capital flows. 6. According to IMF statistics, net capital inflow to emerging markets was less than US$ 50 billion a year at the beginning of the decade. By 1996, however, this had increased to US$ 235 billion. Asia has received roughly half of this capital inflow. In some Asian economies, net capital inflows have averaged 5% to 8% of GDP over a long period. Contributing to this surge of international capital flows was financial liberalization undertaken by economies which had the foresight to do so, with a view to encouraging financial intermediation, domestically as well as internationally, so that the high savings could be channelled into productive investments, thus promoting economic growth. Meanwhile, there has been continued willingness on the part of the developed economies to export capital, under the influence of sustained economic growth, low inflation and low interest rates. Increasing amount of mutual funds and pension funds of these economies looked for higher returns in the emerging markets. In the case of Japan, sustained large current account surpluses, coupled with the earlier appreciation of the yen, have forced many Japanese firms to relocate their production to the rest of Asia. Thus capital inflows into the Asian region have been large. 7. With financial liberalization and the globalization of financial markets, a substantial part of the capital inflow into Asia has been in the form of foreign portfolio investments directed principally at financial instruments in the form of equity and bonds, and, where available, derivatives thereof. These international funds are generally highly alert to shifts in the expectation of risk, return and liquidity. They can therefore be highly volatile, with the tendency of reversing direction whenever there is the slightest hint of trouble, in respect of the macroeconomic policies, in particular financial policies pursued by governments, the robustness of the financial markets in which they operate, the soundness of the financial intermediaries with which they deal, etc. 8. Those economies which are dependent upon such capital inflows are clearly vulnerable to their reversal. Ideally therefore they ought to pay a lot of attention to pursuing sound macroeconomic policies and be transparent about them. This has perhaps proven to be politically difficult to achieve in some cases. They also need to ensure that they are in a position to deal with the volatility that characterizes the flow of international capital. And this means having: first, an effective monetary management mechanism that is capable of delivering currency stability; second, a regulatory and supervisory framework that safeguards the integrity of financial markets and the financial intermediaries in accordance with internationally accepted standards; and third, a robust financial infrastructure that enables financial transactions to be conducted efficiently and with a minimum of risk of failure. 9. This is a tall order, even for a relatively closed financial system that operates under more benign circumstances, not to mention for a newly liberalized financial system under stressful conditions. It is therefore understandable that when the reversal of capital inflows came, it caused the damaging financial turmoil that we have seen in a number of Asian economies. 10. Financial liberalization encourages greater financial intermediation, domestically and internationally, and this obviously is beneficial to economic growth and development. But clearly the risks arising from this worthy process must be identified and managed properly before the long term beneficial effects could be realized. The risks are, nevertheless, not well appreciated, simple as they may be, particularly with the benefit of hindsight. 11. There is, as always, credit risk. Yet it is such a common feature that undue exuberance on the part of investors would push price to earning ratios well beyond fundamentals. Bankers also fail to assess the impact of interest rate hikes on the value of collateral or on cash flows. The result is therefore the usual over exposure of investors and lenders to asset losses. Then there is maturity risk. To say that it is risky to finance illiquid non-tradables, such as property, with short term capital inflows is, I suppose, teaching grandmothers to suck eggs, particularly in this company, but this again has been a common feature underlying financial shocks, not just in Asia but also in other parts of the world. The same with currency risk. Many borrowers, in both the private and public sectors, were keen to borrow foreign currency funds to finance investments that do not generate sufficient foreign exchange to repay the debt. Such debts were also unhedged. And so when exchange rates move sharply, which they do, the currency mismatch results in large losses. 12. But I suppose we all learn from mistakes. We in Hong Kong did so the hard way in the early 1980s when the situation was compounded by uncertainties about the political future of Hong Kong. We had our currency crisis in 1983, after nine years of operating with a floating exchange rate, against volatile capital flows, without any effective mechanism for monetary management or currency anchor. Our banks had been overly exposed to credit, maturity and currency risks, and a total of seven banks had to be rescued directly or indirectly through the use of public funds. In short, we had been complacent. 13. But, thankfully, never have we been in any doubt about the need to maintain free and open markets, and a liberal financial system. The correct response to financial turmoil is not to resort to controls or to apportion blame, but to put one's own house in order, and ensure that one is in a position to cope. This we did through a series of reform measures to strengthen our monetary and financial systems implemented in the past ten years. This was, in part, also spurred by the desire to minimize the risk of possible financial disturbance ahead of and through political transition, and to provide the environment for Hong Kong's continuing development as an international financial centre, as required under the Basic Law. Our experience tells us that financial reform takes time and determination, and the ability to bite the bullet and bear the short-term pain. It is also very much a continuous process, with financial innovation creating new circumstances and presenting new challenges all the time. 14. I believe that we have successfully achieved this, which is the important reason why we have stood out as an oasis of calm, at least relatively speaking, in the storm of financial turmoil that is currently sweeping through the region and beyond. Some say that we are sticking out like a sore thumb, referring particularly to our fixed exchange rate link with the US dollar. I can of course respond to that by pointing to how well our linked exchange rate system, a currency board system that functions on auto-pilot, has worked. I can point to the supervisory efforts which have put our banking system on a very sound footing, and to our advanced financial infrastructure which has helped tremendously to contain and manage risks of a systemic nature. But many of you are, I am sure, already sick of my talking all the time, and may even dismiss what I say as trumpeting. I do not blame you. I am well aware of the possibility that over ten years of direct involvement in monetary reform in Hong Kong may have introduced a degree of bias in my views on the subject, which I have tried consciously to avoid. 15. But I would urge you instead to look at the reports of our annual medical check-ups conducted by the IMF since 1990 in the form of what are known as the Article IV Consultations. The IMF team was in fact in Hong Kong for this year's Consultation in the second half of October, when the short-lived but somewhat intense attack on our currency occurred. It was the best time for any diagnosis of financial problems. But after observing us closely over the period the team again gave us a clean bill of health. Let me give you a few relevant quotes from the Concluding Statement of the Consultation, which has already been published. It said that: "The authorities' commitment to a rules-based and non-interventionist approach should enhance the economy's ability to withstand the recent regional and financial market turmoil." "As in the past, the mission strongly endorses the authorities' continued commitment to the linked exchange rate system." "Appropriately, the authorities have taken forceful action during the past two weeks to tighten significantly monetary conditions, and have successfully demonstrated their ability and commitment to defend the link." "It is important to recognize that allowing interest rates to rise in response to exchange market pressures is an essential element of the currency board mechanism that lies at the heart of Hong Kong's monetary arrangements." "Recent events demonstrate that the system is working exactly as intended ..." "Our discussions with market participants have indicated a widely-held consensus that the prudential and regulatory oversight of the financial sector is strong, which has helped underpin confidence in the system." 16. But what the internationally renowned doctor, in the form of the IMF, says may not always be universally acceptable, particularly for those who may have been innocent parties having to suffer the pain of market adjustment, inevitable as it may be. It is quite understandable therefore that there will always be grievances and consequently calls for prescriptions for pain killers and other preventive medicine. I welcome constructive suggestions very much and we are in the process of meeting with those who are so kind as to offer their views and go through the vigorous technical discussions that good ideas deserve. 17. So far I am glad that there is full support for our linked exchange rate system. No one liked the prospect of Hong Kong being swept along in the process of competitive devaluation in the region and sharper downward adjustment in asset prices. At the technical level, two schools of thought could be identified at this stage. One expressed concern on the scope in which the Hong Kong Monetary Authority exercised discretion in our rule-based monetary system. Associated with this are also suggestions for improvement on how the system could be allowed to work more effectively and automatically. The other felt that the HKMA should have been more forthcoming in relieving the tightness in the money market and therefore the pain of those affected. 18. Interestingly, the two schools of thought are quite polarized. And, as always, the correct course should be somewhere in between, involving a good mix of pragmatism in the light of present day circumstances in financial markets, having regard also to the need for the HKMA to function as the lender of last resort to the banking system, but without any departure from the strict discipline of the currency board system requiring full US dollar backing for the Hong Kong dollar monetary base. This, incidentally, has very much been the attitude of the HKMA. Discussions continue, as part of the review initiated by the Financial Secretary, and I look forward to more of the technical scrutiny of ideas which can be quite enjoyable and revealing. 19. Meanwhile, elsewhere in the region, the full doses of the medicine prescribed by the IMF for a number of the Asian economies are being dutifully and courageously taken. If they persevere, they stand a good chance of coming out of this financial turmoil quickly and the damaging contagion that has spread across the world would be effectively contained. And for the longer term, I am hopeful that the new framework for enhanced Asian regional cooperation to promote financial stability, agreed upon at the Manila meeting of Asian finance and central bank deputies, and subsequently endorsed by APEC economic leaders at the Vancouver meeting, would play an effective role. 20. The framework, which recognizes the central role of the IMF in the international monetary system, includes important initiatives: first, there will be established a mechanism for regional surveillance to complement global surveillance by the IMF; second, there will be enhanced economic and technical cooperation particularly in strengthening domestic financial systems and regulatory capacities; third, there will be measures to strengthen the IMF's capacity to respond to financial crisis; and fourth, there will be a cooperative financial arrangement that would supplement IMF resources on a case by case, contingent basis. 21. But it is perhaps in the nature of financial flows that they do more often than not lead to overshooting in financial markets. The strong growth track record of Asia and indeed of other emerging markets has, with the benefit of hindsight, brought about excess optimism in these markets, producing a compression of yield spreads which underpriced the underlying credit, market and other risks that are typical of emerging markets going through financial liberalization. Indeed, Alan Greenspan said recently that "in retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk". With the sharp correction seen in financial markets in Asia, against the background that the economic fundamentals have largely remained sound, whether in isolation or relative to other emerging markets beyond the region, it is possible that there might now have been overshooting in the other direction. 22. I am sure, however, that the markets will eventually find their right levels, reflecting new circumstances, for better or for worse. I am not convinced, in any case, that the devaluation brought about by floating the exchange rate is necessarily the panacea for the ills of our Asian neighbours. First year economics tells us that the four elasticities of demand and supply of imports and exports may not interact to produce a clearly positive contribution to the balance of payments position from devaluation. Furthermore, when stable exchange rates are replaced by flexible, volatile and, in all likelihood, depreciating ones, the demand for hedging in the more volatile environment and under liberalized arrangements may drive exchange rates to such debilitating levels that many would regret the lack of resolve in pursuing sensible policies and in the defence of stable exchange rates in the first place. There is no doubt that confidence in the stability of a few Asian currencies has now been badly undermined and rebuilding it may take more than just time. Nevertheless, as the very productive Asian economies find their feet again, they will soon be on their way with renewed vigour. 23. For Hong Kong, as very much a service-oriented economy, any erosion of competitiveness, as a result of our currency holding stable against the US dollar while others have fallen, is likely to be mild. Our economy is not particularly sensitive to exchange rate changes. The IMF forecast for Hong Kong's growth rate next year is 4.25%, only a shade below our trend growth rate of 5%, representing a healthy consolidation in the circumstances.	['address by the chief mr. yam comments on the financial turmoil in asia executive of the hong kong monetary institute, mr. joseph yam, jp, at the euromoney asia pacific issuers and investors forum on 2/12/97.', "1. ladies and gentlemen, i am honoured to have been invited this year to deliver the opening address for euromoney's asia pacific issuers and investors forum.", '2. the year 1997 has been an unusual year for asia, particularly for hong kong.', "amidst financial turmoil of the worst kind in the history of asia, hong kong went through political transition to become a special administrative region of the people's republic of china.", 'this was achieved in the smoothest manner one could imagine.', 'and as the currencies of asia tumbled one after another in a process of competitive devaluation, involving sharp depletions of foreign reserves and requiring financial assistance from the international monetary fund and others, and sending shock waves to financial markets throughout the region and beyond, our currency, the hong kong dollar, remained very stable and our already very substantial foreign reserves increased.', 'although our asset markets have been affected by the contagion, some consolidation was in any case overdue; and in the event, for the year to date, the downward adjustment has been significantly less severe than those of many others in the region.', '3. hong kong has thus held up extremely well under the circumstances.', 'this has perhaps surprised many, just as they have been surprised that the financial turmoil of the region could so suddenly erupt with such severity and contagion.', '4. indeed, not long ago, stories about the asian miracle abounded.', 'asia had been the fastest growing region in the world and the economic numbers had been generally sound.', 'asian economies had low inflation rates and exchange rates had been stable, at least until recently.', 'current account for the region as a whole had been broadly in balance, although understandably the situation for individual economies varied.', 'the fiscal account excluding japan had been in surplus.', 'asia also had exceptionally high savings rates of over 30% of gdp and investment rates were equally high.', "official sector savings of the asian economies, in terms of their foreign currency reserves, were very substantial, accounting for about 40% of the world's foreign exchange reserves.", 'now five of the top six foreign reserves holders in the world are in asia.', 'the work force in asia was young, educated and flexible.', 'the political situation was stable.', 'policies were outward-looking with a commitment to open markets and free trade.', '5. so what went wrong in asia?', 'what turned the asian miracle into what is now referred to, quite unkindly in my opinion, as the asian myth or the asian mirage?', 'a few months into this fall out, there have been many explanations offered.', 'the most talked about was the rapid growth and volatility of international capital flows.', '6. according to imf statistics, net capital inflow to emerging markets was less than us$ 50 billion a year at the beginning of the decade.', 'by 1996, however, this had increased to us$ 235 billion.', 'asia has received roughly half of this capital inflow.', 'in some asian economies, net capital inflows have averaged 5% to 8% of gdp over a long period.', 'contributing to this surge of international capital flows was financial liberalization undertaken by economies which had the foresight to do so, with a view to encouraging financial intermediation, domestically as well as internationally, so that the high savings could be channelled into productive investments, thus promoting economic growth.', 'meanwhile, there has been continued willingness on the part of the developed economies to export capital, under the influence of sustained economic growth, low inflation and low interest rates.', 'increasing amount of mutual funds and pension funds of these economies looked for higher returns in the emerging markets.', 'in the case of japan, sustained large current account surpluses, coupled with the earlier appreciation of the yen, have forced many japanese firms to relocate their production to the rest of asia.', 'thus capital inflows into the asian region have been large.', '7. with financial liberalization and the globalization of financial markets, a substantial part of the capital inflow into asia has been in the form of foreign portfolio investments directed principally at financial instruments in the form of equity and bonds, and, where available, derivatives thereof.', 'these international funds are generally highly alert to shifts in the expectation of risk, return and liquidity.', 'they can therefore be highly volatile, with the tendency of reversing direction whenever there is the slightest hint of trouble, in respect of the macroeconomic policies, in particular financial policies pursued by governments, the robustness of the financial markets in which they operate, the soundness of the financial intermediaries with which they deal, etc.', '8. those economies which are dependent upon such capital inflows are clearly vulnerable to their reversal.', 'ideally therefore they ought to pay a lot of attention to pursuing sound macroeconomic policies and be transparent about them.', 'this has perhaps proven to be politically difficult to achieve in some cases.', 'they also need to ensure that they are in a position to deal with the volatility that characterizes the flow of international capital.', 'and this means having: first, an effective monetary management mechanism that is capable of delivering currency stability; second, a regulatory and supervisory framework that safeguards the integrity of financial markets and the financial intermediaries in accordance with internationally accepted standards; and third, a robust financial infrastructure that enables financial transactions to be conducted efficiently and with a minimum of risk of failure.', '9. this is a tall order, even for a relatively closed financial system that operates under more benign circumstances, not to mention for a newly liberalized financial system under stressful conditions.', 'it is therefore understandable that when the reversal of capital inflows came, it caused the damaging financial turmoil that we have seen in a number of asian economies.', '10. financial liberalization encourages greater financial intermediation, domestically and internationally, and this obviously is beneficial to economic growth and development.', 'but clearly the risks arising from this worthy process must be identified and managed properly before the long term beneficial effects could be realized.', 'the risks are, nevertheless, not well appreciated, simple as they may be, particularly with the benefit of hindsight.', '11. there is, as always, credit risk.', 'yet it is such a common feature that undue exuberance on the part of investors would push price to earning ratios well beyond fundamentals.', 'bankers also fail to assess the impact of interest rate hikes on the value of collateral or on cash flows.', 'the result is therefore the usual over exposure of investors and lenders to asset losses.', 'then there is maturity risk.', 'to say that it is risky to finance illiquid non-tradables, such as property, with short term capital inflows is, i suppose, teaching grandmothers to suck eggs, particularly in this company, but this again has been a common feature underlying financial shocks, not just in asia but also in other parts of the world.', 'the same with currency risk.', 'many borrowers, in both the private and public sectors, were keen to borrow foreign currency funds to finance investments that do not generate sufficient foreign exchange to repay the debt.', 'such debts were also unhedged.', 'and so when exchange rates move sharply, which they do, the currency mismatch results in large losses.', '12. but i suppose we all learn from mistakes.', 'we in hong kong did so the hard way in the early 1980s when the situation was compounded by uncertainties about the political future of hong kong.', 'we had our currency crisis in 1983, after nine years of operating with a floating exchange rate, against volatile capital flows, without any effective mechanism for monetary management or currency anchor.', 'our banks had been overly exposed to credit, maturity and currency risks, and a total of seven banks had to be rescued directly or indirectly through the use of public funds.', 'in short, we had been complacent.', '13. but, thankfully, never have we been in any doubt about the need to maintain free and open markets, and a liberal financial system.', "the correct response to financial turmoil is not to resort to controls or to apportion blame, but to put one's own house in order, and ensure that one is in a position to cope.", 'this we did through a series of reform measures to strengthen our monetary and financial systems implemented in the past ten years.', "this was, in part, also spurred by the desire to minimize the risk of possible financial disturbance ahead of and through political transition, and to provide the environment for hong kong's continuing development as an international financial centre, as required under the basic law.", 'our experience tells us that financial reform takes time and determination, and the ability to bite the bullet and bear the short-term pain.', 'it is also very much a continuous process, with financial innovation creating new circumstances and presenting new challenges all the time.', '14. i believe that we have successfully achieved this, which is the important reason why we have stood out as an oasis of calm, at least relatively speaking, in the storm of financial turmoil that is currently sweeping through the region and beyond.', 'some say that we are sticking out like a sore thumb, referring particularly to our fixed exchange rate link with the us dollar.', 'i can of course respond to that by pointing to how well our linked exchange rate system, a currency board system that functions on auto-pilot, has worked.', 'i can point to the supervisory efforts which have put our banking system on a very sound footing, and to our advanced financial infrastructure which has helped tremendously to contain and manage risks of a systemic nature.', 'but many of you are, i am sure, already sick of my talking all the time, and may even dismiss what i say as trumpeting.', 'i do not blame you.', 'i am well aware of the possibility that over ten years of direct involvement in monetary reform in hong kong may have introduced a degree of bias in my views on the subject, which i have tried consciously to avoid.', '15. but i would urge you instead to look at the reports of our annual medical check-ups conducted by the imf since 1990 in the form of what are known as the article iv consultations.', "the imf team was in fact in hong kong for this year's consultation in the second half of october, when the short-lived but somewhat intense attack on our currency occurred.", 'it was the best time for any diagnosis of financial problems.', 'but after observing us closely over the period the team again gave us a clean bill of health.', 'let me give you a few relevant quotes from the concluding statement of the consultation, which has already been published.', 'it said that: "the authorities\' commitment to a rules-based and non-interventionist approach should enhance the economy\'s ability to withstand the recent regional and financial market turmoil."', '"as in the past, the mission strongly endorses the authorities\' continued commitment to the linked exchange rate system."', '"appropriately, the authorities have taken forceful action during the past two weeks to tighten significantly monetary conditions, and have successfully demonstrated their ability and commitment to defend the link."', '"it is important to recognize that allowing interest rates to rise in response to exchange market pressures is an essential element of the currency board mechanism that lies at the heart of hong kong\'s monetary arrangements."', '"recent events demonstrate that the system is working exactly as intended ..." "our discussions with market participants have indicated a widely-held consensus that the prudential and regulatory oversight of the financial sector is strong, which has helped underpin confidence in the system."', '16. but what the internationally renowned doctor, in the form of the imf, says may not always be universally acceptable, particularly for those who may have been innocent parties having to suffer the pain of market adjustment, inevitable as it may be.', 'it is quite understandable therefore that there will always be grievances and consequently calls for prescriptions for pain killers and other preventive medicine.', 'i welcome constructive suggestions very much and we are in the process of meeting with those who are so kind as to offer their views and go through the vigorous technical discussions that good ideas deserve.', '17. so far i am glad that there is full support for our linked exchange rate system.', 'no one liked the prospect of hong kong being swept along in the process of competitive devaluation in the region and sharper downward adjustment in asset prices.', 'at the technical level, two schools of thought could be identified at this stage.', 'one expressed concern on the scope in which the hong kong monetary authority exercised discretion in our rule-based monetary system.', 'associated with this are also suggestions for improvement on how the system could be allowed to work more effectively and automatically.', 'the other felt that the hkma should have been more forthcoming in relieving the tightness in the money market and therefore the pain of those affected.', '18. interestingly, the two schools of thought are quite polarized.', 'and, as always, the correct course should be somewhere in between, involving a good mix of pragmatism in the light of present day circumstances in financial markets, having regard also to the need for the hkma to function as the lender of last resort to the banking system, but without any departure from the strict discipline of the currency board system requiring full us dollar backing for the hong kong dollar monetary base.', 'this, incidentally, has very much been the attitude of the hkma.', 'discussions continue, as part of the review initiated by the financial secretary, and i look forward to more of the technical scrutiny of ideas which can be quite enjoyable and revealing.', '19. meanwhile, elsewhere in the region, the full doses of the medicine prescribed by the imf for a number of the asian economies are being dutifully and courageously taken.', 'if they persevere, they stand a good chance of coming out of this financial turmoil quickly and the damaging contagion that has spread across the world would be effectively contained.', 'and for the longer term, i am hopeful that the new framework for enhanced asian regional cooperation to promote financial stability, agreed upon at the manila meeting of asian finance and central bank deputies, and subsequently endorsed by apec economic leaders at the vancouver meeting, would play an effective role.', "20. the framework, which recognizes the central role of the imf in the international monetary system, includes important initiatives: first, there will be established a mechanism for regional surveillance to complement global surveillance by the imf; second, there will be enhanced economic and technical cooperation particularly in strengthening domestic financial systems and regulatory capacities; third, there will be measures to strengthen the imf's capacity to respond to financial crisis; and fourth, there will be a cooperative financial arrangement that would supplement imf resources on a case by case, contingent basis.", '21. but it is perhaps in the nature of financial flows that they do more often than not lead to overshooting in financial markets.', 'the strong growth track record of asia and indeed of other emerging markets has, with the benefit of hindsight, brought about excess optimism in these markets, producing a compression of yield spreads which underpriced the underlying credit, market and other risks that are typical of emerging markets going through financial liberalization.', 'indeed, alan greenspan said recently that "in retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk".', 'with the sharp correction seen in financial markets in asia, against the background that the economic fundamentals have largely remained sound, whether in isolation or relative to other emerging markets beyond the region, it is possible that there might now have been overshooting in the other direction.', '22. i am sure, however, that the markets will eventually find their right levels, reflecting new circumstances, for better or for worse.', 'i am not convinced, in any case, that the devaluation brought about by floating the exchange rate is necessarily the panacea for the ills of our asian neighbours.', 'first year economics tells us that the four elasticities of demand and supply of imports and exports may not interact to produce a clearly positive contribution to the balance of payments position from devaluation.', 'furthermore, when stable exchange rates are replaced by flexible, volatile and, in all likelihood, depreciating ones, the demand for hedging in the more volatile environment and under liberalized arrangements may drive exchange rates to such debilitating levels that many would regret the lack of resolve in pursuing sensible policies and in the defence of stable exchange rates in the first place.', 'there is no doubt that confidence in the stability of a few asian currencies has now been badly undermined and rebuilding it may take more than just time.', 'nevertheless, as the very productive asian economies find their feet again, they will soon be on their way with renewed vigour.', '23. for hong kong, as very much a service-oriented economy, any erosion of competitiveness, as a result of our currency holding stable against the us dollar while others have fallen, is likely to be mild.', 'our economy is not particularly sensitive to exchange rate changes.', "the imf forecast for hong kong's growth rate next year is 4.25%, only a shade below our trend growth rate of 5%, representing a healthy consolidation in the circumstances."]	Joseph Yam	Hong Kong Monetary Authority	Chief Executive	Hong Kong
https://www.bis.org/review/r980102a.pdf	Mr. Tietmeyer considers the euro as a denationalised currency (Central Bank Articles and Speeches, 27 Nov 1997)	Speech delivered by the President of the Deutsche Bundesbank, Prof. Hans Tietmeyer, to the Österreichisch-deutsche Kulturgesellschaft in Vienna on 27/11/1997.	1997-11-27 00:00:00	Mr. Tietmeyer considers the euro as a denationalised currency Speech delivered by the President of the Deutsche Bundesbank, Prof. Hans Tietmeyer, to the Österreichisch-deutsche Kulturgesellschaft in Vienna on 27/11/1997. I Currency is more than just a part of the economy. A currency is always a reflection of its country, its politics and its culture. As Joseph A. Schumpeter, probably the most versatile Austrian economist of this century, famously put it: a nation's monetary system reflects everything which that nation desires, suffers, is. "Nothing reveals as clearly what a nation is made of as what it does in monetary policy." It is tempting to place Schumpeter's words -- just for a moment -- in the context of a supranational currency (like the euro). Then the proposition would be that a single monetary system reflects everything that these nations (note the change from singular to plural) "desire, suffer, are". For one thing, those words express the idea of a community which is bound together by a common destiny. (Even though the verb "suffer" sounds somewhat emphatic.) That is because the single currency binds the people in the participating countries together in terms of money and currency, for better or for worse, for ever. After all, monetary union no longer provides for an orderly secession. For another, Schumpeter's words are a reminder of the necessary communality. If the monetary system reflects what the peoples of those nations want, what they do, and what they are, then it will be crucial to monetary union that the individual participating countries also want and do the same things; in other words, that they attach largely identical aims and expectations to the single currency and also act accordingly -- at least in terms of their basic stance. Otherwise, the single currency would contain the potential for conflict which could easily lead to real tensions. And, sooner or later, such conflicts would have a detrimental effect not only on the currency, but also on the economy, integration, and Europe's political and social culture. II Under the terms of the Maastricht Treaty, European monetary union will ultimately begin on January 1, 1999. The euro will then become the dominant currency in Europe, at least in the money and capital markets. Since the euro banknotes and coins will not be available until the end of 2001 and the beginning of 2002, the national currencies will continue to play a dominant role in the interim for wage and salary earners, consumers, retailers and probably among medium-sized businesses, too. However, those national currencies will also be inextricably linked to one another by irrevocably fixed conversion rates -- as in a single currency. The decision on which countries are to be in at the start of monetary union will not be taken until the spring of 1998, and will be based on the convergence situation, which will then be verifiable; in the end, this binding decision will be taken by the heads of state or government of the EU countries by qualified majority vote. Out of respect for this decision-making process, which has been laid down in the Treaty, I do not wish to indulge in speculation on the future membership. Instead, I would like to go into more detail on the supranational nature of the new currency and the resulting advantages and implications which follow from it. The euro is intended to be a denationalised currency. In precise terms, that implies two characteristics: • the euro as a largely borderless currency, • and the euro as a largely depoliticised currency. The euro is intended to be a borderless currency in the sense that the national borders within the supranational euro area will have no bearing either on the fixing of monetary policy or on the use of the currency. It will be the common currency of all the participating countries, and for that currency, there will be only one single, supranational monetary policy, even if the national central banks will still be responsible for its implementation. Moreover, the euro will provide a crucial boost to the opening-up of borders across markets and economies in Europe which was already initiated by the Common Market. In monetary union, the participating countries can no longer adjust the exchange rates against each other. This means that what were once major barriers for entrepreneurs and consumers have now been eliminated: the exchange-rate risk, conversion and transaction costs. However, one means of protection will also disappear -- and for ever -- namely, exchange rate adjustments as the former last resort in the event of declining competitiveness or radical structural changes. At the same time, the euro has also been designed as a depoliticised currency. The European Central Bank is, by intention, to operate independently of political influence exerted by governments, parliaments and other European institutions. It has a clear mandate to safeguard the value of money. At all events, that is its primary task. The monetary system is hence removed from the realm of everyday policy-making. The objective of monetary stability is protected in a particular manner. And policy makers cannot subordinate it to other objectives -- subject to expedience, the political leaning of the government, or election dates. By choosing that structure, the signatories of the Treaty made a conscious decision to continue a tradition which, especially in the postwar era, has become established in a number of countries in Europe whose currencies have shown a particular degree of stability. Even countries which, for a long time, had tied their currency regimes much more closely to everyday policy-making have evidently come to recognise the advantages of unpolitical monetary systems in the run-up to Maastricht. This does not, of course, rule out the possibility of the earlier tradition occasionally rearing its head in some isolated issues. Denationalisation and depoliticisation, though, are certainly linked in a particular fashion. At all events, removing monetary boundaries in any form calls for a modicum of matching depoliticisation. This is true not just for the ultimate form in which boundaries are removed, monetary union -- but it is particularly applicable to it. But even the first steps in removing boundaries -- such as the transition to convertibility -- reduce the leeway for a monetary regime which is simultaneously intended to serve other political ends. With convertibility, a currency exposes itself to a comparison of its stability with that of other currencies. That means that external pressure towards stability begins to be exerted. This was clearly recognisable when a number of European currencies made the transition to convertibility in the 1950s and 1960s. National political influence on the monetary system is restricted even more by participation in an exchange rate system with fixed parities, regardless of whether a multilateral system or a unilateral pegging to another currency is involved. It is true that every country continues to have a national monetary policy to a certain extent. However, if the national monetary policies -- for instance, owing to different political leanings and preferences -- diverge too greatly, then the respective parities will no longer be realistic. In most cases, this results in unrest in the markets which sooner or later forces parities to change. But if parity changes are frequent, participation in an exchange rate system makes little sense; if anything, it becomes counterproductive. If there are no more currency boundaries in monetary union, there can only be a single strategy and a common orientation for the monetary system. III This uniform strategy and this common orientation can only be a currency which is largely depoliticised, especially in a supranational monetary union in which the basic structures of the nation state remain. If monetary union is not embedded from the outset in a largely homogeneous and political union which is constituted along the lines of national government, but is founded instead on the basis of different nation states, that supranational monetary policy can only be largely unpolitical, meaning disengaged from the political influence of nation states which goes beyond the legal mandate to safeguard the stability of the currency. This is particularly valid as long as there is no all-encompassing decision-making process at the European level -- and that will probably not exist in Europe for a long time to come. In addition, experience has shown that a depoliticised, consistent, long-term strategy is also superior in two crucial respects to a discretionary approach which submits to political expedience: • by creating more confidence on the part of the markets, and • above all, by being better able to provide stable money and to safeguard it on a long-term basis. Therefore, a depoliticised currency is most likely to provide the opportunity of reaching a sustainable consensus among the countries participating in monetary union. After all, special national political interests do not apply here. The only thing that counts is the common objective of an enduringly stable currency. It is precisely a consensus of that kind which underlies the Maastricht Treaty. In future, Europe must safeguard and preserve it. Therefore, it is also important to see to it that, in the course of the establishment of monetary union and its institutions, there is no attempt at a sort of re-nationalisation. That goes for the appointment of the executive staff of the future European Central Bank as well as for how their tasks are construed. As envisaged in the Treaty, neither the members of the ECB Executive Board nor the presidents of the national central banks represented in the Governing Council are there to represent national interests. Rather, they are the caretakers and guardians of the new single currency -- no more, but also no less. And if a sort of accountability is considered necessary, it should be to the European institutions (the European Parliament, for instance) -- as provided for the Treaty. Therefore, the question of the national origin and/or the distribution of the seats in the ECB Executive Board by nationality should not be the key criterion for appointment -- at least this is the idea behind monetary union, and this is the letter, and certainly the spirit, of the Treaty. Internally, too, the participating countries should not lean towards a re-nationalisation. Of course, there will be a flow of information between a country's political bodies and the respective central bank management in future, too. However, reporting requirements on the part of the national central bank management would be a cause for concern, if this were tied to the idea that the governor of a given central bank were a sort of representative of that country's national interests regarding monetary policy in the Governing Council. That is not the case. Every member of the Governing Council (regardless of whether he/she belongs to the Executive Board or is the governor of a national central bank) has a personal responsibility, namely for the long-term stability of the euro throughout the monetary union. The governor of a national central bank must not even be bound by his own bank in the sense of an "imperative mandate". That is also the logic behind the "one person -- one vote" rule in the Council. If the governors were the defenders of national interests in monetary policy decision-making, it would have been a much more obvious thing to weight the individual votes in terms of the respective share of capital -- as is done in the IMF, for instance. A structure of that kind was consciously rejected, in view of the desired denationalisation of money. After all, the euro must not become merely the sum of national orientations and interests. It must become an independent currency which safeguards monetary stability throughout the euro area. The euro cannot peg itself externally and thus attract credibility and stability from without, as smaller currencies could before. Rather, it must first set a stability benchmark itself. And to that end, a consensus on stable money or a stable exchange rate, important as it may be, is not enough. There will always be situations in which monetary policy makers have to take decisions which -- at least momentarily -- will have an adverse impact on one group or another in society and which do not conform with the intentions of one government or another. It is precisely in such difficult moments that the European Central Bank must also be able to take decisions and have the capacity to act in its area of competence. It cannot and must not wait for a general social and political consensus. Decisions regarding stability policy do require courage every now and then, even though they are, of course, guided by sound judgement. In such critical moments, I hope that Sarasto's wish in Mozart's "The Magic Flute" will be granted to the future President and the Vice-President (and, of course, the other Governing Council members, too): "Oh, Isis and Osiris, send the spirit of wisdom to the young couple! You who guide the wanderers' steps, strengthen them with patience when in danger". (Whether or not that immediately leads you to believe that the European Central Bank resides "in these holy halls" is something I shall leave up to you.) The independence of the future European Central Bank by no means implies, of course, that it will be detached from the Community or from the general public. (Much as the Bundesbank today is involved at the centre of German public life and public debate.) It is precisely that independent position which requires the central bank to engage with the general public, to explain its monetary policy, and to make its motives and strategy as transparent as possible. It is not least for that reason that the Bundesbank is advocating a pre-announced monetary target for European monetary policy, by which it must then allow itself to be judged. Conversely, I can assure you that the general public, too, is keeping a close watch on monetary policy and subjecting it to a critical assessment. It notes every word which is written and spoken (and, in some cases, precisely those words which remain unspoken). I therefore believe that an independent central bank tends to be subjected to closer scrutiny by the public than some areas of policy. And this is as it should be. After all, a depoliticised currency is a currency which has remained as close to people as a borderless currency. But the crucial point is: a borderless currency must go hand in hand with a depoliticised currency. As a denationalised currency, the euro needs both elements. IV In the eyes of some analysts, the euro brings the monetary policy experiments of this century full circle. The century began and will end with a denationalised money. At its beginning, there was the gold standard. At its end, there will be the euro. The currencies on the gold standard were borderless owing to the fixed parities and to gold as a common point of reference. They were depoliticised in the sense that the anonymous mechanism of pegging to the gold standard forced corrections to the gold standard. Independent central banks followed a clear monetary mandate, namely that of maintaining gold parity. Historians may argue over whether the days of the gold standard were indeed a golden era. At all events, the experience of the past cannot simply be transferred to the present-day situation. At that time, wages and prices were more flexible than they are today. Above all, the position of the state within and vis-à-vis the economy was different. The government ratio tended to be below rather than above ten per cent back then; today, in most European countries, it is over fifty per cent. That has implications for adjustment potential and flexibility. Naturally, it is primarily the private sector which must shoulder the burden of adjustment in the event of exogenous shocks and changes in competitiveness. At the time of the gold standard, the private sector still made up the lion's share of the economy. Nowadays, by contrast, the burden of adjustment is concentrated on just under half of the economy. The fact that society in general has little desire to allow market mechanisms to act on their own is reflected precisely in today's government ratio. After the collapse of the gold standard, three trends initially prevailed in the following decades -- and it was no accident that those trends coincided: • Firstly, the currency became increasingly (re-)politicised. It became associated more closely with other non-monetary objectives. Secondly, the heyday of the independent central bank came to an end in just about every • country; in many countries, that was the case until only just recently. • Thirdly, the politicisation of money went hand-in-hand with an increased isolation of the currency and the economy from external influences. International links declined significantly. Therefore, a central motive of the Bretton Woods System, adopted in 1944, was to promote world economic integration by means of orderly monetary conditions. And in this sense, the system performed good service. Regarding the criteria of borderless and depoliticised money, the Bretton Woods System was, as it were, a wanderer between the worlds. Money was not truly without borders. Until well into the 1960s, capital controls were an instrument frequently employed by a large number of countries. Indeed, in many cases such controls were being used precisely in Europe, too, until the end of the 1980s. And currency was not entirely depoliticised in the Bretton Woods System, either. It was not only determined by the dominant position of the United States and whatever political views prevailed there at any given time. Many capital controls also mostly concealed differing political strategies and preferences. In the long term, the monetary system created after World War II was not depoliticised enough in order to keep pace with the increasing denationalisation of currency brought about by increasingly efficient and powerful international financial markets. At any rate, it was often the case that the rules of the fixed-rate system were not observed. • Countries running deficits were often too hesitant in correcting their balances of payments. • Exchange rates were adjusted too late in most cases. • And, above all, by the mid-1960s onwards, the US dollar, the key currency, was increasingly failing to fulfil its role as an objective point of reference for stable money -a role which only an unpolitical currency could have performed. It was thus no great surprise that the Bretton Woods System finally collapsed in 1973. Fixed exchange rates accompanied by differing preferences were something the increasingly developing and emancipated financial markets no longer allowed. V The 1970s then witnessed the great contest of monetary strategies -- particularly within Europe, too -- especially once the first oil crisis began to pose major challenges. On the one hand, there was the concept of political money. The objective of monetary stability took a back seat. Monetary policy was to promote other objectives: employment, absorption of the oil shock, in some cases even foreign policy and foreign trade objectives. On the other hand, there was the concept of unpolitical money. Regaining internal monetary stability and safeguarding it -- in other words, the "natural" objective of monetary policy -- prevailed. Particularly independent central banks -- such as the Bundesbank and the Swiss National Bank -- put this stance into practice. In Germany, that was an important test for the concept of unpolitical money, introduced in 1948 with the currency reform and secured institutionally by the independence of the central bank. The outcome has left no room for doubt in economic terms. Countries with unpolitical money have not only had lower inflation rates, but also less unemployment. And, on the whole, they were also able to handle the oil shock and the unpredictability of the US dollar and other currencies much better. Besides, they were able to acquire an increasingly high stock of confidence on the part of the financial markets, resulting in relatively low capital market rates. This positive experience is something you in Austria have also gained. The reasoning behind your hard-currency policy -- if I understand it correctly, as an outsider -- is likewise based on the realisation that inflation does not solve any problems. Austria has been consistent in applying this hard-currency policy -- even during a period which was somewhat difficult (the second half of the 1960s). On the whole, this has led to the financial markets and the public having a justifiably high degree of confidence in the schilling. The question of whether monetary policy can be employed to promote and secure jobs also crops up every now and then in Germany as well as in your country. On the one hand, this seems understandable. A high degree of monetary stability has been achieved at the moment worldwide. By contrast, high unemployment is a pressing problem, especially on the European continent. However, for those who have been following monetary policy practice over the past decades, the debate sometimes seems quite eerie. For monetary history has indeed pronounced a clear-cut judgement: maintaining monetary stability over the medium and long term is undoubtedly the best contribution monetary policy can make to employment, even if monetary policy by itself can neither secure nor create employment. For some time now, Europeans have been increasingly interested in findings in the United States, where, for some time now, a rather dynamic upswing, a relatively tight labor market, and yet a comparatively low rate of inflation have coincided. What can and should we in Europe learn from that? If Europe succeeds in making its labour markets significantly more flexible, and if competitive pressure in the goods markets rises significantly; and if this causes the wind of the global markets and of worldwide competition to be conveyed more strongly internally via flexible, highly competitive structures, and the European economy is given a breath of fresh air, then the conditions for sustained price stability in Europe will improve. Then, perhaps even the European Central Bank can get by with relatively low interest rates in future in order to keep inflation in check. The key to that, though, is certainly not a lax or pseudo-employment-oriented monetary policy (which would, in actual fact, backfire), but more market economy and competition. And the road to more competitive structures is only through a stable, i.e. tight, money. It is true that the great master of Viennese popular theatre, Johann Nestroy, once philosophised: "The Phoenecians invented money -- but why so little of it?" However, the central bank must limit the supply of money and set the interest rates accordingly. That is its task. It is also true that Arthur Schopenhauer once said: "There are people who would pay any price for money." Yet philosophers are not always right, especially when it comes to analysing the economy. The same applies to Schopenhauer's dictum; otherwise, it would be virtually impossible, above all, to manage the money stock by using interest rates. VI The disintegration of monetary policy strategies in the 1970s did not only have the economic implication that countries had diverging degrees of economic success. There was an important European policy implication, too. The plan to implement a phased monetary union that we developed in the Werner Group in 1970 soon foundered; not only on differing monetary strategies, but also on the lack of willingness of at least one country, at that time, to surrender national sovereignty. In its day, in fact, the Werner Plan had two advantages over today's Maastricht Treaty: Firstly, the six-nation EC of the time was relatively homogeneous in economic terms. • • Secondly, with regard to its strategy for integration, the Werner Plan was more consistent than the Maastricht Treaty. It envisaged a marked intensification of both political and monetary integration. But, in the final analysis, at that time there was neither the willingness to realise this deeper political integration nor a convergence in monetary policy. The monetary union, which had already been planned for the 1980s, did not come into being. The lack of convergence in the 1970s was not even enough to keep a larger monetary arrangement together. In the end, all that was left was the "mini-snake". The exchange rate mechanism (ERM) of the European Monetary System, newly formed in 1979, was also not very stable to begin with. It was not until 1983 that an important change took place in the history of monetary integration in Europe. With Finance Minister Delors at the helm, France changed course towards a clearly non-inflationary policy. Others followed. This step, initiated by France, paved the way for a gradual convergence of inflation rates at a low level in the 1980s, • for increasingly stable exchange rates within the ERM, • • and, finally, for making a further-reaching monetary union conceivable again. At all events, in 1988 the Delors Group was commissioned to develop a framework taking account of the new conditions. VII The Maastricht Treaty, negotiated in the early 1990s, gave a sound legal structure to the idea of monetary union -- even if some critics, not without reason, occasionally described it as a torso, in light of the fact that the structures of a political union were lacking. In order to really comprehend the Maastricht Treaty and its significance, I feel two things have to be realised: The first realisation is that the essential elements of the Maastricht Treaty did not fall into Europe's lap. They are the result of experience, and not just of the positive kind. The same applies to a sufficiently well-founded economic convergence which the Maastricht Treaty rightly calls for. Over long stretches of Europe's postwar history, this convergence has tended to be absent. This has changed at least in some respects. It was a decidedly arduous process which led to today's high level of monetary convergence. However, despite a large number of major advances, the level of convergence is regrettably much lower in the area of public finance, at least if the looming future burdens posed by demographic trends and the mounting debts which have already been run up are taken into account. It was also difficult at that time to anchor the concept of a depoliticised currency in the Treaty. Differing national traditions regarding the perceived role of the state and society understandably played a part in that. This idea naturally fits in particularly well with the German tradition of decentralised structures. It has been and still is more difficult for other countries on account of their traditions and structures -- despite the obvious economic superiority of this concept. And the second realisation is that Maastricht is not merely the logical continuation of a historic trend. Monetary union is a quantum leap in qualitative terms. We are daring to start anew what did not succeed in the 1970s. And this time it must succeed, and this success must be enduring. Participation is final. Under the terms of the Treaty, there is no longer an escape hatch -- no matter what economic or political developments a given country may undergo. That is what makes it different from an exchange rate system or unilateral exchange rate pegging. This monetary finality, if you will, means putting a crucial political and economic framework in place for future generations, too. Maastricht enshrines the concept of a depoliticised currency, and hence stable money, as the primary objective for the central bank, for all time. Under the terms of the Treaty, once a country has entered into monetary union, it no longer has the option of trying a different path. And each of the participating countries is in intra-European competition for ever without being able to adjust its exchange rate or to adapt central bank rates to its own economic situation. Of course, these monetary restrictions -- technically speaking -- already result from a tight exchange rate pegging. Only, with a fixed exchange rate corridor, a country still has it in its power to decide on those self-commitments -- but that will no longer be so once monetary union commences. Under the conditions of the 21st century, it will certainly not get any easier to maintain economic convergence and to safeguard a country's own competitiveness. • One reason is that competition will continue to increase, in Europe and most certainly all over the world. The technological driving forces of globalisation will continue to exert an effect. The other reason is that just about all the European countries -- more or less -- are still • facing great structural challenges which are still a long way from being overcome, such as persistent unemployment. The countries have to work hard to find solutions. The national governments and parliaments should not forget the words of your fellow Austrian, Karl-Heinrich Waggerl: "Ask for God's blessing for your work -- but do not ask Him to do the work Himself as well." The subject of convergence in monetary union therefore does not just present itself -- as economic textbooks call it -- in external shocks which affect individual countries to varying degrees. The key issue here is for countries to tackle the structural challenges they are facing, which are identifiable now, in a similar manner and at a similar pace. Otherwise, "internal shocks" would ensue. The individual economies would grow apart. But not due to an external event hitting a given region like a comet. Rather, because monetary union would smoulder inside, giving rise to tectonic tension. At any rate, it will probably not suffice to set aside the topic of convergence by using the learned argument that a country which is in competition and does not have access to central bank money and credit has no choice but to maintain its competitiveness and keep its public finances in shape. It is basically correct that a country's policy makers can also rise to the occasion, as it were, along with the challenges of competition. But of course, a country -- just like an enterprise -- can also founder as a result of failing to meet those challenges, if its starting position is too unfavourable. The difference is that an enterprise then just disappears from the market, whereas a country naturally continues to exist. If a country were to encounter difficulties with the conditions of monetary union, then an economic problem would arise. And -- let us not deceive ourselves -- that would soon create a political problem. Europe must avoid that problem as far as possible. Therefore, monetary union requires a minimum level of convergence on the part of all its participants, both before accession and, of course, most certainly thereafter. VII The euro will have to be a denationalised currency; there cannot and must not be any doubt about that. It will thus be in keeping with an increasingly borderless economy. And therein lie the key economic arguments in favour of the euro. The path to monetary union offers Europe major new opportunities. In a Europe which is heading towards a single market, and in a world which is converging in economic terms, a large single monetary area offers major advantages -- always provided the euro remains enduringly stable. Monetary union and the single currency, the euro, will not just mean the elimination of many risks and costs. If it becomes and remains sufficiently stable, the euro also has great prospects of building on the D-mark's position as a world currency. And, it can improve the efficiency of the European single market and, moreover, give further impetus to political integration. Those great opportunities and advantages of that historic step into monetary union are not qualified by pointing to the reality of today's situation in Europe and the resulting challenges. As a denationalised currency, the euro will be embedded in a political Europe which is still largely characterised by national structures. As a borderless currency, the euro will encounter bordered national economic, social and tax policies still searching for answers to the borderless economy. And, as a depoliticised money, the euro will encounter a political reality in which some people and groups still expect enormous, and fundamentally unrealistic, favours from the welfare state. Both are a sign of tensi	['mr. tietmeyer considers the euro as a denationalised currency speech delivered by the president of the deutsche bundesbank, prof. hans tietmeyer, to the österreichisch-deutsche kulturgesellschaft in vienna on 27/11/1997.', 'i currency is more than just a part of the economy.', 'a currency is always a reflection of its country, its politics and its culture.', "as joseph a. schumpeter, probably the most versatile austrian economist of this century, famously put it: a nation's monetary system reflects everything which that nation desires, suffers, is.", '"nothing reveals as clearly what a nation is made of as what it does in monetary policy."', "it is tempting to place schumpeter's words -- just for a moment -- in the context of a supranational currency (like the euro).", 'then the proposition would be that a single monetary system reflects everything that these nations (note the change from singular to plural) "desire, suffer, are".', 'for one thing, those words express the idea of a community which is bound together by a common destiny.', '(even though the verb "suffer" sounds somewhat emphatic.)', 'that is because the single currency binds the people in the participating countries together in terms of money and currency, for better or for worse, for ever.', 'after all, monetary union no longer provides for an orderly secession.', "for another, schumpeter's words are a reminder of the necessary communality.", 'if the monetary system reflects what the peoples of those nations want, what they do, and what they are, then it will be crucial to monetary union that the individual participating countries also want and do the same things; in other words, that they attach largely identical aims and expectations to the single currency and also act accordingly -- at least in terms of their basic stance.', 'otherwise, the single currency would contain the potential for conflict which could easily lead to real tensions.', "and, sooner or later, such conflicts would have a detrimental effect not only on the currency, but also on the economy, integration, and europe's political and social culture.", 'ii under the terms of the maastricht treaty, european monetary union will ultimately begin on january 1, 1999. the euro will then become the dominant currency in europe, at least in the money and capital markets.', 'since the euro banknotes and coins will not be available until the end of 2001 and the beginning of 2002, the national currencies will continue to play a dominant role in the interim for wage and salary earners, consumers, retailers and probably among medium-sized businesses, too.', 'however, those national currencies will also be inextricably linked to one another by irrevocably fixed conversion rates -- as in a single currency.', 'the decision on which countries are to be in at the start of monetary union will not be taken until the spring of 1998, and will be based on the convergence situation, which will then be verifiable; in the end, this binding decision will be taken by the heads of state or government of the eu countries by qualified majority vote.', 'out of respect for this decision-making process, which has been laid down in the treaty, i do not wish to indulge in speculation on the future membership.', 'instead, i would like to go into more detail on the supranational nature of the new currency and the resulting advantages and implications which follow from it.', 'the euro is intended to be a denationalised currency.', 'in precise terms, that implies two characteristics: • the euro as a largely borderless currency, • and the euro as a largely depoliticised currency.', 'the euro is intended to be a borderless currency in the sense that the national borders within the supranational euro area will have no bearing either on the fixing of monetary policy or on the use of the currency.', 'it will be the common currency of all the participating countries, and for that currency, there will be only one single, supranational monetary policy, even if the national central banks will still be responsible for its implementation.', 'moreover, the euro will provide a crucial boost to the opening-up of borders across markets and economies in europe which was already initiated by the common market.', 'in monetary union, the participating countries can no longer adjust the exchange rates against each other.', 'this means that what were once major barriers for entrepreneurs and consumers have now been eliminated: the exchange-rate risk, conversion and transaction costs.', 'however, one means of protection will also disappear -- and for ever -- namely, exchange rate adjustments as the former last resort in the event of declining competitiveness or radical structural changes.', 'at the same time, the euro has also been designed as a depoliticised currency.', 'the european central bank is, by intention, to operate independently of political influence exerted by governments, parliaments and other european institutions.', 'it has a clear mandate to safeguard the value of money.', 'at all events, that is its primary task.', 'the monetary system is hence removed from the realm of everyday policy-making.', 'the objective of monetary stability is protected in a particular manner.', 'and policy makers cannot subordinate it to other objectives -- subject to expedience, the political leaning of the government, or election dates.', 'by choosing that structure, the signatories of the treaty made a conscious decision to continue a tradition which, especially in the postwar era, has become established in a number of countries in europe whose currencies have shown a particular degree of stability.', 'even countries which, for a long time, had tied their currency regimes much more closely to everyday policy-making have evidently come to recognise the advantages of unpolitical monetary systems in the run-up to maastricht.', 'this does not, of course, rule out the possibility of the earlier tradition occasionally rearing its head in some isolated issues.', 'denationalisation and depoliticisation, though, are certainly linked in a particular fashion.', 'at all events, removing monetary boundaries in any form calls for a modicum of matching depoliticisation.', 'this is true not just for the ultimate form in which boundaries are removed, monetary union -- but it is particularly applicable to it.', 'but even the first steps in removing boundaries -- such as the transition to convertibility -- reduce the leeway for a monetary regime which is simultaneously intended to serve other political ends.', 'with convertibility, a currency exposes itself to a comparison of its stability with that of other currencies.', 'that means that external pressure towards stability begins to be exerted.', 'this was clearly recognisable when a number of european currencies made the transition to convertibility in the 1950s and 1960s.', 'national political influence on the monetary system is restricted even more by participation in an exchange rate system with fixed parities, regardless of whether a multilateral system or a unilateral pegging to another currency is involved.', 'it is true that every country continues to have a national monetary policy to a certain extent.', 'however, if the national monetary policies -- for instance, owing to different political leanings and preferences -- diverge too greatly, then the respective parities will no longer be realistic.', 'in most cases, this results in unrest in the markets which sooner or later forces parities to change.', 'but if parity changes are frequent, participation in an exchange rate system makes little sense; if anything, it becomes counterproductive.', 'if there are no more currency boundaries in monetary union, there can only be a single strategy and a common orientation for the monetary system.', 'iii this uniform strategy and this common orientation can only be a currency which is largely depoliticised, especially in a supranational monetary union in which the basic structures of the nation state remain.', 'if monetary union is not embedded from the outset in a largely homogeneous and political union which is constituted along the lines of national government, but is founded instead on the basis of different nation states, that supranational monetary policy can only be largely unpolitical, meaning disengaged from the political influence of nation states which goes beyond the legal mandate to safeguard the stability of the currency.', 'this is particularly valid as long as there is no all-encompassing decision-making process at the european level -- and that will probably not exist in europe for a long time to come.', 'in addition, experience has shown that a depoliticised, consistent, long-term strategy is also superior in two crucial respects to a discretionary approach which submits to political expedience: • by creating more confidence on the part of the markets, and • above all, by being better able to provide stable money and to safeguard it on a long-term basis.', 'therefore, a depoliticised currency is most likely to provide the opportunity of reaching a sustainable consensus among the countries participating in monetary union.', 'after all, special national political interests do not apply here.', 'the only thing that counts is the common objective of an enduringly stable currency.', 'it is precisely a consensus of that kind which underlies the maastricht treaty.', 'in future, europe must safeguard and preserve it.', 'therefore, it is also important to see to it that, in the course of the establishment of monetary union and its institutions, there is no attempt at a sort of re-nationalisation.', 'that goes for the appointment of the executive staff of the future european central bank as well as for how their tasks are construed.', 'as envisaged in the treaty, neither the members of the ecb executive board nor the presidents of the national central banks represented in the governing council are there to represent national interests.', 'rather, they are the caretakers and guardians of the new single currency -- no more, but also no less.', 'and if a sort of accountability is considered necessary, it should be to the european institutions (the european parliament, for instance) -- as provided for the treaty.', 'therefore, the question of the national origin and/or the distribution of the seats in the ecb executive board by nationality should not be the key criterion for appointment -- at least this is the idea behind monetary union, and this is the letter, and certainly the spirit, of the treaty.', 'internally, too, the participating countries should not lean towards a re-nationalisation.', "of course, there will be a flow of information between a country's political bodies and the respective central bank management in future, too.", "however, reporting requirements on the part of the national central bank management would be a cause for concern, if this were tied to the idea that the governor of a given central bank were a sort of representative of that country's national interests regarding monetary policy in the governing council.", 'that is not the case.', 'every member of the governing council (regardless of whether he/she belongs to the executive board or is the governor of a national central bank) has a personal responsibility, namely for the long-term stability of the euro throughout the monetary union.', 'the governor of a national central bank must not even be bound by his own bank in the sense of an "imperative mandate".', 'that is also the logic behind the "one person -- one vote" rule in the council.', 'if the governors were the defenders of national interests in monetary policy decision-making, it would have been a much more obvious thing to weight the individual votes in terms of the respective share of capital -- as is done in the imf, for instance.', 'a structure of that kind was consciously rejected, in view of the desired denationalisation of money.', 'after all, the euro must not become merely the sum of national orientations and interests.', 'it must become an independent currency which safeguards monetary stability throughout the euro area.', 'the euro cannot peg itself externally and thus attract credibility and stability from without, as smaller currencies could before.', 'rather, it must first set a stability benchmark itself.', 'and to that end, a consensus on stable money or a stable exchange rate, important as it may be, is not enough.', 'there will always be situations in which monetary policy makers have to take decisions which -- at least momentarily -- will have an adverse impact on one group or another in society and which do not conform with the intentions of one government or another.', 'it is precisely in such difficult moments that the european central bank must also be able to take decisions and have the capacity to act in its area of competence.', 'it cannot and must not wait for a general social and political consensus.', 'decisions regarding stability policy do require courage every now and then, even though they are, of course, guided by sound judgement.', 'in such critical moments, i hope that sarasto\'s wish in mozart\'s "the magic flute" will be granted to the future president and the vice-president (and, of course, the other governing council members, too): "oh, isis and osiris, send the spirit of wisdom to the young couple!', 'you who guide the wanderers\' steps, strengthen them with patience when in danger".', '(whether or not that immediately leads you to believe that the european central bank resides "in these holy halls" is something i shall leave up to you.)', 'the independence of the future european central bank by no means implies, of course, that it will be detached from the community or from the general public.', '(much as the bundesbank today is involved at the centre of german public life and public debate.)', 'it is precisely that independent position which requires the central bank to engage with the general public, to explain its monetary policy, and to make its motives and strategy as transparent as possible.', 'it is not least for that reason that the bundesbank is advocating a pre-announced monetary target for european monetary policy, by which it must then allow itself to be judged.', 'conversely, i can assure you that the general public, too, is keeping a close watch on monetary policy and subjecting it to a critical assessment.', 'it notes every word which is written and spoken (and, in some cases, precisely those words which remain unspoken).', 'i therefore believe that an independent central bank tends to be subjected to closer scrutiny by the public than some areas of policy.', 'and this is as it should be.', 'after all, a depoliticised currency is a currency which has remained as close to people as a borderless currency.', 'but the crucial point is: a borderless currency must go hand in hand with a depoliticised currency.', 'as a denationalised currency, the euro needs both elements.', 'iv in the eyes of some analysts, the euro brings the monetary policy experiments of this century full circle.', 'the century began and will end with a denationalised money.', 'at its beginning, there was the gold standard.', 'at its end, there will be the euro.', 'the currencies on the gold standard were borderless owing to the fixed parities and to gold as a common point of reference.', 'they were depoliticised in the sense that the anonymous mechanism of pegging to the gold standard forced corrections to the gold standard.', 'independent central banks followed a clear monetary mandate, namely that of maintaining gold parity.', 'historians may argue over whether the days of the gold standard were indeed a golden era.', 'at all events, the experience of the past cannot simply be transferred to the present-day situation.', 'at that time, wages and prices were more flexible than they are today.', 'above all, the position of the state within and vis-à-vis the economy was different.', 'the government ratio tended to be below rather than above ten per cent back then; today, in most european countries, it is over fifty per cent.', 'that has implications for adjustment potential and flexibility.', 'naturally, it is primarily the private sector which must shoulder the burden of adjustment in the event of exogenous shocks and changes in competitiveness.', "at the time of the gold standard, the private sector still made up the lion's share of the economy.", 'nowadays, by contrast, the burden of adjustment is concentrated on just under half of the economy.', "the fact that society in general has little desire to allow market mechanisms to act on their own is reflected precisely in today's government ratio.", 'after the collapse of the gold standard, three trends initially prevailed in the following decades -- and it was no accident that those trends coincided: • firstly, the currency became increasingly (re-)politicised.', 'it became associated more closely with other non-monetary objectives.', 'secondly, the heyday of the independent central bank came to an end in just about every • country; in many countries, that was the case until only just recently.', '• thirdly, the politicisation of money went hand-in-hand with an increased isolation of the currency and the economy from external influences.', 'international links declined significantly.', 'therefore, a central motive of the bretton woods system, adopted in 1944, was to promote world economic integration by means of orderly monetary conditions.', 'and in this sense, the system performed good service.', 'regarding the criteria of borderless and depoliticised money, the bretton woods system was, as it were, a wanderer between the worlds.', 'money was not truly without borders.', 'until well into the 1960s, capital controls were an instrument frequently employed by a large number of countries.', 'indeed, in many cases such controls were being used precisely in europe, too, until the end of the 1980s.', 'and currency was not entirely depoliticised in the bretton woods system, either.', 'it was not only determined by the dominant position of the united states and whatever political views prevailed there at any given time.', 'many capital controls also mostly concealed differing political strategies and preferences.', 'in the long term, the monetary system created after world war ii was not depoliticised enough in order to keep pace with the increasing denationalisation of currency brought about by increasingly efficient and powerful international financial markets.', 'at any rate, it was often the case that the rules of the fixed-rate system were not observed.', '• countries running deficits were often too hesitant in correcting their balances of payments.', '• exchange rates were adjusted too late in most cases.', '• and, above all, by the mid-1960s onwards, the us dollar, the key currency, was increasingly failing to fulfil its role as an objective point of reference for stable money -a role which only an unpolitical currency could have performed.', 'it was thus no great surprise that the bretton woods system finally collapsed in 1973. fixed exchange rates accompanied by differing preferences were something the increasingly developing and emancipated financial markets no longer allowed.', 'v the 1970s then witnessed the great contest of monetary strategies -- particularly within europe, too -- especially once the first oil crisis began to pose major challenges.', 'on the one hand, there was the concept of political money.', 'the objective of monetary stability took a back seat.', 'monetary policy was to promote other objectives: employment, absorption of the oil shock, in some cases even foreign policy and foreign trade objectives.', 'on the other hand, there was the concept of unpolitical money.', 'regaining internal monetary stability and safeguarding it -- in other words, the "natural" objective of monetary policy -- prevailed.', 'particularly independent central banks -- such as the bundesbank and the swiss national bank -- put this stance into practice.', 'in germany, that was an important test for the concept of unpolitical money, introduced in 1948 with the currency reform and secured institutionally by the independence of the central bank.', 'the outcome has left no room for doubt in economic terms.', 'countries with unpolitical money have not only had lower inflation rates, but also less unemployment.', 'and, on the whole, they were also able to handle the oil shock and the unpredictability of the us dollar and other currencies much better.', 'besides, they were able to acquire an increasingly high stock of confidence on the part of the financial markets, resulting in relatively low capital market rates.', 'this positive experience is something you in austria have also gained.', 'the reasoning behind your hard-currency policy -- if i understand it correctly, as an outsider -- is likewise based on the realisation that inflation does not solve any problems.', 'austria has been consistent in applying this hard-currency policy -- even during a period which was somewhat difficult (the second half of the 1960s).', 'on the whole, this has led to the financial markets and the public having a justifiably high degree of confidence in the schilling.', 'the question of whether monetary policy can be employed to promote and secure jobs also crops up every now and then in germany as well as in your country.', 'on the one hand, this seems understandable.', 'a high degree of monetary stability has been achieved at the moment worldwide.', 'by contrast, high unemployment is a pressing problem, especially on the european continent.', 'however, for those who have been following monetary policy practice over the past decades, the debate sometimes seems quite eerie.', 'for monetary history has indeed pronounced a clear-cut judgement: maintaining monetary stability over the medium and long term is undoubtedly the best contribution monetary policy can make to employment, even if monetary policy by itself can neither secure nor create employment.', 'for some time now, europeans have been increasingly interested in findings in the united states, where, for some time now, a rather dynamic upswing, a relatively tight labor market, and yet a comparatively low rate of inflation have coincided.', 'what can and should we in europe learn from that?', 'if europe succeeds in making its labour markets significantly more flexible, and if competitive pressure in the goods markets rises significantly; and if this causes the wind of the global markets and of worldwide competition to be conveyed more strongly internally via flexible, highly competitive structures, and the european economy is given a breath of fresh air, then the conditions for sustained price stability in europe will improve.', 'then, perhaps even the european central bank can get by with relatively low interest rates in future in order to keep inflation in check.', 'the key to that, though, is certainly not a lax or pseudo-employment-oriented monetary policy (which would, in actual fact, backfire), but more market economy and competition.', 'and the road to more competitive structures is only through a stable, i.e.', 'it is true that the great master of viennese popular theatre, johann nestroy, once philosophised: "the phoenecians invented money -- but why so little of it?"', 'however, the central bank must limit the supply of money and set the interest rates accordingly.', 'that is its task.', 'it is also true that arthur schopenhauer once said: "there are people who would pay any price for money."', 'yet philosophers are not always right, especially when it comes to analysing the economy.', "the same applies to schopenhauer's dictum; otherwise, it would be virtually impossible, above all, to manage the money stock by using interest rates.", 'vi the disintegration of monetary policy strategies in the 1970s did not only have the economic implication that countries had diverging degrees of economic success.', 'there was an important european policy implication, too.', 'the plan to implement a phased monetary union that we developed in the werner group in 1970 soon foundered; not only on differing monetary strategies, but also on the lack of willingness of at least one country, at that time, to surrender national sovereignty.', "in its day, in fact, the werner plan had two advantages over today's maastricht treaty: firstly, the six-nation ec of the time was relatively homogeneous in economic terms.", '• • secondly, with regard to its strategy for integration, the werner plan was more consistent than the maastricht treaty.', 'it envisaged a marked intensification of both political and monetary integration.', 'but, in the final analysis, at that time there was neither the willingness to realise this deeper political integration nor a convergence in monetary policy.', 'the monetary union, which had already been planned for the 1980s, did not come into being.', 'the lack of convergence in the 1970s was not even enough to keep a larger monetary arrangement together.', 'in the end, all that was left was the "mini-snake".', 'the exchange rate mechanism (erm) of the european monetary system, newly formed in 1979, was also not very stable to begin with.', 'it was not until 1983 that an important change took place in the history of monetary integration in europe.', 'with finance minister delors at the helm, france changed course towards a clearly non-inflationary policy.', 'this step, initiated by france, paved the way for a gradual convergence of inflation rates at a low level in the 1980s, • for increasingly stable exchange rates within the erm, • • and, finally, for making a further-reaching monetary union conceivable again.', 'at all events, in 1988 the delors group was commissioned to develop a framework taking account of the new conditions.', 'vii the maastricht treaty, negotiated in the early 1990s, gave a sound legal structure to the idea of monetary union -- even if some critics, not without reason, occasionally described it as a torso, in light of the fact that the structures of a political union were lacking.', "in order to really comprehend the maastricht treaty and its significance, i feel two things have to be realised: the first realisation is that the essential elements of the maastricht treaty did not fall into europe's lap.", 'they are the result of experience, and not just of the positive kind.', 'the same applies to a sufficiently well-founded economic convergence which the maastricht treaty rightly calls for.', "over long stretches of europe's postwar history, this convergence has tended to be absent.", 'this has changed at least in some respects.', "it was a decidedly arduous process which led to today's high level of monetary convergence.", 'however, despite a large number of major advances, the level of convergence is regrettably much lower in the area of public finance, at least if the looming future burdens posed by demographic trends and the mounting debts which have already been run up are taken into account.', 'it was also difficult at that time to anchor the concept of a depoliticised currency in the treaty.', 'differing national traditions regarding the perceived role of the state and society understandably played a part in that.', 'this idea naturally fits in particularly well with the german tradition of decentralised structures.', 'it has been and still is more difficult for other countries on account of their traditions and structures -- despite the obvious economic superiority of this concept.', 'and the second realisation is that maastricht is not merely the logical continuation of a historic trend.', 'monetary union is a quantum leap in qualitative terms.', 'we are daring to start anew what did not succeed in the 1970s.', 'and this time it must succeed, and this success must be enduring.', 'under the terms of the treaty, there is no longer an escape hatch -- no matter what economic or political developments a given country may undergo.', 'that is what makes it different from an exchange rate system or unilateral exchange rate pegging.', 'this monetary finality, if you will, means putting a crucial political and economic framework in place for future generations, too.', 'maastricht enshrines the concept of a depoliticised currency, and hence stable money, as the primary objective for the central bank, for all time.', 'under the terms of the treaty, once a country has entered into monetary union, it no longer has the option of trying a different path.', 'and each of the participating countries is in intra-european competition for ever without being able to adjust its exchange rate or to adapt central bank rates to its own economic situation.', 'of course, these monetary restrictions -- technically speaking -- already result from a tight exchange rate pegging.', 'only, with a fixed exchange rate corridor, a country still has it in its power to decide on those self-commitments -- but that will no longer be so once monetary union commences.', "under the conditions of the 21st century, it will certainly not get any easier to maintain economic convergence and to safeguard a country's own competitiveness.", '• one reason is that competition will continue to increase, in europe and most certainly all over the world.', 'the technological driving forces of globalisation will continue to exert an effect.', 'the other reason is that just about all the european countries -- more or less -- are still • facing great structural challenges which are still a long way from being overcome, such as persistent unemployment.', 'the countries have to work hard to find solutions.', 'the national governments and parliaments should not forget the words of your fellow austrian, karl-heinrich waggerl: "ask for god\'s blessing for your work -- but do not ask him to do the work himself as well."', 'the subject of convergence in monetary union therefore does not just present itself -- as economic textbooks call it -- in external shocks which affect individual countries to varying degrees.', 'the key issue here is for countries to tackle the structural challenges they are facing, which are identifiable now, in a similar manner and at a similar pace.', 'otherwise, "internal shocks" would ensue.', 'the individual economies would grow apart.', 'but not due to an external event hitting a given region like a comet.', 'rather, because monetary union would smoulder inside, giving rise to tectonic tension.', 'at any rate, it will probably not suffice to set aside the topic of convergence by using the learned argument that a country which is in competition and does not have access to central bank money and credit has no choice but to maintain its competitiveness and keep its public finances in shape.', "it is basically correct that a country's policy makers can also rise to the occasion, as it were, along with the challenges of competition.", 'but of course, a country -- just like an enterprise -- can also founder as a result of failing to meet those challenges, if its starting position is too unfavourable.', 'the difference is that an enterprise then just disappears from the market, whereas a country naturally continues to exist.', 'if a country were to encounter difficulties with the conditions of monetary union, then an economic problem would arise.', 'and -- let us not deceive ourselves -- that would soon create a political problem.', 'europe must avoid that problem as far as possible.', 'therefore, monetary union requires a minimum level of convergence on the part of all its participants, both before accession and, of course, most certainly thereafter.', 'vii the euro will have to be a denationalised currency; there cannot and must not be any doubt about that.', 'it will thus be in keeping with an increasingly borderless economy.', 'and therein lie the key economic arguments in favour of the euro.', 'the path to monetary union offers europe major new opportunities.', 'in a europe which is heading towards a single market, and in a world which is converging in economic terms, a large single monetary area offers major advantages -- always provided the euro remains enduringly stable.', 'monetary union and the single currency, the euro, will not just mean the elimination of many risks and costs.', "if it becomes and remains sufficiently stable, the euro also has great prospects of building on the d-mark's position as a world currency.", 'and, it can improve the efficiency of the european single market and, moreover, give further impetus to political integration.', "those great opportunities and advantages of that historic step into monetary union are not qualified by pointing to the reality of today's situation in europe and the resulting challenges.", 'as a denationalised currency, the euro will be embedded in a political europe which is still largely characterised by national structures.', 'as a borderless currency, the euro will encounter bordered national economic, social and tax policies still searching for answers to the borderless economy.', 'and, as a depoliticised money, the euro will encounter a political reality in which some people and groups still expect enormous, and fundamentally unrealistic, favours from the welfare state.', 'both are a sign of tensi']	Hans Tietmeyer	Deutsche Bundesbank	President	Germany
https://www.bis.org/review/r971216c.pdf	Mr. Thiessen's remarks to the Canadian Club of Toronto (Central Bank Articles and Speeches, 1 Dec 97)	Notes for remarks by the Governor of the Bank of Canada, Mr. Gordon Thiessen, to the Canadian Club of Toronto in Toronto, on 1/12/97.	1997-12-01 00:00:00	Mr. Thiessen's remarks to the Canadian Club of Toronto Notes for remarks by the Governor of the Bank of Canada, Mr. Gordon Thiessen, to the Canadian Club of Toronto in Toronto, on 1/12/97. What can monetary policy do to help the economy reach its full potential? Today, we meet against a backdrop of some uncertainty in the international economy. I would like to begin my remarks with an assessment of what the recent financial and economic events in Asia could mean for Canada. The nervousness and uncertainty that spread around the world in the wake of the problems in Southeast Asia highlight the growing interactions among national economies and financial markets. The events in Asia also underscore how crucial prudent macroeconomic policies and sound financial sector management are to good economic performance. The measures that have been taken, mainly through the International Monetary Fund, are important first steps for the affected Asian economies in dealing with their problems. I believe that these measures have helped to contain at least some of the potential spillover effects to other countries and, thus, they are helping to settle global financial markets. Canada's direct trade links with Southeast Asia are not large. However, those with Japan and Korea are more important to us, and there are also potential effects on our other trading partners that need to be taken into account. The problems in Asia and their possible implications for the world economy are probably the source of some of the recent softening in world commodity prices. Because of the importance of commodities to Canada, this softening has been a factor behind the recent weakness in our currency. Our judgment at this stage is that the overall impact of these recent developments on Canada does not look likely to be large. However, we are sensitive to the fact that some industries and regions will be affected more than others. I can assure you that we will continue to monitor the situation very closely, in view of the uncertainty that remains about the likely outcome of events in Asia. Even with this uncertainty, however, recent suggestions that there is a risk of worldwide deflation strike me as being very pessimistic. Developments in Asia will slow somewhat the pace of global economic expansion. But as long as the world's largest economy, the United States, is pressing against its capacity limits, with the possibility of upward pressure on its inflation rate, the risk of worldwide deflation looks rather remote. Certainly, from Canada's perspective, the U.S. economy is by far the most important influence. I would now like to turn from these recent events and talk about the Bank of Canada's longer-term strategy for monetary policy. In any discussion of strategy, the place to start is with the objective. In conducting monetary policy, the Bank of Canada's ultimate objective is to help the Canadian economy achieve its full potential. And that means more jobs and rising standards of living. I am sure that all Canadians would agree that this is an appropriate objective. The Bank pursues this objective through a policy aimed at keeping inflation low and stable. Today, I would like to explain why such a policy is the best way to achieve Canada's full economic potential and to extend the current expansion. In this connection, I will review the recent U.S. experience in this area -- an experience that I find both relevant and instructive. On the road to full economic potential The performance of the Canadian economy over the past 25 years has been rather disappointing. The economy has suffered from recurring bouts of boom and bust, and unemployment has been very high. The growth of productivity and, thus, the improvement in our standard of living have been very gradual. Canada is not unique in this respect. Most industrial countries have shared this experience to varying degrees. And that includes the United States. Since the early 1990s, however, the U.S. economy has performed remarkably well and substantially better than other industrial economies. That country has enjoyed a solid, six-and-a-half-year-long economic expansion. Over that period, employment growth has averaged 2 per cent per year. The unemployment rate has declined from a peak of 8 per cent to under 5 per cent. Household incomes have risen by 21⁄2 per cent a year (after correction for inflation). U.S. businesses have become highly competitive, even in areas where prospects did not look all that good at the end of the 1980s. What's more, inflation has been on a declining path, albeit with some help from temporary factors (such as an appreciating U.S. dollar, declines in energy prices, and the slack in overseas economies). Why has the U.S. economy done so well? Are there any lessons here for Canada? Lessons from the U.S. experience There are, undoubtedly, a number of factors behind this striking U.S. performance. But, to me, there are at least two that seem to have been particularly important: the early adjustment of that economy to changing technology and globalization; and the credible, low-inflation policy pursued by the U.S. central bank. The Americans started adjusting in earnest in the 1980s to the new realities of heightened global competition and rapidly changing technology. As a result, they are ahead of most other industrial countries on that score. And, with improving productivity and highly competitive enterprises in a wide range of sectors, the U.S. economy has been able to expand rapidly and to support rising employment on a sustained basis. But taking full advantage of that improved potential for economic growth has required a climate of confidence in monetary policy. Bringing inflation down in a credible manner has helped to create that climate. And because of this, the U.S. monetary authorities have been in a position to encourage the economy to test its full capacity to produce, to create jobs, and to support rising incomes. This would not have been possible in an environment of high inflation and high inflation expectations. In such an environment, businesses, workers, and investors respond swiftly to any signs of demand pressures by pushing up prices, wages, and interest rates. And this has the effect of undermining the sustainability of the economic expansion. What precisely did the U.S. Federal Reserve do? In the early 1990s, problems in the banking sector were restraining the economic recovery in that country by limiting access to financing and undermining confidence. To counter these "headwinds", as Alan Greenspan called them, the Fed responded by providing a high degree of monetary stimulus. Then, in early 1994, when it became evident that the economy had started to pick up steam and move ahead on its own, the Fed began withdrawing the excess monetary stimulus. This timely, pre-emptive action to moderate monetary stimulus accomplished two things. First, it sent a strong reassuring signal to investors, businesses, and consumers that the Fed would not let inflation break out as the economy surged ahead. Indeed, after short-term rates went up in 1994-95, long-term rates declined, as investors became more confident that the economic expansion would remain non-inflationary and, thus, sustainable. Second, the pre-emptive action helped avoid the need for stronger, more disruptive, tightening later on. The less-accommodative monetary conditions that have prevailed since then certainly have not stopped the U.S. economic expansion dead in its tracks, as some had feared at the time. On the contrary, the expansion has continued at a healthy pace. And with widespread belief in the Fed's commitment to low inflation, there has been some room to explore the possibility that capacity has improved. As a result, the Fed has been able to set monetary conditions that have encouraged output and employment to expand at rates that in the past could not have been sustained. And both unemployment and inflation have come down at the same time. To be sure, with tightening labour markets, there is some risk of an increase in inflation pressures in the United States. Thus, one cannot rule out the possibility that the Fed may have to raise interest rates somewhat further at some point. But any future increases in interest rates should not have to be large and may be conditioned by the implications of the recent international developments I mentioned earlier. What parallels can we find in all this for Canada? The recent Canadian experience The adjustment in Canada to the forces of technological change and globalization has run behind that in the United States. Because the restructuring was delayed, Canada had to respond in a more dramatic fashion. We had to do more and do it faster. More importantly, our fiscal situation was more precarious and required stronger medicine. As a result, we ended up with more pronounced short-run disruptions and more catching up to do in terms of output and employment. These difficult but necessary adjustments in the private and public sectors of our economy were Canada's parallel to the U.S. headwinds. To compensate for the direct impact of these adjustments, as well as for their indirect effects on consumer confidence, the economy needed a substantial amount of monetary support. The Bank of Canada was able to provide such support once investor concerns about Canada's fiscal and political problems began to subside in late 1995. We did that by systematically reducing interest rates over the next year or so. As in the United States in 1991-92, short-term rates in Canada were brought down during 1995-96 from over 6 per cent to about 3 per cent -- their lowest level in over 30 years. At the same time, the Canadian dollar has been relatively low, providing support to the export sector. When we put interest rates and the exchange rate together -- as we must in order to correctly gauge the amount of monetary stimulus -- it is clear that monetary conditions in Canada have been exceptionally stimulative for well over a year. This was entirely appropriate while our economy was still struggling against the headwinds of private and public sector restructuring. To return to my automobile analogy of recent speeches, we needed to put the "pedal to the metal" to buck those headwinds and get the economy going. The monetary stimulus has done its job. The economy has been gathering speed and absorbing unused capacity. We now expect it to have expanded by about 4 per cent from the end of 1996 to the end of 1997. The diminishing effects of fiscal restraint, along with evidence of continued strong demand, output, and money growth, suggest another year of healthy expansion in 1998. Thus, in terms of the economic cycle, we are about where the Americans were in 1994. What should the role of monetary policy be in the period ahead? As we move towards full capacity over the next year or so, the task for monetary policy will be to try to ensure that this process goes smoothly and that inflationary pressures do not re-emerge. I want to make it clear that the Bank does not see an overheated economy at this point, nor a threat of inflation lurking around the corner. There is still unused capacity and, thus, room for strong expansion for some time yet. But, with monetary policy actions taking between one to two years to have their full effects on the economy, we always have to look ahead. And we have to ask, What sort of monetary support will the economy need at that point? The measures -- especially the fiscal measures -- needed to restructure our economy will be largely in place by then. Thus, monetary policy will no longer need to compensate for these sources of restraint on demand. By gradually easing off on the monetary gas pedal, we can steady our economy at a safe cruising speed down the road. As we look still further down the road, we will face other important issues. How well will our economy perform once it reaches full capacity? How rapid can growth be and still be sustainable? And how far can we reduce our unemployment rate? Given the complexity of the factors affecting economic performance, it is not possible to make precise predictions on these matters. Much will depend on the flexibility, efficiency, and productivity of Canadian enterprises; on how effectively new technology is used; on the skills, training, and adaptability of our labour force; on our ability to control costs; and on the initiative and ability of Canadian businesses to develop new products and new and expanded foreign markets for those products. Still, I believe that the restructuring that has taken place in the Canadian economy provides good reason to think that our potential to grow and create jobs is the best we have had in years. I also believe that continued credible fiscal and monetary policies have an important role to play. The best contribution monetary policy can make towards achieving that potential is to ensure that the economic expansion remains sustainable over the medium term. As we have learned over the past 25 years, a sustained expansion is not possible unless we can avoid a resurgence of inflation and the painful cycles of boom and bust that go with it. Thus, the challenge for monetary policy will be to set monetary conditions at levels that allow the economy to expand at a pace that makes full use of its production capacity and at the same time preserves low inflation. It is by conducting monetary policy prudently during the upswing that the Bank can assure Canadians that inflation will not break out when the economy begins to operate at levels that push against capacity limits. If we succeed in providing that confidence, we will then have the flexibility that will allow us to carefully explore the limits of growth and employment without immediately putting the economic expansion at risk. Concluding remarks Let me summarize my main messages to you today. The extraordinary monetary stimulus of the recent past has accomplished its task. It has supported the economy through a period of difficult but necessary restructuring. As the impact of this restructuring subsides and our economy enters a phase of self-sustaining expansion, we will no longer need the same amount of monetary stimulus. Because the economy takes time to respond to monetary policy actions, the Bank has to focus on the future. This means taking steps early to ensure that we will reach full capacity at a sustainable cruising speed. Of course, projections of future economic trends need constant reassessment. And that is particularly true at a time of nervous financial markets and uncertainty about the implications that events in Asia may have for the world economy. As I said earlier, the Bank continues to monitor the current global situation carefully. Aside from any complications that could arise from a prolonged period of international instability, the Canadian economy in the next year or so should absorb the unused capacity that we now see. At that point, we will begin to see concrete evidence of the kind of payoffs we are going to get from the economic restructuring process we have been through. With low inflation and a sound fiscal position, the Canadian economy is now in a better position than it has been for years to weather the impact of unexpected international developments and to make progress in generating higher incomes and employment.	["mr. thiessen's remarks to the canadian club of toronto notes for remarks by the governor of the bank of canada, mr. gordon thiessen, to the canadian club of toronto in toronto, on 1/12/97.", 'what can monetary policy do to help the economy reach its full potential?', 'today, we meet against a backdrop of some uncertainty in the international economy.', 'i would like to begin my remarks with an assessment of what the recent financial and economic events in asia could mean for canada.', 'the nervousness and uncertainty that spread around the world in the wake of the problems in southeast asia highlight the growing interactions among national economies and financial markets.', 'the events in asia also underscore how crucial prudent macroeconomic policies and sound financial sector management are to good economic performance.', 'the measures that have been taken, mainly through the international monetary fund, are important first steps for the affected asian economies in dealing with their problems.', 'i believe that these measures have helped to contain at least some of the potential spillover effects to other countries and, thus, they are helping to settle global financial markets.', "canada's direct trade links with southeast asia are not large.", 'however, those with japan and korea are more important to us, and there are also potential effects on our other trading partners that need to be taken into account.', 'the problems in asia and their possible implications for the world economy are probably the source of some of the recent softening in world commodity prices.', 'because of the importance of commodities to canada, this softening has been a factor behind the recent weakness in our currency.', 'our judgment at this stage is that the overall impact of these recent developments on canada does not look likely to be large.', 'however, we are sensitive to the fact that some industries and regions will be affected more than others.', 'i can assure you that we will continue to monitor the situation very closely, in view of the uncertainty that remains about the likely outcome of events in asia.', 'even with this uncertainty, however, recent suggestions that there is a risk of worldwide deflation strike me as being very pessimistic.', 'developments in asia will slow somewhat the pace of global economic expansion.', "but as long as the world's largest economy, the united states, is pressing against its capacity limits, with the possibility of upward pressure on its inflation rate, the risk of worldwide deflation looks rather remote.", "certainly, from canada's perspective, the u.s. economy is by far the most important influence.", "i would now like to turn from these recent events and talk about the bank of canada's longer-term strategy for monetary policy.", 'in any discussion of strategy, the place to start is with the objective.', "in conducting monetary policy, the bank of canada's ultimate objective is to help the canadian economy achieve its full potential.", 'and that means more jobs and rising standards of living.', 'i am sure that all canadians would agree that this is an appropriate objective.', 'the bank pursues this objective through a policy aimed at keeping inflation low and stable.', "today, i would like to explain why such a policy is the best way to achieve canada's full economic potential and to extend the current expansion.", 'in this connection, i will review the recent u.s. experience in this area -- an experience that i find both relevant and instructive.', 'on the road to full economic potential the performance of the canadian economy over the past 25 years has been rather disappointing.', 'the economy has suffered from recurring bouts of boom and bust, and unemployment has been very high.', 'the growth of productivity and, thus, the improvement in our standard of living have been very gradual.', 'canada is not unique in this respect.', 'most industrial countries have shared this experience to varying degrees.', 'and that includes the united states.', 'since the early 1990s, however, the u.s. economy has performed remarkably well and substantially better than other industrial economies.', 'that country has enjoyed a solid, six-and-a-half-year-long economic expansion.', 'over that period, employment growth has averaged 2 per cent per year.', 'the unemployment rate has declined from a peak of 8 per cent to under 5 per cent.', 'household incomes have risen by 21⁄2 per cent a year (after correction for inflation).', 'u.s. businesses have become highly competitive, even in areas where prospects did not look all that good at the end of the 1980s.', "what's more, inflation has been on a declining path, albeit with some help from temporary factors (such as an appreciating u.s. dollar, declines in energy prices, and the slack in overseas economies).", 'why has the u.s. economy done so well?', 'are there any lessons here for canada?', 'lessons from the u.s. experience there are, undoubtedly, a number of factors behind this striking u.s. performance.', 'but, to me, there are at least two that seem to have been particularly important: the early adjustment of that economy to changing technology and globalization; and the credible, low-inflation policy pursued by the u.s. central bank.', 'the americans started adjusting in earnest in the 1980s to the new realities of heightened global competition and rapidly changing technology.', 'as a result, they are ahead of most other industrial countries on that score.', 'and, with improving productivity and highly competitive enterprises in a wide range of sectors, the u.s. economy has been able to expand rapidly and to support rising employment on a sustained basis.', 'but taking full advantage of that improved potential for economic growth has required a climate of confidence in monetary policy.', 'bringing inflation down in a credible manner has helped to create that climate.', 'and because of this, the u.s. monetary authorities have been in a position to encourage the economy to test its full capacity to produce, to create jobs, and to support rising incomes.', 'this would not have been possible in an environment of high inflation and high inflation expectations.', 'in such an environment, businesses, workers, and investors respond swiftly to any signs of demand pressures by pushing up prices, wages, and interest rates.', 'and this has the effect of undermining the sustainability of the economic expansion.', 'what precisely did the u.s. federal reserve do?', 'in the early 1990s, problems in the banking sector were restraining the economic recovery in that country by limiting access to financing and undermining confidence.', 'to counter these "headwinds", as alan greenspan called them, the fed responded by providing a high degree of monetary stimulus.', 'then, in early 1994, when it became evident that the economy had started to pick up steam and move ahead on its own, the fed began withdrawing the excess monetary stimulus.', 'this timely, pre-emptive action to moderate monetary stimulus accomplished two things.', 'first, it sent a strong reassuring signal to investors, businesses, and consumers that the fed would not let inflation break out as the economy surged ahead.', 'indeed, after short-term rates went up in 1994-95, long-term rates declined, as investors became more confident that the economic expansion would remain non-inflationary and, thus, sustainable.', 'second, the pre-emptive action helped avoid the need for stronger, more disruptive, tightening later on.', 'the less-accommodative monetary conditions that have prevailed since then certainly have not stopped the u.s. economic expansion dead in its tracks, as some had feared at the time.', 'on the contrary, the expansion has continued at a healthy pace.', "and with widespread belief in the fed's commitment to low inflation, there has been some room to explore the possibility that capacity has improved.", 'as a result, the fed has been able to set monetary conditions that have encouraged output and employment to expand at rates that in the past could not have been sustained.', 'and both unemployment and inflation have come down at the same time.', 'to be sure, with tightening labour markets, there is some risk of an increase in inflation pressures in the united states.', 'thus, one cannot rule out the possibility that the fed may have to raise interest rates somewhat further at some point.', 'but any future increases in interest rates should not have to be large and may be conditioned by the implications of the recent international developments i mentioned earlier.', 'what parallels can we find in all this for canada?', 'the recent canadian experience the adjustment in canada to the forces of technological change and globalization has run behind that in the united states.', 'because the restructuring was delayed, canada had to respond in a more dramatic fashion.', 'we had to do more and do it faster.', 'more importantly, our fiscal situation was more precarious and required stronger medicine.', 'as a result, we ended up with more pronounced short-run disruptions and more catching up to do in terms of output and employment.', "these difficult but necessary adjustments in the private and public sectors of our economy were canada's parallel to the u.s. headwinds.", 'to compensate for the direct impact of these adjustments, as well as for their indirect effects on consumer confidence, the economy needed a substantial amount of monetary support.', "the bank of canada was able to provide such support once investor concerns about canada's fiscal and political problems began to subside in late 1995. we did that by systematically reducing interest rates over the next year or so.", 'as in the united states in 1991-92, short-term rates in canada were brought down during 1995-96 from over 6 per cent to about 3 per cent -- their lowest level in over 30 years.', 'at the same time, the canadian dollar has been relatively low, providing support to the export sector.', 'when we put interest rates and the exchange rate together -- as we must in order to correctly gauge the amount of monetary stimulus -- it is clear that monetary conditions in canada have been exceptionally stimulative for well over a year.', 'this was entirely appropriate while our economy was still struggling against the headwinds of private and public sector restructuring.', 'to return to my automobile analogy of recent speeches, we needed to put the "pedal to the metal" to buck those headwinds and get the economy going.', 'the monetary stimulus has done its job.', 'the economy has been gathering speed and absorbing unused capacity.', 'we now expect it to have expanded by about 4 per cent from the end of 1996 to the end of 1997. the diminishing effects of fiscal restraint, along with evidence of continued strong demand, output, and money growth, suggest another year of healthy expansion in 1998. thus, in terms of the economic cycle, we are about where the americans were in 1994. what should the role of monetary policy be in the period ahead?', 'as we move towards full capacity over the next year or so, the task for monetary policy will be to try to ensure that this process goes smoothly and that inflationary pressures do not re-emerge.', 'i want to make it clear that the bank does not see an overheated economy at this point, nor a threat of inflation lurking around the corner.', 'there is still unused capacity and, thus, room for strong expansion for some time yet.', 'but, with monetary policy actions taking between one to two years to have their full effects on the economy, we always have to look ahead.', 'and we have to ask, what sort of monetary support will the economy need at that point?', 'the measures -- especially the fiscal measures -- needed to restructure our economy will be largely in place by then.', 'thus, monetary policy will no longer need to compensate for these sources of restraint on demand.', 'by gradually easing off on the monetary gas pedal, we can steady our economy at a safe cruising speed down the road.', 'as we look still further down the road, we will face other important issues.', 'how well will our economy perform once it reaches full capacity?', 'how rapid can growth be and still be sustainable?', 'and how far can we reduce our unemployment rate?', 'given the complexity of the factors affecting economic performance, it is not possible to make precise predictions on these matters.', 'much will depend on the flexibility, efficiency, and productivity of canadian enterprises; on how effectively new technology is used; on the skills, training, and adaptability of our labour force; on our ability to control costs; and on the initiative and ability of canadian businesses to develop new products and new and expanded foreign markets for those products.', 'still, i believe that the restructuring that has taken place in the canadian economy provides good reason to think that our potential to grow and create jobs is the best we have had in years.', 'i also believe that continued credible fiscal and monetary policies have an important role to play.', 'the best contribution monetary policy can make towards achieving that potential is to ensure that the economic expansion remains sustainable over the medium term.', 'as we have learned over the past 25 years, a sustained expansion is not possible unless we can avoid a resurgence of inflation and the painful cycles of boom and bust that go with it.', 'thus, the challenge for monetary policy will be to set monetary conditions at levels that allow the economy to expand at a pace that makes full use of its production capacity and at the same time preserves low inflation.', 'it is by conducting monetary policy prudently during the upswing that the bank can assure canadians that inflation will not break out when the economy begins to operate at levels that push against capacity limits.', 'if we succeed in providing that confidence, we will then have the flexibility that will allow us to carefully explore the limits of growth and employment without immediately putting the economic expansion at risk.', 'concluding remarks let me summarize my main messages to you today.', 'the extraordinary monetary stimulus of the recent past has accomplished its task.', 'it has supported the economy through a period of difficult but necessary restructuring.', 'as the impact of this restructuring subsides and our economy enters a phase of self-sustaining expansion, we will no longer need the same amount of monetary stimulus.', 'because the economy takes time to respond to monetary policy actions, the bank has to focus on the future.', 'this means taking steps early to ensure that we will reach full capacity at a sustainable cruising speed.', 'of course, projections of future economic trends need constant reassessment.', 'and that is particularly true at a time of nervous financial markets and uncertainty about the implications that events in asia may have for the world economy.', 'as i said earlier, the bank continues to monitor the current global situation carefully.', 'aside from any complications that could arise from a prolonged period of international instability, the canadian economy in the next year or so should absorb the unused capacity that we now see.', 'at that point, we will begin to see concrete evidence of the kind of payoffs we are going to get from the economic restructuring process we have been through.', 'with low inflation and a sound fiscal position, the canadian economy is now in a better position than it has been for years to weather the impact of unexpected international developments and to make progress in generating higher incomes and employment.']	Gordon Thiessen	Bank of Canada	Governor	Canada
https://www.bis.org/review/r971216b.pdf	Mr. Grenville considers Asia and the financial sector (Central Bank Articles and Speeches, 4 Dec 97)	Talk given by Mr Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the 10th Annual Australasian Finance and Banking Conference in Sydney, on 4/12/97.	1997-12-04 00:00:00	Mr. Grenville considers Asia and the financial sector Talk given by Mr Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the 10th Annual Australasian Finance and Banking Conference in Sydney, on 4/12/97. The Managing Director of the IMF described the Mexican economic problems of 1994/95 as "the first crisis of the 21st century", with the implication that this was something new and, more ominously, perhaps there would be more of them. Before the new century has dawned, there has now been a series of similar problems, concentrated in the region of most interest to us -- East Asia. This is relevant to a conference on finance and banking, because the financial sector in each of these countries has been the key factor in the crisis and is central to its resolution. Those who spend time thinking about financial sectors and how they evolve over time may find some interest in examining what went wrong, why it went wrong, and how it might be put right. It is also of considerable importance to Australia -- not just for the effect on our economy (which is hard to quantify at this stage), but also for the opportunity it presents for Australia to deepen its engagement with the region. What went wrong? The problems in Asia, like the Mexican crisis of 1994, exhibit a variety of symptoms, with the most prominent being large falls in exchange rates and equity markets. But exchange rate changes of this size are not unknown in other countries which have not experienced the trauma currently underway in Asia. In Australia in the mid-1980s the exchange rate fell by 35 per cent, and in the early 1990s it fell by close to 25 per cent. Nor is this uncommon internationally. Even the mighty US dollar went up and down by amounts like this in the mid-1980s. More recently, Japan, between April 1995 and April 1997, experienced a depreciation of similar size. These exchange rate changes may well have been a trigger which set off a chain reaction of other events. But by themselves, the exchange rate changes would have been an uncomfortable policy problem, not a crisis. An uncomfortable problem became a crisis because the weakness in the exchange rate infected the financial sector. This occurred through a variety of channels -- in some cases, banks had borrowed heavily in foreign currency; more often, the borrowers were the non-bank business sector. As the exchange rate fell, their burgeoning foreign exchange obligations pushed the enterprises under water, and they defaulted on their debts to the domestic banking sector. At the same time, foreign lenders, who had felt protected by the foreign currency denomination of the loans, now realised that a fall in the exchange rate increased their credit risk, and so they pulled credit lines or failed to roll over short-term debt. This exchange rate shock impinged on financial systems which already had fracture lines and structural tensions. There were a number of specific weaknesses -- connected lending, government-directed loans, poor credit evaluation, lack of transparency, and inadequate prudential supervision. The situation was sustainable if growth and capital flows were maintained, but was not sustainable in the harsh world in which we live, where confidence is fragile, capital flows are flighty, and the stabilising forces of the "fundamentals" are slow to assert themselves. Why did it happen? The first point that should be made is that the praise which had been heaped on these countries for several decades is entirely understandable. These countries have been high savers, budgets have been balanced or in surplus, inflation has been reasonably well contained, and exports had been the dynamic driving-force of growth (with the globalisation that this implies). They ran high current account deficits because, however much they were saving, they were investing even more. Who could, ex ante, have criticised the broad-brush developments in the financial sector? Open capital markets were a merit-badge of economic maturity and a requirement for entry into the industrial-nations' economics club -- the OECD. Not only were these markets generally opened up and linked in with international capital markets, they embraced this eagerly, including the latest sophisticated products of the financial sector. Equity markets burgeoned and the arcane products of Wall Street were readily available. International agencies urged further and faster deregulation, commercial financial interests (domestic and foreign) were eager to stake out a role for themselves in the fast-growing sector, and sophistication in financial products was seen as being as important as having the latest in industrial technology. While it is easy enough now to see the fracture lines and lack of resilience of these financial sectors, it was less easy to predict the outcomes beforehand. The transition from a regulated financial system to a deregulated financial system is intrinsically difficult. Under the best of circumstances, it was inevitably going to be accompanied by false starts and mis-cues. The pace of growth of credit is difficult to evaluate in a world where you would expect it to be growing quickly because financial repression (McKinnon's phrase) is ending. The transition leaves the financial system quite fragile during the process. There is a fair bit of evidence that problems have arisen for almost every country during the transition, with the problem usually taking the form of excessive lending as each institution in the deregulated financial sector competes vigorously for its share in the new world. In the process, poor loans are made and asset prices are bid up. These two things come together in mutual reinforcement when the problems come to a head. Lenders who had used collateral as their main loan-evaluation technique find their security to be illiquid and inadequate. At the same time, it is almost inevitable that the process of financial deregulation will run ahead of the capacity of the prudential supervisors to devise a suitable regulatory framework. To start with, the climate of deregulation is often inimical to the regulators. This was certainly our experience in Australia during the 1980s: as we tried to put in place the basis of some "rules of the game" for the new deregulated financial sector, many people who should have known better were calling this "re-regulation by the back-door", and criticising us for being out of sympathy with the brave new world of deregulation. This experience seems to have been repeated elsewhere. Managers at all levels have been dealing with products and systems with which they are unfamiliar (but to admit this would disqualify them from participating in this exciting new world), and commercial imperatives encouraged them "to boldly go where no man has gone before". As we look at the problems of foreign currency borrowings in some of our Asian neighbours, one might recall the similar experience with Swiss franc loans in Australia during the 1980s, with the (fortunate) difference that these were, in a macro sense, quite small for Australia. There is another difficult issue here for the authorities. Even when problems were identified, there was the classic dilemma well known to prudential supervisors -- do you "blow the whistle" on the problem and precipitate a crisis (for which you will surely be blamed), or do you quietly work behind the scenes to try to avert the perceived problem, in the hope that you will succeed or the problem will go away of its own accord, but knowing that if it doesn't, it will be a bigger problem than if you had precipitated it early on. No credit is given for precipitating a crisis early, but there is plenty of blame for being present at the scene of the crime. So it is not surprising that there was, beforehand, a certain amount of hand-wringing about financial sector weaknesses, but this was muted background noise in the general enthusiasm to embrace the new world. What might be done? The first point that should be made here is that the main burden for getting things sorted out again clearly rests with these countries themselves. The related point here is that, for some, (to borrow the catch-cry from positive-thinking management texts) "this isn't a problem, it's an opportunity". For some of these countries, the process of institutional reform may be like punctuated development in evolutionary theory, where progress takes place in jerky stages, with a crisis such as this causing people to focus on the issues and to reform weaknesses. In this view, countries can come out of this trauma stronger than before. It seems quite likely that some countries will be better than others at turning these problems into opportunities. While part of the reaction to these problems must be institutional strengthening of the financial system, there remains a question whether the broad thrust of macro policy -- and, by implication, the spanking rates of growth which these countries have achieved over the past couple of decades -- is sustainable. To put this more specifically, is it possible to achieve the sorts of integration with international markets, the large inflows of capital which went with this and the rapid transformation of economies, without leaving these economies vulnerable to the sorts of changes of sentiment that we have seen in recent months? The constraint on growth is not the conventional one of resources and technology. The constraining factor here is just how resilient can the financial sector be made: the more robust it can be made, the faster these countries will be able to travel. We know the historical experience of Singapore, which ran current account deficits averaging 10 per cent of GDP for more than two decades. We know, too, that this was an important element in the extraordinary progress that Singapore has made. We know, however, that large current account deficits were one of the elements which made the other ASEAN countries vulnerable in recent years (and this vulnerability has always been a concern in Australia, too, despite the academic case that current account deficits resulting from private sector decisions were matters between "consenting adults" and therefore not something with which policy should concern itself). Analysts have pointed to the problems caused by the US-dollar-fixed exchange rates that prevailed in these countries until recently. They argue that, if exchange rates had been allowed to appreciate, credit growth would have been better contained and the economy held on a tighter rein. Greater exchange rate flexibility is surely an element in the new policy regimes. But the lesson of recent months is that, once a fixed exchange rate is freed, it can move by large amounts. Over-shooting is par for the course. All the more reason why a resilient and robust financial sector must be in place if flexible exchange rate regimes are now the norm. Much of this involves careful, slogging, time-consuming institutional improvement -- making accounting systems better, tightening up legal and bankruptcy systems, improving disclosure, and strengthening and deepening experience in prudential supervision. One point that might be noted is that some capital flows seem to create more vulnerability than others, so there is a case for discouraging short-term flows and encouraging direct investment/equity and longer-term bond flows. The best talent in these countries should go into the core financial institutions -- principally banks -- even if this means that the latest whiz-bang innovation of the financial rocket scientists remains unexploited. This is not to argue for stepping back from financial development -- on the contrary, these countries must move forward to deepen markets. But the resources should go into design and implementation of a robust financial architecture and -- to continue the analogy -- useful design parameters are simplicity, a strong basic structure, and attention to detail. One useful objective is to put the banking system in a central position as the guardians on the gateway of investment. If a project has to pass the scrutiny of a bank which will hold the loan on its balance sheet, there is still no guarantee of success, but maybe the chances are improved. What is clear is that private businesses have mis-assessed the risk they faced, tempted by attractively-lower foreign currency interest rates but not sufficiently aware of the need to worry about the variance of the prospective cash flows. An experienced banker might have helped. Of course, this will only work if the banking system is allowed to do its job, untrammelled by connected or directed lending. Banks cannot provide "due diligence" scrutiny on loans which they were required to make. The first priority, always, is to get the banks -- the core of the financial system -- sorted out quickly. The need is to keep the process of financial intermediation flowing: it is the life-blood of the real business sector. The problems are not, in fact, examples of some new "crisis of the 21st century": they are, at heart, the old problems of bank collapses and the remedy is, in principle, well established. Restoring confidence is the critical factor and for this (as Bagehot observed) central banks should "lend freely, but at a penalty rate". Insolvent institutions must be separated from the solvent, dealt with, and the remaining institutions supported. None of this is easy. Intractable problems of moral hazard exist, but this should not be allowed to paralyse action. Serious money will be required to fix the problems. Experience over the past couple of decades shows just how expensive these financial sector rescues can be. The 1994 Mexican problems have cost about 12-15 per cent of GDP; the Nordic countries spent 4-8 per cent of their GDP fixing their problems a few years ago; even the S&L problems in the United States (merely a small sub-group of the financial sector) cost around 3 per cent of GDP to sort out. But the cost of failing to address these problems decisively can be more painful still -- a long drawn-out period of financial introspection and inertia which severely retards real activity. A positive point is the strong fiscal positions (and therefore low government debt outstanding) of these countries, so the capacity to fund the restructuring exists. All this is, clearly, largely a matter of domestic policy, with the costs to be borne mainly by taxpayers in these countries. In a more speculative vein, let me return to the idea that what we are witnessing is a problem of the 21st century, and acknowledge that, while what we see has many of the characteristics of an old-fashioned financial sector crisis, it has one important new element -- the major role played by international capital flows. Domestic financial intermediation takes place within a broad set of "rules of the game", laid down by prudential regulators. There is no international analogue of this. Over time, it can develop, as countries implement consistent rules of prudential supervision, perhaps along the lines of the BIS Core Principles. This might -- together with better information on private capital flows and cross-country position-taking -- provide a response to this new element of the current problems -- the role of large-scale capital flows. What relevance is it to Australia, and to this audience (Australian and overseas)? We acknowledge our stake in the outcome, with two-thirds of our exports going to East Asia (including Japan). Australia is taking part in the IMF-co-ordinated facilities for Thailand, Indonesia and Korea. These funds help restore confidence and help the process of adjustment. We will use our relationships -- via our regional central bankers group EMEAP and, in due course, the newly-formed Asian Surveillance Group -- to provide examples of how prudential systems work elsewhere, analysis of how the specifics might be done in particular countries, technical assistance where it can be useful, and -- the most difficult and subtle task of all -- understated and understanding support for the reform elements who have the task of fashioning a stronger financial sector. A last word directed specifically at this audience. Some of you come from the countries involved: I wish you well in the vital task ahead. For the rest of us, is this, too, not a problem but rather an opportunity? The countries to our near north are going to be devoting considerable resources to strengthening their financial sectors. I hope some of you will find a role for yourselves in this process, and by doing so will look back on this as an opportunity to strengthen our links with our northern neighbours.	['mr. grenville considers asia and the financial sector talk given by mr stephen grenville, a deputy governor of the reserve bank of australia, to the 10th annual australasian finance and banking conference in sydney, on 4/12/97.', 'the managing director of the imf described the mexican economic problems of 1994/95 as "the first crisis of the 21st century", with the implication that this was something new and, more ominously, perhaps there would be more of them.', 'before the new century has dawned, there has now been a series of similar problems, concentrated in the region of most interest to us -- east asia.', 'this is relevant to a conference on finance and banking, because the financial sector in each of these countries has been the key factor in the crisis and is central to its resolution.', 'those who spend time thinking about financial sectors and how they evolve over time may find some interest in examining what went wrong, why it went wrong, and how it might be put right.', 'it is also of considerable importance to australia -- not just for the effect on our economy (which is hard to quantify at this stage), but also for the opportunity it presents for australia to deepen its engagement with the region.', 'the problems in asia, like the mexican crisis of 1994, exhibit a variety of symptoms, with the most prominent being large falls in exchange rates and equity markets.', 'but exchange rate changes of this size are not unknown in other countries which have not experienced the trauma currently underway in asia.', 'in australia in the mid-1980s the exchange rate fell by 35 per cent, and in the early 1990s it fell by close to 25 per cent.', 'nor is this uncommon internationally.', 'even the mighty us dollar went up and down by amounts like this in the mid-1980s.', 'more recently, japan, between april 1995 and april 1997, experienced a depreciation of similar size.', 'these exchange rate changes may well have been a trigger which set off a chain reaction of other events.', 'but by themselves, the exchange rate changes would have been an uncomfortable policy problem, not a crisis.', 'an uncomfortable problem became a crisis because the weakness in the exchange rate infected the financial sector.', 'this occurred through a variety of channels -- in some cases, banks had borrowed heavily in foreign currency; more often, the borrowers were the non-bank business sector.', 'as the exchange rate fell, their burgeoning foreign exchange obligations pushed the enterprises under water, and they defaulted on their debts to the domestic banking sector.', 'at the same time, foreign lenders, who had felt protected by the foreign currency denomination of the loans, now realised that a fall in the exchange rate increased their credit risk, and so they pulled credit lines or failed to roll over short-term debt.', 'this exchange rate shock impinged on financial systems which already had fracture lines and structural tensions.', 'there were a number of specific weaknesses -- connected lending, government-directed loans, poor credit evaluation, lack of transparency, and inadequate prudential supervision.', 'the situation was sustainable if growth and capital flows were maintained, but was not sustainable in the harsh world in which we live, where confidence is fragile, capital flows are flighty, and the stabilising forces of the "fundamentals" are slow to assert themselves.', 'why did it happen?', 'the first point that should be made is that the praise which had been heaped on these countries for several decades is entirely understandable.', 'these countries have been high savers, budgets have been balanced or in surplus, inflation has been reasonably well contained, and exports had been the dynamic driving-force of growth (with the globalisation that this implies).', 'they ran high current account deficits because, however much they were saving, they were investing even more.', 'who could, ex ante, have criticised the broad-brush developments in the financial sector?', "open capital markets were a merit-badge of economic maturity and a requirement for entry into the industrial-nations' economics club -- the oecd.", 'not only were these markets generally opened up and linked in with international capital markets, they embraced this eagerly, including the latest sophisticated products of the financial sector.', 'equity markets burgeoned and the arcane products of wall street were readily available.', 'international agencies urged further and faster deregulation, commercial financial interests (domestic and foreign) were eager to stake out a role for themselves in the fast-growing sector, and sophistication in financial products was seen as being as important as having the latest in industrial technology.', 'while it is easy enough now to see the fracture lines and lack of resilience of these financial sectors, it was less easy to predict the outcomes beforehand.', 'the transition from a regulated financial system to a deregulated financial system is intrinsically difficult.', 'under the best of circumstances, it was inevitably going to be accompanied by false starts and mis-cues.', "the pace of growth of credit is difficult to evaluate in a world where you would expect it to be growing quickly because financial repression (mckinnon's phrase) is ending.", 'the transition leaves the financial system quite fragile during the process.', 'there is a fair bit of evidence that problems have arisen for almost every country during the transition, with the problem usually taking the form of excessive lending as each institution in the deregulated financial sector competes vigorously for its share in the new world.', 'in the process, poor loans are made and asset prices are bid up.', 'these two things come together in mutual reinforcement when the problems come to a head.', 'lenders who had used collateral as their main loan-evaluation technique find their security to be illiquid and inadequate.', 'at the same time, it is almost inevitable that the process of financial deregulation will run ahead of the capacity of the prudential supervisors to devise a suitable regulatory framework.', 'to start with, the climate of deregulation is often inimical to the regulators.', 'this was certainly our experience in australia during the 1980s: as we tried to put in place the basis of some "rules of the game" for the new deregulated financial sector, many people who should have known better were calling this "re-regulation by the back-door", and criticising us for being out of sympathy with the brave new world of deregulation.', 'this experience seems to have been repeated elsewhere.', 'managers at all levels have been dealing with products and systems with which they are unfamiliar (but to admit this would disqualify them from participating in this exciting new world), and commercial imperatives encouraged them "to boldly go where no man has gone before".', 'as we look at the problems of foreign currency borrowings in some of our asian neighbours, one might recall the similar experience with swiss franc loans in australia during the 1980s, with the (fortunate) difference that these were, in a macro sense, quite small for australia.', 'there is another difficult issue here for the authorities.', 'even when problems were identified, there was the classic dilemma well known to prudential supervisors -- do you "blow the whistle" on the problem and precipitate a crisis (for which you will surely be blamed), or do you quietly work behind the scenes to try to avert the perceived problem, in the hope that you will succeed or the problem will go away of its own accord, but knowing that if it doesn\'t, it will be a bigger problem than if you had precipitated it early on.', 'no credit is given for precipitating a crisis early, but there is plenty of blame for being present at the scene of the crime.', 'so it is not surprising that there was, beforehand, a certain amount of hand-wringing about financial sector weaknesses, but this was muted background noise in the general enthusiasm to embrace the new world.', 'what might be done?', 'the first point that should be made here is that the main burden for getting things sorted out again clearly rests with these countries themselves.', 'the related point here is that, for some, (to borrow the catch-cry from positive-thinking management texts) "this isn\'t a problem, it\'s an opportunity".', 'for some of these countries, the process of institutional reform may be like punctuated development in evolutionary theory, where progress takes place in jerky stages, with a crisis such as this causing people to focus on the issues and to reform weaknesses.', 'in this view, countries can come out of this trauma stronger than before.', 'it seems quite likely that some countries will be better than others at turning these problems into opportunities.', 'while part of the reaction to these problems must be institutional strengthening of the financial system, there remains a question whether the broad thrust of macro policy -- and, by implication, the spanking rates of growth which these countries have achieved over the past couple of decades -- is sustainable.', 'to put this more specifically, is it possible to achieve the sorts of integration with international markets, the large inflows of capital which went with this and the rapid transformation of economies, without leaving these economies vulnerable to the sorts of changes of sentiment that we have seen in recent months?', 'the constraint on growth is not the conventional one of resources and technology.', 'the constraining factor here is just how resilient can the financial sector be made: the more robust it can be made, the faster these countries will be able to travel.', 'we know the historical experience of singapore, which ran current account deficits averaging 10 per cent of gdp for more than two decades.', 'we know, too, that this was an important element in the extraordinary progress that singapore has made.', 'we know, however, that large current account deficits were one of the elements which made the other asean countries vulnerable in recent years (and this vulnerability has always been a concern in australia, too, despite the academic case that current account deficits resulting from private sector decisions were matters between "consenting adults" and therefore not something with which policy should concern itself).', 'analysts have pointed to the problems caused by the us-dollar-fixed exchange rates that prevailed in these countries until recently.', 'they argue that, if exchange rates had been allowed to appreciate, credit growth would have been better contained and the economy held on a tighter rein.', 'greater exchange rate flexibility is surely an element in the new policy regimes.', 'but the lesson of recent months is that, once a fixed exchange rate is freed, it can move by large amounts.', 'over-shooting is par for the course.', 'all the more reason why a resilient and robust financial sector must be in place if flexible exchange rate regimes are now the norm.', 'much of this involves careful, slogging, time-consuming institutional improvement -- making accounting systems better, tightening up legal and bankruptcy systems, improving disclosure, and strengthening and deepening experience in prudential supervision.', 'one point that might be noted is that some capital flows seem to create more vulnerability than others, so there is a case for discouraging short-term flows and encouraging direct investment/equity and longer-term bond flows.', 'the best talent in these countries should go into the core financial institutions -- principally banks -- even if this means that the latest whiz-bang innovation of the financial rocket scientists remains unexploited.', 'this is not to argue for stepping back from financial development -- on the contrary, these countries must move forward to deepen markets.', 'but the resources should go into design and implementation of a robust financial architecture and -- to continue the analogy -- useful design parameters are simplicity, a strong basic structure, and attention to detail.', 'one useful objective is to put the banking system in a central position as the guardians on the gateway of investment.', 'if a project has to pass the scrutiny of a bank which will hold the loan on its balance sheet, there is still no guarantee of success, but maybe the chances are improved.', 'what is clear is that private businesses have mis-assessed the risk they faced, tempted by attractively-lower foreign currency interest rates but not sufficiently aware of the need to worry about the variance of the prospective cash flows.', 'an experienced banker might have helped.', 'of course, this will only work if the banking system is allowed to do its job, untrammelled by connected or directed lending.', 'banks cannot provide "due diligence" scrutiny on loans which they were required to make.', 'the first priority, always, is to get the banks -- the core of the financial system -- sorted out quickly.', 'the need is to keep the process of financial intermediation flowing: it is the life-blood of the real business sector.', 'the problems are not, in fact, examples of some new "crisis of the 21st century": they are, at heart, the old problems of bank collapses and the remedy is, in principle, well established.', 'restoring confidence is the critical factor and for this (as bagehot observed) central banks should "lend freely, but at a penalty rate".', 'insolvent institutions must be separated from the solvent, dealt with, and the remaining institutions supported.', 'none of this is easy.', 'intractable problems of moral hazard exist, but this should not be allowed to paralyse action.', 'serious money will be required to fix the problems.', 'experience over the past couple of decades shows just how expensive these financial sector rescues can be.', 'the 1994 mexican problems have cost about 12-15 per cent of gdp; the nordic countries spent 4-8 per cent of their gdp fixing their problems a few years ago; even the s&l problems in the united states (merely a small sub-group of the financial sector) cost around 3 per cent of gdp to sort out.', 'but the cost of failing to address these problems decisively can be more painful still -- a long drawn-out period of financial introspection and inertia which severely retards real activity.', 'a positive point is the strong fiscal positions (and therefore low government debt outstanding) of these countries, so the capacity to fund the restructuring exists.', 'all this is, clearly, largely a matter of domestic policy, with the costs to be borne mainly by taxpayers in these countries.', 'in a more speculative vein, let me return to the idea that what we are witnessing is a problem of the 21st century, and acknowledge that, while what we see has many of the characteristics of an old-fashioned financial sector crisis, it has one important new element -- the major role played by international capital flows.', 'domestic financial intermediation takes place within a broad set of "rules of the game", laid down by prudential regulators.', 'there is no international analogue of this.', 'over time, it can develop, as countries implement consistent rules of prudential supervision, perhaps along the lines of the bis core principles.', 'this might -- together with better information on private capital flows and cross-country position-taking -- provide a response to this new element of the current problems -- the role of large-scale capital flows.', 'what relevance is it to australia, and to this audience (australian and overseas)?', 'we acknowledge our stake in the outcome, with two-thirds of our exports going to east asia (including japan).', 'australia is taking part in the imf-co-ordinated facilities for thailand, indonesia and korea.', 'these funds help restore confidence and help the process of adjustment.', 'we will use our relationships -- via our regional central bankers group emeap and, in due course, the newly-formed asian surveillance group -- to provide examples of how prudential systems work elsewhere, analysis of how the specifics might be done in particular countries, technical assistance where it can be useful, and -- the most difficult and subtle task of all -- understated and understanding support for the reform elements who have the task of fashioning a stronger financial sector.', 'a last word directed specifically at this audience.', 'some of you come from the countries involved: i wish you well in the vital task ahead.', 'for the rest of us, is this, too, not a problem but rather an opportunity?', 'the countries to our near north are going to be devoting considerable resources to strengthening their financial sectors.', 'i hope some of you will find a role for yourselves in this process, and by doing so will look back on this as an opportunity to strengthen our links with our northern neighbours.']	Stephen Grenville	Reserve Bank of Australia	Deputy Governor	Australia
https://www.bis.org/review/r971216a.pdf	Bank of Japan presents summaries of articles published in the November edition of its Quarterly Bulletin (Central Bank Articles and Speeches, 28 Nov 97)	BANK OF JAPAN, COMMUNICATION, 28/11/97.	1997-11-28 00:00:00	Bank of Japan presents summaries of articles published in the November edition of its Quarterly Bulletin BANK OF JAPAN, COMMUNICATION, 28/11/97. Flow of Funds in Japan, 1996 Summary In 1996, the gross amounts of fund-raising and financial investment by the domestic nonfinancial sector (comprising the corporate business, personal, and public sectors) during the year both decreased from the previous year, remaining at low levels compared with the past. The sector's fund-raising through borrowing declined, while funds raised through government bond issues reached a record high. As for financial investment, there was a larger net redemption of securities (excluding investment trusts) than in 1995, and the net investment in insurance products narrowed significantly. In the corporate business sector, the financial surplus marked a record high. This was because (1) cash flow improved in excess of the continued growth in fixed investment, due mainly to a recovery in sales; and (2) interest payments decreased, reflecting low interest rates. The sector's fund-raising was at its lowest level since 1956 -- the third year of compilation of the flow of funds accounts -- primarily on account of a net decline in loans, which was more significant than the previous year, particularly in those from private financial institutions. At the same time, financial investment also declined from the previous year. Such overall sluggishness of fund-raising and financial investment activities can be attributed to the persisting balance-sheet adjustment pressure. In the personal sector, the financial surplus narrowed, the ratio of financial surplus to nominal GDP marking a record low. This was because (1) consumption expenditures increased by a larger margin than the improvement in employees' income; and (2) housing investment increased due to the effects of low interest rates and a surge in demand ahead of the rise in the consumption tax rate in fiscal 1997. Both fund-raising and financial investment fell below the previous year's levels, with conspicuous declines in investments in long-term assets such as insurance, securities, and trusts. The outstanding amount of financial assets in the personal sector reached ¥1,200 trillion for the first time at the end of 1996. In the public sector, a large financial deficit remained, due to expanded public-sector investment during the first half of the year. Fund-raising through government bond issues, almost all of which were purchased by the financial sector, marked a record high. Profits and Balance-Sheet Developments of Japanese Banks in Fiscal 1996 Overview Operating profits1 of Japanese banks2 in fiscal 1996 amounted to ¥6.4 trillion, 5 percent lower than in the previous year. This decline reflects a decrease in the net bond-related - 2 - profits and in the net interest income of city banks. Excluding a temporary factor3 which contributed to an increase in profits on trust accounts, the decline in operating profits from the previous year was about 10 percent. Loan write-offs and loan-loss provisions4 marked approximately ¥7.6 trillion (including trust accounts), which is the second highest level following fiscal 1995 when the jusen (housing loan companies) were liquidated. This suggests that most banks continued to give high priority to solving the problem of nonperforming loans. Net stock-related profits5 were no more than about ¥1.0 trillion, approximately ¥2.9 trillion lower than the fiscal 1995 level, due to substantial stock write-downs resulting from the fall in stock prices. This reflects the fact that banks' balance sheets have become more exposed to volatility in stock prices because of a rise in the book values of stocks which resulted from recent cross transactions -- sets of purchases and sales transactions on the same stocks in order to acquire unrealized capital gain. As the loan write-offs and loan-loss provisions virtually matched the total of operating profits and stock-related profits, recurring profits and net income reached close to zero levels, although this represented an improvement from the previous year. On the Relationship between Monetary Aggregates and Economic Activities in Japan: A Study Focusing on Long-Term Equilibrium Relationships Introduction This paper empirically analyzes the relationship between monetary aggregates and economic activities in Japan using actual data and focusing on long-term equilibrium relationships. Long-term time-series data from the 1960s to 1996 are used in the analysis in order to observe long-term relationships between the most commonly used monetary aggregate, M2+CDs, and macroeconomic indicators, such as GDP, rather than limiting the analysis to short-term relationships during the past year or two.1 In addition to long-term relationships, the discounts, deposits and securities), "net fee and commission income" (e.g., fees and commissions received/paid) and "net other operating income" (e.g., net profits related to bonds and foreign exchange). 2 "Japanese banks" or "banks" in this article refers to "All Banks," comprising the member banks of the Federation of Bankers Associations of Japan, which consists of city banks, long-term credit banks, seven trust banks (excluding foreign-owned trust banks and trust banks that started business after October 1993), the 64 member banks of the Regional Banks Association of Japan (hereafter referred to as regional banks), and the 65 member banks of the Second Association of Regional Banks (hereafter referred to as regional banks II). However, calculated figures exclude data for Hyogo Bank (the present Midori Bank), Taiheiyo Bank (the present Wakashio Bank), and Hanwa Bank. 3 Specifically, the temporary factor here refers to profits resulting from withdrawals from special reserve funds held by trust banks. The withdrawal profit resulted from a revision of a government ordinance that reduced the ratio of funds to set aside for the special reserve funds (from 3 percent of principal to 0.5 percent of principal). These are accumulated to provide for situations in which the value of a loan trust falls below the value of the principal. The trust banks applied part of the profit to write off nonperforming loans in trusts, and the remainder to be accounted as trust fees and be registered in the banking accounts as net fee and commission income. 4 This includes not only loan write-offs, but also transfers to special loan-loss accounts (provisions), losses from the sales of nonperforming loans to the Cooperative Credit Purchasing Company (CCPC), and renunciations of claims. 5 Stock-related profits/losses are calculated by subtracting from "gains on stock-selling operations" the sum of "losses from stock-selling operations" and "stock write-downs". 1 Note that the sample period includes the period when M2+CDs underwent large fluctuations, i.e. from the latter half of the 1980s to the early 1990s. stability of the money demand function and also the lead/lag relationships between monetary aggregates and other macroeconomic indicators are tested. The conclusions of the paper can be summarized as follows. (1) When developments in M2+CDs and other macroeconomic indicators are viewed in the long term, fluctuations in nominal M2+CDs have a relatively stable relationship with movements in nominal GDP. This can also be confirmed by applying an econometric technique called "cointegration analysis", which suggests that there is a long-term equilibrium relationship between the two. On the other hand, the relationship between M2+CDs and prices -- which along with real GDP make up nominal GDP -- has changed since the latter half of the 1980s, in the sense that fluctuations in prices have clearly diminished relative to those of M2+CDs. (2) A relatively stable money demand function can be estimated, based on the above long-term equilibrium relationship and incorporating factors for short-term fluctuations. At least in the sample period, the mechanism of short-term fluctuations has been relatively stable in M2+CDs, GDP, interest rates, and asset factors, as represented by the money demand function. (3) An analysis in terms of lagged cross correlation on the lead/lag relationships between M2+CDs and other macroeconomic variables reveals that M2+CDs basically leads nominal and real GDP, domestic private demand, and prices. However, there are differences in results across sample periods that cannot be ignored. (4) Similar analyses are conducted, from the standpoints of conclusions (1)-(3) above, on selected monetary and credit aggregates other than M2+CDs, and on monetary aggregates obtained by partially changing the components of M1 and M2+CDs. The results show that these aggregates did not have more stable relationships with macroeconomic indicators than did M2+CDs. (5) The above results suggest that, in analyzing monetary aggregates, it would be effective to use the long-term equilibrium relationship between M2+CDs and GDP as well as the money demand function incorporating the relationship. In interpreting the empirical results using the statistical techniques, however, it is necessary to bear in mind the following limitations: (a) Long-term equilibrium relationships indicate only the average relationship in the long run, and hence considerable deviations from equilibrium values may arise in the short term; and (b) There still remains a possibility that the long-term equilibrium relationships or money demand functions derived from the previously observed data may change, as a result of a large shift of funds caused by deregulation and other structural changes in the financial markets in the future. Checklist for the Year 2000 Problem Introduction The Bank Supervision Department of the Bank of Japan compiled the following checklist (the original is in Japanese) to assist bank examiners in assessing the adequacy of financial institutions' risk management framework for addressing the Year 2000 problem (hereinafter simply "the Problem").1 On August 19, 1997, the checklist was also distributed to financial institutions to help them in their own evaluation of their action plans. The checklist emphasizes the significance of each financial institution's understanding and awareness of the Problem, and calls for the commitment of each institution, including the top management, to its action plans. In proceeding with the action plans, each institution is advised to fully assess the effects of the Problem, carefully arrange the scheduling of the plans, and complete renovation and testing prior to the implementation of the action plans. The checklist also stresses the importance of other matters including (1) the monitoring of the progress as to the implementation of the action plans, (2) the scrutiny of legal responsibilities of outside vendors, and (3) the establishment of contingency plans. 1 Many computer operating systems and applications use six-digit codes for dates -- date fields -- comprising two digits for the year, two digits for the month, and two digits for the day (for example, December 31, 1999 reads 991231). With such a coding system, the code for the year 2000 will be "00," which may be interpreted as the year 1900, not 2000. This will cause errors in date-sensitive calculations and other issues. Such problems are referred to as the Year 2000 problem. If measures are not taken to address the problem, normal operations of financial institutions will be disrupted, which would lead to disturbances in payment and settlement systems nationwide, the effects of which may spread to other industries. * * * NB This Review is available on the BIS Worldwide Web site (http://www.bis.org) __________________________	['bank of japan presents summaries of articles published in the november edition of its quarterly bulletin bank of japan, communication, 28/11/97.', 'flow of funds in japan, 1996 summary in 1996, the gross amounts of fund-raising and financial investment by the domestic nonfinancial sector (comprising the corporate business, personal, and public sectors) during the year both decreased from the previous year, remaining at low levels compared with the past.', "the sector's fund-raising through borrowing declined, while funds raised through government bond issues reached a record high.", 'as for financial investment, there was a larger net redemption of securities (excluding investment trusts) than in 1995, and the net investment in insurance products narrowed significantly.', 'in the corporate business sector, the financial surplus marked a record high.', 'this was because (1) cash flow improved in excess of the continued growth in fixed investment, due mainly to a recovery in sales; and (2) interest payments decreased, reflecting low interest rates.', "the sector's fund-raising was at its lowest level since 1956 -- the third year of compilation of the flow of funds accounts -- primarily on account of a net decline in loans, which was more significant than the previous year, particularly in those from private financial institutions.", 'at the same time, financial investment also declined from the previous year.', 'such overall sluggishness of fund-raising and financial investment activities can be attributed to the persisting balance-sheet adjustment pressure.', 'in the personal sector, the financial surplus narrowed, the ratio of financial surplus to nominal gdp marking a record low.', "this was because (1) consumption expenditures increased by a larger margin than the improvement in employees' income; and (2) housing investment increased due to the effects of low interest rates and a surge in demand ahead of the rise in the consumption tax rate in fiscal 1997. both fund-raising and financial investment fell below the previous year's levels, with conspicuous declines in investments in long-term assets such as insurance, securities, and trusts.", 'the outstanding amount of financial assets in the personal sector reached ¥1,200 trillion for the first time at the end of 1996. in the public sector, a large financial deficit remained, due to expanded public-sector investment during the first half of the year.', 'fund-raising through government bond issues, almost all of which were purchased by the financial sector, marked a record high.', 'profits and balance-sheet developments of japanese banks in fiscal 1996 overview operating profits1 of japanese banks2 in fiscal 1996 amounted to ¥6.4 trillion, 5 percent lower than in the previous year.', 'this decline reflects a decrease in the net bond-related - 2 - profits and in the net interest income of city banks.', 'excluding a temporary factor3 which contributed to an increase in profits on trust accounts, the decline in operating profits from the previous year was about 10 percent.', 'loan write-offs and loan-loss provisions4 marked approximately ¥7.6 trillion (including trust accounts), which is the second highest level following fiscal 1995 when the jusen (housing loan companies) were liquidated.', 'this suggests that most banks continued to give high priority to solving the problem of nonperforming loans.', 'net stock-related profits5 were no more than about ¥1.0 trillion, approximately ¥2.9 trillion lower than the fiscal 1995 level, due to substantial stock write-downs resulting from the fall in stock prices.', "this reflects the fact that banks' balance sheets have become more exposed to volatility in stock prices because of a rise in the book values of stocks which resulted from recent cross transactions -- sets of purchases and sales transactions on the same stocks in order to acquire unrealized capital gain.", 'as the loan write-offs and loan-loss provisions virtually matched the total of operating profits and stock-related profits, recurring profits and net income reached close to zero levels, although this represented an improvement from the previous year.', 'on the relationship between monetary aggregates and economic activities in japan: a study focusing on long-term equilibrium relationships introduction this paper empirically analyzes the relationship between monetary aggregates and economic activities in japan using actual data and focusing on long-term equilibrium relationships.', 'long-term time-series data from the 1960s to 1996 are used in the analysis in order to observe long-term relationships between the most commonly used monetary aggregate, m2+cds, and macroeconomic indicators, such as gdp, rather than limiting the analysis to short-term relationships during the past year or two.1 in addition to long-term relationships, the discounts, deposits and securities), "net fee and commission income" (e.g., fees and commissions received/paid) and "net other operating income" (e.g., net profits related to bonds and foreign exchange).', '2 "japanese banks" or "banks" in this article refers to "all banks," comprising the member banks of the federation of bankers associations of japan, which consists of city banks, long-term credit banks, seven trust banks (excluding foreign-owned trust banks and trust banks that started business after october 1993), the 64 member banks of the regional banks association of japan (hereafter referred to as regional banks), and the 65 member banks of the second association of regional banks (hereafter referred to as regional banks ii).', 'however, calculated figures exclude data for hyogo bank (the present midori bank), taiheiyo bank (the present wakashio bank), and hanwa bank.', '3 specifically, the temporary factor here refers to profits resulting from withdrawals from special reserve funds held by trust banks.', 'the withdrawal profit resulted from a revision of a government ordinance that reduced the ratio of funds to set aside for the special reserve funds (from 3 percent of principal to 0.5 percent of principal).', 'these are accumulated to provide for situations in which the value of a loan trust falls below the value of the principal.', 'the trust banks applied part of the profit to write off nonperforming loans in trusts, and the remainder to be accounted as trust fees and be registered in the banking accounts as net fee and commission income.', '4 this includes not only loan write-offs, but also transfers to special loan-loss accounts (provisions), losses from the sales of nonperforming loans to the cooperative credit purchasing company (ccpc), and renunciations of claims.', '5 stock-related profits/losses are calculated by subtracting from "gains on stock-selling operations" the sum of "losses from stock-selling operations" and "stock write-downs".', '1 note that the sample period includes the period when m2+cds underwent large fluctuations, i.e.', 'from the latter half of the 1980s to the early 1990s.', 'stability of the money demand function and also the lead/lag relationships between monetary aggregates and other macroeconomic indicators are tested.', 'the conclusions of the paper can be summarized as follows.', '(1) when developments in m2+cds and other macroeconomic indicators are viewed in the long term, fluctuations in nominal m2+cds have a relatively stable relationship with movements in nominal gdp.', 'this can also be confirmed by applying an econometric technique called "cointegration analysis", which suggests that there is a long-term equilibrium relationship between the two.', 'on the other hand, the relationship between m2+cds and prices -- which along with real gdp make up nominal gdp -- has changed since the latter half of the 1980s, in the sense that fluctuations in prices have clearly diminished relative to those of m2+cds.', '(2) a relatively stable money demand function can be estimated, based on the above long-term equilibrium relationship and incorporating factors for short-term fluctuations.', 'at least in the sample period, the mechanism of short-term fluctuations has been relatively stable in m2+cds, gdp, interest rates, and asset factors, as represented by the money demand function.', '(3) an analysis in terms of lagged cross correlation on the lead/lag relationships between m2+cds and other macroeconomic variables reveals that m2+cds basically leads nominal and real gdp, domestic private demand, and prices.', 'however, there are differences in results across sample periods that cannot be ignored.', '(4) similar analyses are conducted, from the standpoints of conclusions (1)-(3) above, on selected monetary and credit aggregates other than m2+cds, and on monetary aggregates obtained by partially changing the components of m1 and m2+cds.', 'the results show that these aggregates did not have more stable relationships with macroeconomic indicators than did m2+cds.', '(5) the above results suggest that, in analyzing monetary aggregates, it would be effective to use the long-term equilibrium relationship between m2+cds and gdp as well as the money demand function incorporating the relationship.', 'in interpreting the empirical results using the statistical techniques, however, it is necessary to bear in mind the following limitations: (a) long-term equilibrium relationships indicate only the average relationship in the long run, and hence considerable deviations from equilibrium values may arise in the short term; and (b) there still remains a possibility that the long-term equilibrium relationships or money demand functions derived from the previously observed data may change, as a result of a large shift of funds caused by deregulation and other structural changes in the financial markets in the future.', 'checklist for the year 2000 problem introduction the bank supervision department of the bank of japan compiled the following checklist (the original is in japanese) to assist bank examiners in assessing the adequacy of financial institutions\' risk management framework for addressing the year 2000 problem (hereinafter simply "the problem").1 on august 19, 1997, the checklist was also distributed to financial institutions to help them in their own evaluation of their action plans.', "the checklist emphasizes the significance of each financial institution's understanding and awareness of the problem, and calls for the commitment of each institution, including the top management, to its action plans.", 'in proceeding with the action plans, each institution is advised to fully assess the effects of the problem, carefully arrange the scheduling of the plans, and complete renovation and testing prior to the implementation of the action plans.', 'the checklist also stresses the importance of other matters including (1) the monitoring of the progress as to the implementation of the action plans, (2) the scrutiny of legal responsibilities of outside vendors, and (3) the establishment of contingency plans.', '1 many computer operating systems and applications use six-digit codes for dates -- date fields -- comprising two digits for the year, two digits for the month, and two digits for the day (for example, december 31, 1999 reads 991231).', 'with such a coding system, the code for the year 2000 will be "00," which may be interpreted as the year 1900, not 2000. this will cause errors in date-sensitive calculations and other issues.', 'such problems are referred to as the year 2000 problem.', 'if measures are not taken to address the problem, normal operations of financial institutions will be disrupted, which would lead to disturbances in payment and settlement systems nationwide, the effects of which may spread to other industries.', '* * * nb this review is available on the bis worldwide web site (http://www.bis.org) __________________________']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r971208g.pdf	Mr. Yam looks at the future of Hong Kong as a financial services centre for China and the Asian region (Central Bank Articles and Speeches, 28 Oct 97)	Speech by the Chief Executive of the Hong Kong Monetary Authority, Mr. Joseph Yam, JP, to Coopers and Lybrand Financial Services Conference in Hong Kong on 28/10/97.	1997-10-28 00:00:00	Mr. Yam looks at the future of Hong Kong as a financial services centre for China and the Asian region Speech by the Chief Executive of the Hong Kong Monetary Authority, Mr. Joseph Yam, JP, to Coopers and Lybrand Financial Services Conference in Hong Kong on 28/10/97. I have been asked to speak on Hong Kong's role as a financial services centre for China and the Asian region. As you know, many of the economies of the Asian region, including of course the mainland of China, have been undergoing a rapid process of financial liberalization. This has brought tremendous benefits to the region, through providing the mechanisms for channelling savings into investments, domestically and internationally, thus promoting growth and development of the region. The process has brought substantial risks to the region as well, as clearly you have witnessed in the past few months when financial turmoil spread in the region. 2. Notwithstanding the financial problems now being faced by the region, the balance of opinion is still firmly that financial liberalization is of long-term benefit. The correct response to such problems is clearly, at least for the immediate future, to take the right medicine and implement the necessary economic adjustment programmes, prescribed if necessary by the International Monetary Fund. Indeed, this has very much been the focus of recent attention when one looks at individual economies in this region that have been subject to financial turmoil. But prevention is always better than cure. Much attention will also be required, in the fullness of time, to make sure that the financial systems through which financial intermediation takes place are robust so that the benefits of financial liberalization could be maximized and the associated risks could be minimized and prudently managed. 3. As a financial services centre which operates with a highly liberal regime, Hong Kong has important roles to play in all this. There is not enough time to go into details here on this occasion, so I shall just identify three general areas for your consideration. 4. The first area concerns financial intermediation within individual economies, in other words, the channelling of domestic savings into domestic investments. Here Hong Kong, at this stage at least, largely only plays an advisory role. The less liberalized financial systems in this region are very much dominated by domestic financial institutions, particularly in the banking market. Further, domestic politics and a desire to protect domestic financial institutions from undue competition are such that liberalization to admit foreign financial institutions to take part in domestic financial intermediation would only proceed at a pace dictated by these considerations. For example, it will, I think, take some time and patience for Hong Kong-based banks to gain a physical presence in the mainland of China, be allowed access to renminbi banking business and command a significant share of that business. 5. But Hong Kong's expertise in developing markets, in building the market infrastructure and, where necessary, in regulating markets and supervising market participants to uphold the efficiency and integrity of financial markets is there for everybody to see and tap. Furthermore, we know the region, and particularly in the case of the mainland of China, I would argue that we know a lot more than others, and so we are in an advantageous position to perform an advisory role. And the financial community of Hong Kong, including the regulators, have been actively playing that advisory role. I can speak from experience here, although it would not be appropriate for me to be too specific. In many of the Hong Kong Monetary Authority's contacts with, for example, our counterparts in the mainland of China, the subjects for discussion are increasingly on financial affairs in the mainland rather than those in Hong Kong. 6. I believe that in performing this advisory role effectively we will open up opportunities for the financial services industry of Hong Kong. As markets are built and liberalized in these neighbouring economies, I am confident that our own financial institutions will gain access to the business in those markets through establishing a presence there, and eventually compete, I hope, on a level playing field with the domestic financial institutions. In any case, the need for a physical presence with a large branch network in the provision of financial services may soon become a thing of the past with the advancement of telecommunications and information technology. It is still early, I think, to come to a definitive view, but the prospects are that electronic money and the use of the internet for banking and other financial services are breaking down geographical boundaries. Barriers to entry and restrictive practices may lead to the diversion of business to offshore markets in locations with liberal practices. 7. The second area concerns financial intermediation in the international dimension, involving the flow of savings into investments across international boundaries. Hong Kong as a financial services centre has a business role of providing the markets, in banking, debt and equity, supported by other efficient financial services and the rule of law, to facilitate the international flow of funds in this region. Our markets have the freedom, the liquidity and the integrity to attract international investors managing institutional savings to come here and those in need of funds to raise them here. The opportunities in this region, in particular in China, are enormous, and international investors would have a preference to operate in markets in which the rules of the game are transparent and familiar to them, and are of internationally accepted standards. And that means coming to Hong Kong. 8. The banking market in Hong Kong is of course a very international one, with a total of 182 licensed banks, 151 of which are incorporated outside Hong Kong. 81 of the largest 100 banks in the world are licensed in Hong Kong. Collectively they provide a wide range of banking and other financial services, not just for Hong Kong but for the region as a whole. The banking sector of Hong Kong is reputed to be amongst the most efficient and profitable in the world. 9. Hong Kong's debt market, which has developed quite rapidly in the past eight years, is also playing a significant role in the region. Financial intermediation through the debt market is still relatively underdeveloped in the region, but the prospects are good. As the very substantial savings of the region is increasingly institutionalized through the establishment of provident funds and pension funds, the demand for debt securities would grow, perhaps much faster than that for banking and equity instruments. At the same time, the huge investments envisaged for the development of the physical infrastructure in the region will require much debt financing, thus increasing the supply of debt securities. With the first class infrastructure in our newly developed debt market, Hong Kong is in a very favourable position to take advantage of these good prospects. 10. Hong Kong's equity market is of course one of the largest and most liquid in the world, and, notwithstanding recent volatility, is the favourite market for institutional investors and for those wishing to raise funds. One popular area recently is, of course, the use of Hong Kong's stock market for raising funds by Chinese state-owned enterprises. Up to late October, 38 enterprises from the mainland of China have made their initial public offerings in Hong Kong in the form of the issue of "H" shares. These shares were bought by investors both in Hong Kong and overseas. It is important to note that when mainland enterprises sought to be listed on the Hong Kong Stock Exchange, they are required to comply with all the listing rules and other relevant regulations in Hong Kong. No favouritism or preferential treatment has been or will be given to mainland companies. Thus, in addition to fund raising, the listing of mainland companies in Hong Kong facilitates the upgrading of corporate governance of these listed companies in line with the international standards practised in Hong Kong. Through this process, Hong Kong has also played a strategic role in the reform of the state-owned enterprises in the mainland. 11. The third area concerns the management of systemic risks arising from but not limited to financial liberalization in this region. There is clearly identified a need for much greater monetary cooperation in this region, and here Hong Kong has been actively playing, and hopes to continue to play actively, a promotional role. We have been instrumental in promoting greater Asian monetary cooperation, not just in the more visible efforts to deal with the financial turmoil we all are facing, in one way or another, but also the upgrading and standardization of supervisory practices, and the building of the financial infrastructure of this region to facilitate safe and efficient international financial intermediation in this region. Our ability to play this role no doubt enhances Hong Kong's status as an international financial centre, which is consistent with the requirement laid down in the Basic Law. 12. We took the initiative on the wake of the Mexican crisis in early 1995 to draw the central banking fraternity of this region together to talk about Asian monetary cooperation, which led first to a set of bilateral agreements for the provision of liquidity to each other in case of need. This was followed by the establishment of three working groups to share knowledge and expertise on financial market development, central bank operations and banking supervision issues. Separately, we are also promoting the establishment of linkages of the financial infrastructures of economies in this region, such as payment systems and debt clearing systems, to facilitate the efficient and safe flow of funds amongst ourselves. These efforts will have long-term benefits for the region, both in terms of the maintenance of financial stability and the development of the financial sector. 13. While important progress is being made, this has recently been overshadowed by financial turmoil in the region, and the focus of attention has as a consequence been diverted to the provision of credit to assist Asian economies in need in making structural adjustments. We had the financial package for Thailand, and there have since been many ideas put forward for a general facility of some sort. These are being actively considered and we are taking an active part in the discussion, although there are currently still quite significant differences of opinion. The position that we are taking is that whilst regional solidarity is highly appropriate for a region with increasing economic, trade and financial integration and increasing interdependence, any regional financial arrangement must be structured with regard to international standards and practices. It would not be appropriate, for example, for a regional institution, if there is to be one, to prescribe medicine, along with financial assistance, that is different from those prescribed by the International Monetary Fund. It would immediately be seen as a soft window for financial support, thus creating moral hazard problems. I am hopeful that well-structured arrangements will emerge in due course. Certainly the climate is right and the momentum is there. 14. Perhaps I should take this opportunity to put the recent financial turmoil in Asia in a global perspective. First, the world is in very good economic shape. World economic output is estimated by the IMF to expand by 4-41⁄2% in 1997 and 1998, the strongest pace in a decade. In the OECD countries, especially in the US, there is solid growth with low inflation, while we are seeing signs of broad-based recovery in Europe. Only in Asia have we seen a slowing of growth, but the growth rates have still been high by world standard and last year Japan grew by 3.6%, the fastest since the late 1980s. 15. Second, because of high global liquidity and low inflation, asset markets around the world are at record levels. Capital flows have increased with globalization, and added to record high stock and bond prices. The fact that Europe has recently raised interest rates, and the Fed is considering whether to pre-emptively raise rates to prevent wage-push inflation, has made the financial markets much more nervous despite the growth environment. This explains why the financial volatility in Asia has become global in nature. It is very flattering to know that Hong Kong can move even the mighty US and European markets, as much as the other way around. 16. Third, Asian fundamentals, and especially Hong Kong fundamentals, are strong. But there have been different degrees of strength in Asia with respect to the fundamentals. The adjustments in exchange rates of currencies in this region reflect partly the market perception of fundamentals. But as I said recently at the Per Jacobsson lecture, there is no perfect exchange rate regime. Some economists think that a shift from a rigid exchange rate regime to a free float would result in lower interest rates to ease the interest rate pain. However, recent experience in Asia has shown that the market demands even higher interest rates than before under a floating rate regime due to the need for hedging, since there is a perception of higher credit risks and exchange rate risks. 17. I interpret the currency turmoil in the region not as exchange rate volatility, but as a painful but necessary adjustment in the real economy (manifested through the financial system and markets) to the new world of greater competition. In essence, we must all work harder to get greater productivity gains to meet the new challenge. No one can afford to be complacent in this global world. To the extent that the free market is demanding higher interest rates because there is a reverse flow of capital from Asia to the OECD markets, we will all have to bear the pain and adjust accordingly. 18. And not all interest rate pain is bad. Higher interest rates would increase savings in Hong Kong and bring inflation down further, thus increasing our competitiveness. To the extent that higher interest rates would reduce house prices, they would also make housing more affordable. 19. The currency board system with a fixed exchange rate is appropriate for a small and highly externally-oriented economy like Hong Kong. It further imposes a strict discipline on public finances. Hong Kong runs budget surpluses, not deficits. On the other hand, a floating exchange rate adds huge volatility to the businesses of the external sector of the economy, requiring further costs in terms of hedging. A volatile exchange rate by contrast does not have quite such serious implications for a large and relatively less externally-oriented economy like Japan, where external trade accounts for less than 20% of GDP. In Hong Kong, with external trade accounting for 285% of GDP, a volatile exchange rate creates huge uncertainties for much of our livelihood, thus undermining our fundamental competitiveness. 20. Hong Kong has always understood that there is no free lunch. We have built up our strengths and our savings through sheer hard work. If there is greater competition out there, we will adjust our quality and our skills accordingly. As accountants in a service economy, you know very well that you cannot price yourselves cheaply in order to compete. Our reputation depends on our ability to deliver quality service that is value for money. This is the strength for Hong Kong. Let me conclude by merely giving you the assurance that our linked exchange rate system, which has served us so well in the past 14 years, is here to stay.	['mr. yam looks at the future of hong kong as a financial services centre for china and the asian region speech by the chief executive of the hong kong monetary authority, mr. joseph yam, jp, to coopers and lybrand financial services conference in hong kong on 28/10/97.', "i have been asked to speak on hong kong's role as a financial services centre for china and the asian region.", 'as you know, many of the economies of the asian region, including of course the mainland of china, have been undergoing a rapid process of financial liberalization.', 'this has brought tremendous benefits to the region, through providing the mechanisms for channelling savings into investments, domestically and internationally, thus promoting growth and development of the region.', 'the process has brought substantial risks to the region as well, as clearly you have witnessed in the past few months when financial turmoil spread in the region.', '2. notwithstanding the financial problems now being faced by the region, the balance of opinion is still firmly that financial liberalization is of long-term benefit.', 'the correct response to such problems is clearly, at least for the immediate future, to take the right medicine and implement the necessary economic adjustment programmes, prescribed if necessary by the international monetary fund.', 'indeed, this has very much been the focus of recent attention when one looks at individual economies in this region that have been subject to financial turmoil.', 'but prevention is always better than cure.', 'much attention will also be required, in the fullness of time, to make sure that the financial systems through which financial intermediation takes place are robust so that the benefits of financial liberalization could be maximized and the associated risks could be minimized and prudently managed.', '3. as a financial services centre which operates with a highly liberal regime, hong kong has important roles to play in all this.', 'there is not enough time to go into details here on this occasion, so i shall just identify three general areas for your consideration.', '4. the first area concerns financial intermediation within individual economies, in other words, the channelling of domestic savings into domestic investments.', 'here hong kong, at this stage at least, largely only plays an advisory role.', 'the less liberalized financial systems in this region are very much dominated by domestic financial institutions, particularly in the banking market.', 'further, domestic politics and a desire to protect domestic financial institutions from undue competition are such that liberalization to admit foreign financial institutions to take part in domestic financial intermediation would only proceed at a pace dictated by these considerations.', 'for example, it will, i think, take some time and patience for hong kong-based banks to gain a physical presence in the mainland of china, be allowed access to renminbi banking business and command a significant share of that business.', "5. but hong kong's expertise in developing markets, in building the market infrastructure and, where necessary, in regulating markets and supervising market participants to uphold the efficiency and integrity of financial markets is there for everybody to see and tap.", 'furthermore, we know the region, and particularly in the case of the mainland of china, i would argue that we know a lot more than others, and so we are in an advantageous position to perform an advisory role.', 'and the financial community of hong kong, including the regulators, have been actively playing that advisory role.', 'i can speak from experience here, although it would not be appropriate for me to be too specific.', "in many of the hong kong monetary authority's contacts with, for example, our counterparts in the mainland of china, the subjects for discussion are increasingly on financial affairs in the mainland rather than those in hong kong.", '6. i believe that in performing this advisory role effectively we will open up opportunities for the financial services industry of hong kong.', 'as markets are built and liberalized in these neighbouring economies, i am confident that our own financial institutions will gain access to the business in those markets through establishing a presence there, and eventually compete, i hope, on a level playing field with the domestic financial institutions.', 'in any case, the need for a physical presence with a large branch network in the provision of financial services may soon become a thing of the past with the advancement of telecommunications and information technology.', 'it is still early, i think, to come to a definitive view, but the prospects are that electronic money and the use of the internet for banking and other financial services are breaking down geographical boundaries.', 'barriers to entry and restrictive practices may lead to the diversion of business to offshore markets in locations with liberal practices.', '7. the second area concerns financial intermediation in the international dimension, involving the flow of savings into investments across international boundaries.', 'hong kong as a financial services centre has a business role of providing the markets, in banking, debt and equity, supported by other efficient financial services and the rule of law, to facilitate the international flow of funds in this region.', 'our markets have the freedom, the liquidity and the integrity to attract international investors managing institutional savings to come here and those in need of funds to raise them here.', 'the opportunities in this region, in particular in china, are enormous, and international investors would have a preference to operate in markets in which the rules of the game are transparent and familiar to them, and are of internationally accepted standards.', 'and that means coming to hong kong.', '8. the banking market in hong kong is of course a very international one, with a total of 182 licensed banks, 151 of which are incorporated outside hong kong.', '81 of the largest 100 banks in the world are licensed in hong kong.', 'collectively they provide a wide range of banking and other financial services, not just for hong kong but for the region as a whole.', 'the banking sector of hong kong is reputed to be amongst the most efficient and profitable in the world.', "9. hong kong's debt market, which has developed quite rapidly in the past eight years, is also playing a significant role in the region.", 'financial intermediation through the debt market is still relatively underdeveloped in the region, but the prospects are good.', 'as the very substantial savings of the region is increasingly institutionalized through the establishment of provident funds and pension funds, the demand for debt securities would grow, perhaps much faster than that for banking and equity instruments.', 'at the same time, the huge investments envisaged for the development of the physical infrastructure in the region will require much debt financing, thus increasing the supply of debt securities.', 'with the first class infrastructure in our newly developed debt market, hong kong is in a very favourable position to take advantage of these good prospects.', "10. hong kong's equity market is of course one of the largest and most liquid in the world, and, notwithstanding recent volatility, is the favourite market for institutional investors and for those wishing to raise funds.", "one popular area recently is, of course, the use of hong kong's stock market for raising funds by chinese state-owned enterprises.", 'up to late october, 38 enterprises from the mainland of china have made their initial public offerings in hong kong in the form of the issue of "h" shares.', 'these shares were bought by investors both in hong kong and overseas.', 'it is important to note that when mainland enterprises sought to be listed on the hong kong stock exchange, they are required to comply with all the listing rules and other relevant regulations in hong kong.', 'no favouritism or preferential treatment has been or will be given to mainland companies.', 'thus, in addition to fund raising, the listing of mainland companies in hong kong facilitates the upgrading of corporate governance of these listed companies in line with the international standards practised in hong kong.', 'through this process, hong kong has also played a strategic role in the reform of the state-owned enterprises in the mainland.', '11. the third area concerns the management of systemic risks arising from but not limited to financial liberalization in this region.', 'there is clearly identified a need for much greater monetary cooperation in this region, and here hong kong has been actively playing, and hopes to continue to play actively, a promotional role.', 'we have been instrumental in promoting greater asian monetary cooperation, not just in the more visible efforts to deal with the financial turmoil we all are facing, in one way or another, but also the upgrading and standardization of supervisory practices, and the building of the financial infrastructure of this region to facilitate safe and efficient international financial intermediation in this region.', "our ability to play this role no doubt enhances hong kong's status as an international financial centre, which is consistent with the requirement laid down in the basic law.", '12. we took the initiative on the wake of the mexican crisis in early 1995 to draw the central banking fraternity of this region together to talk about asian monetary cooperation, which led first to a set of bilateral agreements for the provision of liquidity to each other in case of need.', 'this was followed by the establishment of three working groups to share knowledge and expertise on financial market development, central bank operations and banking supervision issues.', 'separately, we are also promoting the establishment of linkages of the financial infrastructures of economies in this region, such as payment systems and debt clearing systems, to facilitate the efficient and safe flow of funds amongst ourselves.', 'these efforts will have long-term benefits for the region, both in terms of the maintenance of financial stability and the development of the financial sector.', '13. while important progress is being made, this has recently been overshadowed by financial turmoil in the region, and the focus of attention has as a consequence been diverted to the provision of credit to assist asian economies in need in making structural adjustments.', 'we had the financial package for thailand, and there have since been many ideas put forward for a general facility of some sort.', 'these are being actively considered and we are taking an active part in the discussion, although there are currently still quite significant differences of opinion.', 'the position that we are taking is that whilst regional solidarity is highly appropriate for a region with increasing economic, trade and financial integration and increasing interdependence, any regional financial arrangement must be structured with regard to international standards and practices.', 'it would not be appropriate, for example, for a regional institution, if there is to be one, to prescribe medicine, along with financial assistance, that is different from those prescribed by the international monetary fund.', 'it would immediately be seen as a soft window for financial support, thus creating moral hazard problems.', 'i am hopeful that well-structured arrangements will emerge in due course.', 'certainly the climate is right and the momentum is there.', '14. perhaps i should take this opportunity to put the recent financial turmoil in asia in a global perspective.', 'first, the world is in very good economic shape.', 'world economic output is estimated by the imf to expand by 4-41⁄2% in 1997 and 1998, the strongest pace in a decade.', 'in the oecd countries, especially in the us, there is solid growth with low inflation, while we are seeing signs of broad-based recovery in europe.', 'only in asia have we seen a slowing of growth, but the growth rates have still been high by world standard and last year japan grew by 3.6%, the fastest since the late 1980s.', '15. second, because of high global liquidity and low inflation, asset markets around the world are at record levels.', 'capital flows have increased with globalization, and added to record high stock and bond prices.', 'the fact that europe has recently raised interest rates, and the fed is considering whether to pre-emptively raise rates to prevent wage-push inflation, has made the financial markets much more nervous despite the growth environment.', 'this explains why the financial volatility in asia has become global in nature.', 'it is very flattering to know that hong kong can move even the mighty us and european markets, as much as the other way around.', '16. third, asian fundamentals, and especially hong kong fundamentals, are strong.', 'but there have been different degrees of strength in asia with respect to the fundamentals.', 'the adjustments in exchange rates of currencies in this region reflect partly the market perception of fundamentals.', 'but as i said recently at the per jacobsson lecture, there is no perfect exchange rate regime.', 'some economists think that a shift from a rigid exchange rate regime to a free float would result in lower interest rates to ease the interest rate pain.', 'however, recent experience in asia has shown that the market demands even higher interest rates than before under a floating rate regime due to the need for hedging, since there is a perception of higher credit risks and exchange rate risks.', '17. i interpret the currency turmoil in the region not as exchange rate volatility, but as a painful but necessary adjustment in the real economy (manifested through the financial system and markets) to the new world of greater competition.', 'in essence, we must all work harder to get greater productivity gains to meet the new challenge.', 'no one can afford to be complacent in this global world.', 'to the extent that the free market is demanding higher interest rates because there is a reverse flow of capital from asia to the oecd markets, we will all have to bear the pain and adjust accordingly.', '18. and not all interest rate pain is bad.', 'higher interest rates would increase savings in hong kong and bring inflation down further, thus increasing our competitiveness.', 'to the extent that higher interest rates would reduce house prices, they would also make housing more affordable.', '19. the currency board system with a fixed exchange rate is appropriate for a small and highly externally-oriented economy like hong kong.', 'it further imposes a strict discipline on public finances.', 'hong kong runs budget surpluses, not deficits.', 'on the other hand, a floating exchange rate adds huge volatility to the businesses of the external sector of the economy, requiring further costs in terms of hedging.', 'a volatile exchange rate by contrast does not have quite such serious implications for a large and relatively less externally-oriented economy like japan, where external trade accounts for less than 20% of gdp.', 'in hong kong, with external trade accounting for 285% of gdp, a volatile exchange rate creates huge uncertainties for much of our livelihood, thus undermining our fundamental competitiveness.', '20. hong kong has always understood that there is no free lunch.', 'we have built up our strengths and our savings through sheer hard work.', 'if there is greater competition out there, we will adjust our quality and our skills accordingly.', 'as accountants in a service economy, you know very well that you cannot price yourselves cheaply in order to compete.', 'our reputation depends on our ability to deliver quality service that is value for money.', 'this is the strength for hong kong.', 'let me conclude by merely giving you the assurance that our linked exchange rate system, which has served us so well in the past 14 years, is here to stay.']	Joseph Yam	Hong Kong Monetary Authority	Chief Executive	Hong Kong
https://www.bis.org/review/r971208f.pdf	Mr. Hannoun discusses the operational framework for EMU and the challenge of managing price stability (Central Bank Articles and Speeches, 20 Nov 97)	Speech by the Deputy Governor of the Banque de France, Mr. Hervé Hannoun, at the Financial Times European Economic and Monetary Union Conference in London on 20/11/97.	1997-11-20 00:00:00	Mr. Hannoun discusses the operational framework for EMU and the challenge of managing price stability Speech by the Deputy Governor of the Banque de France, Mr. Hervé Hannoun, at the Financial Times European Economic and Monetary Union Conference in London on 20/11/97. I am delighted to take part in this discussion on the framework for the single monetary policy in Stage Three. I will address what I consider to be the two main categories of issues in this context: those related to monetary policy strategy on the one hand, and those related to the execution of monetary policy operations on the other hand; in other words, strategic and operational issues. 1. STRATEGIC ISSUES What are the main strategic issues relating to the formulation of the single monetary policy? I will consider in turn: the final objective, • • the intermediate target, • the role of the exchange rate as an indicator, and • the starting level of interest rates in the euro area at the end of next year. 1.1. Final objective: a quantified definition of price stability The final objective of the single monetary policy is clearly stated in the Maastricht Treaty: according to article 105, "the primary objective of the ESCB shall be to maintain price stability". Only a monetary policy geared towards the objective of price stability can create the conditions for durable and sustainable growth. To reach this objective, three conditions need, in my view, to be fulfilled: • firstly, the monetary strategy should be set in a More generally, medium-term framework. the European policy mix should consist both of a medium-term stability-oriented monetary policy and of a medium-term fiscal policy aiming at a balanced budget (or "close to balance" as stated in the Stability Pact).1 This medium-term stability-oriented policy mix is the best we can do to create the conditions for durable growth in the euro area. And it is now widely agreed in the European Union that the policy mix should not give the illusion that it can fine tune the economy; • secondly, the strategy pursued should provide a clear anchor to inflation expectations. This implies the public announcement of a of the final objective of quantified definition price stability; for instance, the Banque de France aims at an inflation rate not exceeding 2%; • thirdly, the strategy should be based on a This is because the forward-looking approach. transmission of monetary policy decisions to the economy takes place with relatively long lags. Estimates of these lags between interest rate changes and their effects on inflation vary between one and two years. As a consequence, central banks have to look ahead before they take monetary policy decisions. A case in point was the recent decision by several continental central banks, including the Banque de France, to raise their main refinancing rates on 9th October. This move was justified by the need to pre-empt inflationary pressures early enough, although inflation remained low. In my view it is very important to current make the public aware of the concept of the "pre-emptive strike", which is at the heart of central banking. 1.2. Intermediate target: more arguments in favour of monetary targeting, with a caveat In order to provide an anchor to inflation expectations and to look ahead, central banks make public an which they commit themselves to respecting. intermediate target Announcing an intermediate target also enhances the accountability of the central bank. This is why Article 12 of the Statute of the ECB explicitly refers to decisions relating to intermediate monetary objectives as one of the main responsibilities of the Governing Council of the ECB. Two possible strategies have been selected by the EMI Council as potential candidates to be recommended to the ECB, namely monetary targeting and direct inflation targeting.2 In the case of direct inflation targeting, the made by the central bank can be viewed as inflation forecast fulfilling the role of the intermediate target.3 Let me dwell a moment on the choice the ECB will have to make between direct inflation targeting and monetary targeting, unless it chooses to combine elements of both strategies. stresses the responsibility of the ESCB for achieving and Inflation targeting maintaining price stability. However, there are some difficulties in the process of forecasting inflation over the medium and longer term. As Mervyn King recently stated, "such a forecast cannot be a single number. It must be presented for what it is, namely a probability distribution".4 Furthermore, inflation targeting could imply more formal cooperation with the Government since the latter is in a position to influence price developments. Finally, inflation targeting has admittedly proven useful in progressing towards price stability, as the experience of the United Kingdom has shown. Nevertheless, the track record of inflation targeting is fairly short and has mostly taken place in a context of world-wide disinflation. monetary targeting by the ESCB would be in continuity with the strategy implemented by the Bundesbank since 1975 and by the Banque de France since 1976. However, this strategy hinges on the stability of money demand. Preliminary research has shown that EU-wide money equations often perform better than comparable national equations.5 Nonetheless, this may provide no safe guidance for the starting period of EMU in so far as the move to Stage Three constitutes a change of regime which might lead to breakdowns in empirical relationships. 1.3. Indicators: an important role for the exchange rate and long term interest rate of the euro It is likely that, while avoiding a "looking-at-everything" approach, the ESCB will closely monitor, in addition to the intermediate objective, a broad set of other economic and financial indicators to help assess the risks to future price stability. In this set of indicators, emphasis will probably have to be laid on the exchange rate and the long-term interest rate of the euro, for at least three reasons. Firstly, the euro exchange rate and long-term interest rate will play an important role in shaping monetary conditions within the euro area, together with the level of short-term interest rates that will be steered by the ESCB. Secondly, although the degree of openness of the euro area will be much lower than is currently the case for any EU Member State, with "foreign" trade representing roughly 9% of GDP for the EU as a whole, the area will remain totally open to foreign capital flows. In that regard, I would like to stress that current holdings of French and German securities by non-residents, including cross-holdings, amount to 1,200 billion dollars. This highlights the importance of keeping a high level of confidence in the euro. Thirdly, in spite of the fact that the ESCB will inherit credibility from the participating national central banks, the ECB will have no track record of its own in targeting money or inflation. It will thus have to build up its reputation and pay due attention to those indicators that reflect most directly the level of confidence placed by investors in the euro. Of course, as underlined above, the external value of the euro will not have the status of an intermediate objective and the ECB's strategy will not be based on exchange rate targeting.6 However, any depreciating trend of the euro would feed domestic inflation through a rise in import prices and, by undermining investors' confidence, would contribute to the building of risk premia into the euro yield curve. This would have negative consequences for investment, competitiveness, growth and employment in the euro area. So there cannot be any "benign neglect" with respect to the exchange rate. A stable and strong currency contributes to lowering long-term interest rates, which play a crucial role in the financing of the economies in continental Europe. All these reasons point to the need for a strong and stable euro, a currency that will be as credible as the franc, the guilder or the Deutsche Mark. The euro must be, and will be, rock solid. Therefore the exchange rate of the euro, even if not targeted as such, will undoubtedly play an important role as an indicator in the conduct of the single monetary policy. 1.4. The starting level of key interest rates in the euro area Let me say a few words on another strategic question: what will be the starting level of key interest rates in the euro area thirteen months from now? Futures contracts on short-term interest rates reflect the market's expectations on this issue. But of course don't expect a central banker to answer this question, one year in advance. I will just mention the Banque de France view on the rationale that should be behind the determination of the starting level of the euro area short-term rates. As you know, we currently observe interest rate differentials between the "core" and more "peripheral" currencies participating in the exchange rate mechanism. Although these spreads have been dramatically reduced in the past two years, due to the remarkable convergence of inflation rates throughout the European Union, some interest rate differentials still exist. They can be attributed partly to differing positions in the business cycle, and partly to differences in credibility. within the potential euro area should not be overestimated. Cyclical differences There is, all in all, a relatively high degree of synchronisation in the business cycle in continental Europe. The convergence criteria laid down in the Maastricht Treaty certainly played an important role in fostering this synchronisation. Moreover, in the future, differences in cyclical developments will gradually be reduced as policies, structures and behaviour will become more and more similar. Lastly, some persisting differences may well be tolerated as is currently the case between the various regions of the same country or, for instance, between the various member states of the USA. between "core" and "peripheral" currencies result from Credibility differences the different lengths of the track records in terms of stability-oriented policies. It is not the same to have reached an inflation goal of less than 2% for one year as for ten years. One of the benefits that the "peripheral countries" could reap from participating in the first wave of monetary union is to achieve the level of interest rate of the most credible currencies without having yet built up a very long track record. I would like to underline that in Europe, we are not converging towards a kind of average of the market interest rates of the potential euro area. One has to understand that the philosophy of EMU is to organize the convergence of the European countries towards the best possible level of monetary credibility and therefore towards the benchmarks in terms of interest rates. As Mr. Trichet recently stated, not an "convergence is a benchmarking concept", averaging process. Convergence does not mean that the "core" currencies' interest rates should go up towards irrelevant "average levels", but that the interest rates of more "peripheral" countries should progressively converge towards the benchmark level. This benchmark level is currently given by the intervention rates of the Bundesbank and of the Banque de France, both at 3.3%. But of course the benchmark level one year from now could be different from 3.3%. 2. OPERATIONAL ISSUES How will the ESCB operate? As you know, central banks implement their policies through the creation and destruction of central bank reserves, of which they are monopoly suppliers. This is done in the framework of domestic credit operations as well as foreign exchange interventions. Credit operations are conducted at maturities that extend overnight or beyond, to implement monetary policy, or on an intraday basis, to provide liquidity to payment systems. Therefore, I will consider in turn monetary policy operations, intraday credit operations and foreign exchange operations. I will focus on the following issues: As regards monetary policy operations, how will a single money market rate be attained and what will be the degree of interest rate volatility that the ESCB will be willing to accept? As regards intraday operations, how to cope with the risk of spillover from intraday credit into overnight credit? As regards domestic credit operations as well as foreign exchange operations, how will the principle of operational decentralisation be applied within the ESCB? 2.1. Monetary policy operations: a short-term money market rate as operational target To implement the single monetary policy, the ESCB will pursue an operational target that will normally be a short-term money-market interest rate. Two issues deserve close attention in that regard: the singleness of the money market on the one hand, and the volatility of the interest rate that will be targeted on the other hand. 2.1.1. Single money market rate The single monetary policy will be characterised by the singleness of interest rate levels in the interbank market: from the 1st January 1999 on, a single money-market interest rate will apply throughout the euro area for a given maturity. The issue is, thus, how to attain this single interest rate level. Two requirements will have to be met for that purpose. The first requirement is that, in the context of a single monetary policy that will be implemented in a decentralised manner, there should be a very high degree of harmonisation of instruments and procedures. The EMI and central banks are working relentlessly to this aim. The second requirement lies in the integration of interbank markets and payment systems. As far as are concerned, two factors should play a key role: interbank markets • the first factor relates to the various rules market operators have to abide by. These rules apply to counterparts, market makers, brokers, rating agencies and market enterprises such as clearing houses. They take the form of codes of conduct, regulations, master agreements and market standards. An appropriate degree of harmonisation of these market rules should be reached under the aegis of central banks and prudential authorities; • the second factor, the use of a single range of reference interest rates would guarantee the transparency of the euro money market. In this respect, short-term maturities are of special interest to central banks. This justifies that they intervene to some extent in the process of elaborating these indicators. As a matter of fact, the EMI has recently agreed that the ESCB should sponsor the computation of an overnight reference rate for the euro area. As regards the TARGET system will also contribute to the payment systems, rapid emergence of a unified money market throughout the euro area. TARGET will connect the domestic real-time gross settlement (RTGS) systems operated by the national central banks. It will enable participants to make totally safe cross-border settlements in euro, in real time and at a low cost, thereby facilitating interest rate arbitrage. All large-value payments related to monetary policy operations will have to process through TARGET. A common closing time for domestic RTGS and the harmonisation of conditions under which intraday liquidity will be provided by national central banks within the euro area should also help prevent any risk of segmentation of the single money market. 2.1.2. Interest rate volatility The EMI has described in various publications the set of monetary policy that will be made available to the ESCB.7 This set will comprise instruments open market It should fulfil two basic functions: operations, standing facilities and minimum reserves. firstly, to enable the ESCB to control efficiently its operational target; secondly, to signal the ESCB monetary policy stance. It should also be consistent with the requirement laid down in the Maastricht Treaty that the ESCB should act in accordance with the principle of an open market economy with free competition, favouring the efficient allocation of resources. In practice, the concrete design and use of monetary policy instruments will depend crucially on the degree of volatility of the short-term rate chosen as the operational This volatility will in turn depend on several target that the ESCB will be willing to accept. factors: • the defined by the two standing facilities available to absorb or width of the corridor provide liquidity (the deposit facility for the floor and the marginal lending facility for the ceiling). Under normal circumstances, the two facilities will bound the overnight interest rate. They will operate at the overnight maturity and will be accessible at the discretion of counterparties and for unlimited amounts, provided, in the case of the marginal lending facility, counterparties can supply adequate collateral. A very narrow corridor, allowing very little room for the functioning of the money market, would not be strictly in line with market principles. On the other hand, a very broad corridor would not help contain excessive market volatility. As a consequence, the width of the corridor is likely to be set pragmatically (currently, it is around 2% for most central banks that operate an interest rate corridor similar to the one planned for the ESCB); the could be a more discriminating factor for interest • frequency of fine tuning operations rate volatility. Very frequent intervention of the ESCB in the money market would not, in my view, be fully consistent with market principles. Moreover, excessive intervention might complicate the extraction of information from movements in market interest rates, especially at the maturity at which the ESCB would intervene. Intensive recourse to fine-tuning operations might also deprive regular refinancing operations and standing facilities of their signalling effect and be conducive to a centralisation of monetary policy operations; • provided they are set at a sufficient level, and include an averaging provision, reserve constitute an efficient buffer against liquidity shocks ; this would help requirements stabilize short-term interest rates over the maintenance period. In turn, setting a fairly high level of minimum reserves might require remunerating them in order not to induce significant delocation or disintermediation; • enhancing the signalling effect of the main refinancing operations should also contribute to lowering interest rate volatility. This may best be achieved through the normal conduct of which send clear signals to the market, rather than variable-rate tenders. fixed-rate tenders, The latter may nevertheless be useful in certain circumstances where the ESCB wishes to gauge market sentiment; • finally, the communication policy of the ESCB could also play a role in smoothing interest rate volatility. The ESCB will have to publish weekly a consolidated balance sheet. It will also publish the results of its tender operations. It could equally wish to release daily aggregate data on the reserve holdings, if averaged reserve requirements are in place, and on the use of the two standing facilities, as measured in both cases at the end of the previous day. 2.2. Intraday operations: the spillover from intraday credit into overnight credit as a borderline case To ensure the smooth functioning of the TARGET system, the national central banks will provide intraday liquidity to participants in the real-time gross settlement systems. This will be done in the form of fully collateralised intraday credit operations, in the sense that a credit extended during the day falls due before the end of the day. From a monetary policy point of view, such operations create the risk of a spillover of intraday credit into overnight credit that would undermine the control of the ESCB over the euro monetary base. In other words, the spillover of intraday credit into overnight credit in the books of the central bank can be viewed as a borderline case between payment systems and monetary policy issues. Within the euro area, this risk will be limited as end-of-day debit positions will be automatically considered to be a request for recourse to the marginal lending facility, i.e. an ESCB monetary policy instrument that bears a penalty interest rate. Outside the euro area, a problem arises as the RTGS systems of non-participating countries will be connected to TARGET, whereas no central bank currently gives non-residents access to its monetary policy instruments. As a consequence, different mechanisms are being prepared in order to prevent intraday credit, if granted to non-euro area NCBs, from spilling over into overnight credit. These mechanisms include the limitation, possibly to zero, of the amount of intraday liquidity non-euro area NCBs could receive, a system of penalties and sanctions applied in case of overnight overdrafts and an early closing time for participants in RTGS systems in non-euro area countries. The decision on which mechanisms to implement will be taken by the ECB. 2.3. Foreign exchange operations Foreign exchange operations include foreign reserve assets management on the one hand, foreign exchange intervention on the other hand. The ESCB will hold and manage two different types of foreign reserve assets: • those that will be transferred from the national central banks to the ECB; according to the Statute, the ECB shall be provided with such foreign reserve assets up to an amount equivalent to euro 50 billion; • and those that will be kept by the national central banks; the management of these foreign assets will be subject to guidelines issued by the ECB to ensure that the operations of national central banks do not interfere with the monetary and exchange rate policies of the euro area. These guidelines will include prior approval by the ECB for transactions exceeding thresholds to be specified and will also apply to member states' transactions with their foreign exchange working balances. The ESCB will have the technical capacity to conduct, if need be, foreign exchange intervention in order to counteract excessive or erratic exchange rate fluctuations of the euro against the major non-EU currencies (e.g., the US dollar). The need for intervention could also arise either in the context of G7 concerted operations or within the framework of the ERM II. To this end, the ESCB will use the pool of foreign assets transferred from the NCBs to the ECB. The framework that has been designed for domestic as well as foreign exchange operations allows the ESCB to build on the expertise that NCBs have acquired over the years and to make an extensive use of existing operational capacities in NCBs (dealing room, front office, back office). Common sense dictates making use of equipment, human resources and expertise currently available at NCBs. 2.4. A decentralised execution of operations A key feature of the single monetary policy is indeed that it will be decided in a centralised manner, by the Governing Council of the ECB, and executed in a decentralised manner, by the national central banks. In my description of operational issues within the context of the single monetary policy, I have made numerous and concrete allusions to this reliance of the ECB on the national central banks, in the areas of monetary policy, payment systems and foreign exchange operations. This organisation scheme of the ESCB is in line with the principle of subsidiarity laid down in the Maastricht Treaty. According to this principle, the ESCB shall have recourse to the national central banks to carry out its operations, to the extent deemed possible and appropriate. Consistently with this principle of decentralisation in the execution of the ESCB's operations, the counterparties (credit institutions) will keep their accounts with the NCBs. Operational decentralisation within the ESCB will be in the very interest of the System. In this regard, let me quote the President of the EMI, Mr. Duisenberg: "Reliance on the infrastructure and operational experience built up by the national central banks will prove a valuable asset. Given that the ESCB needs to be cognisant of differences between financial market participants and structures in the EU, operating through the national central banks will ensure that it has the best possible knowledge of market conditions throughout the euro area".8 The credibility of the ECB as the decision-making centre will by no means be undermined by this decentralised scheme. It will not depend on the technicalities in the execution of operations. The credibility of the ECB will crucially depend on its ability to adamantly pursue its strategy aiming at price stability and on its fortitude in resisting any pressure to deviate from this strategy.	['mr. hannoun discusses the operational framework for emu and the challenge of managing price stability speech by the deputy governor of the banque de france, mr. hervé hannoun, at the financial times european economic and monetary union conference in london on 20/11/97.', 'i am delighted to take part in this discussion on the framework for the single monetary policy in stage three.', 'i will address what i consider to be the two main categories of issues in this context: those related to monetary policy strategy on the one hand, and those related to the execution of monetary policy operations on the other hand; in other words, strategic and operational issues.', '1. strategic issues what are the main strategic issues relating to the formulation of the single monetary policy?', 'i will consider in turn: the final objective, • • the intermediate target, • the role of the exchange rate as an indicator, and • the starting level of interest rates in the euro area at the end of next year.', '1.1. final objective: a quantified definition of price stability the final objective of the single monetary policy is clearly stated in the maastricht treaty: according to article 105, "the primary objective of the escb shall be to maintain price stability".', 'only a monetary policy geared towards the objective of price stability can create the conditions for durable and sustainable growth.', 'to reach this objective, three conditions need, in my view, to be fulfilled: • firstly, the monetary strategy should be set in a more generally, medium-term framework.', 'the european policy mix should consist both of a medium-term stability-oriented monetary policy and of a medium-term fiscal policy aiming at a balanced budget (or "close to balance" as stated in the stability pact).1 this medium-term stability-oriented policy mix is the best we can do to create the conditions for durable growth in the euro area.', 'and it is now widely agreed in the european union that the policy mix should not give the illusion that it can fine tune the economy; • secondly, the strategy pursued should provide a clear anchor to inflation expectations.', 'this implies the public announcement of a of the final objective of quantified definition price stability; for instance, the banque de france aims at an inflation rate not exceeding 2%; • thirdly, the strategy should be based on a this is because the forward-looking approach.', 'transmission of monetary policy decisions to the economy takes place with relatively long lags.', 'estimates of these lags between interest rate changes and their effects on inflation vary between one and two years.', 'as a consequence, central banks have to look ahead before they take monetary policy decisions.', 'a case in point was the recent decision by several continental central banks, including the banque de france, to raise their main refinancing rates on 9th october.', 'this move was justified by the need to pre-empt inflationary pressures early enough, although inflation remained low.', 'in my view it is very important to current make the public aware of the concept of the "pre-emptive strike", which is at the heart of central banking.', '1.2. intermediate target: more arguments in favour of monetary targeting, with a caveat in order to provide an anchor to inflation expectations and to look ahead, central banks make public an which they commit themselves to respecting.', 'intermediate target announcing an intermediate target also enhances the accountability of the central bank.', 'this is why article 12 of the statute of the ecb explicitly refers to decisions relating to intermediate monetary objectives as one of the main responsibilities of the governing council of the ecb.', 'two possible strategies have been selected by the emi council as potential candidates to be recommended to the ecb, namely monetary targeting and direct inflation targeting.2 in the case of direct inflation targeting, the made by the central bank can be viewed as inflation forecast fulfilling the role of the intermediate target.3 let me dwell a moment on the choice the ecb will have to make between direct inflation targeting and monetary targeting, unless it chooses to combine elements of both strategies.', 'stresses the responsibility of the escb for achieving and inflation targeting maintaining price stability.', 'however, there are some difficulties in the process of forecasting inflation over the medium and longer term.', 'as mervyn king recently stated, "such a forecast cannot be a single number.', 'it must be presented for what it is, namely a probability distribution".4 furthermore, inflation targeting could imply more formal cooperation with the government since the latter is in a position to influence price developments.', 'finally, inflation targeting has admittedly proven useful in progressing towards price stability, as the experience of the united kingdom has shown.', 'nevertheless, the track record of inflation targeting is fairly short and has mostly taken place in a context of world-wide disinflation.', 'monetary targeting by the escb would be in continuity with the strategy implemented by the bundesbank since 1975 and by the banque de france since 1976. however, this strategy hinges on the stability of money demand.', 'preliminary research has shown that eu-wide money equations often perform better than comparable national equations.5 nonetheless, this may provide no safe guidance for the starting period of emu in so far as the move to stage three constitutes a change of regime which might lead to breakdowns in empirical relationships.', '1.3. indicators: an important role for the exchange rate and long term interest rate of the euro it is likely that, while avoiding a "looking-at-everything" approach, the escb will closely monitor, in addition to the intermediate objective, a broad set of other economic and financial indicators to help assess the risks to future price stability.', 'in this set of indicators, emphasis will probably have to be laid on the exchange rate and the long-term interest rate of the euro, for at least three reasons.', 'firstly, the euro exchange rate and long-term interest rate will play an important role in shaping monetary conditions within the euro area, together with the level of short-term interest rates that will be steered by the escb.', 'secondly, although the degree of openness of the euro area will be much lower than is currently the case for any eu member state, with "foreign" trade representing roughly 9% of gdp for the eu as a whole, the area will remain totally open to foreign capital flows.', 'in that regard, i would like to stress that current holdings of french and german securities by non-residents, including cross-holdings, amount to 1,200 billion dollars.', 'this highlights the importance of keeping a high level of confidence in the euro.', 'thirdly, in spite of the fact that the escb will inherit credibility from the participating national central banks, the ecb will have no track record of its own in targeting money or inflation.', 'it will thus have to build up its reputation and pay due attention to those indicators that reflect most directly the level of confidence placed by investors in the euro.', "of course, as underlined above, the external value of the euro will not have the status of an intermediate objective and the ecb's strategy will not be based on exchange rate targeting.6 however, any depreciating trend of the euro would feed domestic inflation through a rise in import prices and, by undermining investors' confidence, would contribute to the building of risk premia into the euro yield curve.", 'this would have negative consequences for investment, competitiveness, growth and employment in the euro area.', 'so there cannot be any "benign neglect" with respect to the exchange rate.', 'a stable and strong currency contributes to lowering long-term interest rates, which play a crucial role in the financing of the economies in continental europe.', 'all these reasons point to the need for a strong and stable euro, a currency that will be as credible as the franc, the guilder or the deutsche mark.', 'the euro must be, and will be, rock solid.', 'therefore the exchange rate of the euro, even if not targeted as such, will undoubtedly play an important role as an indicator in the conduct of the single monetary policy.', '1.4. the starting level of key interest rates in the euro area let me say a few words on another strategic question: what will be the starting level of key interest rates in the euro area thirteen months from now?', "futures contracts on short-term interest rates reflect the market's expectations on this issue.", "but of course don't expect a central banker to answer this question, one year in advance.", 'i will just mention the banque de france view on the rationale that should be behind the determination of the starting level of the euro area short-term rates.', 'as you know, we currently observe interest rate differentials between the "core" and more "peripheral" currencies participating in the exchange rate mechanism.', 'although these spreads have been dramatically reduced in the past two years, due to the remarkable convergence of inflation rates throughout the european union, some interest rate differentials still exist.', 'they can be attributed partly to differing positions in the business cycle, and partly to differences in credibility.', 'within the potential euro area should not be overestimated.', 'cyclical differences there is, all in all, a relatively high degree of synchronisation in the business cycle in continental europe.', 'the convergence criteria laid down in the maastricht treaty certainly played an important role in fostering this synchronisation.', 'moreover, in the future, differences in cyclical developments will gradually be reduced as policies, structures and behaviour will become more and more similar.', 'lastly, some persisting differences may well be tolerated as is currently the case between the various regions of the same country or, for instance, between the various member states of the usa.', 'between "core" and "peripheral" currencies result from credibility differences the different lengths of the track records in terms of stability-oriented policies.', 'it is not the same to have reached an inflation goal of less than 2% for one year as for ten years.', 'one of the benefits that the "peripheral countries" could reap from participating in the first wave of monetary union is to achieve the level of interest rate of the most credible currencies without having yet built up a very long track record.', 'i would like to underline that in europe, we are not converging towards a kind of average of the market interest rates of the potential euro area.', 'one has to understand that the philosophy of emu is to organize the convergence of the european countries towards the best possible level of monetary credibility and therefore towards the benchmarks in terms of interest rates.', 'as mr. trichet recently stated, not an "convergence is a benchmarking concept", averaging process.', 'convergence does not mean that the "core" currencies\' interest rates should go up towards irrelevant "average levels", but that the interest rates of more "peripheral" countries should progressively converge towards the benchmark level.', 'this benchmark level is currently given by the intervention rates of the bundesbank and of the banque de france, both at 3.3%.', 'but of course the benchmark level one year from now could be different from 3.3%.', '2. operational issues how will the escb operate?', 'as you know, central banks implement their policies through the creation and destruction of central bank reserves, of which they are monopoly suppliers.', 'this is done in the framework of domestic credit operations as well as foreign exchange interventions.', 'credit operations are conducted at maturities that extend overnight or beyond, to implement monetary policy, or on an intraday basis, to provide liquidity to payment systems.', 'therefore, i will consider in turn monetary policy operations, intraday credit operations and foreign exchange operations.', 'i will focus on the following issues: as regards monetary policy operations, how will a single money market rate be attained and what will be the degree of interest rate volatility that the escb will be willing to accept?', 'as regards intraday operations, how to cope with the risk of spillover from intraday credit into overnight credit?', 'as regards domestic credit operations as well as foreign exchange operations, how will the principle of operational decentralisation be applied within the escb?', '2.1. monetary policy operations: a short-term money market rate as operational target to implement the single monetary policy, the escb will pursue an operational target that will normally be a short-term money-market interest rate.', 'two issues deserve close attention in that regard: the singleness of the money market on the one hand, and the volatility of the interest rate that will be targeted on the other hand.', '2.1.1. single money market rate the single monetary policy will be characterised by the singleness of interest rate levels in the interbank market: from the 1st january 1999 on, a single money-market interest rate will apply throughout the euro area for a given maturity.', 'the issue is, thus, how to attain this single interest rate level.', 'two requirements will have to be met for that purpose.', 'the first requirement is that, in the context of a single monetary policy that will be implemented in a decentralised manner, there should be a very high degree of harmonisation of instruments and procedures.', 'the emi and central banks are working relentlessly to this aim.', 'the second requirement lies in the integration of interbank markets and payment systems.', 'as far as are concerned, two factors should play a key role: interbank markets • the first factor relates to the various rules market operators have to abide by.', 'these rules apply to counterparts, market makers, brokers, rating agencies and market enterprises such as clearing houses.', 'they take the form of codes of conduct, regulations, master agreements and market standards.', 'an appropriate degree of harmonisation of these market rules should be reached under the aegis of central banks and prudential authorities; • the second factor, the use of a single range of reference interest rates would guarantee the transparency of the euro money market.', 'in this respect, short-term maturities are of special interest to central banks.', 'this justifies that they intervene to some extent in the process of elaborating these indicators.', 'as a matter of fact, the emi has recently agreed that the escb should sponsor the computation of an overnight reference rate for the euro area.', 'as regards the target system will also contribute to the payment systems, rapid emergence of a unified money market throughout the euro area.', 'target will connect the domestic real-time gross settlement (rtgs) systems operated by the national central banks.', 'it will enable participants to make totally safe cross-border settlements in euro, in real time and at a low cost, thereby facilitating interest rate arbitrage.', 'all large-value payments related to monetary policy operations will have to process through target.', 'a common closing time for domestic rtgs and the harmonisation of conditions under which intraday liquidity will be provided by national central banks within the euro area should also help prevent any risk of segmentation of the single money market.', '2.1.2. interest rate volatility the emi has described in various publications the set of monetary policy that will be made available to the escb.7 this set will comprise instruments open market it should fulfil two basic functions: operations, standing facilities and minimum reserves.', 'firstly, to enable the escb to control efficiently its operational target; secondly, to signal the escb monetary policy stance.', 'it should also be consistent with the requirement laid down in the maastricht treaty that the escb should act in accordance with the principle of an open market economy with free competition, favouring the efficient allocation of resources.', 'in practice, the concrete design and use of monetary policy instruments will depend crucially on the degree of volatility of the short-term rate chosen as the operational this volatility will in turn depend on several target that the escb will be willing to accept.', 'factors: • the defined by the two standing facilities available to absorb or width of the corridor provide liquidity (the deposit facility for the floor and the marginal lending facility for the ceiling).', 'under normal circumstances, the two facilities will bound the overnight interest rate.', 'they will operate at the overnight maturity and will be accessible at the discretion of counterparties and for unlimited amounts, provided, in the case of the marginal lending facility, counterparties can supply adequate collateral.', 'a very narrow corridor, allowing very little room for the functioning of the money market, would not be strictly in line with market principles.', 'on the other hand, a very broad corridor would not help contain excessive market volatility.', 'as a consequence, the width of the corridor is likely to be set pragmatically (currently, it is around 2% for most central banks that operate an interest rate corridor similar to the one planned for the escb); the could be a more discriminating factor for interest • frequency of fine tuning operations rate volatility.', 'very frequent intervention of the escb in the money market would not, in my view, be fully consistent with market principles.', 'moreover, excessive intervention might complicate the extraction of information from movements in market interest rates, especially at the maturity at which the escb would intervene.', 'intensive recourse to fine-tuning operations might also deprive regular refinancing operations and standing facilities of their signalling effect and be conducive to a centralisation of monetary policy operations; • provided they are set at a sufficient level, and include an averaging provision, reserve constitute an efficient buffer against liquidity shocks ; this would help requirements stabilize short-term interest rates over the maintenance period.', 'in turn, setting a fairly high level of minimum reserves might require remunerating them in order not to induce significant delocation or disintermediation; • enhancing the signalling effect of the main refinancing operations should also contribute to lowering interest rate volatility.', 'this may best be achieved through the normal conduct of which send clear signals to the market, rather than variable-rate tenders.', 'fixed-rate tenders, the latter may nevertheless be useful in certain circumstances where the escb wishes to gauge market sentiment; • finally, the communication policy of the escb could also play a role in smoothing interest rate volatility.', 'the escb will have to publish weekly a consolidated balance sheet.', 'it will also publish the results of its tender operations.', 'it could equally wish to release daily aggregate data on the reserve holdings, if averaged reserve requirements are in place, and on the use of the two standing facilities, as measured in both cases at the end of the previous day.', '2.2. intraday operations: the spillover from intraday credit into overnight credit as a borderline case to ensure the smooth functioning of the target system, the national central banks will provide intraday liquidity to participants in the real-time gross settlement systems.', 'this will be done in the form of fully collateralised intraday credit operations, in the sense that a credit extended during the day falls due before the end of the day.', 'from a monetary policy point of view, such operations create the risk of a spillover of intraday credit into overnight credit that would undermine the control of the escb over the euro monetary base.', 'in other words, the spillover of intraday credit into overnight credit in the books of the central bank can be viewed as a borderline case between payment systems and monetary policy issues.', 'within the euro area, this risk will be limited as end-of-day debit positions will be automatically considered to be a request for recourse to the marginal lending facility, i.e.', 'an escb monetary policy instrument that bears a penalty interest rate.', 'outside the euro area, a problem arises as the rtgs systems of non-participating countries will be connected to target, whereas no central bank currently gives non-residents access to its monetary policy instruments.', 'as a consequence, different mechanisms are being prepared in order to prevent intraday credit, if granted to non-euro area ncbs, from spilling over into overnight credit.', 'these mechanisms include the limitation, possibly to zero, of the amount of intraday liquidity non-euro area ncbs could receive, a system of penalties and sanctions applied in case of overnight overdrafts and an early closing time for participants in rtgs systems in non-euro area countries.', 'the decision on which mechanisms to implement will be taken by the ecb.', '2.3. foreign exchange operations foreign exchange operations include foreign reserve assets management on the one hand, foreign exchange intervention on the other hand.', 'the escb will hold and manage two different types of foreign reserve assets: • those that will be transferred from the national central banks to the ecb; according to the statute, the ecb shall be provided with such foreign reserve assets up to an amount equivalent to euro 50 billion; • and those that will be kept by the national central banks; the management of these foreign assets will be subject to guidelines issued by the ecb to ensure that the operations of national central banks do not interfere with the monetary and exchange rate policies of the euro area.', "these guidelines will include prior approval by the ecb for transactions exceeding thresholds to be specified and will also apply to member states' transactions with their foreign exchange working balances.", 'the escb will have the technical capacity to conduct, if need be, foreign exchange intervention in order to counteract excessive or erratic exchange rate fluctuations of the euro against the major non-eu currencies (e.g., the us dollar).', 'the need for intervention could also arise either in the context of g7 concerted operations or within the framework of the erm ii.', 'to this end, the escb will use the pool of foreign assets transferred from the ncbs to the ecb.', 'the framework that has been designed for domestic as well as foreign exchange operations allows the escb to build on the expertise that ncbs have acquired over the years and to make an extensive use of existing operational capacities in ncbs (dealing room, front office, back office).', 'common sense dictates making use of equipment, human resources and expertise currently available at ncbs.', '2.4. a decentralised execution of operations a key feature of the single monetary policy is indeed that it will be decided in a centralised manner, by the governing council of the ecb, and executed in a decentralised manner, by the national central banks.', 'in my description of operational issues within the context of the single monetary policy, i have made numerous and concrete allusions to this reliance of the ecb on the national central banks, in the areas of monetary policy, payment systems and foreign exchange operations.', 'this organisation scheme of the escb is in line with the principle of subsidiarity laid down in the maastricht treaty.', 'according to this principle, the escb shall have recourse to the national central banks to carry out its operations, to the extent deemed possible and appropriate.', "consistently with this principle of decentralisation in the execution of the escb's operations, the counterparties (credit institutions) will keep their accounts with the ncbs.", 'operational decentralisation within the escb will be in the very interest of the system.', 'in this regard, let me quote the president of the emi, mr. duisenberg: "reliance on the infrastructure and operational experience built up by the national central banks will prove a valuable asset.', 'given that the escb needs to be cognisant of differences between financial market participants and structures in the eu, operating through the national central banks will ensure that it has the best possible knowledge of market conditions throughout the euro area".8 the credibility of the ecb as the decision-making centre will by no means be undermined by this decentralised scheme.', 'it will not depend on the technicalities in the execution of operations.', 'the credibility of the ecb will crucially depend on its ability to adamantly pursue its strategy aiming at price stability and on its fortitude in resisting any pressure to deviate from this strategy.']	Hervé Hannoun	Banque de France	Deputy Governor	France
https://www.bis.org/review/r971208e.pdf	Bank of Japan's November review of monetary and economic trends in Japan (Central Bank Articles and Speeches, 26 Nov 97)	BANK OF JAPAN, COMMUNICATION, 26/11/97.	1997-11-26 00:00:00	Bank of Japan's November review of monetary and economic trends in Japan BANK OF JAPAN, COMMUNICATION, 26/11/97. Japan's economic growth is decelerating further. Although corporate profits, employment and income conditions continue to improve moderately, weak household expenditures since April have gradually begun to affect production, and corporate sentiment is also weakening. With respect to final demand, public-sector investment has been decreasing, and housing investment has also dropped significantly. Personal consumption has continued to be weak on the whole, although the impact of the consumption tax hike has gradually begun to subside. On the other hand, net exports have continued to increase and business fixed investment has been rising moderately against the background of the increase in corporate profits. Excessive inventories are seen in some industries. Owing to weak final demand and inventory adjustments, industrial production has recently declined somewhat. The pace of improvement in employment and income conditions has slowed somewhat. Prices have remained stable on the whole, with the exception of wholesale prices which have declined somewhat. The growth of monetary aggregates has recently slowed. Personal consumption has continued to be weak on the whole. Outlays for travel have been increasing moderately, and there are some signs in the sales of goods which suggest that the impact of the consumption tax hike has gradually begun to subside. However, sales at department stores and supermarkets have been below the previous year's level, while passenger car sales have fallen below the level recorded in the second half of fiscal 1996 when sales surged, and have not even recovered the levels recorded before then. Among leading indicators of business fixed investment, machinery orders have continued on an increasing trend since early 1997 after having surged in the second half of 1996. Recently, however, orders from non-manufacturing firms have been weak. Construction floor area has followed a moderate recovery trend, albeit with some fluctuations. With respect to housing investment, housing starts in terms of the seasonally-adjusted annual rate declined in July to 1.24 million, the lowest level since September 1985, following the surge in demand in the second half of 1996 ahead of the consumption tax hike. Housing starts have since remained weak at around 1.3 - 1.35 million. Regarding public-sector investment, the amount of public works contracted has followed a decreasing trend reflecting the restrained budget for fiscal 1997. Against the background of steady overseas demand and the yen's depreciation to date, real exports remained high in the third quarter 1997, although they decreased somewhat from the second quarter when exports showed a significant rise. Real exports rose again in October. Real imports, on the other hand, have remained virtually unchanged on average. As a result, the real trade surplus has been increasing with some fluctuations. Reflecting these developments in exports and imports, the nominal current-account surplus has also been expanding significantly since April 1997. Industrial production has recently been somewhat weak. Production in the third quarter 1997 remained virtually unchanged on the whole. This is because production has been cut back mainly in the industries with excessive inventories, such as consumer durables and construction-related goods, although production of electrical machinery continued to increase, reflecting steady exports. Production in October and November is expected to decrease as a result of inventory adjustment pressures. With respect to labor market conditions, the unemployment rate has remained at a high level, and the ratio of job offers to job applications has recently eased somewhat. Growth in overtime working hours and nominal wages has slowed slightly reflecting weak production. However, year-to-year employment growth has been moderate but steady. Thus, employment and income conditions continue to improve moderately on the whole, but the pace of recovery has slowed somewhat. Prices remained stable on the whole, excluding the effect of the consumption tax hike. Domestic wholesale prices (adjusted for seasonal electricity rates) have declined to some extent as domestic demand and supply conditions started to ease, particularly in construction-related goods. The year-to-year declines in corporate service prices on the whole have been narrowing further owing to the improvement in supply and demand conditions, particularly for real estate rents and information services, although leasing charges continue declining. Consumer prices (nationwide, excluding perishables) rose year to year in September, reflecting the temporary factor; i.e., a rise in medical charges which resulted from medical insurance reform. Excluding this, however, consumer prices have remained stable at a level slightly above that of the previous year. Monetary aggregates, measured in terms of year-to-year growth of M2 + CDs average outstanding, declined somewhat in October to 2.7 per cent. Regarding money market rates, the overnight call rate (uncollateralized) has moved at a level slightly below the official discount rate. The 3-month CD rate has stayed at around 0.50 - 0.55 per cent. Against the background of uncertainties about future economic growth, the long-term government bond yield had been declining since the end of May and reached the record low of 1.5 - 1.6 per cent at the end of October, but recently rose to 1.6 - 1.8 per cent. With respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since September 1995. The long-term prime lending rate has been lowered since June and reached a record low of 2.3 per cent in October. In these circumstances, short- and long-term contracted interest rates for new loans and discounts (up to September) have stayed at record low levels. On the stock exchange, the Nikkei 225 stock average has been declining since August, partly reflecting uncertainties about future economic growth and the fall in U.S. stock prices, and fell below ¥18,000 in early September. It dropped further after late October as a result of the precipitous decline in Hong Kong stock prices and temporarily reached around ¥15,000, but has recently recovered to around ¥16,000. In the foreign exchange market, the yen moved at around ¥119-123 to the U.S. dollar between September and October. However, the yen later depreciated in early November, owing to growing concerns about future economic growth, as well as the fall in stock prices. Recently, it has moved at around ¥125-128. Meanwhile, the yen started to depreciate against the Deutsche Mark, after having peaked at around ¥62 in mid-August, and has recently moved at around ¥7174.	["bank of japan's november review of monetary and economic trends in japan bank of japan, communication, 26/11/97.", "japan's economic growth is decelerating further.", 'although corporate profits, employment and income conditions continue to improve moderately, weak household expenditures since april have gradually begun to affect production, and corporate sentiment is also weakening.', 'with respect to final demand, public-sector investment has been decreasing, and housing investment has also dropped significantly.', 'personal consumption has continued to be weak on the whole, although the impact of the consumption tax hike has gradually begun to subside.', 'on the other hand, net exports have continued to increase and business fixed investment has been rising moderately against the background of the increase in corporate profits.', 'excessive inventories are seen in some industries.', 'owing to weak final demand and inventory adjustments, industrial production has recently declined somewhat.', 'the pace of improvement in employment and income conditions has slowed somewhat.', 'prices have remained stable on the whole, with the exception of wholesale prices which have declined somewhat.', 'the growth of monetary aggregates has recently slowed.', 'personal consumption has continued to be weak on the whole.', 'outlays for travel have been increasing moderately, and there are some signs in the sales of goods which suggest that the impact of the consumption tax hike has gradually begun to subside.', "however, sales at department stores and supermarkets have been below the previous year's level, while passenger car sales have fallen below the level recorded in the second half of fiscal 1996 when sales surged, and have not even recovered the levels recorded before then.", 'among leading indicators of business fixed investment, machinery orders have continued on an increasing trend since early 1997 after having surged in the second half of 1996. recently, however, orders from non-manufacturing firms have been weak.', 'construction floor area has followed a moderate recovery trend, albeit with some fluctuations.', 'with respect to housing investment, housing starts in terms of the seasonally-adjusted annual rate declined in july to 1.24 million, the lowest level since september 1985, following the surge in demand in the second half of 1996 ahead of the consumption tax hike.', 'housing starts have since remained weak at around 1.3 - 1.35 million.', "regarding public-sector investment, the amount of public works contracted has followed a decreasing trend reflecting the restrained budget for fiscal 1997. against the background of steady overseas demand and the yen's depreciation to date, real exports remained high in the third quarter 1997, although they decreased somewhat from the second quarter when exports showed a significant rise.", 'real exports rose again in october.', 'real imports, on the other hand, have remained virtually unchanged on average.', 'as a result, the real trade surplus has been increasing with some fluctuations.', 'reflecting these developments in exports and imports, the nominal current-account surplus has also been expanding significantly since april 1997. industrial production has recently been somewhat weak.', 'production in the third quarter 1997 remained virtually unchanged on the whole.', 'this is because production has been cut back mainly in the industries with excessive inventories, such as consumer durables and construction-related goods, although production of electrical machinery continued to increase, reflecting steady exports.', 'production in october and november is expected to decrease as a result of inventory adjustment pressures.', 'with respect to labor market conditions, the unemployment rate has remained at a high level, and the ratio of job offers to job applications has recently eased somewhat.', 'growth in overtime working hours and nominal wages has slowed slightly reflecting weak production.', 'however, year-to-year employment growth has been moderate but steady.', 'thus, employment and income conditions continue to improve moderately on the whole, but the pace of recovery has slowed somewhat.', 'prices remained stable on the whole, excluding the effect of the consumption tax hike.', 'domestic wholesale prices (adjusted for seasonal electricity rates) have declined to some extent as domestic demand and supply conditions started to ease, particularly in construction-related goods.', 'the year-to-year declines in corporate service prices on the whole have been narrowing further owing to the improvement in supply and demand conditions, particularly for real estate rents and information services, although leasing charges continue declining.', 'consumer prices (nationwide, excluding perishables) rose year to year in september, reflecting the temporary factor; i.e., a rise in medical charges which resulted from medical insurance reform.', 'excluding this, however, consumer prices have remained stable at a level slightly above that of the previous year.', 'monetary aggregates, measured in terms of year-to-year growth of m2 + cds average outstanding, declined somewhat in october to 2.7 per cent.', 'regarding money market rates, the overnight call rate (uncollateralized) has moved at a level slightly below the official discount rate.', 'the 3-month cd rate has stayed at around 0.50 - 0.55 per cent.', 'against the background of uncertainties about future economic growth, the long-term government bond yield had been declining since the end of may and reached the record low of 1.5 - 1.6 per cent at the end of october, but recently rose to 1.6 - 1.8 per cent.', 'with respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since september 1995. the long-term prime lending rate has been lowered since june and reached a record low of 2.3 per cent in october.', 'in these circumstances, short- and long-term contracted interest rates for new loans and discounts (up to september) have stayed at record low levels.', 'on the stock exchange, the nikkei 225 stock average has been declining since august, partly reflecting uncertainties about future economic growth and the fall in u.s. stock prices, and fell below ¥18,000 in early september.', 'it dropped further after late october as a result of the precipitous decline in hong kong stock prices and temporarily reached around ¥15,000, but has recently recovered to around ¥16,000.', 'in the foreign exchange market, the yen moved at around ¥119-123 to the u.s. dollar between september and october.', 'however, the yen later depreciated in early november, owing to growing concerns about future economic growth, as well as the fall in stock prices.', 'recently, it has moved at around ¥125-128.', 'meanwhile, the yen started to depreciate against the deutsche mark, after having peaked at around ¥62 in mid-august, and has recently moved at around ¥7174.']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r971208d.pdf	Mr. Greenspan's remarks to the Economic Club of New York (Central Bank Articles and Speeches, 2 Dec 97)	Remarks by the Chairman of the Board of the U S Federal Reserve System, Mr. Alan Greenspan, at the Economic Club of New York in New York City, on 02/12/97.	1997-12-02 00:00:00	Mr. Greenspan's remarks to the Economic Club of New York Remarks by the Chairman of the Board of the U S Federal Reserve System, Mr. Alan Greenspan, at the Economic Club of New York in New York City, on 02/12/97. Dramatic advances in the global financial system have enabled us to materially improve the efficiency of the flows of capital and payments. Those advances, however, have also enhanced the ability of the system to rapidly transmit problems in one part of the globe to another. The events of recent weeks have underscored this latter process. The lessons we are learning from these experiences hopefully can be applied to better the workings of the international financial system, a system that has done so much to foster gains in living standards worldwide. The current crisis is likely to accelerate the dismantling in many Asian countries of the remnants of a system with large elements of government-directed investment, in which finance played a key role in carrying out the state's objectives. Such a system inevitably has led to the investment excesses and errors to which all similar endeavors seem prone. Government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports. Gluts and shortages are inevitable. The accelerated opening up in recent years of product and financial markets worldwide offers enormous benefits to all nations over the long run. However, it has also exposed more quickly and harshly the underlying rigidities of economic systems in which governments -- or governments working with large industrial groups -- exercise substantial influence over resource allocation. Such systems can produce vigorous growth for a time when the gap between indigenous applied technologies and world standards is large, such as in the Soviet Union in the 1960s and 1970s and Southeast Asia in the 1980s and 1990s. But as the gap narrows, the ability of these systems to handle their increasingly sophisticated economies declines markedly. In western developed economies, in contrast, market forces have been allowed much freer rein to dictate production schedules. Rapid responses by businesses to changes in free-market prices have muted much of the tendency for unsold goods to back up, or unmet needs to produce shortages. Recent improvements in technology have significantly compressed business response times and enhanced the effectiveness of the market mechanism. Most Asian policymakers, while justly proud of the enormous success of their economies in recent decades, nonetheless have been moving of late toward these more open and flexible economies. Belatedly perhaps, they have perceived the problems to which their systems are prone and recognized the unforgiving nature of the new global market forces. Doubtless, the current crises will hasten that trend. While the adjustments may be difficult for a time, these crises will pass. Stronger individual economies and a more robust and efficient international economic and financial system will surely emerge in their wake. While each of the Asian economies is unique in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and high rates of savings and investment -- including investment in human capital through education -- contributed to a sustained period of rapid growth. In some cases this started in the 1960s and 1970s, but by the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recently were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia-Pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996; less comprehensive data suggest that inflows rose to a still higher rate earlier this year. Sustained, spectacular growth in Asian economies fostered expectations of high returns with moderate risk. Moreover the global stock market boom of the 1990s provided the impetus to seek these perceived high returns. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had reached levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment outflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at reasonable risk. It may have been inevitable in those conditions of rapid growth, ample liquidity, and an absence of sufficient profitable alternatives, that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects that had little economic rationale. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were already less than robust, beset with problems of poor lending standards, weak supervisory regimes, and inadequate capital. At the same time, rising business leverage added to financial fragility. Businesses were borrowing to maintain high rates of return on equity and weak financial systems were poorly disciplining this process. In addition, explicit government guarantees of debt or, more often, the presumption of such guarantees by the investment community, encouraged insufficient vigilance by lenders and hence greater leverage. But high debt burdens allow little tolerance for rising interest rates or slowdowns in economic growth, as recent events have demonstrated. Moreover, the rapidly growing foreign-currency-denominated debt, in part the result of pegged exchange rates to the dollar, put pressure on companies to earn foreign exchange. But earning it became increasingly difficult. The substantial rise in the value of the dollar since mid-1995, especially relative to the yen, made exports of the Southeast Asian economies less competitive. In addition, in some cases, the glut of semiconductors in 1996 and the accelerated drop in their prices suppressed export earnings growth, exerting further pressures on highly leveraged businesses. In time, the pressures on what had become fixed-exchange-rate regimes mounted as investors, confronted with ever fewer profitable prospects, slowed the pace of new capital inflows. Fearing devaluation, many domestic Asian businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. To counter pressures on exchange rates, countries raised interest rates. For fixed-exchange-rate, highly leveraged economies, it was only a matter of time before slower growth and higher interest rates led to difficulties for borrowers, especially those with fixed obligations. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. This is an age-old phenomenon. When investors are unsettled by uncertainties and fears, they withdraw commitments on a broad front; the finer distinctions between countries and currencies are lost. There is a flight to safe-haven investments, many of which are in developed nations. Perhaps, given the circumstances, it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would encounter a temporary slowdown or pause. I say temporary because there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time, provided their markets are opened to the full force of competition. Nonetheless, free-market, even partially free-market, economies do periodically run into difficulties because investment mistakes invariably occur. And, as I noted earlier, many of these mistakes arose from government-directed or influenced investments. When this happens, private capital flows may temporarily turn adverse. In these circumstances, individual companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion. New growth opportunities must be allowed to emerge. Although the economies of the troubled Asian countries were usually characterized by a combination of current account deficits, large net foreign currency exposures, and constraints on exchange rate fluctuations, one cannot generalize that these are always signs of impending difficulties. Large current account deficits, per se, are not dangerous if they result from direct investment inflows that are not subject to rapid withdrawal and that generate an increase in income sufficient to compensate the investors. Foreign currency exposures need not be a problem if positions are properly managed and the risks are recognized. Fixed exchange rates, also, are not necessarily a problem. Indeed, if they can be sustained, they yield extensive benefits in lower risk and lower costs for all international transactions. But a small open economy can maintain an exchange rate fixed to a hard currency only under certain conditions. Both Austria and the Netherlands, for example, have been able to lock their currencies against the Deutsche Mark because their economies are tightly linked through trade with Germany, they mirror the Bundesbank's monetary policies, and they are perceived to engage in prudent fiscal policies. Were it not for issues of national identity and seignorage, they could just as readily embrace the DM as their domestic currency without any economic disruption. Other economies, such as Argentina and Hong Kong, have fixed their exchange rates essentially through currency boards. Changes in dollar reserves directly affect the monetary base of those economies. But when exchange rates are fixed, with or without currency boards, should monetary and fiscal policies diverge significantly from those of the larger economy, the currency lock of the smaller economy would be difficult to hold irrespective of the size of reserves. Large reserves can delay adjustment. They cannot prevent it if policies are inconsistent, or prices in the smaller country are inflexible. A well-functioning international financial system will seek out anomalies in policy alignments and exchange rates and set them right. In such a system, the exploitation of above-normal profit opportunities, that is, arbitrage, will force prices to change until expected returns have been equalized. To policymakers in the country whose currency is not appropriately aligned, capital outflows are too often seen as attacks by marauding currency speculators. There have no doubt been some such attempts on occasion. But speculators rarely succeed in dislodging an exchange rate that is firmly rooted in compatible policies and cost structures. More often, speculation forces currencies through arbitrage into a closer alignment with underlying market values to the benefit of the international economic and financial system as a whole. We used to describe capital flight as "hot money". But we soon recognized that it was not the money that was "hot", but the place it was running from. The prodigious expansion of cross-border financial transactions in recent years has tightened and refined the arbitrage process significantly. But, to repeat, the inestimable advantages that it brings to trade and standards of living also carry a price. The inevitable investment mistakes and governmental policy failures are more rapidly transmitted to other markets by this process than was the case say twenty, or even ten, years ago. Moreover, there is little evidence to suggest that the rate of increase of financial transactions will slow materially in the years immediately ahead. Technology will continue to reduce the costs of finding and exploiting perceived differences in risk-adjusted rates of return around the world, helping to direct capital even more to its most efficient use. Already, covered rates of return on actively traded interest-rate instruments have been equalized among many industrial countries. But the broader merging of world savings and investment markets, clearly, has not been achieved, largely because investors are fearful of investing in countries they do not understand to the extent that they do their own, or are uninformed of the opportunities. One measure of this so-called home bias in world investments is the degree that portfolios remain substantially local. Foreign investments, on average, represent less than 10 percent of U.S. portfolios, for example. The percentage of Japanese portfolios is only slightly higher, and 15 percent of German portfolios is in foreign assets. The partial exception is Great Britain, where, with a longer history of global financial involvement, one-third of portfolios is invested in foreign assets. Home bias in investments is considerably less than it was ten years ago, but we are still far from full globalization. Unless government restrictions inhibit the expansion of ever more sophisticated financial products that enable savers in one part of the world to reduce risk by investing in another, the bias will continue to diminish and the size of the international financial system will continue to expand at a significant pace. It is this overall diversification, and hence lowering of risk, that an effective international financial system offers. It facilitates the ever more efficient functioning of the global economic system and, hence, is a major contributor to rising standards of living worldwide. Nonetheless, there are those who ask whether the price of so sophisticated a financial system is too high. Would it not be better to slow it down a bit, and perhaps achieve a system somewhat more forgiving of mistakes, even recognizing that such a slowing may entail some shortfall in long-term economic growth? Even if we could implement such a tradeoff, with only minor disruption, should we try? For centuries groups in our societies have railed against, and endeavored on occasion to destroy, new inventions. Fortunately for us the Luddites and their ilk failed, and recent generations have enjoyed the fruits of those technologies. Moreover such a slowdown may not even be possible -- at least without major disruption and cost. Newer technologies, especially advanced telecommunications, make it exceptionally difficult for open markets, with associated opportunities, to be suppressed. Price and capital controls, which might have been feasible a half century ago, would be very difficult to implement in today's more technologically advanced environment. Tinkering at the edges of our system in order to produce a less frenetic pace of change would be easily circumvented. Arguably, it would take massive government controls to substantially slow the advance toward greater efficiency of our systems. This would surely produce a far more negative impact on economic growth than would be acceptable to even the most ardent advocates of reining in the rapid expansion of our international financial system. If, as I suspect, it turns out after due deliberation and analysis, that slowing the pace of financial modernization is not in fact seen as a feasible alternative, what policy alternatives confront the international financial community to contain the periodic disruptions that are bound to occur in any free market economy? A financial system, like all structures, is as strong as its weakest link. As the international financial system has become even more complex, the particular areas of weakness to be addressed have changed. At the risk of oversimplification, let's examine some of the key links of our current infrastructure. Today, the organized exchanges and over-the-counter markets of industrial countries can handle massive volumes of transactions. Even in emerging countries exchanges are developing and expanding. In contrast, during the world-wide stock market crash of October 1987, the transactions systems were under severe stress and, indeed, some broke down, incapable of handling the enlarged volumes. At that time, the Hong Kong stock exchange could not open for several days. The New York Stock Exchange was straining badly under the near 400 million daily share volume of late October 1987, with long reporting delays creating uncertainties that, doubtless, exaggerated the price declines. Those weaker links have since been strengthened by large infrastructure investments. Almost 1.2 billion shares traded on the NYSE on October 28 of this year, three times the 1987 volumes with no evident problems or delays. Our equity, debt, and foreign exchange trading systems, and their peripheral futures and options markets have functioned well under stress recently. These systems are not weak links in the developed economies, nor, for the most part are they in other economies. Neither is the payment system, that complex network, which transfers funds and securities in huge and growing volumes domestically and internationally, rapidly and efficiently. The private and public sectors across the globe have endeavored diligently for years to expand the capacity of the system to meet the increasing demands put upon it. And they have initiated and strengthened procedures for reducing risk in settling transactions, and diminishing uncertainties. That they have generally succeeded is evident from the smoothness with which huge volumes of funds produced under recent stressed market conditions were transferred and settled with finality, through various netting and clearing arrangements. Banks are another matter. These are highly leveraged institutions, financed in part by interbank credits and, hence, prone to crises of confidence that can quickly spread. In most developed nations banking systems appear reasonably solid. Japan has been somewhat of an exception, but there have been some positive signs there, as well. Banks have been recognizing losses, and the government seems finally to be appropriately addressing their problems. In a large number of emerging nations, as I indicated previously, banks are in poor shape. Lax lending has created a high incidence of non-performing loans, supported by inadequate capital, leaving banks vulnerable to declines in collateral values and non-performance by borrowers. How can such deficient institutions be elevated to a level that would allow their economies to function effectively in our increasingly sophisticated international financial system? Certainly, improved cost and risk management and elimination of poor lending practices are a good place to start. But these cannot be accomplished overnight. Loan officers with experience judging credit and market risks are in very short supply in emerging economies. Training will require time. The same difficulties confront bank supervision and regulation. Important efforts in this area have been underway for several years through the auspices of the Bank for International Settlements, the International Monetary Fund, and the World Bank. But again, it will take time to develop adequate systems and trained personnel. Moreover, robust banking and financial systems require firmly enforced laws of contract, and transparent, market-oriented systems of corporate reporting and governance. The current crisis in Asia is, to a much greater extent than many previous crises, one of private, not public, debts, at least de jure. Arguably, the absence of efficient and transparent work-out arrangements for troubled private borrowers makes the problems more difficult to deal with. Efficient bankruptcy arrangements reduce disruptions to economic activity that often arise when losses have to be imposed on creditors. Many developing countries do not have good work-out arrangements for troubled debtors, and, as a result, governments in these countries often feel compelled to bail them out rather than accept the consequences of defaults. The most troublesome aspect of many banking systems of emerging countries, to expand on the issue I raised earlier, is the widespread prevalence of loans driven by "industrial policy" imperatives rather than market forces. What is wrong with policy -- that is, politically-driven -- loans? Potentially nothing if they were made to firms to finance expansions that just happened to coincide with a rise in consumer or business or overseas demand for their newly-produced products. In these circumstances, the loan proceeds would have been profitably employed and the loan repaid at maturity with interest. Unfortunately, this is often not the case. Policy loans, in too many instances, foster misuse of resources, unprofitable expansions, losses, and eventually loan defaults. In many cases, of course, these loans regrettably end up being guaranteed by governments. If denominated in local currency, they can be financed with the printing press -- though with consequent risk of inflation. Too often, however, they are foreign-currency denominated, where governments face greater constraints on access to credit. Restructuring of financial systems, while indispensable, cannot be implemented quickly. Yes, the potential risks to the banking systems of many Asian countries and the potential contagion effects for their neighbors, and other trading partners, should have been spotted earlier and addressed. But flaws, seen clearly in retrospect, are never so evident at the time. Moreover, there is significant bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by unreported declines in reserves, issuance by the government of equivalents to foreign currency obligations, or unreported large new forward short positions against foreign currencies. It is very difficult for political leaders to incur what they perceive as large, immediate political costs to contain problems they see as only prospective. Reality eventually replaces hope, and the cost of the delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive. Increased transparency for businesses and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers. Increased transparency can counter political bias in part by exposing for all to see the risks of current policies to stability as they develop. Under such conditions, failure to act would also be perceived as having political costs. We should strongly stress to the newer members of the international financial system -- the emerging economies -- that they should accelerate the restructuring of their financial systems in their own interests. But having delayed timely restructuring, many now find themselves with major shortfalls in bank liquidity and equity capital that put their systems at severe risk of collapse before any full restructuring is feasible. The IMF, the World Bank, and their major shareholders, the developed countries, may wish to facilitate adjustment through temporary loans to governments and the encouragement of private equity infusions to these banking systems. Since any severe breakdown can have contagion effects on a world-wide basis, it is in our interest to do so. These loans must be judged in their entirety. They transform short-term obligations into medium-term loans, but they do so contingent on the country using the time to reform financial systems as well as adopt sound economic policies. Such conditionality accelerates the adjustments in financial systems needed to lay the foundation for resumption of robust, sustainable, growth, while cushioning to some degree the economic effects of the immediate crisis. Assistance without further reform of financial systems and economic policies would be worse than useless since it would foster expectations of being perpetually bailed out. That, in turn, could induce perverse behavior on the part of emerging nations' governments and of private sector investors in emerging nations. Believing that the international financial community will support these economies, in part by backstopping the obligations they incur, induces investors to commit more than they would otherwise. This has tended in the past to push the expansion of investment beyond prudence -- given the limit of profitable opportunities. As the international financial system becomes ever larger and more efficient, the size of the financial response -- whether to help banks or to add to foreign currency reserves -- may have to be correspondingly larger per unit of crisis, if I may put it that way -unless we alter our approach. While it is precarious to generalize from one observation, it is likely that the Mexican financial crisis of the 1980s was broader than in 1994-95, but the size of the assistance program, to set things right, was much larger in the latter than in the former case. The reason appears to be that the increased efficiency of the financial system created a larger negative spillover, which had to be contained. Among other developments, the marked shift from bank credits in the earlier crisis, to a more securitized, anonymous, set of liabilities made workouts far more complex. It is, hence, all the more essential that the weaker links in our international financial system, the banking systems of the emerging nations, be strengthened. Preventive programs should be accelerated sufficiently far in advance of the next crisis to effectively thwart or contain it. Moreover, it is incumbent on governmental policymakers to insure that unstable economic environments do not induce or exacerbate international financial disruptions. But governments and international financial institutions should be brought on the scene only rarely. To do otherwise risks the perverse incentives I spoke of earlier. Markets should be allowed to work. Recent events in Asia have sharpened our understanding of the complexity of today's international capital flows and, presumably, of similar episodes that may emerge in the future. The rapid integration of national financial systems has fostered the growth of trade and standards of living worldwide. It has also forced a review of the soundness and viability of our burgeoning financial systems. We should welcome such pressures even as they impose challenges to all of us. The end result is very worthwhile having.	["mr. greenspan's remarks to the economic club of new york remarks by the chairman of the board of the u s federal reserve system, mr. alan greenspan, at the economic club of new york in new york city, on 02/12/97.", 'dramatic advances in the global financial system have enabled us to materially improve the efficiency of the flows of capital and payments.', 'those advances, however, have also enhanced the ability of the system to rapidly transmit problems in one part of the globe to another.', 'the events of recent weeks have underscored this latter process.', 'the lessons we are learning from these experiences hopefully can be applied to better the workings of the international financial system, a system that has done so much to foster gains in living standards worldwide.', "the current crisis is likely to accelerate the dismantling in many asian countries of the remnants of a system with large elements of government-directed investment, in which finance played a key role in carrying out the state's objectives.", 'such a system inevitably has led to the investment excesses and errors to which all similar endeavors seem prone.', 'government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports.', 'gluts and shortages are inevitable.', 'the accelerated opening up in recent years of product and financial markets worldwide offers enormous benefits to all nations over the long run.', 'however, it has also exposed more quickly and harshly the underlying rigidities of economic systems in which governments -- or governments working with large industrial groups -- exercise substantial influence over resource allocation.', 'such systems can produce vigorous growth for a time when the gap between indigenous applied technologies and world standards is large, such as in the soviet union in the 1960s and 1970s and southeast asia in the 1980s and 1990s.', 'but as the gap narrows, the ability of these systems to handle their increasingly sophisticated economies declines markedly.', 'in western developed economies, in contrast, market forces have been allowed much freer rein to dictate production schedules.', 'rapid responses by businesses to changes in free-market prices have muted much of the tendency for unsold goods to back up, or unmet needs to produce shortages.', 'recent improvements in technology have significantly compressed business response times and enhanced the effectiveness of the market mechanism.', 'most asian policymakers, while justly proud of the enormous success of their economies in recent decades, nonetheless have been moving of late toward these more open and flexible economies.', 'belatedly perhaps, they have perceived the problems to which their systems are prone and recognized the unforgiving nature of the new global market forces.', 'doubtless, the current crises will hasten that trend.', 'while the adjustments may be difficult for a time, these crises will pass.', 'stronger individual economies and a more robust and efficient international economic and financial system will surely emerge in their wake.', 'while each of the asian economies is unique in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them.', 'following the early post-world war ii period, policies generally fostering low levels of inflation and high rates of savings and investment -- including investment in human capital through education -- contributed to a sustained period of rapid growth.', 'in some cases this started in the 1960s and 1970s, but by the 1980s most economies in the region were expanding vigorously.', 'foreign net capital inflows grew, but until recently were relatively modest.', 'the world bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the asia-pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996; less comprehensive data suggest that inflows rose to a still higher rate earlier this year.', 'sustained, spectacular growth in asian economies fostered expectations of high returns with moderate risk.', 'moreover the global stock market boom of the 1990s provided the impetus to seek these perceived high returns.', 'as that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had reached levels perceived as uncompetitive with the earnings potential in emerging economies, especially in asia.', 'the resultant diversification induced a sharp increase in capital flows into those economies.', 'to a large extent, they came from investors in the united states and western europe.', 'a substantial amount came from japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country.', 'the rising yen through mid-1995 also encouraged a substantial increase in direct investment outflows from japan.', 'in retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at reasonable risk.', 'it may have been inevitable in those conditions of rapid growth, ample liquidity, and an absence of sufficient profitable alternatives, that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects that had little economic rationale.', 'these real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems.', 'in many instances, those financial systems were already less than robust, beset with problems of poor lending standards, weak supervisory regimes, and inadequate capital.', 'at the same time, rising business leverage added to financial fragility.', 'businesses were borrowing to maintain high rates of return on equity and weak financial systems were poorly disciplining this process.', 'in addition, explicit government guarantees of debt or, more often, the presumption of such guarantees by the investment community, encouraged insufficient vigilance by lenders and hence greater leverage.', 'but high debt burdens allow little tolerance for rising interest rates or slowdowns in economic growth, as recent events have demonstrated.', 'moreover, the rapidly growing foreign-currency-denominated debt, in part the result of pegged exchange rates to the dollar, put pressure on companies to earn foreign exchange.', 'but earning it became increasingly difficult.', 'the substantial rise in the value of the dollar since mid-1995, especially relative to the yen, made exports of the southeast asian economies less competitive.', 'in addition, in some cases, the glut of semiconductors in 1996 and the accelerated drop in their prices suppressed export earnings growth, exerting further pressures on highly leveraged businesses.', 'in time, the pressures on what had become fixed-exchange-rate regimes mounted as investors, confronted with ever fewer profitable prospects, slowed the pace of new capital inflows.', 'fearing devaluation, many domestic asian businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies.', 'to counter pressures on exchange rates, countries raised interest rates.', 'for fixed-exchange-rate, highly leveraged economies, it was only a matter of time before slower growth and higher interest rates led to difficulties for borrowers, especially those with fixed obligations.', 'particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities.', 'this is an age-old phenomenon.', 'when investors are unsettled by uncertainties and fears, they withdraw commitments on a broad front; the finer distinctions between countries and currencies are lost.', 'there is a flight to safe-haven investments, many of which are in developed nations.', 'perhaps, given the circumstances, it was inevitable that the impressive and rapid growth experienced by the economies in the asian region would encounter a temporary slowdown or pause.', 'i say temporary because there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time, provided their markets are opened to the full force of competition.', 'nonetheless, free-market, even partially free-market, economies do periodically run into difficulties because investment mistakes invariably occur.', 'and, as i noted earlier, many of these mistakes arose from government-directed or influenced investments.', 'when this happens, private capital flows may temporarily turn adverse.', 'in these circumstances, individual companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion.', 'new growth opportunities must be allowed to emerge.', 'although the economies of the troubled asian countries were usually characterized by a combination of current account deficits, large net foreign currency exposures, and constraints on exchange rate fluctuations, one cannot generalize that these are always signs of impending difficulties.', 'large current account deficits, per se, are not dangerous if they result from direct investment inflows that are not subject to rapid withdrawal and that generate an increase in income sufficient to compensate the investors.', 'foreign currency exposures need not be a problem if positions are properly managed and the risks are recognized.', 'fixed exchange rates, also, are not necessarily a problem.', 'indeed, if they can be sustained, they yield extensive benefits in lower risk and lower costs for all international transactions.', 'but a small open economy can maintain an exchange rate fixed to a hard currency only under certain conditions.', "both austria and the netherlands, for example, have been able to lock their currencies against the deutsche mark because their economies are tightly linked through trade with germany, they mirror the bundesbank's monetary policies, and they are perceived to engage in prudent fiscal policies.", 'were it not for issues of national identity and seignorage, they could just as readily embrace the dm as their domestic currency without any economic disruption.', 'other economies, such as argentina and hong kong, have fixed their exchange rates essentially through currency boards.', 'changes in dollar reserves directly affect the monetary base of those economies.', 'but when exchange rates are fixed, with or without currency boards, should monetary and fiscal policies diverge significantly from those of the larger economy, the currency lock of the smaller economy would be difficult to hold irrespective of the size of reserves.', 'large reserves can delay adjustment.', 'they cannot prevent it if policies are inconsistent, or prices in the smaller country are inflexible.', 'a well-functioning international financial system will seek out anomalies in policy alignments and exchange rates and set them right.', 'in such a system, the exploitation of above-normal profit opportunities, that is, arbitrage, will force prices to change until expected returns have been equalized.', 'to policymakers in the country whose currency is not appropriately aligned, capital outflows are too often seen as attacks by marauding currency speculators.', 'there have no doubt been some such attempts on occasion.', 'but speculators rarely succeed in dislodging an exchange rate that is firmly rooted in compatible policies and cost structures.', 'more often, speculation forces currencies through arbitrage into a closer alignment with underlying market values to the benefit of the international economic and financial system as a whole.', 'we used to describe capital flight as "hot money".', 'but we soon recognized that it was not the money that was "hot", but the place it was running from.', 'the prodigious expansion of cross-border financial transactions in recent years has tightened and refined the arbitrage process significantly.', 'but, to repeat, the inestimable advantages that it brings to trade and standards of living also carry a price.', 'the inevitable investment mistakes and governmental policy failures are more rapidly transmitted to other markets by this process than was the case say twenty, or even ten, years ago.', 'moreover, there is little evidence to suggest that the rate of increase of financial transactions will slow materially in the years immediately ahead.', 'technology will continue to reduce the costs of finding and exploiting perceived differences in risk-adjusted rates of return around the world, helping to direct capital even more to its most efficient use.', 'already, covered rates of return on actively traded interest-rate instruments have been equalized among many industrial countries.', 'but the broader merging of world savings and investment markets, clearly, has not been achieved, largely because investors are fearful of investing in countries they do not understand to the extent that they do their own, or are uninformed of the opportunities.', 'one measure of this so-called home bias in world investments is the degree that portfolios remain substantially local.', 'foreign investments, on average, represent less than 10 percent of u.s. portfolios, for example.', 'the percentage of japanese portfolios is only slightly higher, and 15 percent of german portfolios is in foreign assets.', 'the partial exception is great britain, where, with a longer history of global financial involvement, one-third of portfolios is invested in foreign assets.', 'home bias in investments is considerably less than it was ten years ago, but we are still far from full globalization.', 'unless government restrictions inhibit the expansion of ever more sophisticated financial products that enable savers in one part of the world to reduce risk by investing in another, the bias will continue to diminish and the size of the international financial system will continue to expand at a significant pace.', 'it is this overall diversification, and hence lowering of risk, that an effective international financial system offers.', 'it facilitates the ever more efficient functioning of the global economic system and, hence, is a major contributor to rising standards of living worldwide.', 'nonetheless, there are those who ask whether the price of so sophisticated a financial system is too high.', 'would it not be better to slow it down a bit, and perhaps achieve a system somewhat more forgiving of mistakes, even recognizing that such a slowing may entail some shortfall in long-term economic growth?', 'even if we could implement such a tradeoff, with only minor disruption, should we try?', 'for centuries groups in our societies have railed against, and endeavored on occasion to destroy, new inventions.', 'fortunately for us the luddites and their ilk failed, and recent generations have enjoyed the fruits of those technologies.', 'moreover such a slowdown may not even be possible -- at least without major disruption and cost.', 'newer technologies, especially advanced telecommunications, make it exceptionally difficult for open markets, with associated opportunities, to be suppressed.', "price and capital controls, which might have been feasible a half century ago, would be very difficult to implement in today's more technologically advanced environment.", 'tinkering at the edges of our system in order to produce a less frenetic pace of change would be easily circumvented.', 'arguably, it would take massive government controls to substantially slow the advance toward greater efficiency of our systems.', 'this would surely produce a far more negative impact on economic growth than would be acceptable to even the most ardent advocates of reining in the rapid expansion of our international financial system.', 'if, as i suspect, it turns out after due deliberation and analysis, that slowing the pace of financial modernization is not in fact seen as a feasible alternative, what policy alternatives confront the international financial community to contain the periodic disruptions that are bound to occur in any free market economy?', 'a financial system, like all structures, is as strong as its weakest link.', 'as the international financial system has become even more complex, the particular areas of weakness to be addressed have changed.', "at the risk of oversimplification, let's examine some of the key links of our current infrastructure.", 'today, the organized exchanges and over-the-counter markets of industrial countries can handle massive volumes of transactions.', 'even in emerging countries exchanges are developing and expanding.', 'in contrast, during the world-wide stock market crash of october 1987, the transactions systems were under severe stress and, indeed, some broke down, incapable of handling the enlarged volumes.', 'at that time, the hong kong stock exchange could not open for several days.', 'the new york stock exchange was straining badly under the near 400 million daily share volume of late october 1987, with long reporting delays creating uncertainties that, doubtless, exaggerated the price declines.', 'those weaker links have since been strengthened by large infrastructure investments.', 'almost 1.2 billion shares traded on the nyse on october 28 of this year, three times the 1987 volumes with no evident problems or delays.', 'our equity, debt, and foreign exchange trading systems, and their peripheral futures and options markets have functioned well under stress recently.', 'these systems are not weak links in the developed economies, nor, for the most part are they in other economies.', 'neither is the payment system, that complex network, which transfers funds and securities in huge and growing volumes domestically and internationally, rapidly and efficiently.', 'the private and public sectors across the globe have endeavored diligently for years to expand the capacity of the system to meet the increasing demands put upon it.', 'and they have initiated and strengthened procedures for reducing risk in settling transactions, and diminishing uncertainties.', 'that they have generally succeeded is evident from the smoothness with which huge volumes of funds produced under recent stressed market conditions were transferred and settled with finality, through various netting and clearing arrangements.', 'banks are another matter.', 'these are highly leveraged institutions, financed in part by interbank credits and, hence, prone to crises of confidence that can quickly spread.', 'in most developed nations banking systems appear reasonably solid.', 'japan has been somewhat of an exception, but there have been some positive signs there, as well.', 'banks have been recognizing losses, and the government seems finally to be appropriately addressing their problems.', 'in a large number of emerging nations, as i indicated previously, banks are in poor shape.', 'lax lending has created a high incidence of non-performing loans, supported by inadequate capital, leaving banks vulnerable to declines in collateral values and non-performance by borrowers.', 'how can such deficient institutions be elevated to a level that would allow their economies to function effectively in our increasingly sophisticated international financial system?', 'certainly, improved cost and risk management and elimination of poor lending practices are a good place to start.', 'but these cannot be accomplished overnight.', 'loan officers with experience judging credit and market risks are in very short supply in emerging economies.', 'training will require time.', 'the same difficulties confront bank supervision and regulation.', 'important efforts in this area have been underway for several years through the auspices of the bank for international settlements, the international monetary fund, and the world bank.', 'but again, it will take time to develop adequate systems and trained personnel.', 'moreover, robust banking and financial systems require firmly enforced laws of contract, and transparent, market-oriented systems of corporate reporting and governance.', 'the current crisis in asia is, to a much greater extent than many previous crises, one of private, not public, debts, at least de jure.', 'arguably, the absence of efficient and transparent work-out arrangements for troubled private borrowers makes the problems more difficult to deal with.', 'efficient bankruptcy arrangements reduce disruptions to economic activity that often arise when losses have to be imposed on creditors.', 'many developing countries do not have good work-out arrangements for troubled debtors, and, as a result, governments in these countries often feel compelled to bail them out rather than accept the consequences of defaults.', 'the most troublesome aspect of many banking systems of emerging countries, to expand on the issue i raised earlier, is the widespread prevalence of loans driven by "industrial policy" imperatives rather than market forces.', 'what is wrong with policy -- that is, politically-driven -- loans?', 'potentially nothing if they were made to firms to finance expansions that just happened to coincide with a rise in consumer or business or overseas demand for their newly-produced products.', 'in these circumstances, the loan proceeds would have been profitably employed and the loan repaid at maturity with interest.', 'unfortunately, this is often not the case.', 'policy loans, in too many instances, foster misuse of resources, unprofitable expansions, losses, and eventually loan defaults.', 'in many cases, of course, these loans regrettably end up being guaranteed by governments.', 'if denominated in local currency, they can be financed with the printing press -- though with consequent risk of inflation.', 'too often, however, they are foreign-currency denominated, where governments face greater constraints on access to credit.', 'restructuring of financial systems, while indispensable, cannot be implemented quickly.', 'yes, the potential risks to the banking systems of many asian countries and the potential contagion effects for their neighbors, and other trading partners, should have been spotted earlier and addressed.', 'but flaws, seen clearly in retrospect, are never so evident at the time.', 'moreover, there is significant bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy.', 'there is often denial and delay in instituting proper adjustments.', 'recent propensities to obscure the need for change have been evidenced by unreported declines in reserves, issuance by the government of equivalents to foreign currency obligations, or unreported large new forward short positions against foreign currencies.', 'it is very difficult for political leaders to incur what they perceive as large, immediate political costs to contain problems they see as only prospective.', 'reality eventually replaces hope, and the cost of the delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive.', 'increased transparency for businesses and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers.', 'increased transparency can counter political bias in part by exposing for all to see the risks of current policies to stability as they develop.', 'under such conditions, failure to act would also be perceived as having political costs.', 'we should strongly stress to the newer members of the international financial system -- the emerging economies -- that they should accelerate the restructuring of their financial systems in their own interests.', 'but having delayed timely restructuring, many now find themselves with major shortfalls in bank liquidity and equity capital that put their systems at severe risk of collapse before any full restructuring is feasible.', 'the imf, the world bank, and their major shareholders, the developed countries, may wish to facilitate adjustment through temporary loans to governments and the encouragement of private equity infusions to these banking systems.', 'since any severe breakdown can have contagion effects on a world-wide basis, it is in our interest to do so.', 'these loans must be judged in their entirety.', 'they transform short-term obligations into medium-term loans, but they do so contingent on the country using the time to reform financial systems as well as adopt sound economic policies.', 'such conditionality accelerates the adjustments in financial systems needed to lay the foundation for resumption of robust, sustainable, growth, while cushioning to some degree the economic effects of the immediate crisis.', 'assistance without further reform of financial systems and economic policies would be worse than useless since it would foster expectations of being perpetually bailed out.', "that, in turn, could induce perverse behavior on the part of emerging nations' governments and of private sector investors in emerging nations.", 'believing that the international financial community will support these economies, in part by backstopping the obligations they incur, induces investors to commit more than they would otherwise.', 'this has tended in the past to push the expansion of investment beyond prudence -- given the limit of profitable opportunities.', 'as the international financial system becomes ever larger and more efficient, the size of the financial response -- whether to help banks or to add to foreign currency reserves -- may have to be correspondingly larger per unit of crisis, if i may put it that way -unless we alter our approach.', 'while it is precarious to generalize from one observation, it is likely that the mexican financial crisis of the 1980s was broader than in 1994-95, but the size of the assistance program, to set things right, was much larger in the latter than in the former case.', 'the reason appears to be that the increased efficiency of the financial system created a larger negative spillover, which had to be contained.', 'among other developments, the marked shift from bank credits in the earlier crisis, to a more securitized, anonymous, set of liabilities made workouts far more complex.', 'it is, hence, all the more essential that the weaker links in our international financial system, the banking systems of the emerging nations, be strengthened.', 'preventive programs should be accelerated sufficiently far in advance of the next crisis to effectively thwart or contain it.', 'moreover, it is incumbent on governmental policymakers to insure that unstable economic environments do not induce or exacerbate international financial disruptions.', 'but governments and international financial institutions should be brought on the scene only rarely.', 'to do otherwise risks the perverse incentives i spoke of earlier.', 'markets should be allowed to work.', "recent events in asia have sharpened our understanding of the complexity of today's international capital flows and, presumably, of similar episodes that may emerge in the future.", 'the rapid integration of national financial systems has fostered the growth of trade and standards of living worldwide.', 'it has also forced a review of the soundness and viability of our burgeoning financial systems.', 'we should welcome such pressures even as they impose challenges to all of us.', 'the end result is very worthwhile having.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman of the Board	US
https://www.bis.org/review/r971208c.pdf	Mr. Camdessus considers the lessons from Southeast Asia (Central Bank Articles and Speeches, 13 Nov 97)	Remarks by the Managing Director of the International Monetary Fund, M. Michel Camdessus, at a press briefing in Singapore, on 13/11/97.	1997-11-13 00:00:00	Mr. Camdessus considers the lessons from Southeast Asia Remarks by the Managing Director of the International Monetary Fund, M. Michel Camdessus, at a press briefing in Singapore, on 13/11/97. How could events in Southeast Asia unfold as they did, after so many years of outstanding performance? We have a fairly clear analysis of what happened in Thailand. The more difficult question is how the crisis spread so quickly to other economies in the region. I'm not sure we have the full picture yet, but let me give you my perspective on the causes of the crisis and where we go from here. I. How could it happen? Certainly, the Thai crisis did not strike out of the clear blue sky. On the contrary, there were numerous signs of a gathering storm. Macroeconomic indicators pointed to substantial imbalances: substantial real exchange rate appreciation; a marked slowdown in export growth; a persistently large current account deficit financed increasingly by portfolio inflows, including a substantial amount of short-term capital; and rising external debt. These problems, in turn, exposed other weaknesses in the Thai economy, including substantial, unhedged foreign currency-denominated borrowing by the private sector, an inflated domestic property market, and a weak and over-exposed banking system. Markets issued their own warnings in the form of declining equity prices and mounting exchange rate pressure, as doubts about the sustainability of policies grew. And as you know, the Fund also stressed these problems and pressed for urgent measures in a continuous dialogue with the Thai authorities. It was, of course, difficult for the authorities in Thailand and elsewhere in the region to recognize, after so many years of outstanding macroeconomic performance, that serious underlying deficiencies could seriously jeopardize their track record. This certainly contributed to the delay in taking the necessary corrective action. And at last, in the absence of convincing policy action, the storm broke. We all have been troubled by developments in the Thai economy, both because they have been so costly for Thailand and its neighbors and because they were so preventable. But at least their origins are by and large clear. What is less evident, and therefore more unsettling to all who are trying to make sense of broader regional developments, is how the crisis spread as it did to economies such as Indonesia, Malaysia and the Philippines, where current account deficits were generally smaller and foreign direct investment more substantial. Although it may be some time yet before we have the complete answer to this question, some elements of the explanation are becoming clear. Part of the explanation lies in the extent to which developments in Thailand have affected conditions in neighboring countries. For example, in expectation that the depreciation of the baht would erode the competitiveness of Thailand's trade competitors, their currencies also weakened. And as these currency slides acquired an almost self-perpetuating character, the debt service costs of the domestic private sector increased. Uncertainty about how far these currencies would slide and how much debt service costs would increase encouraged a rush to hedge external liabilities that only intensified exchange rate and interest rate pressures. Another factor is that problems in the Thai economy prompted markets to take a closer look at the risks in other countries. And what they saw -- to different degrees in different places -- were many of the same problems affecting Thailand: among them, overvalued real estate markets, weak and over-extended banking sectors, poor prudential supervision, and substantial private short-term borrowing in foreign currency. Moreover, after Thailand, markets began to look more critically at weaknesses they had previously considered minor, or at least manageable in an orderly way, given time. I see two other factors that hastened the stampede: one, the lack of transparency, and hence the increased uncertainty, about government and central bank operations, about the true state of financial sectors, about the links between banks, industry, and government and the impact these links might have on economic policy; and two, the controls -- and threat of controls -- on market activity. Given the tendency of financial markets participants to run with the herd, this was a sure-fire way to send the herd scrambling for safer pastures and set back efforts to restore confidence. II. What lessons should we draw from all of this? The first lesson is the most obvious one: the necessity of taking early action to correct macroeconomic imbalances before they precipitate a crisis. This did not happen in Thailand, despite timely and vigorous warnings. On the contrary, policymakers attacked the symptom of the crisis, the pressure on the baht, accumulating large reserve losses and forward foreign exchange liabilities in the process. This, together with delays in addressing Thailand's severe financial sector problems and lingering political uncertainties, clearly contributed to a deepening of the crisis and its spread to other economies in the region. The second lesson is that other countries can find that their vulnerability to crises in other markets is greater than economic fundamentals would suggest. Consequently, they need to take pre-emptive actions to strengthen their policies. Where might such action be needed? Several suggestions come to mind: • one, maintaining an appropriate exchange rate and exchange rate regime. Clearly, there is no single "right" choice, but more flexible exchange rates can help provide early and visible signals of the need for policy adjustments and are less likely to invite reckless behavior on the part of borrowers and lenders. But regardless of the exchange rate arrangement chosen, appropriate macroeconomic policies are essential to ensure its success; • two, maintaining a proper policy mix -- among other reasons -- so that high domestic interest rates do not damage the domestic economy, attract excessive amounts of short-term capital, or preclude further monetary tightening if market conditions require; indeed, it is important to keep the option of using the interest rate instrument open, so that the authorities have some room for manoeuvre in times of international instability; • three, strengthening structural policies -- especially the policies and institutions such as better prudential supervision, needed to underpin a sound financial system; • and four, carrying out other supporting reforms -- what we call "second generation" reforms -- to promote domestic competition, increase transparency and accountability, improve governance, help ensure that the benefits of future growth are widely shared, and otherwise strengthen the foundations for future growth. III. Restoring confidence As developments have shown, confidence, once lost, is hard to regain. Restoring confidence takes a strong commitment to economic adjustment and reform demonstrated by the implementation of often painful measures. It also requires a free flow of timely, accurate, and comprehensive information so that markets can assess the extent of underlying problems and the seriousness of efforts to correct them and uncertainty can be reduced. And, of course, restoring confidence takes time. This process is now under way in Southeast Asia. With the support of the IMF, Japan, and a number of other countries in the region, Thailand has launched a courageous and comprehensive program that addresses the problems of large external deficits and troubled financial institutions. As a result, the budget is moving back into surplus and a comprehensive restructuring of the financial sector is getting under way. The Philippines, for its part, has taken necessary measures and extended its program with the IMF under which a substantial amount of economic adjustment and reform had already taken place. Malaysia is also adapting to changing conditions by scaling back investment plans, tightening its fiscal stance, and strengthening prudential banking regulations. Indonesia has strengthened its policy stance in continuous dialogue with us, and has recently reached agreement with the Fund on a major program consisting of: strong monetary and fiscal policies to bring about orderly adjustment in the economy and restore confidence to financial markets; a major restructuring of the financial sector, along with measures to ensure its future soundness; and significant deregulation measures and trade reforms that should improve economic efficiency immediately and over the longer term. The Fund has agreed to support this program with a loan of $10 billion in a total package of $23 billion, of which $18 billion will consist of multilateral financing. On top of that, a contingency safety net is being established through which an important group of countries have declared their readiness to complement our package in the case of unexpected need. Naturally, it will take time for these efforts to bear fruit. But developments in recent months have by no means wiped out the achievements of past decades. On the contrary, the region's longer term fundamentals -- including its high domestic saving rates, strong fiscal positions, dynamic private sectors, and recent gains in competitiveness -- remain favorable. Moreover, all of these countries still have a long way to go to catch up with advanced economies. Thus, with sound policies, they should be able to sustain high rates of growth for another two decades or more. In the less distant future, growth can be expected to rebound strongly after a relatively short, but sharp, weakening of economic activity, especially in Thailand, and a rapid narrowing of external deficits. In fact, we are already seeing improvements in exports, even though recent exchange rate changes have not had much opportunity yet to generate their effects. And as these adjustments take place, each of these countries will have seized the opportunity to strengthen their economies in fundamental ways. This leads me to agree with those in the region who see this crisis not as a blight on the future, but as a blessing in disguise. Indeed, after this period of adjustment, these economies will emerge stronger than before. In the meantime, I hope that some perspective about the benefits of global markets will be maintained. First, we must give credit where credit is due: the capital provided by global markets has been a key factor in Southeast Asia's exceptional growth rates and its ability to lift so many out of poverty. Certainly, there are risks in tapping global markets to which no country is immune. At times, markets can be slow to react to changes in economic conditions and then react sharply; and in some instances, herd instinct seems to prevail. But let us not forget that markets also provide tremendous opportunities to accelerate growth and development, as Southeast Asia itself so vividly shows. Thus, the lesson to be drawn from recent developments is not about the risks of global markets, but rather about the importance of approaching markets in a responsible manner -- with strong macroeconomic fundamentals and sound structural policies that give markets confidence and therefore encourage long-term investment; with respect for the signals that markets provide; and with transparent and market-friendly policies that allow markets to allocate resources efficiently. IV. Perspectives for stronger regional cooperation Spillover and contagion effects can be so rapid, so costly, to countries with basically sound policies, that every country has an obligation to keep its own house in order. No country should run the risk of becoming the tinder for a wider conflagration. At the same time, there is also much that can be done on a regional and multilateral basis to bolster the efforts of individual countries seeking to manage their economies well. At the regional level, countries can make a valuable contribution to regional and global stability by joining voluntarily with their neighbors in mutual surveillance. The objective should be to complement IMF surveillance by developing a "club spirit" through which neighboring countries can encourage one another -- and, at times, exert some peer pressure on one another -- to pursue sound policies. We welcome the efforts being made in this direction in various fora. To be effective, such regional surveillance will, of course, have to be based on sound economic analysis. In this connection, the management and staff of the IMF are ready to contribute to regional surveillance in Asia, as they already do in Europe, the G-7, and other fora. Indeed, one of the tasks of our new regional office in Tokyo could be to help promote more intensive regional surveillance. V. The response of the Fund At the multilateral level, the international community sees it as indispensable to work and cooperate through a central institution, the IMF, in order to help countries deal with the opportunities and risks of globalization. And given the challenges of the global financial markets, the international community has encouraged the Fund to strengthen its capacity in this respect. The Fund's response centers on four broad areas. First, we have strengthened Fund surveillance, which, as you know, lies at the heart of the IMF's efforts to maintain an orderly international monetary system. In order to detect financial tensions as early as possible, we have sought to make our dialogue with member countries more continuous and probing and put more emphasis on the continuous and timely provision of accurate data. We are also concentrating more on policies decided at a regional level, on the regional implications of national economic policies, on banking and financial sector soundness, and on the policies and institutions that sound financial systems require. Second, we are doing what we can to help markets function more smoothly. Considerable progress has been made in liberalising current account transactions worldwide so that countries can take advantage of the opportunities offered by the expansion of world trade. Now, we must turn our attention to fostering an orderly liberalization of capital account transactions, so that countries can also reap the benefits of global capital markets, while minimizing their risks. To this end, IMF members have agreed that the Fund's charter should be amended to make the liberalization of capital movements one of the purposes of the Fund and to extend the Fund's jurisdiction to capital movements, with appropriate safeguards, including transitional arrangements, to ensure that liberalization is neither premature nor unduly delayed. At the same time, the IMF is actively encouraging all countries to be transparent about their economic performance by improving the dissemination of economic and financial data to the public. Greater transparency will help strengthen market discipline and avoid market surprises that can lead to disruptive market reactions. To this end, the Fund has developed a set of standards regarding the quality, coverage, frequency, and timeliness of data made available to the public and has established a Dissemination Standards Bulletin Board on the Internet to which 43 economies have now subscribed, including Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, and Thailand. Procedures have also been put in place through which countries can make known to the markets, and to the public in general, the Fund's views on their economic policies and situation. Recognizing the importance for growth of creating an environment that encourages private sector activity, the Fund has also become more active -- in close collaboration with the World Bank, regional development banks, and others -- in promoting the "second generation" reforms that I referred to earlier. These include developing an institutional framework that will, among other things, provide an efficient, professional justice system, help limit arbitrary and corrupt government practices, and set clear regulatory and supervisory standards for markets, including financial markets. They also include policies to improve the quality of public expenditure, making adequate allocations for education and health to help ensure that individuals are able to realize their potential to participate actively in a market economy, and providing social protection to those who bear the brunt of the changes of a dynamic economy. Third, the Fund has taken action on several fronts to strengthen its resource base and adapt its procedures and financing facilities. As you may know, the membership has just agreed to an increase of 45 percent, equivalent to about $90 billion, in IMF quotas. This will raise the capital base of the institution to some $290 billion. In addition, the Fund has taken steps to augment its financial resources through the agreement on the New Arrangements to Borrow. Under these arrangements, participants would be prepared to lend up to the equivalent of some $47 billion when additional resources are needed to forestall or cope with an impairment of the international monetary system, or deal with an exceptional situation that poses a threat to the stability of the system. We hope that participants who have not yet done so will complete the necessary legislative action so that these arrangements can enter into force soon. Furthermore, in order to allow all members to participate on an equitable basis in the SDR system, agreement has been reached on a proposal to amend the Fund's Articles of Agreement to authorize a special one-time allocation of SDRs of about $30 billion that would equalize all members' ratios of SDR allocations to quotas and would double the amount of SDRs allocated to date. These resources will supplement members' reserves, giving them more flexibility in economic policies and a cushion against adverse developments. Last but not least, recent experience has demonstrated once again that early warnings cannot always prevent crisis from blowing up. This makes it indispensable for the international community to strengthen the financial capacity of its central monetary institution to assist countries in a crisis situation. This is also why the Fund has established an emergency financing mechanism to allow financial assistance to be provided more speedily, when countries facing external crises are willing to take strong corrective action. This mechanism was used effectively to expedite the recent programs for the Philippines, Thailand, and Indonesia. Even if it would be naive to believe that such programs could produce an immediate return to the status quo ante, we are confident that once these programs have produced their full effects in the next months, these economies will be in a much better position to start growing again at a strong, but more sustainable, rate. In conclusion, these are trying times in Southeast Asia. But the mechanisms are in place at the national and multilateral levels-and soon, I hope, at the regional level -- to enable your countries not just to pull through this crisis, but to emerge stronger than before. The only other pre-requisite for your success is the resolve to put current problems behind you. I see no reason why we will not see the same determination in Southeast Asia in the future as we have seen in the past.	['mr. camdessus considers the lessons from southeast asia remarks by the managing director of the international monetary fund, m. michel camdessus, at a press briefing in singapore, on 13/11/97.', 'how could events in southeast asia unfold as they did, after so many years of outstanding performance?', 'we have a fairly clear analysis of what happened in thailand.', 'the more difficult question is how the crisis spread so quickly to other economies in the region.', "i'm not sure we have the full picture yet, but let me give you my perspective on the causes of the crisis and where we go from here.", 'i. how could it happen?', 'certainly, the thai crisis did not strike out of the clear blue sky.', 'on the contrary, there were numerous signs of a gathering storm.', 'macroeconomic indicators pointed to substantial imbalances: substantial real exchange rate appreciation; a marked slowdown in export growth; a persistently large current account deficit financed increasingly by portfolio inflows, including a substantial amount of short-term capital; and rising external debt.', 'these problems, in turn, exposed other weaknesses in the thai economy, including substantial, unhedged foreign currency-denominated borrowing by the private sector, an inflated domestic property market, and a weak and over-exposed banking system.', 'markets issued their own warnings in the form of declining equity prices and mounting exchange rate pressure, as doubts about the sustainability of policies grew.', 'and as you know, the fund also stressed these problems and pressed for urgent measures in a continuous dialogue with the thai authorities.', 'it was, of course, difficult for the authorities in thailand and elsewhere in the region to recognize, after so many years of outstanding macroeconomic performance, that serious underlying deficiencies could seriously jeopardize their track record.', 'this certainly contributed to the delay in taking the necessary corrective action.', 'and at last, in the absence of convincing policy action, the storm broke.', 'we all have been troubled by developments in the thai economy, both because they have been so costly for thailand and its neighbors and because they were so preventable.', 'but at least their origins are by and large clear.', 'what is less evident, and therefore more unsettling to all who are trying to make sense of broader regional developments, is how the crisis spread as it did to economies such as indonesia, malaysia and the philippines, where current account deficits were generally smaller and foreign direct investment more substantial.', 'although it may be some time yet before we have the complete answer to this question, some elements of the explanation are becoming clear.', 'part of the explanation lies in the extent to which developments in thailand have affected conditions in neighboring countries.', "for example, in expectation that the depreciation of the baht would erode the competitiveness of thailand's trade competitors, their currencies also weakened.", 'and as these currency slides acquired an almost self-perpetuating character, the debt service costs of the domestic private sector increased.', 'uncertainty about how far these currencies would slide and how much debt service costs would increase encouraged a rush to hedge external liabilities that only intensified exchange rate and interest rate pressures.', 'another factor is that problems in the thai economy prompted markets to take a closer look at the risks in other countries.', 'and what they saw -- to different degrees in different places -- were many of the same problems affecting thailand: among them, overvalued real estate markets, weak and over-extended banking sectors, poor prudential supervision, and substantial private short-term borrowing in foreign currency.', 'moreover, after thailand, markets began to look more critically at weaknesses they had previously considered minor, or at least manageable in an orderly way, given time.', 'i see two other factors that hastened the stampede: one, the lack of transparency, and hence the increased uncertainty, about government and central bank operations, about the true state of financial sectors, about the links between banks, industry, and government and the impact these links might have on economic policy; and two, the controls -- and threat of controls -- on market activity.', 'given the tendency of financial markets participants to run with the herd, this was a sure-fire way to send the herd scrambling for safer pastures and set back efforts to restore confidence.', 'what lessons should we draw from all of this?', 'the first lesson is the most obvious one: the necessity of taking early action to correct macroeconomic imbalances before they precipitate a crisis.', 'this did not happen in thailand, despite timely and vigorous warnings.', 'on the contrary, policymakers attacked the symptom of the crisis, the pressure on the baht, accumulating large reserve losses and forward foreign exchange liabilities in the process.', "this, together with delays in addressing thailand's severe financial sector problems and lingering political uncertainties, clearly contributed to a deepening of the crisis and its spread to other economies in the region.", 'the second lesson is that other countries can find that their vulnerability to crises in other markets is greater than economic fundamentals would suggest.', 'consequently, they need to take pre-emptive actions to strengthen their policies.', 'where might such action be needed?', 'several suggestions come to mind: • one, maintaining an appropriate exchange rate and exchange rate regime.', 'clearly, there is no single "right" choice, but more flexible exchange rates can help provide early and visible signals of the need for policy adjustments and are less likely to invite reckless behavior on the part of borrowers and lenders.', 'but regardless of the exchange rate arrangement chosen, appropriate macroeconomic policies are essential to ensure its success; • two, maintaining a proper policy mix -- among other reasons -- so that high domestic interest rates do not damage the domestic economy, attract excessive amounts of short-term capital, or preclude further monetary tightening if market conditions require; indeed, it is important to keep the option of using the interest rate instrument open, so that the authorities have some room for manoeuvre in times of international instability; • three, strengthening structural policies -- especially the policies and institutions such as better prudential supervision, needed to underpin a sound financial system; • and four, carrying out other supporting reforms -- what we call "second generation" reforms -- to promote domestic competition, increase transparency and accountability, improve governance, help ensure that the benefits of future growth are widely shared, and otherwise strengthen the foundations for future growth.', 'restoring confidence as developments have shown, confidence, once lost, is hard to regain.', 'restoring confidence takes a strong commitment to economic adjustment and reform demonstrated by the implementation of often painful measures.', 'it also requires a free flow of timely, accurate, and comprehensive information so that markets can assess the extent of underlying problems and the seriousness of efforts to correct them and uncertainty can be reduced.', 'and, of course, restoring confidence takes time.', 'this process is now under way in southeast asia.', 'with the support of the imf, japan, and a number of other countries in the region, thailand has launched a courageous and comprehensive program that addresses the problems of large external deficits and troubled financial institutions.', 'as a result, the budget is moving back into surplus and a comprehensive restructuring of the financial sector is getting under way.', 'the philippines, for its part, has taken necessary measures and extended its program with the imf under which a substantial amount of economic adjustment and reform had already taken place.', 'malaysia is also adapting to changing conditions by scaling back investment plans, tightening its fiscal stance, and strengthening prudential banking regulations.', 'indonesia has strengthened its policy stance in continuous dialogue with us, and has recently reached agreement with the fund on a major program consisting of: strong monetary and fiscal policies to bring about orderly adjustment in the economy and restore confidence to financial markets; a major restructuring of the financial sector, along with measures to ensure its future soundness; and significant deregulation measures and trade reforms that should improve economic efficiency immediately and over the longer term.', 'the fund has agreed to support this program with a loan of $10 billion in a total package of $23 billion, of which $18 billion will consist of multilateral financing.', 'on top of that, a contingency safety net is being established through which an important group of countries have declared their readiness to complement our package in the case of unexpected need.', 'naturally, it will take time for these efforts to bear fruit.', 'but developments in recent months have by no means wiped out the achievements of past decades.', "on the contrary, the region's longer term fundamentals -- including its high domestic saving rates, strong fiscal positions, dynamic private sectors, and recent gains in competitiveness -- remain favorable.", 'moreover, all of these countries still have a long way to go to catch up with advanced economies.', 'thus, with sound policies, they should be able to sustain high rates of growth for another two decades or more.', 'in the less distant future, growth can be expected to rebound strongly after a relatively short, but sharp, weakening of economic activity, especially in thailand, and a rapid narrowing of external deficits.', 'in fact, we are already seeing improvements in exports, even though recent exchange rate changes have not had much opportunity yet to generate their effects.', 'and as these adjustments take place, each of these countries will have seized the opportunity to strengthen their economies in fundamental ways.', 'this leads me to agree with those in the region who see this crisis not as a blight on the future, but as a blessing in disguise.', 'indeed, after this period of adjustment, these economies will emerge stronger than before.', 'in the meantime, i hope that some perspective about the benefits of global markets will be maintained.', "first, we must give credit where credit is due: the capital provided by global markets has been a key factor in southeast asia's exceptional growth rates and its ability to lift so many out of poverty.", 'certainly, there are risks in tapping global markets to which no country is immune.', 'at times, markets can be slow to react to changes in economic conditions and then react sharply; and in some instances, herd instinct seems to prevail.', 'but let us not forget that markets also provide tremendous opportunities to accelerate growth and development, as southeast asia itself so vividly shows.', 'thus, the lesson to be drawn from recent developments is not about the risks of global markets, but rather about the importance of approaching markets in a responsible manner -- with strong macroeconomic fundamentals and sound structural policies that give markets confidence and therefore encourage long-term investment; with respect for the signals that markets provide; and with transparent and market-friendly policies that allow markets to allocate resources efficiently.', 'perspectives for stronger regional cooperation spillover and contagion effects can be so rapid, so costly, to countries with basically sound policies, that every country has an obligation to keep its own house in order.', 'no country should run the risk of becoming the tinder for a wider conflagration.', 'at the same time, there is also much that can be done on a regional and multilateral basis to bolster the efforts of individual countries seeking to manage their economies well.', 'at the regional level, countries can make a valuable contribution to regional and global stability by joining voluntarily with their neighbors in mutual surveillance.', 'the objective should be to complement imf surveillance by developing a "club spirit" through which neighboring countries can encourage one another -- and, at times, exert some peer pressure on one another -- to pursue sound policies.', 'we welcome the efforts being made in this direction in various fora.', 'to be effective, such regional surveillance will, of course, have to be based on sound economic analysis.', 'in this connection, the management and staff of the imf are ready to contribute to regional surveillance in asia, as they already do in europe, the g-7, and other fora.', 'indeed, one of the tasks of our new regional office in tokyo could be to help promote more intensive regional surveillance.', 'v. the response of the fund at the multilateral level, the international community sees it as indispensable to work and cooperate through a central institution, the imf, in order to help countries deal with the opportunities and risks of globalization.', 'and given the challenges of the global financial markets, the international community has encouraged the fund to strengthen its capacity in this respect.', "the fund's response centers on four broad areas.", "first, we have strengthened fund surveillance, which, as you know, lies at the heart of the imf's efforts to maintain an orderly international monetary system.", 'in order to detect financial tensions as early as possible, we have sought to make our dialogue with member countries more continuous and probing and put more emphasis on the continuous and timely provision of accurate data.', 'we are also concentrating more on policies decided at a regional level, on the regional implications of national economic policies, on banking and financial sector soundness, and on the policies and institutions that sound financial systems require.', 'second, we are doing what we can to help markets function more smoothly.', 'considerable progress has been made in liberalising current account transactions worldwide so that countries can take advantage of the opportunities offered by the expansion of world trade.', 'now, we must turn our attention to fostering an orderly liberalization of capital account transactions, so that countries can also reap the benefits of global capital markets, while minimizing their risks.', "to this end, imf members have agreed that the fund's charter should be amended to make the liberalization of capital movements one of the purposes of the fund and to extend the fund's jurisdiction to capital movements, with appropriate safeguards, including transitional arrangements, to ensure that liberalization is neither premature nor unduly delayed.", 'at the same time, the imf is actively encouraging all countries to be transparent about their economic performance by improving the dissemination of economic and financial data to the public.', 'greater transparency will help strengthen market discipline and avoid market surprises that can lead to disruptive market reactions.', 'to this end, the fund has developed a set of standards regarding the quality, coverage, frequency, and timeliness of data made available to the public and has established a dissemination standards bulletin board on the internet to which 43 economies have now subscribed, including hong kong, indonesia, korea, malaysia, the philippines, singapore, and thailand.', "procedures have also been put in place through which countries can make known to the markets, and to the public in general, the fund's views on their economic policies and situation.", 'recognizing the importance for growth of creating an environment that encourages private sector activity, the fund has also become more active -- in close collaboration with the world bank, regional development banks, and others -- in promoting the "second generation" reforms that i referred to earlier.', 'these include developing an institutional framework that will, among other things, provide an efficient, professional justice system, help limit arbitrary and corrupt government practices, and set clear regulatory and supervisory standards for markets, including financial markets.', 'they also include policies to improve the quality of public expenditure, making adequate allocations for education and health to help ensure that individuals are able to realize their potential to participate actively in a market economy, and providing social protection to those who bear the brunt of the changes of a dynamic economy.', 'third, the fund has taken action on several fronts to strengthen its resource base and adapt its procedures and financing facilities.', 'as you may know, the membership has just agreed to an increase of 45 percent, equivalent to about $90 billion, in imf quotas.', 'this will raise the capital base of the institution to some $290 billion.', 'in addition, the fund has taken steps to augment its financial resources through the agreement on the new arrangements to borrow.', 'under these arrangements, participants would be prepared to lend up to the equivalent of some $47 billion when additional resources are needed to forestall or cope with an impairment of the international monetary system, or deal with an exceptional situation that poses a threat to the stability of the system.', 'we hope that participants who have not yet done so will complete the necessary legislative action so that these arrangements can enter into force soon.', "furthermore, in order to allow all members to participate on an equitable basis in the sdr system, agreement has been reached on a proposal to amend the fund's articles of agreement to authorize a special one-time allocation of sdrs of about $30 billion that would equalize all members' ratios of sdr allocations to quotas and would double the amount of sdrs allocated to date.", "these resources will supplement members' reserves, giving them more flexibility in economic policies and a cushion against adverse developments.", 'last but not least, recent experience has demonstrated once again that early warnings cannot always prevent crisis from blowing up.', 'this makes it indispensable for the international community to strengthen the financial capacity of its central monetary institution to assist countries in a crisis situation.', 'this is also why the fund has established an emergency financing mechanism to allow financial assistance to be provided more speedily, when countries facing external crises are willing to take strong corrective action.', 'this mechanism was used effectively to expedite the recent programs for the philippines, thailand, and indonesia.', 'even if it would be naive to believe that such programs could produce an immediate return to the status quo ante, we are confident that once these programs have produced their full effects in the next months, these economies will be in a much better position to start growing again at a strong, but more sustainable, rate.', 'in conclusion, these are trying times in southeast asia.', 'but the mechanisms are in place at the national and multilateral levels-and soon, i hope, at the regional level -- to enable your countries not just to pull through this crisis, but to emerge stronger than before.', 'the only other pre-requisite for your success is the resolve to put current problems behind you.', 'i see no reason why we will not see the same determination in southeast asia in the future as we have seen in the past.']	M Camdessus	International Monetary Fund	Managing Director	IMF
https://www.bis.org/review/r971208b.pdf	Mr. Fazio considers the issue of efficiency and instability in global finance (Central Bank Articles and Speeches, 20 Nov 97)	Address given by the Governor of the Bank of Italy, Dott. Antonio Fazio, at an international conference celebrating 50 years of Quarterly Review/Moneta e Credito in Rome, on 20/11/97.	1997-11-20 00:00:00	Mr. Fazio considers the issue of efficiency and instability in global finance Address given by the Governor of the Bank of Italy, Dott. Antonio Fazio, at an international conference celebrating 50 years of Quarterly Review/Moneta e Credito in Rome, on 20/11/97. In the wake of the Great Depression and the Second World War, the new monetary system set up by the Bretton Woods agreements, together with the liberalisation and expansion of international trade, laid the foundations for a long period of economic growth and stability. From 1950 to 1973 the world economy grew at an annual rate of 4.9%; the industrial countries achieved 4.4%, Latin America, Asia and Oceania a higher rate. Inflation was a little above 3% in the industrial countries and less than 5% in the world as a whole. The economic devastation of the Great Depression had undermined the classical vision of the economy based on the hypothesis of equilibrium, in which the action of policy-makers was constrained by the rigid rules of the gold standard. Following Keynes, in the new monetary order economic policies were assigned a pre-eminent role in governing the cycle. Controls were imposed on capital movements to permit interest rates to be managed in pursuit of domestic objectives. The liberalisation of trade contrasted with a segmentation of the market for savings and financial assets on a national basis. Current account imbalances were to be promptly corrected by means of a fiscal policy serving to re-establish the equality between saving and investment. The system broke down in August 1971, with the suspension of the dollar's convertibility into gold. The main cause of the crisis lay in the US budget and balance-of-payments deficits, which generated an overhang that was incompatible with the dollar's role of anchor. Other factors included economic policies in most countries focused primarily on domestic growth and employment, the rise in public expenditure in relation to GDP, the emergence of international financial markets and increasingly large flows of hot money, which reduced the effectiveness of the restrictions on capital movements. In a situation where monetary policies were still concerned with the control of interest rates rather than credit flows and the quantity of money, floating rates ended up by fostering an increase in inflation in the industrial countries and in the rest of the world. Monetary growth in the leading industrial countries continued, at an annual rate of 13%. The oil crisis had an impact that was simultaneously inflationary and recessionary. The growth rate of the industrial countries slowed to around 2.5% in the years from 1973 to 1980, inflation accelerated to 10%. Except in Germany, where monetary policy was directed with greater determination to controlling inflation, the 1970s were marked by high negative real interest rates. The shift in US monetary policy introduced by Paul Volcker in 1979 gave priority to controlling the quantities of credit and money; interest rates rose sharply to well above the inflation rate. The upward movement spread to all the other leading countries. 1. Global finance During the 1980s flexibility of the exchange rates between the main economic regions of the world was accompanied by the dismantling of the barriers to capital movements. Growth in the industrial countries was no more rapid than in the previous decade; it slowed in the 1990s. The persistence of budget deficits and large external imbalances, the rapid advances in data processing and telecommunications, financial innovation and the activity of institutions that collect and invest savings on a world scale all contributed to the creation of a single, global market for currencies and finance. The harbinger of this development was the growth of the Eurodollar market, which had been boosted in the 1970s by the recycling of the surpluses of the oil-producing countries. The new conditions made it possible for countries to adopt a gradualist approach to correcting budget and, above all, external deficits; it was no longer necessary for saving to equal investment in any given period. The global market was fuelled by the steady accumulation of external debt by the United States and the build-up of a net credit position by Germany and Japan. In all the leading industrial countries except the United Kingdom public debt continued to rise in relation to GDP. Gross financial assets and liabilities continued to grow much more rapidly than economic activity. Between 1982 and 1995 the total liabilities of the six largest industrial countries rose from US$ 25 trillion to US$ 110 trillion and from four to six times their GDP. Over the same period the degree of financial integration increased; today, external liabilities are equal to 60% of GDP. The growth in foreign exchange trading proceeded apace. Favourable investment opportunities encouraged huge flows of capital into the emerging economies; high rates of economic growth were often coupled with large balance-of-payments deficits and stable exchange rates. Foreign investment in these markets increased from US$ 50 billion in 1990 to US$ 200 billion in 1995. In the OECD countries the assets managed by institutional investors rose over the same period from US$ 14 trillion to US$ 23 trillion and from 85 to 102% of the area's GDP. These intermediaries manage portfolios that tend to be global and take on technically complex risks. They can modify the composition of their assets extremely rapidly even for the sake of making small gains; they exploit the arbitrage opportunities stemming from fiscal segmentation or price differences between different financial centres. 2. Efficiency and stability Savings are now freer to flow towards what investors consider the most profitable investment opportunities. This results in a more efficient allocation of the resources available, support for capital formation and better growth prospects, especially for backward economies. The increase in lending to the developing countries, where the return on capital is higher, is certainly evidence of the markets' efficiency; on the other hand it brings with it the problem of the sustainability of these countries' foreign debt and the associated risks for stability, including that of the international financial system. The Mexico crisis and that still open in South-East Asia, like the debt crisis of the early 1980s in Latin America, have shown that a large inflow of funds can temporarily prop up unsustainable economic conditions. Anchoring the national currency to strong currencies when economic policies are inadequate causes the real exchange rate to rise, creating the conditions for a crisis. Insufficient supervision of banks and markets is a contributory factor. The liquidity of markets, the belief that securities can be sold without incurring substantial losses can lead to an erroneous perception of the risk. Widespread expectations that the international organisations will intervene can accentuate behaviour on the part of intermediaries that is not consistent with the riskiness of investments. It is becoming increasingly important to ensure sound and orderly economic conditions and at the same time to strengthen and enhance the effectiveness of the supervision of intermediaries and markets at the supranational as well as the national level, with the aim of forestalling systemic crises. The restrictive monetary policies adopted in the industrial countries brought annual inflation down from 10% in the 1970s to 5.8% in the 1980s. In the 1990s the objectives have become more ambitious; inflation has fallen further, to an average of 3.1%. Prices have also slowed down considerably in the last three years in the countries of eastern Europe and above all in Latin America. Real interest rates rose substantially in the industrial countries in the 1980s and 1990s. They increased by around 6 percentage points in the early 1980s in response to the change in the focus of US monetary policy. Real long-term rates stood at about 5% in the first half of the 1980s. Today, excluding Japan, they still stand at around 4%, above the rate of economic growth. The high level of real interest rates is a reflection of the high returns that can be earned on investments in the emerging countries and the growing risks of a financial nature, which, even though they originate in national markets, affect the whole system. To an even greater extent, with the money supply constant or even slightly declining in relation to GDP as a consequence of rigorous monetary policies, real interest rates are influenced by the rapid growth in the volume of private and, above all, public sector securities. The ratio of the quantity of money to nominal output has held steady or fallen a little in the leading countries in the 1990s; in 1996 it stood at about 64%. After rising sharply in the 1980s, international liquidity as measured by cross-border deposits has remained virtually unchanged. For the private sector to acquire the growing stock of financial assets, real interest rates have to be high; the growth in public debt, due first and foremost to the imbalances in social security systems, is a source of pressure on real resources. The gap between interest rates and economic growth rates is a cause of rising unemployment. 3. Italy's role in international finance In the course of the 1990s, with the complete liberalisation of capital movements, Italy has become a full participant in the international financial markets. Gross capital inflows and outflows have increased enormously. This process has sustained the accumulation of financial assets and encouraged residents to diversify their portfolios by type of instrument, country of issue and currency of denomination. Between 1990 and 1996 net portfolio investment abroad by the private sector amounted to 190 trillion lire, accounting for 9% of the growth in total financial assets. The share of foreign instruments in the total financial assets of the private sector rose from 6% at the end of 1989 to 14% at the end of 1996. The growing flow of savings invested abroad also reflects a domestic supply of financial instruments that is still not sufficiently diversified in terms of risks and returns. Italy's participation in the global market of finance has encouraged foreign capital inflows, mainly directed towards the government securities market. At the end of last year non-residents held 370 trillion lire of Italian government securities or 20% of the total amount outstanding, compared with 4% at the end of the 1980s. When doubts have emerged about the soundness of economic policy, foreign capital inflows have ceased suddenly and given way to outflows, supplemented by substantial exports of Italian capital. In late 1992 and again in early 1995 non-residents disposed of very large quantities of Italian securities; at the same time residents' purchases of foreign financial assets increased considerably. These outflows put the lira and securities prices under very heavy pressure. The reaffirmation of monetary policy's counter-inflationary commitment, the continuation, albeit with pauses, of the efforts to adjust the public finances, and the policy of wage moderation were decisive in easing the pressure and restoring conditions for a stable inflow of capital from abroad. Looking ahead to a situation of recovery in economic activity and a reduction in the external current account surplus, the diversification of residents' financial portfolios will not put pressure on the exchange rate if non-residents continue to buy large amounts of Italian securities. During the current year, characterised by favourable expectations regarding the Italian economy and the prospects for Economic and Monetary Union, non-residents' purchases of government securities, totalling more than 80 trillion lire up to September, have contributed to the sharp contraction in the long-term interest rate differential between Italy and the countries with a longer record of price stability and a lower level of public debt. Exports of Italian capital have also increased, however. One of the reasons for the gradualness with which monetary policy has been eased has been to ensure favourable conditions for foreign investment in Italy, taking into account the continual, structural outflow of Italian capital. As Economic and Monetary Union draws closer and national monetary policy's room for manoeuvre gradually narrows to the point of disappearing, the macroeconomic equilibrium of each country will come to depend increasingly on budgetary, incomes and structural policies. In the absence of changes in the relative values of currencies, imbalances will impinge on competitiveness, production and employment. Public spending in Italy is now equal to more than 50% of GDP. Reducing this ratio will make it possible to ease the burden of taxation and social security contributions. In order to enhance Italy's competitiveness and reduce the cost of labour, it is also necessary to remove the obstacles hindering competition in the markets for goods and arrive at a more flexible use of labour. 4. Concluding remarks In addition to benefiting the participating countries, the creation of a stable monetary area in Europe will contribute to the stability of the real and financial macroeconomy at the world level. In recent years Europe has been beset by modest growth and insufficient use of available resources; between 1990 and 1996 employment declined by 2 million units. Adverse factors include inefficiencies in some parts of the productive system, market rigidities and excessively large budgets. The implementation of a closer economic union and the soundness of money and finance over time cannot be entrusted exclusively to monetary policy. They require conditions of greater economic efficiency and the harmonisation of institutional arrangements in the participating countries. A sound currency requires a dynamic economy. Money is largely the product of the credit granted to firms and the State. The stability of its value does not depend only on the quantity in circulation but also on the efficient use of credit. Economic convergence must therefore be pursued not only in the nominal variables but also in labour productivity, a level of taxation that will enhance international competitiveness, and an efficient use of the resources the public sector appropriates. These are the conditions for a monetary union to have the necessary stability and solidity. The global market for currencies and finance influences the performance of all economies. The conditions in that market increasingly appear as exogenous variables of decisive importance. The macroeconomic equilibria of individual economies have to be related to the level and movements of interest rates determined in it and to the exchange rates established there between the leading currencies. The external constraint is increasingly taking the form of the need for each country and economic region to be in overall balance, in terms of financial assets and liabilities, with respect to the rest of the world. The development of the global financial market in the last ten years parallels that of national financial markets in the later nineteenth century and the first half of this century. The increase in financial activity within each national market, the expansion of credit and the development of intermediaries all made a decisive contribution to investment, production and employment. But the need rapidly emerged for overall control of money creation and even earlier for a system of prudential supervision of intermediaries' activities. Today's central banks are the result. At the international level the expansion in the nominal amounts of credit and money has no longer been limited by the availability of primary liquidity since the link with gold was broken. The present configuration of the market has evolved spontaneously, largely in conditions of fierce competition. However, given the nature of the variables involved, it is unlikely that a Pareto-efficient equilibrium will be reached. Money produces credit and credit produces more money; it is necessary to govern the growth of these aggregates; an anchor is needed to stabilise their value in terms of goods. In the absence of binding rules and appropriate policies, national economies and the international economy are exposed to the risks of inflation and instability in intermediaries and markets. This inflationary drift is likely to lead to speculative bubbles, excessive increases in the value of real and financial assets. The international crises that occur from time to time diminish the value of financial wealth and curb inflationary pressures at the world level. With many economies suffering from stagnation and poor fundamentals, the low cost and rapid expansion of dollar financing in the early 1990s and the subsequent restriction, together with the more recent monetary expansion in Japan and loss of value of the yen, have probably contributed to the instability of the global market for finance. The efforts, redoubled in recent years, to achieve monetary stability in most of the industrial countries, the banking supervision started by the Group of Ten for developed countries, its extension to the emerging countries and the surveillance performed by the IMF are playing a role of great systemic importance. Faced with open and competitive markets, the strengthening of cooperation helps to forestall crises, increases the efficacy of corrective action. Effective action by central banks, supervisory authorities and the IMF is a first response to the new problems of monetary and financial stability raised by the globalisation of markets; it may require more certain and firmly based international institutional arrangements.	['mr. fazio considers the issue of efficiency and instability in global finance address given by the governor of the bank of italy, dott.', 'antonio fazio, at an international conference celebrating 50 years of quarterly review/moneta e credito in rome, on 20/11/97.', 'in the wake of the great depression and the second world war, the new monetary system set up by the bretton woods agreements, together with the liberalisation and expansion of international trade, laid the foundations for a long period of economic growth and stability.', 'from 1950 to 1973 the world economy grew at an annual rate of 4.9%; the industrial countries achieved 4.4%, latin america, asia and oceania a higher rate.', 'inflation was a little above 3% in the industrial countries and less than 5% in the world as a whole.', 'the economic devastation of the great depression had undermined the classical vision of the economy based on the hypothesis of equilibrium, in which the action of policy-makers was constrained by the rigid rules of the gold standard.', 'following keynes, in the new monetary order economic policies were assigned a pre-eminent role in governing the cycle.', 'controls were imposed on capital movements to permit interest rates to be managed in pursuit of domestic objectives.', 'the liberalisation of trade contrasted with a segmentation of the market for savings and financial assets on a national basis.', 'current account imbalances were to be promptly corrected by means of a fiscal policy serving to re-establish the equality between saving and investment.', "the system broke down in august 1971, with the suspension of the dollar's convertibility into gold.", "the main cause of the crisis lay in the us budget and balance-of-payments deficits, which generated an overhang that was incompatible with the dollar's role of anchor.", 'other factors included economic policies in most countries focused primarily on domestic growth and employment, the rise in public expenditure in relation to gdp, the emergence of international financial markets and increasingly large flows of hot money, which reduced the effectiveness of the restrictions on capital movements.', 'in a situation where monetary policies were still concerned with the control of interest rates rather than credit flows and the quantity of money, floating rates ended up by fostering an increase in inflation in the industrial countries and in the rest of the world.', 'monetary growth in the leading industrial countries continued, at an annual rate of 13%.', 'the oil crisis had an impact that was simultaneously inflationary and recessionary.', 'the growth rate of the industrial countries slowed to around 2.5% in the years from 1973 to 1980, inflation accelerated to 10%.', 'except in germany, where monetary policy was directed with greater determination to controlling inflation, the 1970s were marked by high negative real interest rates.', 'the shift in us monetary policy introduced by paul volcker in 1979 gave priority to controlling the quantities of credit and money; interest rates rose sharply to well above the inflation rate.', 'the upward movement spread to all the other leading countries.', '1. global finance during the 1980s flexibility of the exchange rates between the main economic regions of the world was accompanied by the dismantling of the barriers to capital movements.', 'growth in the industrial countries was no more rapid than in the previous decade; it slowed in the 1990s.', 'the persistence of budget deficits and large external imbalances, the rapid advances in data processing and telecommunications, financial innovation and the activity of institutions that collect and invest savings on a world scale all contributed to the creation of a single, global market for currencies and finance.', 'the harbinger of this development was the growth of the eurodollar market, which had been boosted in the 1970s by the recycling of the surpluses of the oil-producing countries.', 'the new conditions made it possible for countries to adopt a gradualist approach to correcting budget and, above all, external deficits; it was no longer necessary for saving to equal investment in any given period.', 'the global market was fuelled by the steady accumulation of external debt by the united states and the build-up of a net credit position by germany and japan.', 'in all the leading industrial countries except the united kingdom public debt continued to rise in relation to gdp.', 'gross financial assets and liabilities continued to grow much more rapidly than economic activity.', 'between 1982 and 1995 the total liabilities of the six largest industrial countries rose from us$ 25 trillion to us$ 110 trillion and from four to six times their gdp.', 'over the same period the degree of financial integration increased; today, external liabilities are equal to 60% of gdp.', 'the growth in foreign exchange trading proceeded apace.', 'favourable investment opportunities encouraged huge flows of capital into the emerging economies; high rates of economic growth were often coupled with large balance-of-payments deficits and stable exchange rates.', "foreign investment in these markets increased from us$ 50 billion in 1990 to us$ 200 billion in 1995. in the oecd countries the assets managed by institutional investors rose over the same period from us$ 14 trillion to us$ 23 trillion and from 85 to 102% of the area's gdp.", 'these intermediaries manage portfolios that tend to be global and take on technically complex risks.', 'they can modify the composition of their assets extremely rapidly even for the sake of making small gains; they exploit the arbitrage opportunities stemming from fiscal segmentation or price differences between different financial centres.', '2. efficiency and stability savings are now freer to flow towards what investors consider the most profitable investment opportunities.', 'this results in a more efficient allocation of the resources available, support for capital formation and better growth prospects, especially for backward economies.', "the increase in lending to the developing countries, where the return on capital is higher, is certainly evidence of the markets' efficiency; on the other hand it brings with it the problem of the sustainability of these countries' foreign debt and the associated risks for stability, including that of the international financial system.", 'the mexico crisis and that still open in south-east asia, like the debt crisis of the early 1980s in latin america, have shown that a large inflow of funds can temporarily prop up unsustainable economic conditions.', 'anchoring the national currency to strong currencies when economic policies are inadequate causes the real exchange rate to rise, creating the conditions for a crisis.', 'insufficient supervision of banks and markets is a contributory factor.', 'the liquidity of markets, the belief that securities can be sold without incurring substantial losses can lead to an erroneous perception of the risk.', 'widespread expectations that the international organisations will intervene can accentuate behaviour on the part of intermediaries that is not consistent with the riskiness of investments.', 'it is becoming increasingly important to ensure sound and orderly economic conditions and at the same time to strengthen and enhance the effectiveness of the supervision of intermediaries and markets at the supranational as well as the national level, with the aim of forestalling systemic crises.', 'the restrictive monetary policies adopted in the industrial countries brought annual inflation down from 10% in the 1970s to 5.8% in the 1980s.', 'in the 1990s the objectives have become more ambitious; inflation has fallen further, to an average of 3.1%.', 'prices have also slowed down considerably in the last three years in the countries of eastern europe and above all in latin america.', 'real interest rates rose substantially in the industrial countries in the 1980s and 1990s.', 'they increased by around 6 percentage points in the early 1980s in response to the change in the focus of us monetary policy.', 'real long-term rates stood at about 5% in the first half of the 1980s.', 'today, excluding japan, they still stand at around 4%, above the rate of economic growth.', 'the high level of real interest rates is a reflection of the high returns that can be earned on investments in the emerging countries and the growing risks of a financial nature, which, even though they originate in national markets, affect the whole system.', 'to an even greater extent, with the money supply constant or even slightly declining in relation to gdp as a consequence of rigorous monetary policies, real interest rates are influenced by the rapid growth in the volume of private and, above all, public sector securities.', 'the ratio of the quantity of money to nominal output has held steady or fallen a little in the leading countries in the 1990s; in 1996 it stood at about 64%.', 'after rising sharply in the 1980s, international liquidity as measured by cross-border deposits has remained virtually unchanged.', 'for the private sector to acquire the growing stock of financial assets, real interest rates have to be high; the growth in public debt, due first and foremost to the imbalances in social security systems, is a source of pressure on real resources.', 'the gap between interest rates and economic growth rates is a cause of rising unemployment.', "3. italy's role in international finance in the course of the 1990s, with the complete liberalisation of capital movements, italy has become a full participant in the international financial markets.", 'gross capital inflows and outflows have increased enormously.', 'this process has sustained the accumulation of financial assets and encouraged residents to diversify their portfolios by type of instrument, country of issue and currency of denomination.', 'between 1990 and 1996 net portfolio investment abroad by the private sector amounted to 190 trillion lire, accounting for 9% of the growth in total financial assets.', 'the share of foreign instruments in the total financial assets of the private sector rose from 6% at the end of 1989 to 14% at the end of 1996. the growing flow of savings invested abroad also reflects a domestic supply of financial instruments that is still not sufficiently diversified in terms of risks and returns.', "italy's participation in the global market of finance has encouraged foreign capital inflows, mainly directed towards the government securities market.", 'at the end of last year non-residents held 370 trillion lire of italian government securities or 20% of the total amount outstanding, compared with 4% at the end of the 1980s.', 'when doubts have emerged about the soundness of economic policy, foreign capital inflows have ceased suddenly and given way to outflows, supplemented by substantial exports of italian capital.', "in late 1992 and again in early 1995 non-residents disposed of very large quantities of italian securities; at the same time residents' purchases of foreign financial assets increased considerably.", 'these outflows put the lira and securities prices under very heavy pressure.', "the reaffirmation of monetary policy's counter-inflationary commitment, the continuation, albeit with pauses, of the efforts to adjust the public finances, and the policy of wage moderation were decisive in easing the pressure and restoring conditions for a stable inflow of capital from abroad.", "looking ahead to a situation of recovery in economic activity and a reduction in the external current account surplus, the diversification of residents' financial portfolios will not put pressure on the exchange rate if non-residents continue to buy large amounts of italian securities.", "during the current year, characterised by favourable expectations regarding the italian economy and the prospects for economic and monetary union, non-residents' purchases of government securities, totalling more than 80 trillion lire up to september, have contributed to the sharp contraction in the long-term interest rate differential between italy and the countries with a longer record of price stability and a lower level of public debt.", 'exports of italian capital have also increased, however.', 'one of the reasons for the gradualness with which monetary policy has been eased has been to ensure favourable conditions for foreign investment in italy, taking into account the continual, structural outflow of italian capital.', "as economic and monetary union draws closer and national monetary policy's room for manoeuvre gradually narrows to the point of disappearing, the macroeconomic equilibrium of each country will come to depend increasingly on budgetary, incomes and structural policies.", 'in the absence of changes in the relative values of currencies, imbalances will impinge on competitiveness, production and employment.', 'public spending in italy is now equal to more than 50% of gdp.', 'reducing this ratio will make it possible to ease the burden of taxation and social security contributions.', "in order to enhance italy's competitiveness and reduce the cost of labour, it is also necessary to remove the obstacles hindering competition in the markets for goods and arrive at a more flexible use of labour.", '4. concluding remarks in addition to benefiting the participating countries, the creation of a stable monetary area in europe will contribute to the stability of the real and financial macroeconomy at the world level.', 'in recent years europe has been beset by modest growth and insufficient use of available resources; between 1990 and 1996 employment declined by 2 million units.', 'adverse factors include inefficiencies in some parts of the productive system, market rigidities and excessively large budgets.', 'the implementation of a closer economic union and the soundness of money and finance over time cannot be entrusted exclusively to monetary policy.', 'they require conditions of greater economic efficiency and the harmonisation of institutional arrangements in the participating countries.', 'a sound currency requires a dynamic economy.', 'money is largely the product of the credit granted to firms and the state.', 'the stability of its value does not depend only on the quantity in circulation but also on the efficient use of credit.', 'economic convergence must therefore be pursued not only in the nominal variables but also in labour productivity, a level of taxation that will enhance international competitiveness, and an efficient use of the resources the public sector appropriates.', 'these are the conditions for a monetary union to have the necessary stability and solidity.', 'the global market for currencies and finance influences the performance of all economies.', 'the conditions in that market increasingly appear as exogenous variables of decisive importance.', 'the macroeconomic equilibria of individual economies have to be related to the level and movements of interest rates determined in it and to the exchange rates established there between the leading currencies.', 'the external constraint is increasingly taking the form of the need for each country and economic region to be in overall balance, in terms of financial assets and liabilities, with respect to the rest of the world.', 'the development of the global financial market in the last ten years parallels that of national financial markets in the later nineteenth century and the first half of this century.', 'the increase in financial activity within each national market, the expansion of credit and the development of intermediaries all made a decisive contribution to investment, production and employment.', "but the need rapidly emerged for overall control of money creation and even earlier for a system of prudential supervision of intermediaries' activities.", "today's central banks are the result.", 'at the international level the expansion in the nominal amounts of credit and money has no longer been limited by the availability of primary liquidity since the link with gold was broken.', 'the present configuration of the market has evolved spontaneously, largely in conditions of fierce competition.', 'however, given the nature of the variables involved, it is unlikely that a pareto-efficient equilibrium will be reached.', 'money produces credit and credit produces more money; it is necessary to govern the growth of these aggregates; an anchor is needed to stabilise their value in terms of goods.', 'in the absence of binding rules and appropriate policies, national economies and the international economy are exposed to the risks of inflation and instability in intermediaries and markets.', 'this inflationary drift is likely to lead to speculative bubbles, excessive increases in the value of real and financial assets.', 'the international crises that occur from time to time diminish the value of financial wealth and curb inflationary pressures at the world level.', 'with many economies suffering from stagnation and poor fundamentals, the low cost and rapid expansion of dollar financing in the early 1990s and the subsequent restriction, together with the more recent monetary expansion in japan and loss of value of the yen, have probably contributed to the instability of the global market for finance.', 'the efforts, redoubled in recent years, to achieve monetary stability in most of the industrial countries, the banking supervision started by the group of ten for developed countries, its extension to the emerging countries and the surveillance performed by the imf are playing a role of great systemic importance.', 'faced with open and competitive markets, the strengthening of cooperation helps to forestall crises, increases the efficacy of corrective action.', 'effective action by central banks, supervisory authorities and the imf is a first response to the new problems of monetary and financial stability raised by the globalisation of markets; it may require more certain and firmly based international institutional arrangements.']	Antonio Fazio	Banca d'Italia	Governor	Italy
https://www.bis.org/review/r971208a.pdf	Mr. Plenderleith considers what is new in the financial markets in the United Kingdom (Central Bank Articles and Speeches, 18 Nov 97)	Speech by Mr. Ian Plenderleith, an Executive Director of the Bank of England, at the 6th Central Banking Conference, in London on 18/11/97.	1997-11-18 00:00:00	Mr. Plenderleith considers what is new in the financial markets in the United Speech by Mr. Ian Plenderleith, an Executive Director of the Bank of England, at the 6th Kingdom Central Banking Conference, in London on 18/11/97. 1. This has been a year marked by important developments in the UK financial markets and I am delighted to have this opportunity to take you through some of the highlights. The UK's new monetary framework 2. Perhaps the single most momentous change in the financial landscape in the UK has been the new government's decision, in May, to give operational responsibility for interest rates to the Bank of England -- essentially, to establish operational independence for the central bank. This significant reform, which took effect immediately, and is to be the subject of legislation recently introduced in the UK Parliament, represented an immediate concrete demonstration of the new government's commitment to monetary stability. It ensures that monetary policy will continue to be directed to the pursuit of low inflation, recognising that that is an essential pre-condition for achieving the sustained growth in output and employment that we all seek to achieve. The step was warmly welcomed by the markets, as was evidenced by the immediate fall of around 50 basis points it precipitated in long bond yields. 3. The framework put in place with that announcement has been carefully constructed and I would like to point to four features of it that I believe will be important to its long-run effectiveness. 4. First, the target the Bank of England is to pursue -- a low inflation target of 21⁄2% -- is set by the government. In an open market economy, the conduct of an effective monetary policy is helped enormously if the authorities can be clear and open about the price stability objective they are pursuing; and in a democratic system, it is absolutely right that the elected government should set this critical strategic objective for the central bank to pursue. 5. Secondly, it is then the responsibility of the Bank of England to achieve this low inflation target, principally through management of interest rates. But this responsibility is to be conducted within a structured framework. Decisions on interest rates are taken by a Monetary Policy Committee in the Bank, consisting of nine members: five of these come from within the Bank -- the Governor, the two Deputy Governors and the two Executive Directors responsible for monetary policy; the other four are appointed by the Chancellor of the Exchequer and are recognised experts in their field -- in fact, four economists of outstanding reputation. A representative of the Treasury attends the meetings and can contribute to the discussion, but has no vote. The Monetary Policy Committee meets monthly. It announces its decision each month as soon as its meeting concludes, and the minutes of its meetings are published within six weeks, including details of how each member voted. 6. A third important feature is that monetary policy is conducted with a high degree of transparency. I have indicated that the Monetary Policy Committee's decisions on interest rates are announced immediately; and that the minutes of its meetings are published. In addition, the Bank of England publishes a quarterly Inflation Report, which gives a full account of its monetary actions, and their effect, over the past quarter, and a detailed assessment of the forward outlook for inflation, including a projection looking two years or so ahead and an assessment of the relevant upside or downside risks. This degree of transparency is, we believe, important in generating greater public understanding of the stance of monetary policy, as well as better-informed public debate and greater public confidence in the process. 7. Closely related is a fourth key feature of the arrangements -- a high degree of accountability by the central bank for its actions. We are accountable in the first instance to our own Court of non-executive Directors, who are specially charged with monitoring the process by which the Monetary Policy Committee discharges its responsibilities. We are accountable also to the government, for which purpose we are required to write an open letter to the Chancellor of the Exchequer if inflation deviates by more than 1% either side of the 21⁄2% target, explaining the divergence and the action taken to bring it back on course -- an open letter, and hence a further element of transparency. We are accountable also to Parliament, which will entail members of the Monetary Policy Committee giving evidence to the House of Commons Treasury Select Committee, most probably on the basis of our quarterly Inflation Report, as well as the Bank's Annual Report being debated in the full House. And we are accountable to the public through the framework of transparency. 8. Put together, these elements provide for greater transparency and accountability of the monetary policy process than in any other country in the world. None of this, of course, guarantees success. But I believe that this new, and carefully-constructed, framework provides the best prospect we have had for years of delivering price stability as a steady foundation for the sustained growth of output and employment that the UK is capable of achieving. This framework for monetary stability, combined with the parallel commitment the government has demonstrated to fiscal responsibility and to promoting a flexible and competitive supply-side structure for the economy, provides a basis for the UK economy to continue to grow on a sustainable basis in the years ahead. Preparations for EMU 9. These changes in the monetary framework have been a major focus of interest of the UK financial markets over the past summer. But in parallel there has also been close focus on the continuing progress being made within the European Union towards Economic and Monetary Union (EMU). 10. The UK government's statement on EMU last month provided a clear account of UK policy in relation to the monetary union. That statement indicated that, in principle, a successful single currency within a single European market would be of benefit to Europe and to Britain. But, in order for EMU to be right for Britain, the economic benefit should be clear and unambiguous. If, in the end, a single currency is successful, and the economic case is clear and unambiguous, then the government believes Britain should be part of it. The statement identified five economic tests that define whether a clear and unambiguous case can be made for the UK to join EMU. These are: whether there can be sustainable convergence between Britain and the economies of a single currency; whether there is sufficient flexibility to cope with economic change; the effect on investment; the impact on the UK's financial services industry; and whether it is good for employment. 11. Applying these five economic tests has led the government to the conclusion that British membership of a single currency in 1999 could not meet the tests, so that joining at the start of EMU is not in the country's economic interests. The government will therefore be notifying our European partners, in accordance with the Maastricht Treaty, that we will not seek membership of the single currency on 1 January 1999; and, barring some fundamental and unforeseen change in economic circumstances, making a decision during this Parliament to join is not seen as realistic. The statement therefore indicates that it is therefore sensible for business and the country to plan on the basis that, in this Parliament, the government does not propose to enter a single currency. However, the government has said that if a single currency works and is successful, Britain should join it. The government believes that we should therefore begin now to prepare ourselves so that, should the economic tests be met, a decision to join a successful single currency can be made early in the next Parliament. To help with the essential preparations, the Chancellor has invited the Governor of the Bank of England and the heads of the two main bodies representing industry and commerce, and two other Ministers, to join him on a Standing Committee to lead the preparations for EMU. 12. In the UK wholesale financial markets, practical preparations are accordingly proceeding apace. 13. We at the Bank of England have been taking an active role in helping the UK financial markets to prepare for the euro. We do this because, even though the UK will not be in at the start, it is plain that banks and financial institutions in the UK, in their wholesale business for their corporate and institutional customers, in the UK and overseas, will want to be able to offer the full range of financial facilities in the euro from the outset. They will want to be able to offer their customers deposits and foreign exchange facilities in the euro, lending and borrowing in the euro, hedging and collateral in the euro and financing and settlement facilities. The London markets will need to be able to operate in euro from the outset across the full range of their wholesale activities, and practical preparations are now well advanced to achieve that by January 1999. 14. The Bank of England's part in this extensive process of market-wide preparation, besides equipping ourselves internally for operations in the euro, is a co-ordinating one, in three main ways: first, our job is to ensure that the necessary infrastructure is developed in the UK to allow anyone • who wishes to do so to use the euro in wholesale payments and across the financial markets from the first day of EMU. • second, we aim to promote discussion between the EMI, national central banks and market participants across Europe about practical issues on which the market is seeking a degree of coordination. • and third, we provide information: for example, through a quarterly publication on Practical Issues Arising from the Introduction of the Euro, which is distributed to around 32,000 recipients, including 4,000 directly overseas. The next edition will appear shortly, neatly timed for people's Christmas reading, and I confidently expect it to be on the best sellers' list for the festive season. And following the successful symposium we held early this year, we are planning to hold a further symposium, next January at the Bank, on London as the international financial centre for the euro. 15. This exercise -- to prepare the UK markets for wholesale activity in the euro by January 1999 -- has now gathered substantial momentum. Let me touch on a few of the main priorities being pursued: 16. First, market participants agree on the need to be able to trade in London the full range of euro-denominated instruments. 17. Secondly, they also agree on the need for appropriate payments mechanisms in London to carry out transactions in euro both between parties within the UK and cross-border to and from the UK. 18. Thirdly, efficient, cost-effective mechanisms for settling transactions in euro-denominated securities also need to be made available in London. 19. Fourthly, there is agreement on the desirability of harmonised market conventions for the issuing and trading of euro-denominated instruments. 20. Fifthly, there is agreement on the need for as sound a legal basis as possible for euro transactions, to provide legal certainty and to ensure continuity of contract. 21. Sixthly, there are tax and accounting issues to be addressed, related to the introduction of the euro. 22. There is work going on in each of these areas, and good progress on many of them. Let me give you one example -- the payments system, which lies at the heart of the UK's preparations for the euro. The UK's sterling Real-Time Gross Settlement (RTGS) system is being developed to accommodate the euro, so that from the beginning of 1999 euro wholesale payments may be made in a safe, efficient and cost-effective way as sterling payments can now, even though the UK will not be a participant in the monetary union at the outset. That development remains on schedule, and it is encouraging that the UK system (CHAPS) has had expressions of interest recently from a number of overseas banks wishing to join. 23. The UK euro system -- CHAPS euro -- will allow payments to be made both between parties within the UK and cross-border from and to the UK through its link to TARGET. Using the knowledge and expertise we have acquired through developing and operating by far the largest RTGS system in Europe -- with average daily volumes of some 70,000 payments, worth some £150 bn -- we are contributing a great deal to the technical development of TARGET. Because it extends the benefits of RTGS systems, in reducing the risk in payments, for the first time cross-border, it is a project we wholeheartedly support. 24. But we also want to see TARGET as efficient and effective as possible, so that it becomes the payment system of first choice for banks, in order to maximise its benefits in reducing systemic risk. We have to recognise that TARGET will be competing with alternative euro payments mechanisms, including correspondent banking and the European Banking Association's net end-of-day settlement systems. Consistently with this view, we believe that it is essential that payments be able to flow freely throughout the TARGET system. 25. Why do we devote this effort for preparing for the euro? The reason is very straightforward. London's pre-eminent position as an international financial centre rests on the fact that it provides broad and liquid markets for the full range of internationally-traded currencies and for the vast array of different instruments and facilities denominated in them. The euro will undoubtedly become a major internationally-traded currency, and it is therefore certain that it will be traded extensively in the London markets. The euro thus represents an opportunity, rather than a threat, for the London markets, and it is important that the London markets prepare in good time the systems and infrastructure needed to take advantage of this opportunity. London as a financial centre after EMU 26. The reason why we are convinced that the euro represents a major opportunity for the London markets relates essentially to the strengths that the London markets have displayed over the years: • London is a global financial centre rather than just a European centre, with much of its business generated around the world, not just within Europe. • London has always thrived on financial innovation, and has a strong track record of capitalising on new opportunities. The euro may very well bring greater financial activity to the main Continental financial markets. • But expansion in these markets is not, on past experience, a zero sum game: it is likely to lead to more, not less, activity in London since London is the major interface with the rest of the world in the European time zone. • The economics of financial market activity point to concentration, to gain economies of scale and facilitate better management control. That is why many firms have been moving their operations, and even headquarters, to London as the preferred financial centre. Uncertainty about UK participation in the single currency has been with us for some time. But undeterred by that uncertainty, firms have continued to concentrate their trading activities in London. London has an unrivalled range of markets and ancillary services; and an associated deep skill • base; and an unbureaucratic approach to financial regulation, which has been developed working with the grain of the market. 27. All these advantages and more help to explain why there are more people working in financial services in the City of London -- over 600,000 -- than there are in the entire population of Frankfurt and its surrounding region! 28. None of this gives any grounds for complacency: the financial services industry is an intensely competitive business. But importantly, if we can harness the strengths of the London markets to the opportunity presented by the euro, I believe that will be an important contribution to the success of the single currency. Of course, London will benefit. But London is not just a UK financial centre. It is a European financial centre, and by providing competitive trading facilities in the euro London can help provide better facilities for business and industry across the whole single market and bring more business into Europe from the rest of the world. Opportunities in euro for market participants 29. I have talked so far principally about the steps the authorities are taking to help prepare the London markets for the euro. But of course, at the end of the day, the authorities can only facilitate: the real challenge in seizing the opportunities presented by the single currency has to be met by market participants themselves. Let me touch on three areas where the advent of the euro is likely to usher in significant changes -- but, I believe, positive changes, offering new business opportunities -- for financial market participants. 30. First, in the bond markets, monetary union will serve to unify the various national government bond markets of the EMU participants, and the already substantial ECU bond market, into a single market in a single currency with multiple national government issuers. Currency risk will be removed, at a stroke. This does not, of course, mean that all government bonds of the different national issuers will trade at the same price: differences will still remain in trading structures and liquidity, in perceptions of sovereign risk and the scale of supply by different governments, and in investors' basic preferences. But the different national government bonds will tend to trade on essentially the same yield curve, with the focus of the market being concentrated, even more so than at present, on spread relationships. 31. This of course raises the interesting question -- spread over what? Who will provide the benchmark issues? Moreover, the intensified focus on spread may produce two further results. First, there will be even greater incentives than at present for national governments, who will remain responsible for their own debt management, to converge in their techniques for issuing and marketing their debt. It will be interesting to see whether this will generate greater co-ordination amongst debt management authorities in managing their debt programmes, including, for example, their auction timetables. 32. A second effect in this area flowing from the concentration on spreads may be greater interest in developing a diversified, deeper corporate bond market in euro, as has long been present in the United States, but much less so in other countries. If this happens, it could be a considerable boon to corporate borrowers as a whole because it would extend the range of financing opportunities open to them. 33. A second area where financial market activity in the euro is likely to generate new opportunities is in the short-dated money markets. Foreign exchange traders do clearly face some contraction in their activity, as an inevitable consequence of currency unification. But I do not expect to see too many destitute foreign exchange traders miserably wandering the streets in search of charity or menial employment because of course, as trading amongst the EMU currencies disappears, new international trading is developing in a range of currencies of leading emerging market economies. But more importantly, the advent of the euro will usher in potentially much deeper markets than exist in the individual national centres at present in a range of different money market instruments -- short-dated government and/or central bank paper, commercial bills, CDs, inter-bank deposits, commercial paper, repos, interest-rate futures, swaps, FRAs, options and a miscellany of tailor-made variants on these basic products. Markets in these products are of very varying depth and liquidity, where they exist at all, in the individual local-currency markets of the countries likely to participate in EMU. But all of these instruments are, as it happens, traded in London in the main international currencies; and with the advent of the euro, all of them will also, for the first time, be traded in the major European currency. This represents a tremendous business opportunity for banks and financial institutions with the capacity to trade these instruments and to harness them to the needs of their customers. 34. But there is a third impact on financial markets from the euro that is essentially a necessary prerequisite that must be fulfilled if the benefits from integration of the bond and money markets that I have identified are to be achieved. This is that the new single-currency, euro, markets develop trading practices and standards of conduct, and the necessary infrastructure, that will genuinely facilitate integration. In terms of infrastructure, for example, real-time, same-day wholesale payments are essential to tie together money market activity conducted in different centres in the same instrument in the single currency; and similarly, linkages may also need to be considered between different settlement systems. Common trading practices, and market conventions, will also need to be developed. The lead here lies in many cases with market participants themselves, and with the systems they have developed to serve their trading needs. But it is a process we are very familiar with in London, where we have sought when necessary to encourage just such common initiatives in order to enhance the effectiveness of international trading activity in London. And with an eye on EMU, we have encouraged trading activity in the ECU, particularly in the money markets: hence, for example, the regular programme of monthly auctions for UK government ECU treasury bills, and the quarterly auctions of UK government three-year ECU notes, which have been running for some years. Because of the international flavour of our markets, and because we are conscious that these markets will want to trade the full range of euro instruments in London, we will continue to support initiatives aimed at achieving the necessary market structure where we feel we can make a contribution. Reforms in the London markets 35. In parallel, we have been pressing ahead with reform in the structure of the UK sterling financial markets, and the pace of progress has notably quickened in 1997. Last year saw two notable events -- the start of the gilt repo market and the completion of the Stock Exchange's Sequence project, to provide it with a new and modern integrated electronic platform for its trading and information services. This year we have already doubled up on last year, with four major initiatives -- reform of the structure of the Bank of England's money market operations; the completion of migration to electronic settlement of equities on CREST; the successful launch of SETS, the Stock Exchange electronic order book for equity trading; and a major upgrade of the CGO electronic settlement system for gilts. We have a fifth advance to come next month, with the start of a strips facility for gilts. But for the fact that a central banker is not supposed to reveal that he knows how to play poker, I would call that a "full house"! 36. I believe these are major steps forward to improve trading market facilities, and the essential market infrastructure, in London. And the fact that the London markets have been able to bring so many major projects to a successful conclusion in so short a space of time speaks highly of the resources in depth available in the London markets and the ancillary services. But I would draw attention to one particular feature, which I think is of wider significance. The upgrade of CGO has been effected utilising CREST software -- deliberately, in order to align those two electronic settlement systems -- CGO for gilts, CREST for equities -- more closely. This was a considerable technical achievement, because the operating processes in the two markets are different -- equities settle on T+5, gilts on T+1 (and in some cases T+0); the equity market comprises a large number of relatively moderate-value deals, the gilt market a smaller number of much higher-value deals; hence delay in settlement in gilts is much more disruptive, and needs to be much less frequent, than in equities. Overcoming these differences has been a considerable challenge to the Bank team and I would like to pay tribute to their dedication and expertise and to their achievement in bringing the CGO upgrade to a successful and so far smooth launch just last week. I say this without immodesty because, though I was closely involved in overseeing the project, it was their technical proficiency that delivered the goods. 37. But this achievement has a wider significance. By utilising CREST software in CGO, we have now achieved for the market much of the benefit sought by those who favour a merger of the two systems. In particular, both utilise the same hardware, and the same software application; they operate on the same networks; and users can access both systems via a single terminal using a common gateway. The Bank is, as already announced, planning to seek the views of market participants on what the relative priorities should be in developing payments and settlement systems in London in the year ahead. This will include the possibility of full merger between CGO and CREST, but recognises that merger is only one of a number of IT projects UK financial markets may have to contemplate over the next few years, all of which represent potential claims on scarce IT resources. What is important in the meantime is that a big step towards integration of systems has been achieved, to the benefit of all market users. Conclusion 38. I have tried in these remarks to explain major developments in UK financial markets over the past year. Looking ahead, there is more to do, and I believe EMU will open up new opportunities for the financial markets. I believe this will be particularly so for the international markets in London. We intend to be ready to take full advantage of these opportunities, right from the outset in January 1999, even though the UK will not participate in EMU at that stage. The reason for this is very simple: London is the major European financial market, and we think that extending its activity to include financial services in euro is a significant contribution we in the UK can make from the outset to the success of the monetary union and of the single European market as a whole.	['mr. plenderleith considers what is new in the financial markets in the united speech by mr. ian plenderleith, an executive director of the bank of england, at the 6th kingdom central banking conference, in london on 18/11/97.', '1. this has been a year marked by important developments in the uk financial markets and i am delighted to have this opportunity to take you through some of the highlights.', "the uk's new monetary framework 2. perhaps the single most momentous change in the financial landscape in the uk has been the new government's decision, in may, to give operational responsibility for interest rates to the bank of england -- essentially, to establish operational independence for the central bank.", "this significant reform, which took effect immediately, and is to be the subject of legislation recently introduced in the uk parliament, represented an immediate concrete demonstration of the new government's commitment to monetary stability.", 'it ensures that monetary policy will continue to be directed to the pursuit of low inflation, recognising that that is an essential pre-condition for achieving the sustained growth in output and employment that we all seek to achieve.', 'the step was warmly welcomed by the markets, as was evidenced by the immediate fall of around 50 basis points it precipitated in long bond yields.', '3. the framework put in place with that announcement has been carefully constructed and i would like to point to four features of it that i believe will be important to its long-run effectiveness.', '4. first, the target the bank of england is to pursue -- a low inflation target of 21⁄2% -- is set by the government.', 'in an open market economy, the conduct of an effective monetary policy is helped enormously if the authorities can be clear and open about the price stability objective they are pursuing; and in a democratic system, it is absolutely right that the elected government should set this critical strategic objective for the central bank to pursue.', '5. secondly, it is then the responsibility of the bank of england to achieve this low inflation target, principally through management of interest rates.', 'but this responsibility is to be conducted within a structured framework.', 'decisions on interest rates are taken by a monetary policy committee in the bank, consisting of nine members: five of these come from within the bank -- the governor, the two deputy governors and the two executive directors responsible for monetary policy; the other four are appointed by the chancellor of the exchequer and are recognised experts in their field -- in fact, four economists of outstanding reputation.', 'a representative of the treasury attends the meetings and can contribute to the discussion, but has no vote.', 'the monetary policy committee meets monthly.', 'it announces its decision each month as soon as its meeting concludes, and the minutes of its meetings are published within six weeks, including details of how each member voted.', '6. a third important feature is that monetary policy is conducted with a high degree of transparency.', "i have indicated that the monetary policy committee's decisions on interest rates are announced immediately; and that the minutes of its meetings are published.", 'in addition, the bank of england publishes a quarterly inflation report, which gives a full account of its monetary actions, and their effect, over the past quarter, and a detailed assessment of the forward outlook for inflation, including a projection looking two years or so ahead and an assessment of the relevant upside or downside risks.', 'this degree of transparency is, we believe, important in generating greater public understanding of the stance of monetary policy, as well as better-informed public debate and greater public confidence in the process.', '7. closely related is a fourth key feature of the arrangements -- a high degree of accountability by the central bank for its actions.', 'we are accountable in the first instance to our own court of non-executive directors, who are specially charged with monitoring the process by which the monetary policy committee discharges its responsibilities.', 'we are accountable also to the government, for which purpose we are required to write an open letter to the chancellor of the exchequer if inflation deviates by more than 1% either side of the 21⁄2% target, explaining the divergence and the action taken to bring it back on course -- an open letter, and hence a further element of transparency.', "we are accountable also to parliament, which will entail members of the monetary policy committee giving evidence to the house of commons treasury select committee, most probably on the basis of our quarterly inflation report, as well as the bank's annual report being debated in the full house.", 'and we are accountable to the public through the framework of transparency.', '8. put together, these elements provide for greater transparency and accountability of the monetary policy process than in any other country in the world.', 'none of this, of course, guarantees success.', 'but i believe that this new, and carefully-constructed, framework provides the best prospect we have had for years of delivering price stability as a steady foundation for the sustained growth of output and employment that the uk is capable of achieving.', 'this framework for monetary stability, combined with the parallel commitment the government has demonstrated to fiscal responsibility and to promoting a flexible and competitive supply-side structure for the economy, provides a basis for the uk economy to continue to grow on a sustainable basis in the years ahead.', 'preparations for emu 9. these changes in the monetary framework have been a major focus of interest of the uk financial markets over the past summer.', 'but in parallel there has also been close focus on the continuing progress being made within the european union towards economic and monetary union (emu).', "10. the uk government's statement on emu last month provided a clear account of uk policy in relation to the monetary union.", 'that statement indicated that, in principle, a successful single currency within a single european market would be of benefit to europe and to britain.', 'but, in order for emu to be right for britain, the economic benefit should be clear and unambiguous.', 'if, in the end, a single currency is successful, and the economic case is clear and unambiguous, then the government believes britain should be part of it.', 'the statement identified five economic tests that define whether a clear and unambiguous case can be made for the uk to join emu.', "these are: whether there can be sustainable convergence between britain and the economies of a single currency; whether there is sufficient flexibility to cope with economic change; the effect on investment; the impact on the uk's financial services industry; and whether it is good for employment.", "11. applying these five economic tests has led the government to the conclusion that british membership of a single currency in 1999 could not meet the tests, so that joining at the start of emu is not in the country's economic interests.", 'the government will therefore be notifying our european partners, in accordance with the maastricht treaty, that we will not seek membership of the single currency on 1 january 1999; and, barring some fundamental and unforeseen change in economic circumstances, making a decision during this parliament to join is not seen as realistic.', 'the statement therefore indicates that it is therefore sensible for business and the country to plan on the basis that, in this parliament, the government does not propose to enter a single currency.', 'however, the government has said that if a single currency works and is successful, britain should join it.', 'the government believes that we should therefore begin now to prepare ourselves so that, should the economic tests be met, a decision to join a successful single currency can be made early in the next parliament.', 'to help with the essential preparations, the chancellor has invited the governor of the bank of england and the heads of the two main bodies representing industry and commerce, and two other ministers, to join him on a standing committee to lead the preparations for emu.', '12. in the uk wholesale financial markets, practical preparations are accordingly proceeding apace.', '13. we at the bank of england have been taking an active role in helping the uk financial markets to prepare for the euro.', 'we do this because, even though the uk will not be in at the start, it is plain that banks and financial institutions in the uk, in their wholesale business for their corporate and institutional customers, in the uk and overseas, will want to be able to offer the full range of financial facilities in the euro from the outset.', 'they will want to be able to offer their customers deposits and foreign exchange facilities in the euro, lending and borrowing in the euro, hedging and collateral in the euro and financing and settlement facilities.', 'the london markets will need to be able to operate in euro from the outset across the full range of their wholesale activities, and practical preparations are now well advanced to achieve that by january 1999.', "14. the bank of england's part in this extensive process of market-wide preparation, besides equipping ourselves internally for operations in the euro, is a co-ordinating one, in three main ways: first, our job is to ensure that the necessary infrastructure is developed in the uk to allow anyone • who wishes to do so to use the euro in wholesale payments and across the financial markets from the first day of emu.", '• second, we aim to promote discussion between the emi, national central banks and market participants across europe about practical issues on which the market is seeking a degree of coordination.', '• and third, we provide information: for example, through a quarterly publication on practical issues arising from the introduction of the euro, which is distributed to around 32,000 recipients, including 4,000 directly overseas.', "the next edition will appear shortly, neatly timed for people's christmas reading, and i confidently expect it to be on the best sellers' list for the festive season.", 'and following the successful symposium we held early this year, we are planning to hold a further symposium, next january at the bank, on london as the international financial centre for the euro.', '15. this exercise -- to prepare the uk markets for wholesale activity in the euro by january 1999 -- has now gathered substantial momentum.', 'let me touch on a few of the main priorities being pursued: 16. first, market participants agree on the need to be able to trade in london the full range of euro-denominated instruments.', '17. secondly, they also agree on the need for appropriate payments mechanisms in london to carry out transactions in euro both between parties within the uk and cross-border to and from the uk.', '18. thirdly, efficient, cost-effective mechanisms for settling transactions in euro-denominated securities also need to be made available in london.', '19. fourthly, there is agreement on the desirability of harmonised market conventions for the issuing and trading of euro-denominated instruments.', '20. fifthly, there is agreement on the need for as sound a legal basis as possible for euro transactions, to provide legal certainty and to ensure continuity of contract.', '21. sixthly, there are tax and accounting issues to be addressed, related to the introduction of the euro.', '22. there is work going on in each of these areas, and good progress on many of them.', "let me give you one example -- the payments system, which lies at the heart of the uk's preparations for the euro.", "the uk's sterling real-time gross settlement (rtgs) system is being developed to accommodate the euro, so that from the beginning of 1999 euro wholesale payments may be made in a safe, efficient and cost-effective way as sterling payments can now, even though the uk will not be a participant in the monetary union at the outset.", 'that development remains on schedule, and it is encouraging that the uk system (chaps) has had expressions of interest recently from a number of overseas banks wishing to join.', '23. the uk euro system -- chaps euro -- will allow payments to be made both between parties within the uk and cross-border from and to the uk through its link to target.', 'using the knowledge and expertise we have acquired through developing and operating by far the largest rtgs system in europe -- with average daily volumes of some 70,000 payments, worth some £150 bn -- we are contributing a great deal to the technical development of target.', 'because it extends the benefits of rtgs systems, in reducing the risk in payments, for the first time cross-border, it is a project we wholeheartedly support.', '24. but we also want to see target as efficient and effective as possible, so that it becomes the payment system of first choice for banks, in order to maximise its benefits in reducing systemic risk.', "we have to recognise that target will be competing with alternative euro payments mechanisms, including correspondent banking and the european banking association's net end-of-day settlement systems.", 'consistently with this view, we believe that it is essential that payments be able to flow freely throughout the target system.', '25. why do we devote this effort for preparing for the euro?', 'the reason is very straightforward.', "london's pre-eminent position as an international financial centre rests on the fact that it provides broad and liquid markets for the full range of internationally-traded currencies and for the vast array of different instruments and facilities denominated in them.", 'the euro will undoubtedly become a major internationally-traded currency, and it is therefore certain that it will be traded extensively in the london markets.', 'the euro thus represents an opportunity, rather than a threat, for the london markets, and it is important that the london markets prepare in good time the systems and infrastructure needed to take advantage of this opportunity.', 'london as a financial centre after emu 26. the reason why we are convinced that the euro represents a major opportunity for the london markets relates essentially to the strengths that the london markets have displayed over the years: • london is a global financial centre rather than just a european centre, with much of its business generated around the world, not just within europe.', '• london has always thrived on financial innovation, and has a strong track record of capitalising on new opportunities.', 'the euro may very well bring greater financial activity to the main continental financial markets.', '• but expansion in these markets is not, on past experience, a zero sum game: it is likely to lead to more, not less, activity in london since london is the major interface with the rest of the world in the european time zone.', '• the economics of financial market activity point to concentration, to gain economies of scale and facilitate better management control.', 'that is why many firms have been moving their operations, and even headquarters, to london as the preferred financial centre.', 'uncertainty about uk participation in the single currency has been with us for some time.', 'but undeterred by that uncertainty, firms have continued to concentrate their trading activities in london.', 'london has an unrivalled range of markets and ancillary services; and an associated deep skill • base; and an unbureaucratic approach to financial regulation, which has been developed working with the grain of the market.', '27. all these advantages and more help to explain why there are more people working in financial services in the city of london -- over 600,000 -- than there are in the entire population of frankfurt and its surrounding region!', '28. none of this gives any grounds for complacency: the financial services industry is an intensely competitive business.', 'but importantly, if we can harness the strengths of the london markets to the opportunity presented by the euro, i believe that will be an important contribution to the success of the single currency.', 'of course, london will benefit.', 'but london is not just a uk financial centre.', 'it is a european financial centre, and by providing competitive trading facilities in the euro london can help provide better facilities for business and industry across the whole single market and bring more business into europe from the rest of the world.', 'opportunities in euro for market participants 29. i have talked so far principally about the steps the authorities are taking to help prepare the london markets for the euro.', 'but of course, at the end of the day, the authorities can only facilitate: the real challenge in seizing the opportunities presented by the single currency has to be met by market participants themselves.', 'let me touch on three areas where the advent of the euro is likely to usher in significant changes -- but, i believe, positive changes, offering new business opportunities -- for financial market participants.', '30. first, in the bond markets, monetary union will serve to unify the various national government bond markets of the emu participants, and the already substantial ecu bond market, into a single market in a single currency with multiple national government issuers.', 'currency risk will be removed, at a stroke.', "this does not, of course, mean that all government bonds of the different national issuers will trade at the same price: differences will still remain in trading structures and liquidity, in perceptions of sovereign risk and the scale of supply by different governments, and in investors' basic preferences.", 'but the different national government bonds will tend to trade on essentially the same yield curve, with the focus of the market being concentrated, even more so than at present, on spread relationships.', '31. this of course raises the interesting question -- spread over what?', 'who will provide the benchmark issues?', 'moreover, the intensified focus on spread may produce two further results.', 'first, there will be even greater incentives than at present for national governments, who will remain responsible for their own debt management, to converge in their techniques for issuing and marketing their debt.', 'it will be interesting to see whether this will generate greater co-ordination amongst debt management authorities in managing their debt programmes, including, for example, their auction timetables.', '32. a second effect in this area flowing from the concentration on spreads may be greater interest in developing a diversified, deeper corporate bond market in euro, as has long been present in the united states, but much less so in other countries.', 'if this happens, it could be a considerable boon to corporate borrowers as a whole because it would extend the range of financing opportunities open to them.', '33. a second area where financial market activity in the euro is likely to generate new opportunities is in the short-dated money markets.', 'foreign exchange traders do clearly face some contraction in their activity, as an inevitable consequence of currency unification.', 'but i do not expect to see too many destitute foreign exchange traders miserably wandering the streets in search of charity or menial employment because of course, as trading amongst the emu currencies disappears, new international trading is developing in a range of currencies of leading emerging market economies.', 'but more importantly, the advent of the euro will usher in potentially much deeper markets than exist in the individual national centres at present in a range of different money market instruments -- short-dated government and/or central bank paper, commercial bills, cds, inter-bank deposits, commercial paper, repos, interest-rate futures, swaps, fras, options and a miscellany of tailor-made variants on these basic products.', 'markets in these products are of very varying depth and liquidity, where they exist at all, in the individual local-currency markets of the countries likely to participate in emu.', 'but all of these instruments are, as it happens, traded in london in the main international currencies; and with the advent of the euro, all of them will also, for the first time, be traded in the major european currency.', 'this represents a tremendous business opportunity for banks and financial institutions with the capacity to trade these instruments and to harness them to the needs of their customers.', '34. but there is a third impact on financial markets from the euro that is essentially a necessary prerequisite that must be fulfilled if the benefits from integration of the bond and money markets that i have identified are to be achieved.', 'this is that the new single-currency, euro, markets develop trading practices and standards of conduct, and the necessary infrastructure, that will genuinely facilitate integration.', 'in terms of infrastructure, for example, real-time, same-day wholesale payments are essential to tie together money market activity conducted in different centres in the same instrument in the single currency; and similarly, linkages may also need to be considered between different settlement systems.', 'common trading practices, and market conventions, will also need to be developed.', 'the lead here lies in many cases with market participants themselves, and with the systems they have developed to serve their trading needs.', 'but it is a process we are very familiar with in london, where we have sought when necessary to encourage just such common initiatives in order to enhance the effectiveness of international trading activity in london.', 'and with an eye on emu, we have encouraged trading activity in the ecu, particularly in the money markets: hence, for example, the regular programme of monthly auctions for uk government ecu treasury bills, and the quarterly auctions of uk government three-year ecu notes, which have been running for some years.', 'because of the international flavour of our markets, and because we are conscious that these markets will want to trade the full range of euro instruments in london, we will continue to support initiatives aimed at achieving the necessary market structure where we feel we can make a contribution.', "reforms in the london markets 35. in parallel, we have been pressing ahead with reform in the structure of the uk sterling financial markets, and the pace of progress has notably quickened in 1997. last year saw two notable events -- the start of the gilt repo market and the completion of the stock exchange's sequence project, to provide it with a new and modern integrated electronic platform for its trading and information services.", "this year we have already doubled up on last year, with four major initiatives -- reform of the structure of the bank of england's money market operations; the completion of migration to electronic settlement of equities on crest; the successful launch of sets, the stock exchange electronic order book for equity trading; and a major upgrade of the cgo electronic settlement system for gilts.", 'we have a fifth advance to come next month, with the start of a strips facility for gilts.', 'but for the fact that a central banker is not supposed to reveal that he knows how to play poker, i would call that a "full house"!', '36. i believe these are major steps forward to improve trading market facilities, and the essential market infrastructure, in london.', 'and the fact that the london markets have been able to bring so many major projects to a successful conclusion in so short a space of time speaks highly of the resources in depth available in the london markets and the ancillary services.', 'but i would draw attention to one particular feature, which i think is of wider significance.', 'the upgrade of cgo has been effected utilising crest software -- deliberately, in order to align those two electronic settlement systems -- cgo for gilts, crest for equities -- more closely.', 'this was a considerable technical achievement, because the operating processes in the two markets are different -- equities settle on t+5, gilts on t+1 (and in some cases t+0); the equity market comprises a large number of relatively moderate-value deals, the gilt market a smaller number of much higher-value deals; hence delay in settlement in gilts is much more disruptive, and needs to be much less frequent, than in equities.', 'overcoming these differences has been a considerable challenge to the bank team and i would like to pay tribute to their dedication and expertise and to their achievement in bringing the cgo upgrade to a successful and so far smooth launch just last week.', 'i say this without immodesty because, though i was closely involved in overseeing the project, it was their technical proficiency that delivered the goods.', '37. but this achievement has a wider significance.', 'by utilising crest software in cgo, we have now achieved for the market much of the benefit sought by those who favour a merger of the two systems.', 'in particular, both utilise the same hardware, and the same software application; they operate on the same networks; and users can access both systems via a single terminal using a common gateway.', 'the bank is, as already announced, planning to seek the views of market participants on what the relative priorities should be in developing payments and settlement systems in london in the year ahead.', 'this will include the possibility of full merger between cgo and crest, but recognises that merger is only one of a number of it projects uk financial markets may have to contemplate over the next few years, all of which represent potential claims on scarce it resources.', 'what is important in the meantime is that a big step towards integration of systems has been achieved, to the benefit of all market users.', 'conclusion 38. i have tried in these remarks to explain major developments in uk financial markets over the past year.', 'looking ahead, there is more to do, and i believe emu will open up new opportunities for the financial markets.', 'i believe this will be particularly so for the international markets in london.', 'we intend to be ready to take full advantage of these opportunities, right from the outset in january 1999, even though the uk will not participate in emu at that stage.', 'the reason for this is very simple: london is the major european financial market, and we think that extending its activity to include financial services in euro is a significant contribution we in the uk can make from the outset to the success of the monetary union and of the single european market as a whole.']	Ian Plenderleith	Bank of England	Executive Director	UK
https://www.bis.org/review/r971202b.pdf	Mr. McDonough gives a US perspective on Economic and Monetary Union in Europe (Central Bank Articles and Speeches, 17 Nov 97)	Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before the Association of German Mortgage Banks in Frankfurt, on 17/11/97.	1997-11-17 00:00:00	Mr. McDonough gives a US perspective on Economic and Monetary Union in Remarks by the President of the Federal Reserve Bank of New York, Mr. William Europe J. McDonough, before the Association of German Mortgage Banks in Frankfurt, on 17/11/97. I am honored to be invited by the German Mortgage Banks to be the keynote speaker tonight at the Association's annual Pfandbrief Forum. It is a great pleasure to be here in Frankfurt among so many distinguished representatives of the German banking and financial community and members of the Bundesbank Council. In my remarks to you this evening, I would like to offer a few thoughts on the implications of Economic and Monetary Union in Europe from my perspective as President of the Federal Reserve Bank of New York. Many in the United States today are following developments in Europe's move toward monetary union with considerable interest. I am certainly among them. There can be no doubt about the magnitude and economic importance of the historic event that will take place on January 1, 1999, when the currencies of up to 15 member countries of the European Union are scheduled to be unified. It is a goal toward which Europe has been working ever since the Treaty of Rome was signed in 1957 creating the European Economic Community. While some might claim that this historic development will have little impact on the U.S. economy, nothing could be further from the truth. The United States will be directly affected in several important ways by the start of Economic and Monetary Union in Europe, or EMU. I would like to review some of the main channels through which EMU is likely to affect American business and policymaking over the next several years. Further, I think it may be useful to highlight some of the important similarities and differences between the currency union that exists in the United States today and the currency union that you are in the process of creating in Europe. The most obvious implication of the start of EMU for the United States -- as well as for the world community -- is the coming into existence of a new currency, the euro, which is intended to function as a major international currency alongside the U.S. dollar. I should make clear at the outset that it would be a mistake to think that the United States looks at this prospect with concern, as if the introduction of the euro could somehow compromise the ability of the United States to continue to conduct trade and financial transactions with the rest of the world. As you well know, the dollar is currently used in roughly 50 percent of world trade transactions and in at least one side of 80 percent of world financial transactions. The introduction of another major international currency will neither harm the depth and liquidity of the dollar market nor hinder the ability of the United States to conduct its external transactions smoothly. On the contrary, to the extent that the birth of the euro fosters deeper trade and financial markets globally and a more efficient international monetary system, all countries stand to benefit, particularly an active participant such as the United States. Let me be more specific. In my view, for the United States and the international monetary system, the implication of a growing international role for the euro over the foreseeable future will be most significant with respect to financial rather than trade transactions. It is quite true that the euro may quickly become the currency of choice in the invoicing of trade between companies in the European Union and their foreign counterparts. Companies in regions with strong links to the European Union, such as those in eastern and central Europe, North Africa, and the CFA French franc zone, may also choose to invoice trade in euros. More generally, the euro may well expand its importance in world trade beyond the relative trade weight of the European Union countries, following a path similar to that taken by the U.S. dollar and -- before that -- by the pound sterling. Nevertheless, I would argue that the economic effects of these potential changes in invoicing practices are likely to be limited. Why do I say this? First, to a large extent, the re-denomination of a significant share of world trade into euros will mainly represent a shift in invoicing practices from the use of former European currencies to euros. Moreover, third-country effects are unlikely to be major, because the European currencies as a whole are already somewhat over-represented in their share of world trade transactions relative to their countries' weights in world trade -- not as much so as the dollar, but certainly more so than the yen. Finally, changes in trade invoicing practices have a direct economic impact only on the two parties involved in the transaction, and these effects are limited to determining who ultimately bears the exchange rate risk. In fact, because of the wide variety of risk-hedging instruments that are available to traders exposed to exchange rate fluctuations, the impact of exchange rate risk on trade patterns is likely to be secondary. This conjecture is confirmed by a substantial amount of empirical research. In short, the economic impact of the euro in international trade transactions is likely to be limited. The same cannot be said of the euro's potential role in international financial transactions. Partly because of their sheer magnitude -- some estimates place the volume of international capital transactions at more than 40 times the volume of international trade transactions -- growth in the use of the euro as the currency of choice in global capital markets will have much more significant repercussions for the United States than will increasing use of the euro in global product markets. To a large extent, these repercussions reflect the well-known gains that stem from increasing returns in the use of a currency as a store of value. As the market for a currency becomes more liquid, the costs of carrying wealth denominated in that currency fall, raising investors' preferences for denominating their portfolios in that currency. These increased preferences in turn lead to a further deepening and broadening of the market for that currency, costs of holdings are reduced further, and the process continues. As in trade transactions, the dollar is the predominant means of exchange in international financial transactions. Its predominance is especially apparent with respect to large issues of international bonds -- a clear reflection of the low cost of covering exchange rate and interest rate risk for long-term dollar instruments. I would suggest, however, that the current role of the dollar should not be taken for granted. Once the euro comes into existence, the simple conversion of the EMU countries' outstanding securities into euros will contribute to the immediate creation of a major securities market. This development alone will create a critical mass for a market in euro-denominated securities. It will give the market depth and liquidity, and, in so doing, bring down the costs of conducting transactions, issuing loans, and trading securities below those currently seen for European national currencies -- possibly to levels comparable to those for dollars. The development of such a virtuous cycle could well feed upon itself and lead to the continuous growth of the market for euros. In this context, I would like to suggest that the experience the United States has had with a large, unified capital market may point to ways in which a unified European capital market may evolve after the advent of EMU. If the U.S. experience is of any relevance, we may expect to see a decreasing use of bank loans in favor of a growing use of securities in Europe after 1999. Repo markets would also likely grow, potentially along the lines we have seen in the United States, where institutional investors such as mutual funds and pension funds, state and local governments, and insurance companies have become the largest providers of capital under repo arrangements -- in contrast with Europe's experience, where these types of investors tend to hold bank deposits. A growing role for repurchase arrangements is already apparent in Europe, and this growth may be expected to accelerate once the European central bank starts to operate in this market, accepting -- and fostering -- the use of a wide range of government paper as collateral. It is useful to keep in mind that the move to a single-currency, highly securitized European capital market cannot be expected to be completely painless. Clearly, since banks are the main intermediaries of cross-border transactions, the banking sector will bear the brunt of the costs associated with the changeover to a common currency. For example, it will suffer losses from reduced foreign exchange trading and transfer revenues. It will also have to pay for the retooling of information management and delivery systems, as well as face increased uncertainties in its core deposits. At the same time, however, the larger single market will create new opportunities for banks, particularly in the areas of investment banking and the cross-border sale of deposits, mutual funds, and other savings products. On balance, it seems fair to conclude that the commercial position and earnings of many European banks are likely to come under pressure. This may accelerate the ongoing restructuring of Europe's banking industry, a process that has been confined, to date, primarily to developments within each country. More broadly, there can be no doubt that the implications of the growth of a more efficient and cost-effective market for euro-denominated capital would extend well beyond Europe. The availability of a new, low-cost channel for portfolio investment, for example, could help reverse the traditional reluctance of households and many institutional investors worldwide to invest internationally -- a reluctance that has long puzzled academics and policymakers. Moreover, a well-developed market for euro-denominated capital would encourage institutional investors from the United States and elsewhere to acquire diversified European portfolios offered in a single currency. In fact, this development could be accelerated if member governments chose to deepen the euro market by increasing the available range of bond maturities, which in some countries is somewhat limited at the short and long ends. In addition, capital might also flow in the opposite direction, as non-European firms and governments tap the euro-denominated capital market as an efficient source of funds, in the same way as European businesses and governments have chosen to borrow dollars in recent decades. While the potential benefits of a more integrated European capital market in the long run are apparent, a number of observers have suggested that the economics of EMU -- as well as its plain mechanics -- may have unwelcome consequences for the dollar and world trade. More specifically, some have argued, EMU may cause a short-run glut of dollars in the international capital markets, leading the dollar to depreciate and the euro to appreciate, with resulting undesirable effects on trade flows. The reason there could be a dollar glut, these observers maintain, is that EMU would eliminate the need for intra-European intervention, reduce the importance of exchange rate management, and allow national central banks to pool reserves for external intervention, thus generally reducing the European central banks' need for dollar reserves. Moreover, if the euro were to become an attractive reserve currency for non-European central banks, the dollar glut could become even more severe. While some decline in the reserve role of the dollar is certainly plausible over time with the creation of EMU, I believe that the risk of a dramatic shift in official dollar reserve holdings both in and outside Europe in the wake of EMU has been exaggerated in terms of both its potential scope and effects. I would suggest that it will take some time before the objectives and operating procedures of the European central bank become clearly understood by market participants. Although low inflation will be the ultimate objective of the new European central bank, markets will have to understand precisely how that objective will be pursued: What price aggregate will be the focus of monetary policy? How will intermediate instruments such as monetary aggregates be used to achieve the ultimate objective? What channels will the central bank choose to signal and implement changes in its policy stance? As these longer-term questions are addressed, the policy importance of the external value of the euro, particularly the euro/dollar exchange rate, will certainly be watched carefully. Both market participants and foreign central banks are likely to focus on the euro exchange rate as a high-frequency and widely available -- if somewhat noisy -- indicator of the current and likely future stance of European monetary policy. Given its need to instil confidence in the markets and to ensure the stability of the euro exchange rate, the European central bank is likely to want to be perceived as ready and able to operate effectively in the dollar market, for which substantial dollar reserves may be required. In the short term, the response of non-European central banks to the introduction of the euro is also likely to be cautious. Ultimately, the desired euro holdings of these central banks will largely depend on the decisions they make about their exchange rate regime. A number of countries -- including the central European countries that have applied for membership in the European Union and other countries in Africa -- may decide to peg their currency to the euro. Yet these countries may well wait for the newly-formed European central bank to establish its policy record and clarify its operating procedures before they commit their currencies to a euro peg. Indeed, history suggests that a currency's role as an international reserve, means of exchange, and store of value is slowly gained and slowly lost -- as the examples of the dollar and pound sterling illustrate. The dollar, in particular, may have seemed on the way to losing much of its international prominence after the demise of the Bretton Woods system in 1973. After declining as a share of international reserves and a means for international transactions from 1974 to the mid-1980s, however, the dollar's relative use has not changed significantly during the past decade. Indeed, as the U.S. economy has grown more efficient and internationally competitive in the past ten years, the dollar has retained its strong role in the international monetary system. In short, it seems safe to assume that significant changes in the international role of the dollar and the functioning of the international monetary system would occur only gradually, and surely in a manner that could be easily coped with, given the turnover in capital markets we observe today. But should a different international monetary system ultimately emerge in which other currencies, such as the euro, play an increasingly important role alongside the dollar, there would be benefits for the United States as well. Such a development would, for example, impose greater market-led discipline on the United States and, in the process, help us address our chronic low-savings problem. There is another indirect -- although potentially more important -- way in which EMU may affect U.S. business and policymaking. This implication of EMU has to do with the contribution a currency union is likely to make to increasing the efficiency and flexibility of the economies that join it. At least since the publication of the "One Market, One Money" study by the European Commission in 1990, observers and analysts of EMU have paid significant attention to the decline in transaction costs that can be achieved by unifying up to 15 different currencies, and to the resulting gains in efficiency for Europe's economies. The experience of the United States is useful in this respect. The fact that 50 states in the United States share a common currency -- and have done so for over 130 years -- provides the critical foundation for an integrated and efficient capital market that extends from Maine to California and on to Alaska and Hawaii. In this market, capital flows smoothly from high-saving to high-investment areas, as required by changing business conditions, without any thought of exchange rate risk. A common U.S. currency, it is important to note, has many advantages beyond simply reducing transaction costs. It also simplifies choices for households and corporate management, enhances the efficiency with which financial institutions and the payments system function, and promotes competition across the whole productive spectrum. While a common currency in Europe can be expected to lead to similar efficiency gains, the economies of the United States and Europe differ in several important dimensions, so that a common currency is likely to work in substantially different ways in the two regions. The ways in which Europe and the United States differ most have to do with the degree of integration of their labor markets and their fiscal systems. The United States enjoys a very mobile labor force -- across sectors and states -which allows job losses arising during sector-specific or state-specific recessions to be rapidly absorbed where jobs are growing faster. This contributes to aggregate unemployment being kept reasonably in check. This willingness of American workers to move themselves and their family is a cultural characteristic of our people, no doubt based in the history of the United States as a nation of immigrants. To complement its high degree of labor mobility, the United States also has in place a federal fiscal system that allows the federal government to channel large transfers from fast-growing regions to slow-growing regions. Progressive income taxation, a high elasticity of corporate tax profits to changes in income, and an integrated federal budget are the main components of this system. In contrast to the United States, Europe is characterized by a more segmented labor market and very limited integration of its national fiscal systems. Both these characteristics limit the ability not only of Europe's private sector to shift resources in response to regional recessions, but also of Europe's public sector to compensate for this rigidity. This lack of flexibility is widely acknowledged to be one of the root causes of the high unemployment rates that Europe has experienced during the last decade. But, we may well ask, does it necessarily follow that because of the greater rigidity of its labor markets and the lack of a federal fiscal system, Europe cannot accommodate a common currency and instead needs to rely on periodic exchange rate adjustments as surrogates for productive flexibility? I do not think so. While less flexible labor markets and the absence of a federal fiscal system will certainly pose constant challenges for the management of a common European currency, a fluctuating exchange rate need not be the optimal way to respond to these shortcomings. The argument that Europe -- even a core component of Europe -- can ill afford to renounce exchange rate flexibility rests crucially on the view that Europe is significantly more heterogeneous than the United States and, therefore, more vulnerable to country-specific shocks that can best be corrected by exchange rate changes. I do not support this view. Rather, I believe that in many respects differences among the European economies have been over-emphasized in the public debate. It is possible to suggest, for example, that the economies of some European countries have more in common today than do those of some individual states in the United States, such as New York and Michigan or California and Idaho. Moreover, as a result of the convergence of economic policy objectives, the economic cycles among many European countries have become more synchronized over the last ten years, a trend that is likely to be reinforced by monetary unification. Furthermore, when shocks are mainly at the industry level -- for instance, when a recession hits the automobile or steel industry in Germany and France -- the German and French economies would hardly benefit from an exchange rate change. Such a change, in this case, simply would not affect the appropriate relative prices. By contrast, American policymakers might have found it helpful to devalue the dollar in Texas when oil prices collapsed in the mid-1980s or the dollar in New England at the end of the defense-led growth of the late 1980s. These options, however, simply were not available. In retrospect, it was the discipline fostered by the absence of the opportunity to alter regional exchange rates that forced our firms, local governments, and workers to reorganize, become more efficient, and grow in what are now some of the most productive areas of the United States. Similarly, if national labor markets in Europe become more flexible and efficient in the presence of a common currency and firms learn to count only on their own resources -- with no help from an occasional exchange rate adjustment -- European capital and labor markets may themselves become more integrated. And if greater integration of labor markets can only proceed slowly -- given persistent and unavoidable cultural and language differences -- this need not be the case for financial markets, where the disappearance of exchange rate risk will cause capital to move in response to interest rate differentials of only a very few percentage points. In this context, I would like to make clear that I do not view as ideal the U.S. model where the burden of recessions tends to fall heavily on the shoulders of workers, who may be obliged to move across regions and industries in response to the business cycle. How to deal with the reality of the business cycle is an area where Europe -- with its tradition of social safety nets -- and the United States -- with its tradition of flexible work arrangements -- can perhaps learn something from each other. To date, neither of us seems yet to have found the optimal way to cope with the unavoidable reality of the business cycle to enable us to avoid both high unemployment rates and too skewed a distribution of income. My last general observation about the implications of EMU for the United States has to do with the dramatic changes in macroeconomic policies that will accompany the creation of monetary union in Europe. Naturally, the main change will concern monetary policy, and it is in this area that the similarities between Europe and the United States will ultimately be the greatest. The first similarity is that, with EMU, the formulation of monetary policy in both Europe and the United States will be highly centralized and the European central bank will enjoy, as the Federal Reserve does, a considerable degree of independence. These institutional features will reduce the scope for national governments to bend monetary policy to the needs of their country's business cycle and will help keep the focus of the European central bank on the objective of price stability. The second similarity we may expect to see between Europe and the United States is that, with EMU, external considerations -- such as the trade balance or the value of the exchange rate -- will over time impinge less and less on the conduct of monetary policy, as now is the case in the United States. Once monetary union is in place for all 15 countries, the openness of Europe's unified economy -- as measured, for example, by the share of exports in relation to GDP -- is likely to be quite similar to that of the U.S. economy, on the order of 10 percent. While the conduct of monetary policy in Europe may increasingly resemble that in the United States, the conduct of fiscal policy will continue to differ significantly in the two regions, largely reflecting the different paths Europe and the United States have taken to monetary unification. In the United States, political union came well ahead of a common monetary policy. The Federal Reserve was not created until 1913, when political unification had been long in place. The situation is, of course, quite different in Europe, where EMU member countries plan to retain substantial political and fiscal independence. Despite this independence, EMU may well foster fiscal coordination among the member countries. This may happen in part because the EMU countries have chosen to subscribe to a set of common guidelines on the magnitude of their fiscal deficits, and in part because these countries will compete for a common pool of savings in an integrated capital market. The prospect of market-based discipline on the fiscal policies pursued by the EMU countries is not so different from the situation faced by individual states and municipalities in the United States. The need for these entities to tap a common capital market to finance their deficits places their actions under a stricter market test than they would face if they could rely mainly on captive local savings. The municipal bond market in the United States is today a very active and competitive market, where yield differences on public debt reflect investors' perceptions of default risk, and inefficient state and local administrations are quickly penalized for fiscal profligacy. Similar markets are likely to evolve in Europe after 1999. In fact, the major rating agencies are already planning for European issues of government debt following the creation of EMU. By all accounts, the agencies expect these ratings to mirror those currently assigned to countries' foreign currency debt, with fiscal factors driving rating changes once EMU is well under way. As I hope I have made clear in my remarks this evening, we in the United States, as elsewhere, have been observing the progress toward monetary unification in Europe with great interest. In the process, I think we have learned to appreciate the complexity of this enormous undertaking. One conclusion I have drawn from my observations over the years is that many of the reforms Europe is pursuing on its path to monetary unification -- including fiscal stabilization, tax harmonization, welfare and labor market reform, trade liberalization, and capital market integration -are goals that are worth pursuing in their own right and for which EMU provides a consistent frame of reference. Continued progress toward furthering these broad-based goals is in the interest not only of Europe but also of the United States. There can be no question that the United States has benefited greatly in the past two decades from Europe's deepening integration. Europe has provided a steady opening of markets for American products and served as a source of an increasingly efficient supply of goods to U.S. households and firms. Europe's growing participation in international capital markets, which a successful EMU and a strong euro are intended to further, has also encouraged an increasing flow of savings between Europe and the United States in response to changing macroeconomic conditions in our two regions. We in the United States have much at stake in Europe's and EMU's future and we stand ready to work with you and support you in the furtherance of your historic efforts.	['mr. mcdonough gives a us perspective on economic and monetary union in remarks by the president of the federal reserve bank of new york, mr. william europe j. mcdonough, before the association of german mortgage banks in frankfurt, on 17/11/97.', "i am honored to be invited by the german mortgage banks to be the keynote speaker tonight at the association's annual pfandbrief forum.", 'it is a great pleasure to be here in frankfurt among so many distinguished representatives of the german banking and financial community and members of the bundesbank council.', 'in my remarks to you this evening, i would like to offer a few thoughts on the implications of economic and monetary union in europe from my perspective as president of the federal reserve bank of new york.', "many in the united states today are following developments in europe's move toward monetary union with considerable interest.", 'i am certainly among them.', 'there can be no doubt about the magnitude and economic importance of the historic event that will take place on january 1, 1999, when the currencies of up to 15 member countries of the european union are scheduled to be unified.', 'it is a goal toward which europe has been working ever since the treaty of rome was signed in 1957 creating the european economic community.', 'while some might claim that this historic development will have little impact on the u.s. economy, nothing could be further from the truth.', 'the united states will be directly affected in several important ways by the start of economic and monetary union in europe, or emu.', 'i would like to review some of the main channels through which emu is likely to affect american business and policymaking over the next several years.', 'further, i think it may be useful to highlight some of the important similarities and differences between the currency union that exists in the united states today and the currency union that you are in the process of creating in europe.', 'the most obvious implication of the start of emu for the united states -- as well as for the world community -- is the coming into existence of a new currency, the euro, which is intended to function as a major international currency alongside the u.s. dollar.', 'i should make clear at the outset that it would be a mistake to think that the united states looks at this prospect with concern, as if the introduction of the euro could somehow compromise the ability of the united states to continue to conduct trade and financial transactions with the rest of the world.', 'as you well know, the dollar is currently used in roughly 50 percent of world trade transactions and in at least one side of 80 percent of world financial transactions.', 'the introduction of another major international currency will neither harm the depth and liquidity of the dollar market nor hinder the ability of the united states to conduct its external transactions smoothly.', 'on the contrary, to the extent that the birth of the euro fosters deeper trade and financial markets globally and a more efficient international monetary system, all countries stand to benefit, particularly an active participant such as the united states.', 'let me be more specific.', 'in my view, for the united states and the international monetary system, the implication of a growing international role for the euro over the foreseeable future will be most significant with respect to financial rather than trade transactions.', 'it is quite true that the euro may quickly become the currency of choice in the invoicing of trade between companies in the european union and their foreign counterparts.', 'companies in regions with strong links to the european union, such as those in eastern and central europe, north africa, and the cfa french franc zone, may also choose to invoice trade in euros.', 'more generally, the euro may well expand its importance in world trade beyond the relative trade weight of the european union countries, following a path similar to that taken by the u.s. dollar and -- before that -- by the pound sterling.', 'nevertheless, i would argue that the economic effects of these potential changes in invoicing practices are likely to be limited.', 'why do i say this?', 'first, to a large extent, the re-denomination of a significant share of world trade into euros will mainly represent a shift in invoicing practices from the use of former european currencies to euros.', "moreover, third-country effects are unlikely to be major, because the european currencies as a whole are already somewhat over-represented in their share of world trade transactions relative to their countries' weights in world trade -- not as much so as the dollar, but certainly more so than the yen.", 'finally, changes in trade invoicing practices have a direct economic impact only on the two parties involved in the transaction, and these effects are limited to determining who ultimately bears the exchange rate risk.', 'in fact, because of the wide variety of risk-hedging instruments that are available to traders exposed to exchange rate fluctuations, the impact of exchange rate risk on trade patterns is likely to be secondary.', 'this conjecture is confirmed by a substantial amount of empirical research.', 'in short, the economic impact of the euro in international trade transactions is likely to be limited.', "the same cannot be said of the euro's potential role in international financial transactions.", 'partly because of their sheer magnitude -- some estimates place the volume of international capital transactions at more than 40 times the volume of international trade transactions -- growth in the use of the euro as the currency of choice in global capital markets will have much more significant repercussions for the united states than will increasing use of the euro in global product markets.', 'to a large extent, these repercussions reflect the well-known gains that stem from increasing returns in the use of a currency as a store of value.', "as the market for a currency becomes more liquid, the costs of carrying wealth denominated in that currency fall, raising investors' preferences for denominating their portfolios in that currency.", 'these increased preferences in turn lead to a further deepening and broadening of the market for that currency, costs of holdings are reduced further, and the process continues.', 'as in trade transactions, the dollar is the predominant means of exchange in international financial transactions.', 'its predominance is especially apparent with respect to large issues of international bonds -- a clear reflection of the low cost of covering exchange rate and interest rate risk for long-term dollar instruments.', 'i would suggest, however, that the current role of the dollar should not be taken for granted.', "once the euro comes into existence, the simple conversion of the emu countries' outstanding securities into euros will contribute to the immediate creation of a major securities market.", 'this development alone will create a critical mass for a market in euro-denominated securities.', 'it will give the market depth and liquidity, and, in so doing, bring down the costs of conducting transactions, issuing loans, and trading securities below those currently seen for european national currencies -- possibly to levels comparable to those for dollars.', 'the development of such a virtuous cycle could well feed upon itself and lead to the continuous growth of the market for euros.', 'in this context, i would like to suggest that the experience the united states has had with a large, unified capital market may point to ways in which a unified european capital market may evolve after the advent of emu.', "if the u.s. experience is of any relevance, we may expect to see a decreasing use of bank loans in favor of a growing use of securities in europe after 1999. repo markets would also likely grow, potentially along the lines we have seen in the united states, where institutional investors such as mutual funds and pension funds, state and local governments, and insurance companies have become the largest providers of capital under repo arrangements -- in contrast with europe's experience, where these types of investors tend to hold bank deposits.", 'a growing role for repurchase arrangements is already apparent in europe, and this growth may be expected to accelerate once the european central bank starts to operate in this market, accepting -- and fostering -- the use of a wide range of government paper as collateral.', 'it is useful to keep in mind that the move to a single-currency, highly securitized european capital market cannot be expected to be completely painless.', 'clearly, since banks are the main intermediaries of cross-border transactions, the banking sector will bear the brunt of the costs associated with the changeover to a common currency.', 'for example, it will suffer losses from reduced foreign exchange trading and transfer revenues.', 'it will also have to pay for the retooling of information management and delivery systems, as well as face increased uncertainties in its core deposits.', 'at the same time, however, the larger single market will create new opportunities for banks, particularly in the areas of investment banking and the cross-border sale of deposits, mutual funds, and other savings products.', 'on balance, it seems fair to conclude that the commercial position and earnings of many european banks are likely to come under pressure.', "this may accelerate the ongoing restructuring of europe's banking industry, a process that has been confined, to date, primarily to developments within each country.", 'more broadly, there can be no doubt that the implications of the growth of a more efficient and cost-effective market for euro-denominated capital would extend well beyond europe.', 'the availability of a new, low-cost channel for portfolio investment, for example, could help reverse the traditional reluctance of households and many institutional investors worldwide to invest internationally -- a reluctance that has long puzzled academics and policymakers.', 'moreover, a well-developed market for euro-denominated capital would encourage institutional investors from the united states and elsewhere to acquire diversified european portfolios offered in a single currency.', 'in fact, this development could be accelerated if member governments chose to deepen the euro market by increasing the available range of bond maturities, which in some countries is somewhat limited at the short and long ends.', 'in addition, capital might also flow in the opposite direction, as non-european firms and governments tap the euro-denominated capital market as an efficient source of funds, in the same way as european businesses and governments have chosen to borrow dollars in recent decades.', 'while the potential benefits of a more integrated european capital market in the long run are apparent, a number of observers have suggested that the economics of emu -- as well as its plain mechanics -- may have unwelcome consequences for the dollar and world trade.', 'more specifically, some have argued, emu may cause a short-run glut of dollars in the international capital markets, leading the dollar to depreciate and the euro to appreciate, with resulting undesirable effects on trade flows.', "the reason there could be a dollar glut, these observers maintain, is that emu would eliminate the need for intra-european intervention, reduce the importance of exchange rate management, and allow national central banks to pool reserves for external intervention, thus generally reducing the european central banks' need for dollar reserves.", 'moreover, if the euro were to become an attractive reserve currency for non-european central banks, the dollar glut could become even more severe.', 'while some decline in the reserve role of the dollar is certainly plausible over time with the creation of emu, i believe that the risk of a dramatic shift in official dollar reserve holdings both in and outside europe in the wake of emu has been exaggerated in terms of both its potential scope and effects.', 'i would suggest that it will take some time before the objectives and operating procedures of the european central bank become clearly understood by market participants.', 'although low inflation will be the ultimate objective of the new european central bank, markets will have to understand precisely how that objective will be pursued: what price aggregate will be the focus of monetary policy?', 'how will intermediate instruments such as monetary aggregates be used to achieve the ultimate objective?', 'what channels will the central bank choose to signal and implement changes in its policy stance?', 'as these longer-term questions are addressed, the policy importance of the external value of the euro, particularly the euro/dollar exchange rate, will certainly be watched carefully.', 'both market participants and foreign central banks are likely to focus on the euro exchange rate as a high-frequency and widely available -- if somewhat noisy -- indicator of the current and likely future stance of european monetary policy.', 'given its need to instil confidence in the markets and to ensure the stability of the euro exchange rate, the european central bank is likely to want to be perceived as ready and able to operate effectively in the dollar market, for which substantial dollar reserves may be required.', 'in the short term, the response of non-european central banks to the introduction of the euro is also likely to be cautious.', 'ultimately, the desired euro holdings of these central banks will largely depend on the decisions they make about their exchange rate regime.', 'a number of countries -- including the central european countries that have applied for membership in the european union and other countries in africa -- may decide to peg their currency to the euro.', 'yet these countries may well wait for the newly-formed european central bank to establish its policy record and clarify its operating procedures before they commit their currencies to a euro peg.', "indeed, history suggests that a currency's role as an international reserve, means of exchange, and store of value is slowly gained and slowly lost -- as the examples of the dollar and pound sterling illustrate.", "the dollar, in particular, may have seemed on the way to losing much of its international prominence after the demise of the bretton woods system in 1973. after declining as a share of international reserves and a means for international transactions from 1974 to the mid-1980s, however, the dollar's relative use has not changed significantly during the past decade.", 'indeed, as the u.s. economy has grown more efficient and internationally competitive in the past ten years, the dollar has retained its strong role in the international monetary system.', 'in short, it seems safe to assume that significant changes in the international role of the dollar and the functioning of the international monetary system would occur only gradually, and surely in a manner that could be easily coped with, given the turnover in capital markets we observe today.', 'but should a different international monetary system ultimately emerge in which other currencies, such as the euro, play an increasingly important role alongside the dollar, there would be benefits for the united states as well.', 'such a development would, for example, impose greater market-led discipline on the united states and, in the process, help us address our chronic low-savings problem.', 'there is another indirect -- although potentially more important -- way in which emu may affect u.s. business and policymaking.', 'this implication of emu has to do with the contribution a currency union is likely to make to increasing the efficiency and flexibility of the economies that join it.', 'at least since the publication of the "one market, one money" study by the european commission in 1990, observers and analysts of emu have paid significant attention to the decline in transaction costs that can be achieved by unifying up to 15 different currencies, and to the resulting gains in efficiency for europe\'s economies.', 'the experience of the united states is useful in this respect.', 'the fact that 50 states in the united states share a common currency -- and have done so for over 130 years -- provides the critical foundation for an integrated and efficient capital market that extends from maine to california and on to alaska and hawaii.', 'in this market, capital flows smoothly from high-saving to high-investment areas, as required by changing business conditions, without any thought of exchange rate risk.', 'a common u.s. currency, it is important to note, has many advantages beyond simply reducing transaction costs.', 'it also simplifies choices for households and corporate management, enhances the efficiency with which financial institutions and the payments system function, and promotes competition across the whole productive spectrum.', 'while a common currency in europe can be expected to lead to similar efficiency gains, the economies of the united states and europe differ in several important dimensions, so that a common currency is likely to work in substantially different ways in the two regions.', 'the ways in which europe and the united states differ most have to do with the degree of integration of their labor markets and their fiscal systems.', 'the united states enjoys a very mobile labor force -- across sectors and states -which allows job losses arising during sector-specific or state-specific recessions to be rapidly absorbed where jobs are growing faster.', 'this contributes to aggregate unemployment being kept reasonably in check.', 'this willingness of american workers to move themselves and their family is a cultural characteristic of our people, no doubt based in the history of the united states as a nation of immigrants.', 'to complement its high degree of labor mobility, the united states also has in place a federal fiscal system that allows the federal government to channel large transfers from fast-growing regions to slow-growing regions.', 'progressive income taxation, a high elasticity of corporate tax profits to changes in income, and an integrated federal budget are the main components of this system.', 'in contrast to the united states, europe is characterized by a more segmented labor market and very limited integration of its national fiscal systems.', "both these characteristics limit the ability not only of europe's private sector to shift resources in response to regional recessions, but also of europe's public sector to compensate for this rigidity.", 'this lack of flexibility is widely acknowledged to be one of the root causes of the high unemployment rates that europe has experienced during the last decade.', 'but, we may well ask, does it necessarily follow that because of the greater rigidity of its labor markets and the lack of a federal fiscal system, europe cannot accommodate a common currency and instead needs to rely on periodic exchange rate adjustments as surrogates for productive flexibility?', 'i do not think so.', 'while less flexible labor markets and the absence of a federal fiscal system will certainly pose constant challenges for the management of a common european currency, a fluctuating exchange rate need not be the optimal way to respond to these shortcomings.', 'the argument that europe -- even a core component of europe -- can ill afford to renounce exchange rate flexibility rests crucially on the view that europe is significantly more heterogeneous than the united states and, therefore, more vulnerable to country-specific shocks that can best be corrected by exchange rate changes.', 'i do not support this view.', 'rather, i believe that in many respects differences among the european economies have been over-emphasized in the public debate.', 'it is possible to suggest, for example, that the economies of some european countries have more in common today than do those of some individual states in the united states, such as new york and michigan or california and idaho.', 'moreover, as a result of the convergence of economic policy objectives, the economic cycles among many european countries have become more synchronized over the last ten years, a trend that is likely to be reinforced by monetary unification.', 'furthermore, when shocks are mainly at the industry level -- for instance, when a recession hits the automobile or steel industry in germany and france -- the german and french economies would hardly benefit from an exchange rate change.', 'such a change, in this case, simply would not affect the appropriate relative prices.', 'by contrast, american policymakers might have found it helpful to devalue the dollar in texas when oil prices collapsed in the mid-1980s or the dollar in new england at the end of the defense-led growth of the late 1980s.', 'these options, however, simply were not available.', 'in retrospect, it was the discipline fostered by the absence of the opportunity to alter regional exchange rates that forced our firms, local governments, and workers to reorganize, become more efficient, and grow in what are now some of the most productive areas of the united states.', 'similarly, if national labor markets in europe become more flexible and efficient in the presence of a common currency and firms learn to count only on their own resources -- with no help from an occasional exchange rate adjustment -- european capital and labor markets may themselves become more integrated.', 'and if greater integration of labor markets can only proceed slowly -- given persistent and unavoidable cultural and language differences -- this need not be the case for financial markets, where the disappearance of exchange rate risk will cause capital to move in response to interest rate differentials of only a very few percentage points.', 'in this context, i would like to make clear that i do not view as ideal the u.s. model where the burden of recessions tends to fall heavily on the shoulders of workers, who may be obliged to move across regions and industries in response to the business cycle.', 'how to deal with the reality of the business cycle is an area where europe -- with its tradition of social safety nets -- and the united states -- with its tradition of flexible work arrangements -- can perhaps learn something from each other.', 'to date, neither of us seems yet to have found the optimal way to cope with the unavoidable reality of the business cycle to enable us to avoid both high unemployment rates and too skewed a distribution of income.', 'my last general observation about the implications of emu for the united states has to do with the dramatic changes in macroeconomic policies that will accompany the creation of monetary union in europe.', 'naturally, the main change will concern monetary policy, and it is in this area that the similarities between europe and the united states will ultimately be the greatest.', 'the first similarity is that, with emu, the formulation of monetary policy in both europe and the united states will be highly centralized and the european central bank will enjoy, as the federal reserve does, a considerable degree of independence.', "these institutional features will reduce the scope for national governments to bend monetary policy to the needs of their country's business cycle and will help keep the focus of the european central bank on the objective of price stability.", 'the second similarity we may expect to see between europe and the united states is that, with emu, external considerations -- such as the trade balance or the value of the exchange rate -- will over time impinge less and less on the conduct of monetary policy, as now is the case in the united states.', "once monetary union is in place for all 15 countries, the openness of europe's unified economy -- as measured, for example, by the share of exports in relation to gdp -- is likely to be quite similar to that of the u.s. economy, on the order of 10 percent.", 'while the conduct of monetary policy in europe may increasingly resemble that in the united states, the conduct of fiscal policy will continue to differ significantly in the two regions, largely reflecting the different paths europe and the united states have taken to monetary unification.', 'in the united states, political union came well ahead of a common monetary policy.', 'the federal reserve was not created until 1913, when political unification had been long in place.', 'the situation is, of course, quite different in europe, where emu member countries plan to retain substantial political and fiscal independence.', 'despite this independence, emu may well foster fiscal coordination among the member countries.', 'this may happen in part because the emu countries have chosen to subscribe to a set of common guidelines on the magnitude of their fiscal deficits, and in part because these countries will compete for a common pool of savings in an integrated capital market.', 'the prospect of market-based discipline on the fiscal policies pursued by the emu countries is not so different from the situation faced by individual states and municipalities in the united states.', 'the need for these entities to tap a common capital market to finance their deficits places their actions under a stricter market test than they would face if they could rely mainly on captive local savings.', "the municipal bond market in the united states is today a very active and competitive market, where yield differences on public debt reflect investors' perceptions of default risk, and inefficient state and local administrations are quickly penalized for fiscal profligacy.", 'similar markets are likely to evolve in europe after 1999. in fact, the major rating agencies are already planning for european issues of government debt following the creation of emu.', "by all accounts, the agencies expect these ratings to mirror those currently assigned to countries' foreign currency debt, with fiscal factors driving rating changes once emu is well under way.", 'as i hope i have made clear in my remarks this evening, we in the united states, as elsewhere, have been observing the progress toward monetary unification in europe with great interest.', 'in the process, i think we have learned to appreciate the complexity of this enormous undertaking.', 'one conclusion i have drawn from my observations over the years is that many of the reforms europe is pursuing on its path to monetary unification -- including fiscal stabilization, tax harmonization, welfare and labor market reform, trade liberalization, and capital market integration -are goals that are worth pursuing in their own right and for which emu provides a consistent frame of reference.', 'continued progress toward furthering these broad-based goals is in the interest not only of europe but also of the united states.', "there can be no question that the united states has benefited greatly in the past two decades from europe's deepening integration.", 'europe has provided a steady opening of markets for american products and served as a source of an increasingly efficient supply of goods to u.s. households and firms.', "europe's growing participation in international capital markets, which a successful emu and a strong euro are intended to further, has also encouraged an increasing flow of savings between europe and the united states in response to changing macroeconomic conditions in our two regions.", "we in the united states have much at stake in europe's and emu's future and we stand ready to work with you and support you in the furtherance of your historic efforts."]	William J McDonough	Federal Reserve Bank of New York	President	US
https://www.bis.org/review/r971202a.pdf	Mr. Sheng looks at asset prices, capital flows and risk management	Address given by the Deputy Chief Executive of the Hong Kong Monetary Authority, Mr. Andrew Sheng, at the Asian Securities Analysts Federation Conference in Bangkok, on 17/11/97 (slightly abridged).	1997-12-01 23:00:00	Address Mr. Sheng looks at asset prices, capital flows and risk management given by the Deputy Chief Executive of the Hong Kong Monetary Authority, Mr. Andrew Sheng, at the Asian Securities Analysts Federation Conference in Bangkok, on 17/11/97 (slightly abridged). 1. I am very honoured to be invited today to address this distinguished Conference. The title of my paper is "Asset Prices, Capital Flows and Risk Management". All these factors have been the main players in the recent market turbulence in the region. I will therefore focus my discussion today on the lessons from the recent Asian market turmoil and also the impact on Hong Kong. The Surge in Capital Flows 2. In the past decade, capital flows surged within the Asian region and globally. According to IMF statistics, average annual net capital inflows to developing countries exceeded US$150 billion in 1990-96, and more than 40% of which actually came to Asia. In the last two years we saw even more capital inflows to the region, recording a net total of US$107 billion in 1996 and a similar growth rate in the first half of 1997. In some Asian economies, net inflows have averaged 5-8% of GDP over long periods, with over half of such capital flows in the form of foreign direct investment. 3. The growth in international capital flows is the result of greater financial liberalization and sophistication in markets around the world, the rise of institutional investors such as mutual and pension funds, and growing financial innovation and intermediation, especially in derivative products. We all know that capital movements help growth through a more global efficient allocation of resources and bring new knowledge and technology to emerging economies. 4. On the other hand, international capital flows can be very volatile in nature, with the tendency of reversing direction when there is the slightest hint of risk, whether it is in the conduct of macroeconomic policies or concerns over the fragility of the financial sector. Capital flows now drive the balance of payments more than trade flows. Portfolio shifts operate on the basis of market expectations of risk, return and liquidity. A high level of arbitraging, such as the borrowing of funds from one market to invest in another market, leads to contagion effects. Losses in one market therefore result in sales in another. This is a risk that should be addressed not only by those who are now under the process of capital liberalization, but also by the whole international community. Global markets mean global contagion. This is no longer a uniquely Asian problem. 5. Let us now consider the recent Asian market turbulence in the global context. Until recently, Asia enjoyed the benefits of the high global liquidity, and recorded admirable levels of capital inflows, as driven by the high global liquidity in G-3 economies. Indeed, high global liquidity is also the consequence of strong productivity growth, low inflation and improved government savings, especially in the United States, which has resulted in the strongest growth in world trade in decades. 6. With well-behaved inflation, the ample international liquidity has resulted in a global stock market boom in the 1990s, in both Europe and the US, as well as emerging markets in Latin America and Eastern Europe. But this has also caused a global compression of interest rate spreads and record levels of new issuance in both domestic and international bond markets. Such narrowing of spreads did not reflect the potential credit and market risks associated with the emerging markets. So when investors finally realize that the emerging markets are carrying more risks than they have assumed, the risk premium as measured by the yield spreads will widen sharply to reflect this. 7. This scenario was complicated by the fact that the flood of global liquidity has been largely channelled to the bond, equity and property markets of East Asia. Buoyed by optimism about the Asian miracle growth of the last decade, both domestic and foreign investors committed the classic "fallacy of composition". Initially, each individual may perceive a high return and increase their investments in assets, leading in aggregate to excess demand and a market overshoot. A reversal of perception leads to a sharp market correction, which is exactly what is happening not only in Asia, but globally. As Chairman Greenspan said recently, "in retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk". 8. The strong Asian growth would have continued but for the fact that global competition in external trade has emerged with newly industrialized and export-oriented economies with cheap labour, such as China, India, Latin American and Eastern Europe. The failure of central planning has brought at least three billion new workers and consumers into the global market. These new markets began to benefit from the growing trade liberalization and inflows of foreign investments, thus putting greater pressure on the markets of the earlier "tigers" of East Asia, leading to a widening of their current account deficits as they continued their investments in infrastructure and real estate. Issues in Asia 9. If we look more closely at the situation in Asia, the economic fundamentals remain intact. Asia has been the fastest-growing region in the world, recording growth rates of around 5%-9%. Asian economies have low inflation rates and exchange rates were stable until recently. Current account for the region as a whole is broadly in balance, while the fiscal account, excluding Japan, is in surplus. Asia has exceptionally high savings rates of above 30% of GDP. Official savings, in terms of foreign currency reserves, were even higher. In Asia, 70% of the inflows contributed to reserve accumulation. As a result, Asian central banks are now holding about 40% of the world's foreign exchange reserves. Five of the top six foreign exchange holders in the world are now Asians. 10. The strong fundamentals -- a young, educated, flexible workforce, stable government, good natural resources and communications infrastructure, openness to trade and innovation, and high savings and investment rates -- these have not basically changed. Asia is still outward-looking, with open markets and openness to technology and innovation. The aspirations of Asia are also real: an entrepreneurial approach to innovation, competition and better standards of living for the rising urban population. Where Asians have perhaps kept their eyes off the ball is the need to develop the services sector in complementary step with the manufacturing or export sectors. Delays in opening the financial sectors to global competition make them vulnerable to real sector excesses or imbalances, such as the overconcentration of risks in certain areas, including the asset markets. 11. The momentum of growth depends critically on continued vigorous trade reform, fiscal prudence and improvements in finance, health and education policies. Increasingly, exports are changing from labour-intensive industrial production, and more toward higher value-added industries and services. This poses the challenge of sustaining productivity growth. 12. The Asian turmoil being a financial turmoil on the surface, let me focus on the interesting way Asia recycles its surplus savings. As my colleague Joseph Yam has consistently pointed out, a large portion of Asian foreign exchange reserves is invested in assets of the OECD countries, which provides safe and liquid instruments. These funds return to the region in the form of foreign direct investment and foreign portfolio investment. This global recycling also exposes Asian economies to volatile portfolio adjustments due to policy mistakes or shifts in the international economic environment. Currently, there are no deep, liquid and mature debt markets in Asia for the intermediation process to function more efficiently. The process has begun in the last few years, and with the building of better financial infrastructure, this round of turmoil should add greater impetus to greater cooperation in building better regional financial intermediation. 13. As we all can see in hindsight, the risks involved in international capital flows are exacerbated when short-term capital flows are all attracted to the asset markets. This has led to asset bubbles, with all the painful consequences of asset price deflation. 14. But what is much more evident in Asia is that the process of hedging, arbitrage and "carry trade", whereby arbitrageurs borrow in one market and invest in another market that offers higher interest rates, has created both regional and global contagion. Portfolio shifts mean that when asset prices change (and in this I would include: consumer prices, interest rates, exchange rates, debt and equity prices and property prices) funds will flow in and out to follow the "law of one price". This suggests that open economies must adjust to global prices. The speed of such adjustments is only determined by the degree of openness of the domestic economy and financial markets. In other words, whether we like it or not, we are being priced globally by the market. 15. Many of us have not fully appreciated the full logic of this. The financial turmoil suggests that while the real sector causes of the stress is global competition, the financial effect is stress on domestic banking systems, as the banks intermediate the global portfolio adjustments. In an open economy, capital inflows will increase the deposit base of domestic banks which may be channelled through credit mistakes into fuelling domestic asset price bubbles. There are two implications. First, asset price inflation eventually feeds into domestic inflation and erodes external competitiveness. Second, excessive lending concentration into less productive assets, either real estate or over-investment in infrastructure and production capacity, exposes the financial institutions to huge risks. 16. From the viewpoint of financial intermediation, there are three major risks in Asia that underlie the shocks there: First, maturity mismatch -- Asian markets made the mistake of borrowing short-term capital • flows to finance illiquid non-tradables, such as property, thus exposing themselves to huge liquidity needs when capital flows reversed. • Second, currency mismatch -- corporations who borrowed foreign currency funds to finance investments that do not generate sufficient foreign exchange to repay the debt run a currency mismatch. • Third, credit risk -- lending or investments ultimately must be against sound profits that generate long-term returns higher than the borrowing rate or prospective dividends. Undue exuberance on the part of investors, when price-earning ratios grow beyond fundamentals, or on the part of bankers who failed to assess the impact of high interest rates on collateral or cash flows, would expose both the investor and the lender to asset losses. 17. Specifically, banks in Asia, having easier access to funds as a result of high global liquidity, were able to expand lending much more quickly and, thereby, incurred higher risks in their portfolios that they need to manage more soundly. Ironically, domestic banks may have been induced to move into more risky lending due to increased competition in the form of new entrants and financial intermediation. There is no question that they need to manage these new risks better. 18. There is also one distinguishing feature of the Asian turmoil. The debt problems have not been those of the public sector. On the contrary, the fiscal positions of Asian governments have by and large been quite sound. East Asia, excluding Japan, ran a fiscal surplus of US$5.4 billion or 0.1% of GDP in 1996. The debt burden, in fact, has been largely one of private sector overborrowing. The resolution of the debt of the private sector makes the Asian problems quite different from the experience of the sovereign debt issues of the 1980s. 19. In essence, the Asian problem is the age-old question of efficient resource allocation. Asia has no shortage of funds, only that its high level of savings are invested in less liquid long-term investments. Thus, one of the more pressing issues in Asia is to build a more competitive, stable financial system and a robust infrastructure to facilitate efficient financial intermediation. The better risk management of the financial system would also assist both corporations and investors to manage also their risks better. Ultimately, a balanced and flexible economy with sound risk management will then be in a better position to withstand global shocks and avoid crisis. The need for national risk management 20. We are all aware of the complexities of risks in financial markets. Aside from credit risks, market risks such as interest rate, exchange rate, legal risks, operational risks and systemic risks all have to be managed, both at the micro level and at the macro level. All markets suffer from the "fallacy of composition". Mistakes at the corporate or bank level will add up to national mistakes, which now may add up to regional or international crisis through contagion. Traditional risk management at corporate or sectoral level simply shift risks from one sector to another. Risks still remain in the economy as a whole. Thus, increasingly in the 1980s, there emerged the awareness that financial sector regulation was all about national risk management. 21. National risk management covers six major aspects: • Credible policies, with monetary and fiscal policies consistent with each other, and applied consistently. Capital account liberalization should be phased appropriately. • Sound fundamentals include a high domestic savings rate, sustainable fiscal and balance of • payments positions, high foreign exchange reserves and prudent debt management. • Good supervision involves the maintenance of solid capital adequacy and liquidity requirements for the financial sector, as well as regular examination and monitoring of financial institutions and markets. The banking system must have the capacity to avoid excessive credit concentrations and risks, and to manage market risks well. • A robust financial infrastructure would encompass an efficient payments and settlements system for domestic and international transactions. In essence, the world is moving towards Real Time Gross Settlement (RTGS) system, which support Delivery vs. Payment (DvP) and Payment vs. Payment (PvP). RTGS reduces payment risks and allows central banks to monitor flows in domestic currency as well as exposure of banks on a real time basis. A non-distortive incentive structure, such as taxation or regulatory restrictions that would not • encourage risk concentrations or excessive leverage in any economic sectors. 22. Put simply, managing national risks is equivalent to achieving three objectives. First, lower national gearing, because leveraging adds risks, especially if this is leveraged from external borrowing. The more you borrow abroad, the more you become vulnerable to external shocks. Second, the higher the level of domestic savings, which should be reflected in higher bank capital, lower credit/GDP ratio, and higher fiscal surpluses, the greater the resilience to the pain of adjustment to external or internal shocks. Third, irrespective of the exchange rate regime, there must be a commitment to a stable currency, and this means strong external reserves, low inflation and a sound banking system. Asset prices and the exchange rate regime 23. The Asian market turmoil also raises the question as to whether the exchange rate regime matters. I believe the debate about whether the nominal exchange rate should be floating or fixed misses the point in Asia. The real issue is the real effective exchange rate of the economy, namely, its underlying productivity and global competitiveness. 24. For example, there is a mistaken perception that fixed exchange rates give rise to asset bubbles. But if you look at the recent evidence of asset price bubbles in advanced economies, asset price bubbles also occurred in the 1980s in countries with flexible exchange rates, such as Japan, Scandinavia and the United Kingdom. Asset price appreciation cannot be tackled alone by interest rates, since there are multiple reasons for such appreciation 25. In Asia, we can perhaps identify four main reasons: • First, the Asian household has always looked upon house ownership not only as a social necessity, but also as the best hedge against inflation. Second, Asia is a young market, experiencing a high rate of urbanization. The strong demand for • housing arising from demographics alone will fairly quickly eliminate excess capacity in many economies. • Third, housing supply constraints also gave rise to high housing costs. Examples are inadequate supply of land, excessive tax burden on housing and construction, and inefficient urban planning and approval procedures that delay market responses to the rising demand for housing. Over-rapid liberalization of supply constraints were also one reason for the emergence of excess supply. • Fourth, the high global liquidity that appeared has improved access to funds, which resulted in excessive exuberance on asset price inflation. The Impact on Hong Kong 26. Amidst the recent attacks to the regional currency markets, no economy in Asia has been totally immune, not least Hong Kong, despite the strong fundamentals. 27. If we identify the real issues in Asia as one of structural competitiveness in the global economy, caused by shifts in global resources and rising productivity outside the region, then structural adjustment must come through changes in either the internal price or the external price. With a fixed exchange rate regime and therefore a fixed external price, such as in Hong Kong, the adjustment comes through changes in the internal prices, especially the asset markets. In those economies with floating exchange rates, there may be adjustment in both the internal and external prices. This is exactly what is happening right now. Using the US dollar still as the benchmark currency, it is very interesting to see that since the beginning of the year, the Hang Seng Index has declined by 26% as of last Friday, Singapore Strait Times Index by 32%, the Nikkei 225 by 28% and the other ASEAN indices by between 50-60%. Thus, markets adjust irrespective of the exchange rate regime and the unit of account. 28. Is there any easy way of avoiding the pain of adjustment in Asia due to rising global competition? The answer is clearly no. As a general rule, the faster we adjust, the less the pain. There have been different approaches to this issue. There are some who think that a floating exchange rate regime would cushion the pain, but many forget that Hong Kong has tried the floating exchange rate regime before, in 1974-83. During that period, growth was more volatile and inflation much higher than what we are experiencing now. As an open economy with trade accounting for 285% of GDP, any inflation would be immediately imported under exchange rate volatility. The recent experience in Asia actually shows that contrary to the theory, floating exchange rates requires even higher interest rates, because of the higher risks associated with exchange rate volatility. 29. Here I would like to correct the common image that the Hong Kong's exchange rate regime is a peg. The Hong Kong dollar is a fixed exchange rate, not a peg which can be adjusted from time to time. The linked exchange rate system in Hong Kong operates as a currency board system whereby the issue of Hong Kong dollar notes is fully backed by the US dollar at the fixed rate of US$1 to HK$7.80. Such a note-issuing mechanism ensures that currency issued is fully backed by foreign exchange. With the sustained budget surplus and accumulated surplus on the Exchange Fund and Land Fund assets, the actual amount of foreign reserves in Hong Kong amounted to US$88.1 billion at the end of September, the third largest in the world. This is more than seven times Hong Kong dollar cash in circulation or over three times HK$ M1. 30. The currency board system has an automatic adjustment mechanism to maintain exchange rate stability. When there are outflows of funds from the Hong Kong dollar, the Hong Kong Monetary Authority (HKMA) will sell US dollars to banks for Hong Kong dollar. On settlement day, the HKMA will debit the clearing accounts of the banks for the necessary amounts of Hong Kong dollars in return for the US dollar that will be credited to the New York accounts of the same banks. Since banks may have sold more Hong Kong dollars than they have in their clearing accounts with the HKMA, they can only obtain Hong Kong dollars by borrowing from other banks, by bidding up the interbank rates, or selling back the US dollars to the HKMA, that is, by reversing their short position. In fact, the banks do not hold excess Hong Kong dollars because they are generally long in foreign currency. The latest data at the end of July shows that the Hong Kong banking system is short roughly HK$33 billion or US$4 billion. 31. In addition to the robust currency board mechanism, the linked exchange rate system is underpinned by some of the strongest fundamentals in Asia, if not the world: • Growth is strong, at 5.5%. Fiscal position has been consistently strong, with an average fiscal surplus averaging 2% of GDP • for the past decade. Fiscal surplus in 1997 so far is 4.4% of GDP and is expected to exceed 5% of GDP. The government has no external debt. • • Exchange Fund and Land Fund together have more than US$100 billion in assets. • Corporate debt ratios are amongst the lowest in Asia. • The external account is broadly in balance. 32. The free markets and strong fundamentals mean that the nature of the shock is absorbable. Hong Kong does have a strong competitive edge, since we are a service economy with 83% in the services sector. As a major investor and integrator of production in the region, with manufacturing concerns in China and Southeast Asia, Hong Kong companies could adjust production to areas which have the greatest export competitiveness. In addition, the mainland Chinese economy is still growing at 8-9% per annum, with low inflation, a balanced external account and strong commitment to reforms in the enterprise and financial sectors. All these auger well for Hong Kong as the main gateway to the Chinese market. 33. The current higher interest rates reflect somewhat a slightly higher risk premium in Asia due to the currency turmoil. We do admit that the higher interest rates affected the stock market and property market. But we should also remember that high interest rates are necessary to cool the overheating in the asset markets that prevailed until recently. Given the excess demand situation in Hong Kong as the economy grew by 6.4% in the second quarter, a correction was expected. A moderation in property prices will help bring houses to more affordable levels to homebuyers. 34. Higher interest rates will also bring down inflation, by encouraging savings. Once inflation and the asset markets correct under the free market regime, Hong Kong will become much more competitive. In real effective exchange rate terms, the competitive effect of neighbouring depreciation will be offset somewhat by a rise in domestic inflation. Higher interest rates will also bring the external account more in line with the fundamentals and improve the trade balance. Hong Kong, as a free market economy, is adjusting exactly according to the textbook. 35. Moreover, our banking sector is very robust and strongly capitalized to withstand any shocks. Operating profits of the local banks grew by about 18% in the first half of 1997 and the bad debt charged fell in the first half of 1997 as the level of classified loans was 2.08%, down from 2.91% a year earlier. The capital adequacy ratios of local banks as a whole exceeds 17%. The average loan-to-value ratio is 70%, with the actual measured loan-to-value ratio being 53.3%, according to our survey at end September 1994. Therefore, HKMA's efforts to build a strong banking sector, including the distribution of maturity risks through the mortgage corporation and the creation of an efficient RTGS payment system are all necessary efforts to prevent an external shock from affecting the banking system. In particular, the RTGS system allows the HKMA to monitor closely banks' settlement transactions on a real time basis. Banks would also have to fund their settlements and provide ample liquidity on a more prudent basis. All these are in line with our objective of making the markets more efficient to enable the free market to clear aggregate supply and demand at an equilibrium price quickly. 36. But we should always remember that there is no free lunch. The fixed exchange rate regime implies a flexible economy to adjust to the exchange rate. Hong Kong has high flexibility, attributable to a high savings rate, entrepreneurial spirit and high labour productivity. A fixed exchange rate is a discipline on both the private and public sectors: the economy adjusts to the exchange rate, not the other way around. We do not pretend to say that a fixed exchange rate is the perfect system, because even the IMF admits that there is no perfect system. But it is the best system for Hong Kong. The linked exchange rate system is here to stay. Conclusion 37. As one of the contributors to the World Bank study on the Asian Miracle, I have never considered the Asian growth story as a miracle. Paul Krugman called it perspiration, not inspiration. Yes, it was the result of hard work, high savings, stable governments and good aspirations. But no one can deny that Asian corporations rank amongst some of the most productive and efficient in the world. Perhaps we were victims of our own success. Global capital inflows were the most sincere form of flattery, and those of us who succumbed to the easy money have now wakened to new challenges and risks. 38. Asia is now in a new growth league, with greater global competition. The adjustments will not be easy, especially building stronger and more robust financial systems to handle the new risks of globalization. There is a new realism in Asia, that however painful the adjustment, we have to make the necessary changes. As competition intensifies at all levels, there can be no reversal to the globalization, and we simply have to recognize that we live in one globe and we share the same growing pains. I am confident that Asia's basic strength of flexibility, realism and pragmatic policies will see the region through, with a little bit of help from the IMF. In the words of Mr. Michel Camdessus, IMF Managing Director, what has happened is a blessing in disguise. Asia will emerge stronger and more resilient, and it will continue to be a pillar of growth in the new global economy.	['address mr. sheng looks at asset prices, capital flows and risk management given by the deputy chief executive of the hong kong monetary authority, mr. andrew sheng, at the asian securities analysts federation conference in bangkok, on 17/11/97 (slightly abridged).', '1. i am very honoured to be invited today to address this distinguished conference.', 'the title of my paper is "asset prices, capital flows and risk management".', 'all these factors have been the main players in the recent market turbulence in the region.', 'i will therefore focus my discussion today on the lessons from the recent asian market turmoil and also the impact on hong kong.', 'the surge in capital flows 2. in the past decade, capital flows surged within the asian region and globally.', 'according to imf statistics, average annual net capital inflows to developing countries exceeded us$150 billion in 1990-96, and more than 40% of which actually came to asia.', 'in the last two years we saw even more capital inflows to the region, recording a net total of us$107 billion in 1996 and a similar growth rate in the first half of 1997. in some asian economies, net inflows have averaged 5-8% of gdp over long periods, with over half of such capital flows in the form of foreign direct investment.', '3. the growth in international capital flows is the result of greater financial liberalization and sophistication in markets around the world, the rise of institutional investors such as mutual and pension funds, and growing financial innovation and intermediation, especially in derivative products.', 'we all know that capital movements help growth through a more global efficient allocation of resources and bring new knowledge and technology to emerging economies.', '4. on the other hand, international capital flows can be very volatile in nature, with the tendency of reversing direction when there is the slightest hint of risk, whether it is in the conduct of macroeconomic policies or concerns over the fragility of the financial sector.', 'capital flows now drive the balance of payments more than trade flows.', 'portfolio shifts operate on the basis of market expectations of risk, return and liquidity.', 'a high level of arbitraging, such as the borrowing of funds from one market to invest in another market, leads to contagion effects.', 'losses in one market therefore result in sales in another.', 'this is a risk that should be addressed not only by those who are now under the process of capital liberalization, but also by the whole international community.', 'global markets mean global contagion.', 'this is no longer a uniquely asian problem.', '5. let us now consider the recent asian market turbulence in the global context.', 'until recently, asia enjoyed the benefits of the high global liquidity, and recorded admirable levels of capital inflows, as driven by the high global liquidity in g-3 economies.', 'indeed, high global liquidity is also the consequence of strong productivity growth, low inflation and improved government savings, especially in the united states, which has resulted in the strongest growth in world trade in decades.', '6. with well-behaved inflation, the ample international liquidity has resulted in a global stock market boom in the 1990s, in both europe and the us, as well as emerging markets in latin america and eastern europe.', 'but this has also caused a global compression of interest rate spreads and record levels of new issuance in both domestic and international bond markets.', 'such narrowing of spreads did not reflect the potential credit and market risks associated with the emerging markets.', 'so when investors finally realize that the emerging markets are carrying more risks than they have assumed, the risk premium as measured by the yield spreads will widen sharply to reflect this.', '7. this scenario was complicated by the fact that the flood of global liquidity has been largely channelled to the bond, equity and property markets of east asia.', 'buoyed by optimism about the asian miracle growth of the last decade, both domestic and foreign investors committed the classic "fallacy of composition".', 'initially, each individual may perceive a high return and increase their investments in assets, leading in aggregate to excess demand and a market overshoot.', 'a reversal of perception leads to a sharp market correction, which is exactly what is happening not only in asia, but globally.', 'as chairman greenspan said recently, "in retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk".', '8. the strong asian growth would have continued but for the fact that global competition in external trade has emerged with newly industrialized and export-oriented economies with cheap labour, such as china, india, latin american and eastern europe.', 'the failure of central planning has brought at least three billion new workers and consumers into the global market.', 'these new markets began to benefit from the growing trade liberalization and inflows of foreign investments, thus putting greater pressure on the markets of the earlier "tigers" of east asia, leading to a widening of their current account deficits as they continued their investments in infrastructure and real estate.', 'issues in asia 9. if we look more closely at the situation in asia, the economic fundamentals remain intact.', 'asia has been the fastest-growing region in the world, recording growth rates of around 5%-9%.', 'asian economies have low inflation rates and exchange rates were stable until recently.', 'current account for the region as a whole is broadly in balance, while the fiscal account, excluding japan, is in surplus.', 'asia has exceptionally high savings rates of above 30% of gdp.', 'official savings, in terms of foreign currency reserves, were even higher.', 'in asia, 70% of the inflows contributed to reserve accumulation.', "as a result, asian central banks are now holding about 40% of the world's foreign exchange reserves.", 'five of the top six foreign exchange holders in the world are now asians.', '10. the strong fundamentals -- a young, educated, flexible workforce, stable government, good natural resources and communications infrastructure, openness to trade and innovation, and high savings and investment rates -- these have not basically changed.', 'asia is still outward-looking, with open markets and openness to technology and innovation.', 'the aspirations of asia are also real: an entrepreneurial approach to innovation, competition and better standards of living for the rising urban population.', 'where asians have perhaps kept their eyes off the ball is the need to develop the services sector in complementary step with the manufacturing or export sectors.', 'delays in opening the financial sectors to global competition make them vulnerable to real sector excesses or imbalances, such as the overconcentration of risks in certain areas, including the asset markets.', '11. the momentum of growth depends critically on continued vigorous trade reform, fiscal prudence and improvements in finance, health and education policies.', 'increasingly, exports are changing from labour-intensive industrial production, and more toward higher value-added industries and services.', 'this poses the challenge of sustaining productivity growth.', '12. the asian turmoil being a financial turmoil on the surface, let me focus on the interesting way asia recycles its surplus savings.', 'as my colleague joseph yam has consistently pointed out, a large portion of asian foreign exchange reserves is invested in assets of the oecd countries, which provides safe and liquid instruments.', 'these funds return to the region in the form of foreign direct investment and foreign portfolio investment.', 'this global recycling also exposes asian economies to volatile portfolio adjustments due to policy mistakes or shifts in the international economic environment.', 'currently, there are no deep, liquid and mature debt markets in asia for the intermediation process to function more efficiently.', 'the process has begun in the last few years, and with the building of better financial infrastructure, this round of turmoil should add greater impetus to greater cooperation in building better regional financial intermediation.', '13. as we all can see in hindsight, the risks involved in international capital flows are exacerbated when short-term capital flows are all attracted to the asset markets.', 'this has led to asset bubbles, with all the painful consequences of asset price deflation.', '14. but what is much more evident in asia is that the process of hedging, arbitrage and "carry trade", whereby arbitrageurs borrow in one market and invest in another market that offers higher interest rates, has created both regional and global contagion.', 'portfolio shifts mean that when asset prices change (and in this i would include: consumer prices, interest rates, exchange rates, debt and equity prices and property prices) funds will flow in and out to follow the "law of one price".', 'this suggests that open economies must adjust to global prices.', 'the speed of such adjustments is only determined by the degree of openness of the domestic economy and financial markets.', 'in other words, whether we like it or not, we are being priced globally by the market.', '15. many of us have not fully appreciated the full logic of this.', 'the financial turmoil suggests that while the real sector causes of the stress is global competition, the financial effect is stress on domestic banking systems, as the banks intermediate the global portfolio adjustments.', 'in an open economy, capital inflows will increase the deposit base of domestic banks which may be channelled through credit mistakes into fuelling domestic asset price bubbles.', 'there are two implications.', 'first, asset price inflation eventually feeds into domestic inflation and erodes external competitiveness.', 'second, excessive lending concentration into less productive assets, either real estate or over-investment in infrastructure and production capacity, exposes the financial institutions to huge risks.', '16. from the viewpoint of financial intermediation, there are three major risks in asia that underlie the shocks there: first, maturity mismatch -- asian markets made the mistake of borrowing short-term capital • flows to finance illiquid non-tradables, such as property, thus exposing themselves to huge liquidity needs when capital flows reversed.', '• second, currency mismatch -- corporations who borrowed foreign currency funds to finance investments that do not generate sufficient foreign exchange to repay the debt run a currency mismatch.', '• third, credit risk -- lending or investments ultimately must be against sound profits that generate long-term returns higher than the borrowing rate or prospective dividends.', 'undue exuberance on the part of investors, when price-earning ratios grow beyond fundamentals, or on the part of bankers who failed to assess the impact of high interest rates on collateral or cash flows, would expose both the investor and the lender to asset losses.', '17. specifically, banks in asia, having easier access to funds as a result of high global liquidity, were able to expand lending much more quickly and, thereby, incurred higher risks in their portfolios that they need to manage more soundly.', 'ironically, domestic banks may have been induced to move into more risky lending due to increased competition in the form of new entrants and financial intermediation.', 'there is no question that they need to manage these new risks better.', '18. there is also one distinguishing feature of the asian turmoil.', 'the debt problems have not been those of the public sector.', 'on the contrary, the fiscal positions of asian governments have by and large been quite sound.', 'east asia, excluding japan, ran a fiscal surplus of us$5.4 billion or 0.1% of gdp in 1996. the debt burden, in fact, has been largely one of private sector overborrowing.', 'the resolution of the debt of the private sector makes the asian problems quite different from the experience of the sovereign debt issues of the 1980s.', '19. in essence, the asian problem is the age-old question of efficient resource allocation.', 'asia has no shortage of funds, only that its high level of savings are invested in less liquid long-term investments.', 'thus, one of the more pressing issues in asia is to build a more competitive, stable financial system and a robust infrastructure to facilitate efficient financial intermediation.', 'the better risk management of the financial system would also assist both corporations and investors to manage also their risks better.', 'ultimately, a balanced and flexible economy with sound risk management will then be in a better position to withstand global shocks and avoid crisis.', 'the need for national risk management 20. we are all aware of the complexities of risks in financial markets.', 'aside from credit risks, market risks such as interest rate, exchange rate, legal risks, operational risks and systemic risks all have to be managed, both at the micro level and at the macro level.', 'all markets suffer from the "fallacy of composition".', 'mistakes at the corporate or bank level will add up to national mistakes, which now may add up to regional or international crisis through contagion.', 'traditional risk management at corporate or sectoral level simply shift risks from one sector to another.', 'risks still remain in the economy as a whole.', 'thus, increasingly in the 1980s, there emerged the awareness that financial sector regulation was all about national risk management.', '21. national risk management covers six major aspects: • credible policies, with monetary and fiscal policies consistent with each other, and applied consistently.', 'capital account liberalization should be phased appropriately.', '• sound fundamentals include a high domestic savings rate, sustainable fiscal and balance of • payments positions, high foreign exchange reserves and prudent debt management.', '• good supervision involves the maintenance of solid capital adequacy and liquidity requirements for the financial sector, as well as regular examination and monitoring of financial institutions and markets.', 'the banking system must have the capacity to avoid excessive credit concentrations and risks, and to manage market risks well.', '• a robust financial infrastructure would encompass an efficient payments and settlements system for domestic and international transactions.', 'in essence, the world is moving towards real time gross settlement (rtgs) system, which support delivery vs. payment (dvp) and payment vs. payment (pvp).', 'rtgs reduces payment risks and allows central banks to monitor flows in domestic currency as well as exposure of banks on a real time basis.', 'a non-distortive incentive structure, such as taxation or regulatory restrictions that would not • encourage risk concentrations or excessive leverage in any economic sectors.', '22. put simply, managing national risks is equivalent to achieving three objectives.', 'first, lower national gearing, because leveraging adds risks, especially if this is leveraged from external borrowing.', 'the more you borrow abroad, the more you become vulnerable to external shocks.', 'second, the higher the level of domestic savings, which should be reflected in higher bank capital, lower credit/gdp ratio, and higher fiscal surpluses, the greater the resilience to the pain of adjustment to external or internal shocks.', 'third, irrespective of the exchange rate regime, there must be a commitment to a stable currency, and this means strong external reserves, low inflation and a sound banking system.', 'asset prices and the exchange rate regime 23. the asian market turmoil also raises the question as to whether the exchange rate regime matters.', 'i believe the debate about whether the nominal exchange rate should be floating or fixed misses the point in asia.', 'the real issue is the real effective exchange rate of the economy, namely, its underlying productivity and global competitiveness.', '24. for example, there is a mistaken perception that fixed exchange rates give rise to asset bubbles.', 'but if you look at the recent evidence of asset price bubbles in advanced economies, asset price bubbles also occurred in the 1980s in countries with flexible exchange rates, such as japan, scandinavia and the united kingdom.', 'asset price appreciation cannot be tackled alone by interest rates, since there are multiple reasons for such appreciation 25. in asia, we can perhaps identify four main reasons: • first, the asian household has always looked upon house ownership not only as a social necessity, but also as the best hedge against inflation.', 'second, asia is a young market, experiencing a high rate of urbanization.', 'the strong demand for • housing arising from demographics alone will fairly quickly eliminate excess capacity in many economies.', '• third, housing supply constraints also gave rise to high housing costs.', 'examples are inadequate supply of land, excessive tax burden on housing and construction, and inefficient urban planning and approval procedures that delay market responses to the rising demand for housing.', 'over-rapid liberalization of supply constraints were also one reason for the emergence of excess supply.', '• fourth, the high global liquidity that appeared has improved access to funds, which resulted in excessive exuberance on asset price inflation.', 'the impact on hong kong 26. amidst the recent attacks to the regional currency markets, no economy in asia has been totally immune, not least hong kong, despite the strong fundamentals.', '27. if we identify the real issues in asia as one of structural competitiveness in the global economy, caused by shifts in global resources and rising productivity outside the region, then structural adjustment must come through changes in either the internal price or the external price.', 'with a fixed exchange rate regime and therefore a fixed external price, such as in hong kong, the adjustment comes through changes in the internal prices, especially the asset markets.', 'in those economies with floating exchange rates, there may be adjustment in both the internal and external prices.', 'this is exactly what is happening right now.', 'using the us dollar still as the benchmark currency, it is very interesting to see that since the beginning of the year, the hang seng index has declined by 26% as of last friday, singapore strait times index by 32%, the nikkei 225 by 28% and the other asean indices by between 50-60%.', 'thus, markets adjust irrespective of the exchange rate regime and the unit of account.', '28. is there any easy way of avoiding the pain of adjustment in asia due to rising global competition?', 'the answer is clearly no.', 'as a general rule, the faster we adjust, the less the pain.', 'there have been different approaches to this issue.', 'there are some who think that a floating exchange rate regime would cushion the pain, but many forget that hong kong has tried the floating exchange rate regime before, in 1974-83. during that period, growth was more volatile and inflation much higher than what we are experiencing now.', 'as an open economy with trade accounting for 285% of gdp, any inflation would be immediately imported under exchange rate volatility.', 'the recent experience in asia actually shows that contrary to the theory, floating exchange rates requires even higher interest rates, because of the higher risks associated with exchange rate volatility.', "29. here i would like to correct the common image that the hong kong's exchange rate regime is a peg.", 'the hong kong dollar is a fixed exchange rate, not a peg which can be adjusted from time to time.', 'the linked exchange rate system in hong kong operates as a currency board system whereby the issue of hong kong dollar notes is fully backed by the us dollar at the fixed rate of us$1 to hk$7.80.', 'such a note-issuing mechanism ensures that currency issued is fully backed by foreign exchange.', 'with the sustained budget surplus and accumulated surplus on the exchange fund and land fund assets, the actual amount of foreign reserves in hong kong amounted to us$88.1 billion at the end of september, the third largest in the world.', 'this is more than seven times hong kong dollar cash in circulation or over three times hk$ m1.', '30. the currency board system has an automatic adjustment mechanism to maintain exchange rate stability.', 'when there are outflows of funds from the hong kong dollar, the hong kong monetary authority (hkma) will sell us dollars to banks for hong kong dollar.', 'on settlement day, the hkma will debit the clearing accounts of the banks for the necessary amounts of hong kong dollars in return for the us dollar that will be credited to the new york accounts of the same banks.', 'since banks may have sold more hong kong dollars than they have in their clearing accounts with the hkma, they can only obtain hong kong dollars by borrowing from other banks, by bidding up the interbank rates, or selling back the us dollars to the hkma, that is, by reversing their short position.', 'in fact, the banks do not hold excess hong kong dollars because they are generally long in foreign currency.', 'the latest data at the end of july shows that the hong kong banking system is short roughly hk$33 billion or us$4 billion.', '31. in addition to the robust currency board mechanism, the linked exchange rate system is underpinned by some of the strongest fundamentals in asia, if not the world: • growth is strong, at 5.5%.', 'fiscal position has been consistently strong, with an average fiscal surplus averaging 2% of gdp • for the past decade.', 'fiscal surplus in 1997 so far is 4.4% of gdp and is expected to exceed 5% of gdp.', 'the government has no external debt.', '• • exchange fund and land fund together have more than us$100 billion in assets.', '• corporate debt ratios are amongst the lowest in asia.', '• the external account is broadly in balance.', '32. the free markets and strong fundamentals mean that the nature of the shock is absorbable.', 'hong kong does have a strong competitive edge, since we are a service economy with 83% in the services sector.', 'as a major investor and integrator of production in the region, with manufacturing concerns in china and southeast asia, hong kong companies could adjust production to areas which have the greatest export competitiveness.', 'in addition, the mainland chinese economy is still growing at 8-9% per annum, with low inflation, a balanced external account and strong commitment to reforms in the enterprise and financial sectors.', 'all these auger well for hong kong as the main gateway to the chinese market.', '33. the current higher interest rates reflect somewhat a slightly higher risk premium in asia due to the currency turmoil.', 'we do admit that the higher interest rates affected the stock market and property market.', 'but we should also remember that high interest rates are necessary to cool the overheating in the asset markets that prevailed until recently.', 'given the excess demand situation in hong kong as the economy grew by 6.4% in the second quarter, a correction was expected.', 'a moderation in property prices will help bring houses to more affordable levels to homebuyers.', '34. higher interest rates will also bring down inflation, by encouraging savings.', 'once inflation and the asset markets correct under the free market regime, hong kong will become much more competitive.', 'in real effective exchange rate terms, the competitive effect of neighbouring depreciation will be offset somewhat by a rise in domestic inflation.', 'higher interest rates will also bring the external account more in line with the fundamentals and improve the trade balance.', 'hong kong, as a free market economy, is adjusting exactly according to the textbook.', '35. moreover, our banking sector is very robust and strongly capitalized to withstand any shocks.', 'operating profits of the local banks grew by about 18% in the first half of 1997 and the bad debt charged fell in the first half of 1997 as the level of classified loans was 2.08%, down from 2.91% a year earlier.', 'the capital adequacy ratios of local banks as a whole exceeds 17%.', "the average loan-to-value ratio is 70%, with the actual measured loan-to-value ratio being 53.3%, according to our survey at end september 1994. therefore, hkma's efforts to build a strong banking sector, including the distribution of maturity risks through the mortgage corporation and the creation of an efficient rtgs payment system are all necessary efforts to prevent an external shock from affecting the banking system.", "in particular, the rtgs system allows the hkma to monitor closely banks' settlement transactions on a real time basis.", 'banks would also have to fund their settlements and provide ample liquidity on a more prudent basis.', 'all these are in line with our objective of making the markets more efficient to enable the free market to clear aggregate supply and demand at an equilibrium price quickly.', '36. but we should always remember that there is no free lunch.', 'the fixed exchange rate regime implies a flexible economy to adjust to the exchange rate.', 'hong kong has high flexibility, attributable to a high savings rate, entrepreneurial spirit and high labour productivity.', 'a fixed exchange rate is a discipline on both the private and public sectors: the economy adjusts to the exchange rate, not the other way around.', 'we do not pretend to say that a fixed exchange rate is the perfect system, because even the imf admits that there is no perfect system.', 'but it is the best system for hong kong.', 'the linked exchange rate system is here to stay.', 'conclusion 37. as one of the contributors to the world bank study on the asian miracle, i have never considered the asian growth story as a miracle.', 'paul krugman called it perspiration, not inspiration.', 'yes, it was the result of hard work, high savings, stable governments and good aspirations.', 'but no one can deny that asian corporations rank amongst some of the most productive and efficient in the world.', 'perhaps we were victims of our own success.', 'global capital inflows were the most sincere form of flattery, and those of us who succumbed to the easy money have now wakened to new challenges and risks.', '38. asia is now in a new growth league, with greater global competition.', 'the adjustments will not be easy, especially building stronger and more robust financial systems to handle the new risks of globalization.', 'there is a new realism in asia, that however painful the adjustment, we have to make the necessary changes.', 'as competition intensifies at all levels, there can be no reversal to the globalization, and we simply have to recognize that we live in one globe and we share the same growing pains.', "i am confident that asia's basic strength of flexibility, realism and pragmatic policies will see the region through, with a little bit of help from the imf.", 'in the words of mr. michel camdessus, imf managing director, what has happened is a blessing in disguise.', 'asia will emerge stronger and more resilient, and it will continue to be a pillar of growth in the new global economy.']	David Carse	Hong Kong Monetary Authority	Deputy Chief Executive	Hong Kong
https://www.bis.org/review/r971127b.pdf	Mr. Brash looks at the implications of the global financial marketplace for New Zealand (Central Bank Articles and Speeches, 19 Nov 97)	Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Single Financial Services Market Conference in Wellington, on 19/11/97.	1997-11-19 00:00:00	Mr. Brash looks at the implications of the global financial marketplace for New Zealand Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Single Financial Services Market Conference in Wellington, on 19/11/97. Introduction It's a great pleasure to be here today to share some thoughts with you on the global financial marketplace, and its implications for New Zealand. We have recently had a dramatic example of how events in one country can spread rapidly. The recent share market collapse that began in Hong Kong and spread to equity markets around the world, including New Zealand, illustrates just how integrated global financial markets have become. Designing and implementing an effective financial policy in pursuit of national goals, in a world of highly integrated capital markets, is one of the most topical and challenging tasks in central banking today. To keep my presentation today within manageable bounds, and reflecting my professional interest, I will constrain my comments to one of the important functions of a central bank, namely, the preservation of stability in the financial system. Our focus at the Reserve Bank is on promoting the maintenance of a sound and efficient financial system in New Zealand. This focus involves establishing a policy environment to counteract the possibility of contagious spread of financial distress, and in particular is aimed at encouraging prudent bank behaviour. I will begin by sketching out some of the key trends in global finance, and will then describe the international regulatory response to these developments. Along the way, I will tease out the implications for New Zealand, and test our approach to banking supervision against these global developments. I will conclude with some crystal ball gazing. Trends in the global financial marketplace Let me begin then with some observations on the rapidly changing global financial marketplace. It is now a commonplace that barriers between countries and financial markets, at least in developed countries, have largely disappeared, and this fact, together with new technologies, new financial instruments and new funding techniques, means that financial intermediation is increasingly global. Fundamental to this trend has been the way in which advances in computer and communications technology have reduced the costs of cross-border transactions by lowering the costs of collecting and analysing data, undertaking transactions, clearing and settling payments and monitoring financial flows. And the cost reductions have been very dramatic. A recent article in The Economist noted that "the cost of a three-minute telephone call between London and New York has fallen from US$300 (in 1996 dollars) in 1930 to US$1 today". The same article stated that "the cost of computer processing power has been falling by an average of 30 percent a year in real terms over the past couple of decades". Such trends allow both the users of financial services and financial institutions themselves to look to global solutions to meet their financial needs. Funds can now be raised and invested, currencies exchanged, and financial risk positions changed around the world at almost anytime. Contributing to the globalisation of finance has been the rapid trend towards financial market liberalisation. This has seen country after country freeing up their financial system. In that process, exchange controls (that had been intended to isolate domestic markets from global influences) have been dismantled. In the increasingly integrated global capital market that has resulted, global financial firms with often complex financial and corporate structures have emerged as dominant players. These firms are to be found operating around the globe -- relatively low transaction costs and the application of new technologies allow such firms to be active players in whichever of the world's financial markets they want to participate in. Distinctions between different types of financial institutions are breaking down as a result of the growth of these conglomerate structures, the relaxation in regulatory constraints, and the way in which derivatives can be used to transform the risk characteristics of institutions' portfolios. A related development is that the risk management practices of global financial firms are becoming increasingly centralised as competitive pressures drive financial organisations seeking the highest risk-adjusted returns for shareholders. With the processing power of modern computers, it is now possible for the risk and return characteristics of large and complex portfolios to be managed centrally and, if not real time, at least on an intra-day basis. Virtually all large bank holding companies are now operated and managed as integrated units. This trend towards centralised risk management raises some fundamental policy issues as to how best to regulate and supervise such large and complex banking organisations. Product innovation has gone hand in hand with liberalisation. One of the more significant developments has been the emergence of derivatives such as financial futures, swaps and options. The total risk of more traditional financial products has been broken into component parts and repackaged into synthetic products that have risk profiles similar to other financial instruments. The synthetic products can then be sold to those domestic and global investors willing and able to bear the associated risks. Such products are now used extensively throughout the world to help firms manage the exposure to interest rate and exchange rate movements that occur in liberalised financial markets. And innovation is ongoing, as is evident with the increasing application of derivatives to credit risk. The rapid globalisation of finance is well illustrated by the phenomenal growth in cross-border financial activity. An April 1995 survey by the Bank for International Settlements estimated that an average of US$1.2 trillion flowed through the world's foreign exchange markets each day, up 45% on three years earlier. Estimated turnover of over-the-counter derivatives on an average day was US$880 billion, 70% of which involved transactions with counterparties in different countries. An article in Institutional Investor in August 1997 provides another illustration of the magnitude of cross-border finance -- "nearly US$150 billion of net new private capital poured into the main Latin American and Asian economies in 1996, almost double the 1995 level". These numbers are enormous however you want to look at them. New sources of systemic risk The globalisation of finance, the liberalisation of financial markets and rapid technological change have opened up new opportunities in commerce for achieving economies of scale, and facilitating the international rationalisation of production and distribution. The resulting benefits include productivity growth and improving living standards. Innovations like derivatives improve the efficiency of financial markets. New technology allows sophisticated management information and control systems, and the application of complex analytical models to help institutions manage risks more effectively. But while considerable benefits flow from such developments, they also inevitably bring with them new risks. One of the most important from a central banker's perspective is the introduction of new sources of risk to the stability of the financial system: • Liberalisation and globalisation bring competition, which squeezes out the rents created by previously protected markets. This produces efficiency gains but it also means that financial institutions in the new environment have less of a buffer of protected profits and are therefore more vulnerable to distress caused by either mismanagement or misfortune. • Derivatives bring new risks in that they can expose financial institutions to greater leverage, thereby allowing for shocks to be amplified. In addition, they increase the linkages between national financial markets, which means that adverse events are quickly transmitted from one market to another. • Furthermore, market participants can now react very rapidly to a problem in a particular country, or even a perceived problem. Capital can move rapidly and in large volumes. Again, a disturbance in one country can now flow rapidly to other countries with the result that other countries' financial systems, and the international financial system more generally, are arguably more exposed to disturbance than before globalisation. In the light of these increased risks, it is worth recalling that there have been relatively frequent episodes of national financial instability over the past couple of decades. Since 1980, over two-thirds of IMF member countries have experienced at least one serious banking-sector difficulty. And, in more than 65 emerging country cases, bank losses nearly or completely exhausted the banking system's capital. In more than a dozen countries in the emerging markets of Asia, Latin America and Eastern Europe, financial collapses have required budgetary expenditure of more than 10% of GDP to resolve. Some industrial countries have also experienced major financial problems over the same period. The list includes the United States, Japan, France, Sweden, Finland, Norway and Spain. In Sweden, for example, 18% of bank loans were lost between 1990 and 1993 with two of the largest banks being bailed out by the state. These and more recent episodes of bank distress, such as Mexico and Thailand, suggest that there is no evidence that financial sector fragility is reducing with time. While New Zealand has not experienced bank problems of the magnitude that I have just described, there have nevertheless been occasions of serious bank distress. In 1989-90, the Bank of New Zealand (which was government-owned at the time) had to be re-capitalised twice by the Government, at a total cost of about 3% of government expenditure. NZI Bank would certainly have failed had it not been re-capitalised by its parent in Scotland. A very significant non-bank financial institution, the DFC, was placed in statutory management in 1989 when it became insolvent. A national financial crisis can not only have a severely adverse impact on the economy of the country directly concerned, it may also threaten the stability of the international financial system. A recent example was Mexico in early 1995. A build up of short-term US dollar-linked debt, combined with the devaluation of the peso and a sharp rise in interest rates, undermined the solvency of most of the Mexican banking system and resulted in a liquidity crisis. International investors shifted their claims away not just from Mexico, but also from other countries where similar weaknesses were suspected. Instability in the international financial system can arise not only from the transmission of a national problem but also from a breakdown in the normal functioning of critical financial interconnections between countries. What I have in mind here are the payments and settlements processes that link national financial systems. This is not a new source of risk, and the best known illustration of the problem was the failure of Bankhaus Herstatt in 1974. This small German bank was active in the foreign exchange market. It defaulted after receiving Deutsche Marks from international banks but before the matching US dollar leg was processed later in the day. This left its counterparties exposed to the full value of the Deutsche Marks delivered. This event severely disrupted CHIPS, the main clearing system for US dollars, led to a collapse in trading in the US dollar/Deutsche Mark market and even resulted in disorder in the inter-bank money markets. The circumstance that led to Herstatt risk is still present today, namely the time lapse between the payment and receipt of currencies in foreign exchange transactions. What is different now is the exponential growth that has occurred in foreign exchange transactions since 1974. In the late 1990s, if a major international bank were unable to meet its obligations in settling an average day's foreign exchange transactions, it would have serious ramifications for the stability of the international financial system, as well for domestic financial markets. Globalisation of finance to date has been most marked in wholesale business. But technology in the form of the Internet is now beginning to allow for retail products to be advertised and sold from anywhere in the world, and paid for electronically by anyone in any other country. There seems little doubt that, when our next conference on financial services is held, this trend to the globalisation of retail financial services will be an important theme. In any event, there is no doubt that finance is now global. Nor is there any doubt that new sources of systemic risk have emerged from the liberalisation of financial markets, from the increased size and greater complexity of institutions, from the greater complexity of some of the new financial instruments, from the greater volume and speed of transactions, and from the increased involvement in the global financial system of national banking systems which are themselves suffering considerable strains. It is probably fair to conclude that, while the threat of serious disruption to the international financial system remains relatively small, should serious disruption occur it could have disastrous consequences for living standards around the world. Regulatory response Faced with these new sources of risk, the objective of safeguarding the soundness of financial systems has become a top policy priority both nationally and internationally. Most obviously, the trend towards large and complex global financial institutions, centralised risk management and the blurring of boundaries between different types of financial institutions is leading to a change in regulatory structures. Generalising somewhat, the traditional approach to regulating the financial industry was for there to be a bank regulator, a securities industry regulator, an insurance industry regulator and so on. This decentralised approach to regulation was seen as being appropriate when institutions were clearly delineated and decision-making was decentralised. However, in today's world of conglomerate financial institutions where decision-making and risk management are centralised, the traditional regulatory approach is seen as being inadequate by many countries. Exposure of a bank to potential risk, for instance, cannot be evaluated independently of the condition and management policies of any conglomerate to which the bank belongs. Whereas efforts have been made in some countries to co-ordinate and exchange information between different kinds of supervisors, in other countries the supervisory structure has been changed so that all financial institutions are supervised by one "umbrella-type" supervisory body. Recent developments in this direction have been seen in Australia, with the Australian Government adopting the recommendations of the Wallis Inquiry. This will see the establishment of the Australian Prudential Regulation Authority to oversee all financial institutions in Australia. Similarly, the new United Kingdom Government has decided to establish a new "super-regulator" that will bring together nine financial regulators in one organisation. New Zealand's regulatory approach Given that the banking industry in New Zealand has always been dominated by foreign-owned banks, particularly from Australia and the United Kingdom, any development that makes supervision of the parent bank more effective is welcomed by us. From the Reserve Bank's perspective, though, we have not seen a pressing need to change our regulatory structures in a similar way. The reasons for this are two-fold. First, we take a rather different approach to promoting financial system stability, an approach which relies less on direct regulation and more on the use of market disciplines and the internal incentives for banks to behave prudently (I will return to this shortly). Secondly, we see our present regulatory structure as being effective. Over recent years, our regulatory structure has been closely aligned to a public policy approach that recognises that open and competitive financial markets are desirable. Within this, all of the key areas where private sector failure may occur have been covered in a way that meets our circumstances. Hence, the Reserve Bank is responsible for the maintenance of the financial system's soundness and efficiency, with our attention focused on the banking sector, where any systemic problems, if they were to occur, would arise. The Commerce Commission has responsibility for protecting the consumer against exploitation and unfair trading. And the Securities Commission is focused on improving the efficiency and fairness of the markets for securities (widely defined) of entities that raise funds in New Zealand. This approach recognises that in New Zealand systemic issues are central in the supervision of banks, whereas in non-bank financial services consumer-protection issues are more important. There has been a strong presumption in economic policy development in New Zealand over the last decade or so that market forces generally produce better outcomes than those arising from bureaucratic rules and regulations. Our approach to banking supervision reflects this. We start with the presumption that financial markets contain powerful and flexible disciplinary mechanisms for rewarding good bank performance and penalising imprudent bank behaviour. Given the widespread public belief in most countries that "governments never allow banks to fail", we do not argue that market forces alone will do the job, but we do see the disciplines of the market as being the dominant and most effective means for promoting a robust financial system. There are three key elements in our market-based approach to banking supervision. • The first is to ensure that the marketplace has sufficient and reliable information on banks on which to base financial assessments and decisions. This is achieved through a public disclosure regime which requires banks to publish a comprehensive range of financial, corporate and risk-related information for the bank and its banking group at quarterly intervals. • The second important element is to promote market discipline by ensuring that government policy supports, or at least does not impede, the development of active inter-bank markets, the diversification of funding instruments and sources, the development of institutional investors and the entry of sophisticated foreign players to the financial market. The rationale is that professional players are the market's strongest disciplinary force. • The third key element has been to strengthen the incentives for the directors and management of banks to manage their banks' affairs in a sound and responsible manner. An important aspect of this is a requirement for the directors of banks to attest to the accuracy of the information in the quarterly disclosure statements, to the fact that their banks have satisfactory risk management policies and to the fact that these are being properly applied. This approach, of harnessing market forces and using improved internal governance to promote financial system soundness, is gaining some support in the international supervisory community, and among academics. This can be highlighted by recent comments from three prominent and highly respected individuals. • "As financial transactions become increasingly rapid and complex, I believe we have no choice but to harness market forces, as best we can, to reinforce our supervisory objectives. The appeal of market-led discipline lies not only in its cost effectiveness and flexibility, but also in its limited intrusiveness and its greater adaptability to changing financial environments. Measures to enhance market discipline involve providing private investors the incentives and the means to reward good bank performance and penalise poor performance. Expanded risk management disclosures by financial institutions is a significant step in this direction." Alan Greenspan, May 1997.1 • "For major banks in industrial countries ..... there needs to be a shift of emphasis towards the re-inforcement of internal managerial risk-control mechanisms, and a recasting of the nature and functions of external regulation, away from generalised rule-setting and towards establishing incentives/sanctions which reinforce such internal control mechanisms." Charles Goodhart, June 1997.2 • "Much recent thinking has focused on incentive-compatible regulation -- using the market's own internal forces -- as the promising next step for strengthening the financial system. It is banks' shareholders and management that have the strongest interest to measure risk accurately." Andrew Crockett, September 1997.3 To illustrate the evolution that is taking place in supervision, let me cite one example. In a recent initiative by the Basle Committee on Banking Supervision to amend the Capital Accord to include market risk, a greater role has been given to banks' own internal models in the measurement of market risk. This reflects a move away from regulation that relies on detailed rules to an approach that places more emphasis on the adequacy of internal risk control mechanisms. Such an approach recognises that it is bank directors and management that have the strongest interest and ability to measure risk accurately, and that an internally-generated measure of risk should be better than one derived from that imposed by supervisors. The ongoing challenge to regulators is to ensure that incentive structures are conducive to this outcome. My own perspective is that a paradigm shift in supervision towards harnessing market forces will make a more significant contribution to promoting sound and efficient financial systems than simply changing regulatory structures within the same external regulation paradigm. Although it is far too early to make conclusive assessments of the success or otherwise of our new supervisory approach (which has now been in operation for nearly two years), I am satisfied that it is encouraging prudent behaviour by banks in New Zealand, and thereby is reducing the likelihood of financial system instability in the future. Moreover, I am confident that it is doing this at lower efficiency, compliance and taxpayer costs than other supervisory options might be expected to achieve. Payments system reform So far, I have discussed the regulatory response to the globalisation of finance in terms of the health of the individual institutions that make up the financial system. Of equal significance to financial stability in this new environment is how resilient payment and settlement systems are, both domestically and internationally. In common with most central banks around the world, we have been devoting considerable attention to payments system reform. Our main focus to date has been developing a real time gross settlement system for large-value transactions between banks. Until quite recently, the standard form of settlement was end-of-day net settlement: all payments and receipts between banks were allowed to accumulate during the day, to be settled by transfer of the very much smaller net amount at the end of the day. The risk of this form of settlement is that it usually requires participants to grant unsecured and unlimited credit to other participants during the period until final settlement occurs. Credit extended to a single counterparty can in some cases exceed a bank's entire capital. One important solution which has been implemented in some countries, and which we have as a high priority to implement within the next few months in New Zealand, is the replacement of this traditional end-of-day settlement arrangement with an RTGS system. Individual transactions under RTGS are settled one-by-one during the day rather than being allowed to accumulate, thereby removing the very large exposures that can build up between banks. Once implemented, RTGS will be a significant milestone in the reduction of domestic payment system risks. Another important initiative that we are promoting to reduce systemic risk is to make bilateral and multilateral netting arrangements for certain transactions legally binding. With legally enforceable netting arrangements in place, the various "gross" obligations to make payments can be offset against one another, and it is only the net amounts due which are called into question in the event of a bank failure. Our attention is also being actively focused on dealing with settlement risk in cross-border foreign exchange transactions. As already noted, the value of foreign exchange deals that are now being settled is so substantial that the resulting settlement risks can be of a size to cause systemic concern for both national and international financial systems. This risk, mentioned earlier in my presentation, is often referred to as Herstatt risk. As in New Zealand, much international attention is currently being focused on this problem. Co-operation amongst supervisors My final comments on the response of regulators to global financial trends concern the co-operation among supervisors and international agencies to address the potential for systemic disruption. These efforts have gained momentum over the last decade as the inherent tension between nationally-based regulatory structures and an increasingly globalised financial sector has become apparent. Co-operation among bank supervisors under the auspices of the Basle Committee on Banking Supervision has produced a number of important agreements on the supervision of banks, including minimum capital standards and minimum standards governing the supervision of banks' cross-border establishments. Similarly other supervisors, such as the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), have pursued co-operation in their areas of responsibility. And in the early 1990s, in recognition of the emergence and growth of financial conglomerates, banking, securities and insurance supervisors from G-10 countries began to work together to identify problems that conglomerates can cause and to consider ways to overcome them. The Mexican crisis in 1995 in particular, and the widespread incidence and high cost of banking problems more generally, have prompted calls for concerted international action to promote the soundness of financial systems. These calls have strengthened over the last couple of years with the G-7 countries calling for "the adoption of strong prudential standards in emerging countries" and encouraging the international financial institutions to "increase their efforts to promote effective supervisory structures in these economies". The Basle Committee on Banking Supervision has been at the forefront of this effort over the past year with the release of its Core Principles for Effective Banking Supervision. These principles have quickly become the focal point for the increased efforts to strengthen financial sectors around the world. Also aiming at more effective bank supervision, the IMF is making the evaluation of financial supervision and regulation part of its annual country reviews, and the World Bank is emphasising the strengthening of financial infrastructure as an important part of its structural assistance programmes. A comment on the international supervisory response While the international regulatory response has many positive elements, to me it has not always been appropriately focused. Often following a crisis, there are calls to "strengthen supervision". For various reasons, I feel that these calls, or the ways in which they have been answered, have not always been well directed. Let me briefly elaborate on why I think this. At both the national and the international levels, the nature of the policy response to a crisis needs to be based on a careful analysis of the "problem". It is certainly clear from the record that there have been significant weaknesses in some countries' banking systems, and that these weaknesses have both contributed to the emergence and severity of financial crises and complicated the task of resolving them. However, I am somewhat sceptical of the general proposition that "poor supervision" has been the primary cause of these weaknesses. There has been a tendency to give supervision the "blame" for problems which have originated elsewhere, and/or to seek supervisory remedies for problems which might well be better solved in other ways. I would note further that "supervision" (in its general sense) has sometimes been part of the "problem" rather than part of the "solution" -- particularly when it has involved excessive forbearance by the regulatory authorities, and/or excessive reliance on the public safety net. I think it important that we supervisors should be appropriately modest about what we can achieve, and supervision should not be seen as an assured remedy for all potential problems. Establishing price stability and a sustainable fiscal position are also critical elements in the pursuit of sound financial systems. While weakness in the financial system can have macroeconomic implications, the reverse is also undoubtedly true -- unsound macroeconomic policies can have long-lasting effects that lead to weakness in financial systems. Excessive credit creation and inflation are obvious examples. Some observers have suggested that virtually every major financial system problem in the last two or three decades was caused, directly or indirectly, by unsound macroeconomic policies. Some of the international regulatory responses also do not sufficiently recognise that the objectives of bank supervision, and the infrastructure within which supervision takes place (for example, the quality of company law, accounting standards, and external auditors), are not the same in all countries. To have any chance of being successful, international initiatives will need to be flexible enough to suit this wide variety of national circumstances. For emerging countries where the banking infrastructure may not be well developed, it may well be sensible to actively pursue financial stability through improving the quality of prescriptive rules. In this regard, the initiative by the Basle Committee to establish an international standard of core principles for effective supervision may be helpful. But regulators in many developed countries are finding that the complexity of banking, the blurring of functional dividing lines amongst financial institutions, globalisation, and the speed of portfolio adjustment are making external regulation based on standard rules less effective and less feasible. This is resulting in an increasing emphasis being placed on internal risk management processes and in harnessing market disciplines to promote prudent banking behaviour. What this suggests to me is that the regulatory approach followed by a particular country will need to fully reflect its own circumstances. Attempting to apply a "one-size-fits-all" approach to all countries is likely to be ineffective, and may even be counterproductive. The Future So, what do I see as being the likely issues of the future? What is certain is that the future will surprise us! But some things seem likely. Innovation in the financial sector will continue, as will the integration of the world's financial markets. Using market disciplines to strengthen the financial system also seems likely to grow in relative importance. New Zealand's approach to promoting financial system stability is entirely consistent with the global trends that I have described and, in particular, with the "incentive-compatible" approach to regulation. It seems absolutely appropriate for our circumstances. There will inevitably need to be refinements made to our regulatory approach from time to time, but I believe that the principles on which it has been established, and its basic design, are soundly based and will remain so for the foreseeable future. At some point in the future the "special" status of banks in the New Zealand supervisory approach may need to be reassessed. This might be prompted by the continued gradual breaking down of the traditional distinction between banks and non-banks in financial intermediation, or perhaps by banking services being provided in New Zealand by institutions not physically located here. It may also be prompted by a risk-proofing of payments an	['mr. brash looks at the implications of the global financial marketplace for new zealand address by the governor of the reserve bank of new zealand, dr. donald brash, to the single financial services market conference in wellington, on 19/11/97.', "introduction it's a great pleasure to be here today to share some thoughts with you on the global financial marketplace, and its implications for new zealand.", 'we have recently had a dramatic example of how events in one country can spread rapidly.', 'the recent share market collapse that began in hong kong and spread to equity markets around the world, including new zealand, illustrates just how integrated global financial markets have become.', 'designing and implementing an effective financial policy in pursuit of national goals, in a world of highly integrated capital markets, is one of the most topical and challenging tasks in central banking today.', 'to keep my presentation today within manageable bounds, and reflecting my professional interest, i will constrain my comments to one of the important functions of a central bank, namely, the preservation of stability in the financial system.', 'our focus at the reserve bank is on promoting the maintenance of a sound and efficient financial system in new zealand.', 'this focus involves establishing a policy environment to counteract the possibility of contagious spread of financial distress, and in particular is aimed at encouraging prudent bank behaviour.', 'i will begin by sketching out some of the key trends in global finance, and will then describe the international regulatory response to these developments.', 'along the way, i will tease out the implications for new zealand, and test our approach to banking supervision against these global developments.', 'i will conclude with some crystal ball gazing.', 'trends in the global financial marketplace let me begin then with some observations on the rapidly changing global financial marketplace.', 'it is now a commonplace that barriers between countries and financial markets, at least in developed countries, have largely disappeared, and this fact, together with new technologies, new financial instruments and new funding techniques, means that financial intermediation is increasingly global.', 'fundamental to this trend has been the way in which advances in computer and communications technology have reduced the costs of cross-border transactions by lowering the costs of collecting and analysing data, undertaking transactions, clearing and settling payments and monitoring financial flows.', 'and the cost reductions have been very dramatic.', 'a recent article in the economist noted that "the cost of a three-minute telephone call between london and new york has fallen from us$300 (in 1996 dollars) in 1930 to us$1 today".', 'the same article stated that "the cost of computer processing power has been falling by an average of 30 percent a year in real terms over the past couple of decades".', 'such trends allow both the users of financial services and financial institutions themselves to look to global solutions to meet their financial needs.', 'funds can now be raised and invested, currencies exchanged, and financial risk positions changed around the world at almost anytime.', 'contributing to the globalisation of finance has been the rapid trend towards financial market liberalisation.', 'this has seen country after country freeing up their financial system.', 'in that process, exchange controls (that had been intended to isolate domestic markets from global influences) have been dismantled.', 'in the increasingly integrated global capital market that has resulted, global financial firms with often complex financial and corporate structures have emerged as dominant players.', "these firms are to be found operating around the globe -- relatively low transaction costs and the application of new technologies allow such firms to be active players in whichever of the world's financial markets they want to participate in.", "distinctions between different types of financial institutions are breaking down as a result of the growth of these conglomerate structures, the relaxation in regulatory constraints, and the way in which derivatives can be used to transform the risk characteristics of institutions' portfolios.", 'a related development is that the risk management practices of global financial firms are becoming increasingly centralised as competitive pressures drive financial organisations seeking the highest risk-adjusted returns for shareholders.', 'with the processing power of modern computers, it is now possible for the risk and return characteristics of large and complex portfolios to be managed centrally and, if not real time, at least on an intra-day basis.', 'virtually all large bank holding companies are now operated and managed as integrated units.', 'this trend towards centralised risk management raises some fundamental policy issues as to how best to regulate and supervise such large and complex banking organisations.', 'product innovation has gone hand in hand with liberalisation.', 'one of the more significant developments has been the emergence of derivatives such as financial futures, swaps and options.', 'the total risk of more traditional financial products has been broken into component parts and repackaged into synthetic products that have risk profiles similar to other financial instruments.', 'the synthetic products can then be sold to those domestic and global investors willing and able to bear the associated risks.', 'such products are now used extensively throughout the world to help firms manage the exposure to interest rate and exchange rate movements that occur in liberalised financial markets.', 'and innovation is ongoing, as is evident with the increasing application of derivatives to credit risk.', 'the rapid globalisation of finance is well illustrated by the phenomenal growth in cross-border financial activity.', "an april 1995 survey by the bank for international settlements estimated that an average of us$1.2 trillion flowed through the world's foreign exchange markets each day, up 45% on three years earlier.", 'estimated turnover of over-the-counter derivatives on an average day was us$880 billion, 70% of which involved transactions with counterparties in different countries.', 'an article in institutional investor in august 1997 provides another illustration of the magnitude of cross-border finance -- "nearly us$150 billion of net new private capital poured into the main latin american and asian economies in 1996, almost double the 1995 level".', 'these numbers are enormous however you want to look at them.', 'new sources of systemic risk the globalisation of finance, the liberalisation of financial markets and rapid technological change have opened up new opportunities in commerce for achieving economies of scale, and facilitating the international rationalisation of production and distribution.', 'the resulting benefits include productivity growth and improving living standards.', 'innovations like derivatives improve the efficiency of financial markets.', 'new technology allows sophisticated management information and control systems, and the application of complex analytical models to help institutions manage risks more effectively.', 'but while considerable benefits flow from such developments, they also inevitably bring with them new risks.', "one of the most important from a central banker's perspective is the introduction of new sources of risk to the stability of the financial system: • liberalisation and globalisation bring competition, which squeezes out the rents created by previously protected markets.", 'this produces efficiency gains but it also means that financial institutions in the new environment have less of a buffer of protected profits and are therefore more vulnerable to distress caused by either mismanagement or misfortune.', '• derivatives bring new risks in that they can expose financial institutions to greater leverage, thereby allowing for shocks to be amplified.', 'in addition, they increase the linkages between national financial markets, which means that adverse events are quickly transmitted from one market to another.', '• furthermore, market participants can now react very rapidly to a problem in a particular country, or even a perceived problem.', 'capital can move rapidly and in large volumes.', "again, a disturbance in one country can now flow rapidly to other countries with the result that other countries' financial systems, and the international financial system more generally, are arguably more exposed to disturbance than before globalisation.", 'in the light of these increased risks, it is worth recalling that there have been relatively frequent episodes of national financial instability over the past couple of decades.', 'since 1980, over two-thirds of imf member countries have experienced at least one serious banking-sector difficulty.', "and, in more than 65 emerging country cases, bank losses nearly or completely exhausted the banking system's capital.", 'in more than a dozen countries in the emerging markets of asia, latin america and eastern europe, financial collapses have required budgetary expenditure of more than 10% of gdp to resolve.', 'some industrial countries have also experienced major financial problems over the same period.', 'the list includes the united states, japan, france, sweden, finland, norway and spain.', 'in sweden, for example, 18% of bank loans were lost between 1990 and 1993 with two of the largest banks being bailed out by the state.', 'these and more recent episodes of bank distress, such as mexico and thailand, suggest that there is no evidence that financial sector fragility is reducing with time.', 'while new zealand has not experienced bank problems of the magnitude that i have just described, there have nevertheless been occasions of serious bank distress.', 'in 1989-90, the bank of new zealand (which was government-owned at the time) had to be re-capitalised twice by the government, at a total cost of about 3% of government expenditure.', 'nzi bank would certainly have failed had it not been re-capitalised by its parent in scotland.', 'a very significant non-bank financial institution, the dfc, was placed in statutory management in 1989 when it became insolvent.', 'a national financial crisis can not only have a severely adverse impact on the economy of the country directly concerned, it may also threaten the stability of the international financial system.', 'a recent example was mexico in early 1995. a build up of short-term us dollar-linked debt, combined with the devaluation of the peso and a sharp rise in interest rates, undermined the solvency of most of the mexican banking system and resulted in a liquidity crisis.', 'international investors shifted their claims away not just from mexico, but also from other countries where similar weaknesses were suspected.', 'instability in the international financial system can arise not only from the transmission of a national problem but also from a breakdown in the normal functioning of critical financial interconnections between countries.', 'what i have in mind here are the payments and settlements processes that link national financial systems.', 'this is not a new source of risk, and the best known illustration of the problem was the failure of bankhaus herstatt in 1974. this small german bank was active in the foreign exchange market.', 'it defaulted after receiving deutsche marks from international banks but before the matching us dollar leg was processed later in the day.', 'this left its counterparties exposed to the full value of the deutsche marks delivered.', 'this event severely disrupted chips, the main clearing system for us dollars, led to a collapse in trading in the us dollar/deutsche mark market and even resulted in disorder in the inter-bank money markets.', 'the circumstance that led to herstatt risk is still present today, namely the time lapse between the payment and receipt of currencies in foreign exchange transactions.', "what is different now is the exponential growth that has occurred in foreign exchange transactions since 1974. in the late 1990s, if a major international bank were unable to meet its obligations in settling an average day's foreign exchange transactions, it would have serious ramifications for the stability of the international financial system, as well for domestic financial markets.", 'globalisation of finance to date has been most marked in wholesale business.', 'but technology in the form of the internet is now beginning to allow for retail products to be advertised and sold from anywhere in the world, and paid for electronically by anyone in any other country.', 'there seems little doubt that, when our next conference on financial services is held, this trend to the globalisation of retail financial services will be an important theme.', 'in any event, there is no doubt that finance is now global.', 'nor is there any doubt that new sources of systemic risk have emerged from the liberalisation of financial markets, from the increased size and greater complexity of institutions, from the greater complexity of some of the new financial instruments, from the greater volume and speed of transactions, and from the increased involvement in the global financial system of national banking systems which are themselves suffering considerable strains.', 'it is probably fair to conclude that, while the threat of serious disruption to the international financial system remains relatively small, should serious disruption occur it could have disastrous consequences for living standards around the world.', 'regulatory response faced with these new sources of risk, the objective of safeguarding the soundness of financial systems has become a top policy priority both nationally and internationally.', 'most obviously, the trend towards large and complex global financial institutions, centralised risk management and the blurring of boundaries between different types of financial institutions is leading to a change in regulatory structures.', 'generalising somewhat, the traditional approach to regulating the financial industry was for there to be a bank regulator, a securities industry regulator, an insurance industry regulator and so on.', 'this decentralised approach to regulation was seen as being appropriate when institutions were clearly delineated and decision-making was decentralised.', "however, in today's world of conglomerate financial institutions where decision-making and risk management are centralised, the traditional regulatory approach is seen as being inadequate by many countries.", 'exposure of a bank to potential risk, for instance, cannot be evaluated independently of the condition and management policies of any conglomerate to which the bank belongs.', 'whereas efforts have been made in some countries to co-ordinate and exchange information between different kinds of supervisors, in other countries the supervisory structure has been changed so that all financial institutions are supervised by one "umbrella-type" supervisory body.', 'recent developments in this direction have been seen in australia, with the australian government adopting the recommendations of the wallis inquiry.', 'this will see the establishment of the australian prudential regulation authority to oversee all financial institutions in australia.', 'similarly, the new united kingdom government has decided to establish a new "super-regulator" that will bring together nine financial regulators in one organisation.', "new zealand's regulatory approach given that the banking industry in new zealand has always been dominated by foreign-owned banks, particularly from australia and the united kingdom, any development that makes supervision of the parent bank more effective is welcomed by us.", "from the reserve bank's perspective, though, we have not seen a pressing need to change our regulatory structures in a similar way.", 'the reasons for this are two-fold.', 'first, we take a rather different approach to promoting financial system stability, an approach which relies less on direct regulation and more on the use of market disciplines and the internal incentives for banks to behave prudently (i will return to this shortly).', 'secondly, we see our present regulatory structure as being effective.', 'over recent years, our regulatory structure has been closely aligned to a public policy approach that recognises that open and competitive financial markets are desirable.', 'within this, all of the key areas where private sector failure may occur have been covered in a way that meets our circumstances.', "hence, the reserve bank is responsible for the maintenance of the financial system's soundness and efficiency, with our attention focused on the banking sector, where any systemic problems, if they were to occur, would arise.", 'the commerce commission has responsibility for protecting the consumer against exploitation and unfair trading.', 'and the securities commission is focused on improving the efficiency and fairness of the markets for securities (widely defined) of entities that raise funds in new zealand.', 'this approach recognises that in new zealand systemic issues are central in the supervision of banks, whereas in non-bank financial services consumer-protection issues are more important.', 'there has been a strong presumption in economic policy development in new zealand over the last decade or so that market forces generally produce better outcomes than those arising from bureaucratic rules and regulations.', 'our approach to banking supervision reflects this.', 'we start with the presumption that financial markets contain powerful and flexible disciplinary mechanisms for rewarding good bank performance and penalising imprudent bank behaviour.', 'given the widespread public belief in most countries that "governments never allow banks to fail", we do not argue that market forces alone will do the job, but we do see the disciplines of the market as being the dominant and most effective means for promoting a robust financial system.', 'there are three key elements in our market-based approach to banking supervision.', '• the first is to ensure that the marketplace has sufficient and reliable information on banks on which to base financial assessments and decisions.', 'this is achieved through a public disclosure regime which requires banks to publish a comprehensive range of financial, corporate and risk-related information for the bank and its banking group at quarterly intervals.', '• the second important element is to promote market discipline by ensuring that government policy supports, or at least does not impede, the development of active inter-bank markets, the diversification of funding instruments and sources, the development of institutional investors and the entry of sophisticated foreign players to the financial market.', "the rationale is that professional players are the market's strongest disciplinary force.", "• the third key element has been to strengthen the incentives for the directors and management of banks to manage their banks' affairs in a sound and responsible manner.", 'an important aspect of this is a requirement for the directors of banks to attest to the accuracy of the information in the quarterly disclosure statements, to the fact that their banks have satisfactory risk management policies and to the fact that these are being properly applied.', 'this approach, of harnessing market forces and using improved internal governance to promote financial system soundness, is gaining some support in the international supervisory community, and among academics.', 'this can be highlighted by recent comments from three prominent and highly respected individuals.', '• "as financial transactions become increasingly rapid and complex, i believe we have no choice but to harness market forces, as best we can, to reinforce our supervisory objectives.', 'the appeal of market-led discipline lies not only in its cost effectiveness and flexibility, but also in its limited intrusiveness and its greater adaptability to changing financial environments.', 'measures to enhance market discipline involve providing private investors the incentives and the means to reward good bank performance and penalise poor performance.', 'expanded risk management disclosures by financial institutions is a significant step in this direction."', 'alan greenspan, may 1997.1 • "for major banks in industrial countries ..... there needs to be a shift of emphasis towards the re-inforcement of internal managerial risk-control mechanisms, and a recasting of the nature and functions of external regulation, away from generalised rule-setting and towards establishing incentives/sanctions which reinforce such internal control mechanisms."', 'charles goodhart, june 1997.2 • "much recent thinking has focused on incentive-compatible regulation -- using the market\'s own internal forces -- as the promising next step for strengthening the financial system.', 'it is banks\' shareholders and management that have the strongest interest to measure risk accurately."', 'andrew crockett, september 1997.3 to illustrate the evolution that is taking place in supervision, let me cite one example.', "in a recent initiative by the basle committee on banking supervision to amend the capital accord to include market risk, a greater role has been given to banks' own internal models in the measurement of market risk.", 'this reflects a move away from regulation that relies on detailed rules to an approach that places more emphasis on the adequacy of internal risk control mechanisms.', 'such an approach recognises that it is bank directors and management that have the strongest interest and ability to measure risk accurately, and that an internally-generated measure of risk should be better than one derived from that imposed by supervisors.', 'the ongoing challenge to regulators is to ensure that incentive structures are conducive to this outcome.', 'my own perspective is that a paradigm shift in supervision towards harnessing market forces will make a more significant contribution to promoting sound and efficient financial systems than simply changing regulatory structures within the same external regulation paradigm.', 'although it is far too early to make conclusive assessments of the success or otherwise of our new supervisory approach (which has now been in operation for nearly two years), i am satisfied that it is encouraging prudent behaviour by banks in new zealand, and thereby is reducing the likelihood of financial system instability in the future.', 'moreover, i am confident that it is doing this at lower efficiency, compliance and taxpayer costs than other supervisory options might be expected to achieve.', 'payments system reform so far, i have discussed the regulatory response to the globalisation of finance in terms of the health of the individual institutions that make up the financial system.', 'of equal significance to financial stability in this new environment is how resilient payment and settlement systems are, both domestically and internationally.', 'in common with most central banks around the world, we have been devoting considerable attention to payments system reform.', 'our main focus to date has been developing a real time gross settlement system for large-value transactions between banks.', 'until quite recently, the standard form of settlement was end-of-day net settlement: all payments and receipts between banks were allowed to accumulate during the day, to be settled by transfer of the very much smaller net amount at the end of the day.', 'the risk of this form of settlement is that it usually requires participants to grant unsecured and unlimited credit to other participants during the period until final settlement occurs.', "credit extended to a single counterparty can in some cases exceed a bank's entire capital.", 'one important solution which has been implemented in some countries, and which we have as a high priority to implement within the next few months in new zealand, is the replacement of this traditional end-of-day settlement arrangement with an rtgs system.', 'individual transactions under rtgs are settled one-by-one during the day rather than being allowed to accumulate, thereby removing the very large exposures that can build up between banks.', 'once implemented, rtgs will be a significant milestone in the reduction of domestic payment system risks.', 'another important initiative that we are promoting to reduce systemic risk is to make bilateral and multilateral netting arrangements for certain transactions legally binding.', 'with legally enforceable netting arrangements in place, the various "gross" obligations to make payments can be offset against one another, and it is only the net amounts due which are called into question in the event of a bank failure.', 'our attention is also being actively focused on dealing with settlement risk in cross-border foreign exchange transactions.', 'as already noted, the value of foreign exchange deals that are now being settled is so substantial that the resulting settlement risks can be of a size to cause systemic concern for both national and international financial systems.', 'this risk, mentioned earlier in my presentation, is often referred to as herstatt risk.', 'as in new zealand, much international attention is currently being focused on this problem.', 'co-operation amongst supervisors my final comments on the response of regulators to global financial trends concern the co-operation among supervisors and international agencies to address the potential for systemic disruption.', 'these efforts have gained momentum over the last decade as the inherent tension between nationally-based regulatory structures and an increasingly globalised financial sector has become apparent.', "co-operation among bank supervisors under the auspices of the basle committee on banking supervision has produced a number of important agreements on the supervision of banks, including minimum capital standards and minimum standards governing the supervision of banks' cross-border establishments.", 'similarly other supervisors, such as the international organisation of securities commissions (iosco) and the international association of insurance supervisors (iais), have pursued co-operation in their areas of responsibility.', 'and in the early 1990s, in recognition of the emergence and growth of financial conglomerates, banking, securities and insurance supervisors from g-10 countries began to work together to identify problems that conglomerates can cause and to consider ways to overcome them.', 'the mexican crisis in 1995 in particular, and the widespread incidence and high cost of banking problems more generally, have prompted calls for concerted international action to promote the soundness of financial systems.', 'these calls have strengthened over the last couple of years with the g-7 countries calling for "the adoption of strong prudential standards in emerging countries" and encouraging the international financial institutions to "increase their efforts to promote effective supervisory structures in these economies".', 'the basle committee on banking supervision has been at the forefront of this effort over the past year with the release of its core principles for effective banking supervision.', 'these principles have quickly become the focal point for the increased efforts to strengthen financial sectors around the world.', 'also aiming at more effective bank supervision, the imf is making the evaluation of financial supervision and regulation part of its annual country reviews, and the world bank is emphasising the strengthening of financial infrastructure as an important part of its structural assistance programmes.', 'a comment on the international supervisory response while the international regulatory response has many positive elements, to me it has not always been appropriately focused.', 'often following a crisis, there are calls to "strengthen supervision".', 'for various reasons, i feel that these calls, or the ways in which they have been answered, have not always been well directed.', 'let me briefly elaborate on why i think this.', 'at both the national and the international levels, the nature of the policy response to a crisis needs to be based on a careful analysis of the "problem".', "it is certainly clear from the record that there have been significant weaknesses in some countries' banking systems, and that these weaknesses have both contributed to the emergence and severity of financial crises and complicated the task of resolving them.", 'however, i am somewhat sceptical of the general proposition that "poor supervision" has been the primary cause of these weaknesses.', 'there has been a tendency to give supervision the "blame" for problems which have originated elsewhere, and/or to seek supervisory remedies for problems which might well be better solved in other ways.', 'i would note further that "supervision" (in its general sense) has sometimes been part of the "problem" rather than part of the "solution" -- particularly when it has involved excessive forbearance by the regulatory authorities, and/or excessive reliance on the public safety net.', 'i think it important that we supervisors should be appropriately modest about what we can achieve, and supervision should not be seen as an assured remedy for all potential problems.', 'establishing price stability and a sustainable fiscal position are also critical elements in the pursuit of sound financial systems.', 'while weakness in the financial system can have macroeconomic implications, the reverse is also undoubtedly true -- unsound macroeconomic policies can have long-lasting effects that lead to weakness in financial systems.', 'excessive credit creation and inflation are obvious examples.', 'some observers have suggested that virtually every major financial system problem in the last two or three decades was caused, directly or indirectly, by unsound macroeconomic policies.', 'some of the international regulatory responses also do not sufficiently recognise that the objectives of bank supervision, and the infrastructure within which supervision takes place (for example, the quality of company law, accounting standards, and external auditors), are not the same in all countries.', 'to have any chance of being successful, international initiatives will need to be flexible enough to suit this wide variety of national circumstances.', 'for emerging countries where the banking infrastructure may not be well developed, it may well be sensible to actively pursue financial stability through improving the quality of prescriptive rules.', 'in this regard, the initiative by the basle committee to establish an international standard of core principles for effective supervision may be helpful.', 'but regulators in many developed countries are finding that the complexity of banking, the blurring of functional dividing lines amongst financial institutions, globalisation, and the speed of portfolio adjustment are making external regulation based on standard rules less effective and less feasible.', 'this is resulting in an increasing emphasis being placed on internal risk management processes and in harnessing market disciplines to promote prudent banking behaviour.', 'what this suggests to me is that the regulatory approach followed by a particular country will need to fully reflect its own circumstances.', 'attempting to apply a "one-size-fits-all" approach to all countries is likely to be ineffective, and may even be counterproductive.', 'the future so, what do i see as being the likely issues of the future?', 'what is certain is that the future will surprise us!', 'but some things seem likely.', "innovation in the financial sector will continue, as will the integration of the world's financial markets.", 'using market disciplines to strengthen the financial system also seems likely to grow in relative importance.', 'new zealand\'s approach to promoting financial system stability is entirely consistent with the global trends that i have described and, in particular, with the "incentive-compatible" approach to regulation.', 'it seems absolutely appropriate for our circumstances.', 'there will inevitably need to be refinements made to our regulatory approach from time to time, but i believe that the principles on which it has been established, and its basic design, are soundly based and will remain so for the foreseeable future.', 'at some point in the future the "special" status of banks in the new zealand supervisory approach may need to be reassessed.', 'this might be prompted by the continued gradual breaking down of the traditional distinction between banks and non-banks in financial intermediation, or perhaps by banking services being provided in new zealand by institutions not physically located here.', 'it may also be prompted by a risk-proofing of payments an']	Donald T Brash	Reserve Bank of New Zealand	Governor	New Zealand
https://www.bis.org/review/r971127a.pdf	Mr. Stals discusses monetary policy challenges in South Africa (Central Bank Articles and Speeches, 7 Nov 97)	Address by the Governor of the South African Reserve Bank, Dr. Chris Stals, at a South African Financial Markets Conference arranged by Standard Bank of South Africa Limited in Cape Town, on 7/11/97.	1997-11-07 00:00:00	Mr. Stals discusses monetary policy challenges in South Africa Address by the Governor of the South African Reserve Bank, Dr. Chris Stals, at a South African Financial Markets Conference arranged by Standard Bank of South Africa Limited in Cape Town, on 7/11/97. 1. Challenge number one - to find consensus on what the objective of monetary policy should be in South Africa In the international community of central bankers, there is widespread consensus that the primary goal of monetary policy must be domestic price stability. Price stability, however, is only a means to an end, and not a final goal of overall macroeconomic policy. The ultimate goal is determined by governments and is normally linked to the objective of maximum economic growth, development and the creation of more employment opportunities. Contemporary economic theory supports the view, however, that financial stability, as measured by a low rate of inflation, is a precondition for the attainment of optimum economic development. Furthermore, monetary policy, being only one of the sub-elements of overall macroeconomic policy, is tasked with the responsibility to create and maintain such a stable financial environment that will be conducive for sustainable economic growth at an optimum rate in the medium and longer term. In South Africa, however, confusion remains on what the task and the functions of the central bank should be. The most important delusion, supported by certain business people, politicians and even some academics, is linked to the now defunct Phillips curve approach in terms of which the assumption is made that a higher inflation rate can produce a sustained lift in growth and employment. World-wide experience, as long back as in the 1970s, provided sufficient evidence that the assumed trade-off of higher inflation for lower unemployment could only be exploited over the limited period in which inflation expectations did not fully adjust to the new higher rate of inflation. With a more effective implementation of the theory of rational expectations within modern communities, this limited period has indeed become very short. Another reason why the conventional theory of demand management through the application of monetary policy is no longer appropriate is the major shift that took place in recent years in macroeconomic management, away from conventional Keynesian demand management to contemporary supply-side economics. The Phillips curve approach is based on the theory of demand-driven inflationary or deflationary conditions. The world-wide situation in the 1970s, when there was a simultaneous rise in inflation and in unemployment in many of the industrial countries, refuted the theory of the trade-off and forced new thinking on particularly the implementation of monetary policy. The present universal approach on monetary policy therefore takes account of the new electronic environment of instant communication leading to a more swift dissection of policy actions and immediate reaction by markets, and of the more general need in most countries to raise production capacity, and not to stimulate demand. In this environment, the appropriate role for monetary policy has been redefined as a responsibility for the creation and maintenance of stable financial conditions that will be reflected in low inflation. This is what central banks can do best to support governmental programmes for overall economic growth and development. In South Africa, considering the many attacks made on Reserve Bank policy during this past year, there is still a major lack of consensus on what the prime objective of monetary policy should be. Unless we can get consensus and support for the almost global approach of contemporary central bank policy, and unless we can agree to pursue these policies also in South Africa, the road to the internationalisation of the South African economy will be rough and difficult. 2. Challenge number two -- deciding on an appropriate framework for monetary policy Given the objective of price stability, each central bank must design a framework or a consistent model within which monetary policy can be implemented, taking account of the structure of the financial system and of the economy of the country. Various models are available to choose from, but whatever model is preferred, the final objective of monetary policy should always be the protection of the value of the currency. In the Bretton Woods system of fixed par values, the main intermediate objective of monetary policy was the protection of exchange rates, or the external value of the currency. By linking global exchange rates through fixed gold parities, there was a convergence of inflation, at a relatively low level, at least for the many countries that succeeded in maintaining fixed exchange rates over relatively long periods of time. Needless to say, the system broke down in the late 1960s and early 1970s when more expansionary monetary policies were followed by some of the major industrial countries, and inflation escalated. Today, some smaller countries still attach their exchange rates to a selected major international currency, and then accept the unavoidable consequence that the rate of inflation in the smaller country must converge with the rate of inflation in the economy of the anchor currency. A good example of this approach is provided by Argentina with its convertibility law of 1 Peso = 1 US dollar. A second widely-used model is the one of monetary targeting where an important monetary aggregate such as the money supply or the amount of bank credit extension is used as an anchor for monetary policy. Within the context of the prime monetary policy objective of maintaining low inflation, a monetary target (or exchange rate target) represents but an intermediate objective of the policy. South Africa is one of the many countries that introduced money supply targeting as an anchor for monetary policy during the course of the 1980s. Initially, the policy served the country well. It made an important contribution to a better understanding of policy decisions, and also made a major contribution towards the successful reduction in the level of the rate of inflation from an average of about 15 per cent over the twenty years from 1973 to 1992, to about 81⁄2 per cent over the past four years. The South African experience with money supply targeting is not very different from those of other comparable countries such as Canada and Australia -- with the difference that the process in South Africa is a slower and lagged one, mainly because of the economic isolation of this country from the rest of the world up to 1993. Australia introduced money supply targets in 1976, and then abandoned them "with reluctance" in February 1985. At the time, Australia tendered two reasons for ending the M3-targeting stage: "The first was the problem of controllability. The fact that targets were often missed was an indication that close control was either not possible, or would have required undesirable movements in the policy instruments. The second was the instability of the relationship between money supply and the ultimate objective of policy such as inflation ...". (Address by Governor Macfarlane at a Conference of Economists in Hobart, 29 September 1997.) It was Governor Gerald Bouey of Canada at the time who made the famous statement: "In Canada, we did not abandon money supply targets, they abandoned us". In view of the liberalisation of the South African financial markets in recent years, the integration of the South African economy in the world financial markets and the increasing importance of large and volatile international capital flows, South Africa may have reached the same stage now where the usefulness of the M3-money supply as a target for monetary policy has been diluted to a point where some alternative anchor should be considered. Following the demise of money supply targeting during the mid 1980s, both Canada and Australia went through a transitional period which lasted until the early 1990s. During this transitional period a policy of "monetary pragmatism" was followed. There was indeed no formal or strictly defined framework to guide monetary policy. A "check-list" of an ad hoc mixture of intermediate objectives was introduced and the central bank was allowed a wide degree of discretion in the implementation of monetary policy. After the "rule" of monetary targeting broke down, the policy was "to look at everything". Although such a pragmatic approach may have some advantages, particularly in an environment of major structural changes and volatile international shocks, it has the major disadvantage of not being transparent. As Charles Goodhart put it: "Supporters would describe it as sensible pragmatism, detractors as a reversion to a muddled discretion which, once again, allows the authorities more rope than is good for them, or us". (The Conduct of Monetary Policy, Economic Journal 1989.) Both Australia and Canada, and a growing number of other countries, have recently moved to direct targeting of inflation. In all these countries, however, not only central banks but also governments commit themselves jointly with the central banks to a predetermined target for inflation. In the United Kingdom, the Chancellor of the Exchequer indeed sets the target for inflation in his Annual Budget, and then instructs the Bank of England to pursue the goal with its monetary policy instruments. Nowhere does the central bank on its own decide on an inflation target. For an inflation target to be credible, there must be a commitment at least of the central bank and the government, and, if possible, also of the business community and labour, to the achievement of the goal. Furthermore, it will do more harm than good for a country to introduce a formal inflation target that is much out of line with the rest of the world. Of the seven countries reported in the BIS Annual Report for 1996 with formal inflation targets, no one has set a goal for inflation of more than 3 per cent per annum. The central bank must be given sufficient operational autonomy to pursue the inflation target with vigour and without the fear of intimidation by politicians or other pressure groups. And, finally, markets must be free, flexible and responsive to underlying changes. Inflation is often a symptom of malfunctioning markets and the cure lies not with monetary policy, but with a restructuring of the markets. It is a big challenge for South Africa to prepare itself for this new age of direct inflation targeting as an anchor for monetary policy. The proposals made by the Reserve Bank last week for the introduction in March next year of a more flexible system of providing accommodation to banking institutions, represents an important further step on this road towards a more effective monetary policy system that will be compatible with global policies. 3. Challenge number three - establishing an effective institutional framework for monetary policy There is a lot of misunderstanding in South Africa about what is meant with the independence of the Reserve Bank. The Bank can never be made responsible for determining the overall macroeconomic policy objectives of the country. This is a prerogative of government. The central bank must, however, be given a clear mandate from government on what its policy objective should be, but should then be given the necessary autonomy to pursue and achieve this objective. Taking account of the powers and influences of central banks, the obvious directive by government to the monetary authority should be to protect the value of the currency in the interest of sustainable optimum economic growth and development in the longer term. To achieve this objective, a central bank must at times apply financial disciplines that are unpopular, will be opposed by pressure groups and are perceived to be against the interests of private sector profiteers, and political popularity. It is inter alia for this reason, and only in respect of the implementation of measures that may at times prove to be unpopular, that central banks should be given "independence" from governments. To quote once more from what a former Governor of the Reserve Bank of Australia once said: "The Reserve Bank must be given all the freedom of the prison exercise yard". (R.A. Johnston - "Comments on Professor Schedvin - Economic Papers - 1992.) Although this autonomy has been given to the South African Reserve Bank in terms of the Constitution of the Republic of South Africa, the disciplinary actions applied by the Bank in the pursuance of its mandate are often challenged by economists, business people and politicians whenever they believe their vested interests are impeded by the actions. Many South Africans must still learn to be more tolerable towards the need of painful financial disciplines, when justified by adverse macroeconomic situations. These may often be forced on us by international developments over which we have no control. Apart from an effective institutional framework for the Reserve Bank, South Africa also needs well-managed private sector banking institutions, well-functioning financial markets and an effective clearing, settlement and payment arrangement for inter-bank transactions. The challenge is therefore not only to liberalise the South African financial sector further, but also to ensure good and prudent financial regulation, and to provide the country with a modern electronically-based national payment system. The new system to be introduced by the Reserve Bank in March 1998 for an improved clearing and settlement system will provide a further step on the road of preparing for an effective integration of the South African financial system in the global economy. The challenge for South Africa is not to isolate itself from the adverse effects of the globalisation process, but to continue to participate in the programme of gradual international integration. 4. The overriding challenge for monetary policy is to keep inflation low Financial stability in South Africa is threatened from time to time by new and more intensive inflationary pressures. We have not yet succeeded in suppressing the prevailing inflation psychosis in this country. Expectations at this juncture may have settled around the 8 per cent per annum level, which is about half of what it used to be at the beginning of this decade. But this is still about three times the amount of actual inflation in the economies of our major trading partners. The process of globalisation unavoidably leads to a convergence of the major financial aggregates such as inflation, real rates of interest and budget deficits. South Africa will either continue to be part of the globalisation process, together with its inevitable convergence effects, or will be marginalised and excluded from the advantages of being part of the world-wide process. In this period of transition from monetary policy targeting to the introduction of a national inflation objective, monetary policy must continue to maintain overall financial stability. This is essential in order to buy time while other policies (as proposed in GEAR) are put in place to handle the more deep-seated structural deficiencies that must be corrected before South Africa will be able to experience optimum economic growth with financial stability. 5. Conclusion and summary The challenges facing monetary policy in South Africa at this stage can be summarised as follows: • We must convince more South Africans that the one and only task for monetary policy must be to protect the value of the currency. • We must adapt monetary policy to the changing environment in which we now have to operate. This may require of us to move away from money supply targeting and to adopt a more direct focus on inflation developments. • We must guard against growing pressures in our country for the curtailment of the autonomy of the central bank. • The Reserve Bank must continue to guide the South African financial markets into the world financial system. This will require further progress in the gradual elimination of exchange control, the modernisation of the payments system, the encouragement of the development of more efficient markets and, in the context of Africa, support for co-operation and integration of financial markets within the Southern Africa Development Community. The overriding challenge remains to bring inflation in South Africa to a lower level that will be more in line with the average rate of inflation of our major trading partners. This will require a sound monetary policy approach, based on realistic (but not necessarily low) interest rates; a stable (but not necessarily fixed) exchange rate; a sound (but not necessarily protected) banking sector, and effective and well-functioning financial markets.	['mr. stals discusses monetary policy challenges in south africa address by the governor of the south african reserve bank, dr. chris stals, at a south african financial markets conference arranged by standard bank of south africa limited in cape town, on 7/11/97.', '1. challenge number one - to find consensus on what the objective of monetary policy should be in south africa in the international community of central bankers, there is widespread consensus that the primary goal of monetary policy must be domestic price stability.', 'price stability, however, is only a means to an end, and not a final goal of overall macroeconomic policy.', 'the ultimate goal is determined by governments and is normally linked to the objective of maximum economic growth, development and the creation of more employment opportunities.', 'contemporary economic theory supports the view, however, that financial stability, as measured by a low rate of inflation, is a precondition for the attainment of optimum economic development.', 'furthermore, monetary policy, being only one of the sub-elements of overall macroeconomic policy, is tasked with the responsibility to create and maintain such a stable financial environment that will be conducive for sustainable economic growth at an optimum rate in the medium and longer term.', 'in south africa, however, confusion remains on what the task and the functions of the central bank should be.', 'the most important delusion, supported by certain business people, politicians and even some academics, is linked to the now defunct phillips curve approach in terms of which the assumption is made that a higher inflation rate can produce a sustained lift in growth and employment.', 'world-wide experience, as long back as in the 1970s, provided sufficient evidence that the assumed trade-off of higher inflation for lower unemployment could only be exploited over the limited period in which inflation expectations did not fully adjust to the new higher rate of inflation.', 'with a more effective implementation of the theory of rational expectations within modern communities, this limited period has indeed become very short.', 'another reason why the conventional theory of demand management through the application of monetary policy is no longer appropriate is the major shift that took place in recent years in macroeconomic management, away from conventional keynesian demand management to contemporary supply-side economics.', 'the phillips curve approach is based on the theory of demand-driven inflationary or deflationary conditions.', 'the world-wide situation in the 1970s, when there was a simultaneous rise in inflation and in unemployment in many of the industrial countries, refuted the theory of the trade-off and forced new thinking on particularly the implementation of monetary policy.', 'the present universal approach on monetary policy therefore takes account of the new electronic environment of instant communication leading to a more swift dissection of policy actions and immediate reaction by markets, and of the more general need in most countries to raise production capacity, and not to stimulate demand.', 'in this environment, the appropriate role for monetary policy has been redefined as a responsibility for the creation and maintenance of stable financial conditions that will be reflected in low inflation.', 'this is what central banks can do best to support governmental programmes for overall economic growth and development.', 'in south africa, considering the many attacks made on reserve bank policy during this past year, there is still a major lack of consensus on what the prime objective of monetary policy should be.', 'unless we can get consensus and support for the almost global approach of contemporary central bank policy, and unless we can agree to pursue these policies also in south africa, the road to the internationalisation of the south african economy will be rough and difficult.', '2. challenge number two -- deciding on an appropriate framework for monetary policy given the objective of price stability, each central bank must design a framework or a consistent model within which monetary policy can be implemented, taking account of the structure of the financial system and of the economy of the country.', 'various models are available to choose from, but whatever model is preferred, the final objective of monetary policy should always be the protection of the value of the currency.', 'in the bretton woods system of fixed par values, the main intermediate objective of monetary policy was the protection of exchange rates, or the external value of the currency.', 'by linking global exchange rates through fixed gold parities, there was a convergence of inflation, at a relatively low level, at least for the many countries that succeeded in maintaining fixed exchange rates over relatively long periods of time.', 'needless to say, the system broke down in the late 1960s and early 1970s when more expansionary monetary policies were followed by some of the major industrial countries, and inflation escalated.', 'today, some smaller countries still attach their exchange rates to a selected major international currency, and then accept the unavoidable consequence that the rate of inflation in the smaller country must converge with the rate of inflation in the economy of the anchor currency.', 'a good example of this approach is provided by argentina with its convertibility law of 1 peso = 1 us dollar.', 'a second widely-used model is the one of monetary targeting where an important monetary aggregate such as the money supply or the amount of bank credit extension is used as an anchor for monetary policy.', 'within the context of the prime monetary policy objective of maintaining low inflation, a monetary target (or exchange rate target) represents but an intermediate objective of the policy.', 'south africa is one of the many countries that introduced money supply targeting as an anchor for monetary policy during the course of the 1980s.', 'initially, the policy served the country well.', 'it made an important contribution to a better understanding of policy decisions, and also made a major contribution towards the successful reduction in the level of the rate of inflation from an average of about 15 per cent over the twenty years from 1973 to 1992, to about 81⁄2 per cent over the past four years.', 'the south african experience with money supply targeting is not very different from those of other comparable countries such as canada and australia -- with the difference that the process in south africa is a slower and lagged one, mainly because of the economic isolation of this country from the rest of the world up to 1993. australia introduced money supply targets in 1976, and then abandoned them "with reluctance" in february 1985. at the time, australia tendered two reasons for ending the m3-targeting stage: "the first was the problem of controllability.', 'the fact that targets were often missed was an indication that close control was either not possible, or would have required undesirable movements in the policy instruments.', 'the second was the instability of the relationship between money supply and the ultimate objective of policy such as inflation ...".', '(address by governor macfarlane at a conference of economists in hobart, 29 september 1997.)', 'it was governor gerald bouey of canada at the time who made the famous statement: "in canada, we did not abandon money supply targets, they abandoned us".', 'in view of the liberalisation of the south african financial markets in recent years, the integration of the south african economy in the world financial markets and the increasing importance of large and volatile international capital flows, south africa may have reached the same stage now where the usefulness of the m3-money supply as a target for monetary policy has been diluted to a point where some alternative anchor should be considered.', 'following the demise of money supply targeting during the mid 1980s, both canada and australia went through a transitional period which lasted until the early 1990s.', 'during this transitional period a policy of "monetary pragmatism" was followed.', 'there was indeed no formal or strictly defined framework to guide monetary policy.', 'a "check-list" of an ad hoc mixture of intermediate objectives was introduced and the central bank was allowed a wide degree of discretion in the implementation of monetary policy.', 'after the "rule" of monetary targeting broke down, the policy was "to look at everything".', 'although such a pragmatic approach may have some advantages, particularly in an environment of major structural changes and volatile international shocks, it has the major disadvantage of not being transparent.', 'as charles goodhart put it: "supporters would describe it as sensible pragmatism, detractors as a reversion to a muddled discretion which, once again, allows the authorities more rope than is good for them, or us".', '(the conduct of monetary policy, economic journal 1989.)', 'both australia and canada, and a growing number of other countries, have recently moved to direct targeting of inflation.', 'in all these countries, however, not only central banks but also governments commit themselves jointly with the central banks to a predetermined target for inflation.', 'in the united kingdom, the chancellor of the exchequer indeed sets the target for inflation in his annual budget, and then instructs the bank of england to pursue the goal with its monetary policy instruments.', 'nowhere does the central bank on its own decide on an inflation target.', 'for an inflation target to be credible, there must be a commitment at least of the central bank and the government, and, if possible, also of the business community and labour, to the achievement of the goal.', 'furthermore, it will do more harm than good for a country to introduce a formal inflation target that is much out of line with the rest of the world.', 'of the seven countries reported in the bis annual report for 1996 with formal inflation targets, no one has set a goal for inflation of more than 3 per cent per annum.', 'the central bank must be given sufficient operational autonomy to pursue the inflation target with vigour and without the fear of intimidation by politicians or other pressure groups.', 'and, finally, markets must be free, flexible and responsive to underlying changes.', 'inflation is often a symptom of malfunctioning markets and the cure lies not with monetary policy, but with a restructuring of the markets.', 'it is a big challenge for south africa to prepare itself for this new age of direct inflation targeting as an anchor for monetary policy.', 'the proposals made by the reserve bank last week for the introduction in march next year of a more flexible system of providing accommodation to banking institutions, represents an important further step on this road towards a more effective monetary policy system that will be compatible with global policies.', '3. challenge number three - establishing an effective institutional framework for monetary policy there is a lot of misunderstanding in south africa about what is meant with the independence of the reserve bank.', 'the bank can never be made responsible for determining the overall macroeconomic policy objectives of the country.', 'this is a prerogative of government.', 'the central bank must, however, be given a clear mandate from government on what its policy objective should be, but should then be given the necessary autonomy to pursue and achieve this objective.', 'taking account of the powers and influences of central banks, the obvious directive by government to the monetary authority should be to protect the value of the currency in the interest of sustainable optimum economic growth and development in the longer term.', 'to achieve this objective, a central bank must at times apply financial disciplines that are unpopular, will be opposed by pressure groups and are perceived to be against the interests of private sector profiteers, and political popularity.', 'it is inter alia for this reason, and only in respect of the implementation of measures that may at times prove to be unpopular, that central banks should be given "independence" from governments.', 'to quote once more from what a former governor of the reserve bank of australia once said: "the reserve bank must be given all the freedom of the prison exercise yard".', '(r.a. johnston - "comments on professor schedvin - economic papers - 1992.)', 'although this autonomy has been given to the south african reserve bank in terms of the constitution of the republic of south africa, the disciplinary actions applied by the bank in the pursuance of its mandate are often challenged by economists, business people and politicians whenever they believe their vested interests are impeded by the actions.', 'many south africans must still learn to be more tolerable towards the need of painful financial disciplines, when justified by adverse macroeconomic situations.', 'these may often be forced on us by international developments over which we have no control.', 'apart from an effective institutional framework for the reserve bank, south africa also needs well-managed private sector banking institutions, well-functioning financial markets and an effective clearing, settlement and payment arrangement for inter-bank transactions.', 'the challenge is therefore not only to liberalise the south african financial sector further, but also to ensure good and prudent financial regulation, and to provide the country with a modern electronically-based national payment system.', 'the new system to be introduced by the reserve bank in march 1998 for an improved clearing and settlement system will provide a further step on the road of preparing for an effective integration of the south african financial system in the global economy.', 'the challenge for south africa is not to isolate itself from the adverse effects of the globalisation process, but to continue to participate in the programme of gradual international integration.', '4. the overriding challenge for monetary policy is to keep inflation low financial stability in south africa is threatened from time to time by new and more intensive inflationary pressures.', 'we have not yet succeeded in suppressing the prevailing inflation psychosis in this country.', 'expectations at this juncture may have settled around the 8 per cent per annum level, which is about half of what it used to be at the beginning of this decade.', 'but this is still about three times the amount of actual inflation in the economies of our major trading partners.', 'the process of globalisation unavoidably leads to a convergence of the major financial aggregates such as inflation, real rates of interest and budget deficits.', 'south africa will either continue to be part of the globalisation process, together with its inevitable convergence effects, or will be marginalised and excluded from the advantages of being part of the world-wide process.', 'in this period of transition from monetary policy targeting to the introduction of a national inflation objective, monetary policy must continue to maintain overall financial stability.', 'this is essential in order to buy time while other policies (as proposed in gear) are put in place to handle the more deep-seated structural deficiencies that must be corrected before south africa will be able to experience optimum economic growth with financial stability.', '5. conclusion and summary the challenges facing monetary policy in south africa at this stage can be summarised as follows: • we must convince more south africans that the one and only task for monetary policy must be to protect the value of the currency.', '• we must adapt monetary policy to the changing environment in which we now have to operate.', 'this may require of us to move away from money supply targeting and to adopt a more direct focus on inflation developments.', '• we must guard against growing pressures in our country for the curtailment of the autonomy of the central bank.', '• the reserve bank must continue to guide the south african financial markets into the world financial system.', 'this will require further progress in the gradual elimination of exchange control, the modernisation of the payments system, the encouragement of the development of more efficient markets and, in the context of africa, support for co-operation and integration of financial markets within the southern africa development community.', 'the overriding challenge remains to bring inflation in south africa to a lower level that will be more in line with the average rate of inflation of our major trading partners.', 'this will require a sound monetary policy approach, based on realistic (but not necessarily low) interest rates; a stable (but not necessarily fixed) exchange rate; a sound (but not necessarily protected) banking sector, and effective and well-functioning financial markets.']	Chris Stals	South African Reserve Bank	Governor	South Africa
https://www.bis.org/review/r971121d.pdf	Mr. Sherwin considers growth, productivity and monetary policy: the longer-term perspective (Central Bank Articles and Speeches, 12 Nov 97)	Address by the Deputy Governor of the Reserve Bank of New Zealand, Mr. Murray Sherwin, to the Annual Conference of the New Zealand Forest Owners Association in Auckland on 12/11/97.	1997-11-12 00:00:00	Mr. Sherwin considers growth, productivity and monetary policy: the Address by the Deputy Governor of the Reserve Bank of New Zealand, longer-term perspective Mr. Murray Sherwin, to the Annual Conference of the New Zealand Forest Owners Association in Auckland on 12/11/97. Introduction: competitiveness and productivity I have been asked to discuss the New Zealand economy in a medium-term context, with particular reference to the place of forestry. I am conscious also of the overall theme of this conference -- The Competition Gap. I applaud the Association for choosing to focus on that theme, because while that is clearly a very relevant issue for the forestry sector to be debating, it is equally relevant to the broader economy. We all wish to raise living standards in New Zealand. The reform effort of the past 13 years has been focused on precisely that goal. To achieve it, we require a sustained lift in productivity, across the New Zealand economy. Improved productivity and "meeting the competition gap" are one and the same thing. It is not my intention to provide a substantive projection of New Zealand's economic prospects over the growth cycle of a GF17 pine tree. Nor do I intend to discuss the likely prospects of the forestry sector. Rather, I will try to lay out a few of the very broad factors that will shape the development of the New Zealand economy over the medium term, and to reflect a little on the factors that influence interest rates and exchange rates over longer time horizons. The determinants of economic growth Last month, Governor Don Brash delivered a speech to the Auckland Rotary Club under the topic "How Fast Can the New Zealand Economy Grow?" The key theme of that speech was that our growth potential is determined ultimately by quantities and quality. The quantity of people and the quantity of capital -- in the form of factories, forests, trucks, roads, computers and all the tools of a modern economy. And the quality of those same inputs -- how well they work, and how efficiently they are deployed. As Dr. Brash went on to say, the Reserve Bank believes that New Zealand's longer-term growth potential is probably of the order of 3 percent annually at present -- a result of a trend growth in the working age population of around 1.5 percent and trend growth in output per person, or productivity, also of around 1.5 percent. Lifting that growth potential requires bigger quantities or better qualities -- of people, attitudes, and equipment. On the quantities side, we can't do a great deal in the short term about the size of the working age population. After centuries of diligent practice, it still takes around 9 months to produce a new Kiwi and, only a little quicker than Pinus Radiata -- around 20 years -- to get that new Kiwi into the work force. Of course, we can import new workers "ready built up". But even then, as we have discovered in recent years, there are limitations on how quickly new immigrants can be absorbed. In any event, while increasing the size of the labour force may enable us to boost overall economic growth, what really matters for living standards is per capita growth. And that means we need to focus on output per person, or the productivity of our work force, not just its raw quantity. In the longer term, and at the risk of doing some violence to the wealth of economic research on the subject, productivity is heavily dependent on one key factor -- the quality of our human resources. Living standards rise on the back of overall educational attainment and attitudes. That implies a continuing need to raise the quality of our general educational effort. It means raising the numbers participating in higher education. It means improved on-the-job training. It means better-trained managers able to make smarter decisions and provide improved management of our work force -- in the forest, on the factory floor, in the research laboratories, within both the public and private sectors. And it means smarter governance from within the nation's boardrooms. The role of capital investment Intertwined with the quality of our work force and how well it is managed is the issue of the quality and quantity of physical capital available to each person. By teaming better-trained people with better technology and working with more and better physical capital we can provide a recipe for making serious progress in raising productivity. And through that, we can make serious advances in our living standards. New Zealand's history provides some useful insights into the role of capital investment. During our slow growth phase -- through the 1970s and 1980s -- our investment levels were quite respectable by the standards of other developed economies -- somewhere around 25 percent of GDP per annum. What was impeding growth was not so much an inadequate quantity of investment, but poor quality investment -- a persistent tendency to direct capital into low-yielding activities. The sources of that misdirection of capital are not hard to find. They lie with government-led investment decisions -- for example, "Think Big" projects -- and with investment encouraged into sectors or activities sheltered by protections of various kinds. It is those protections -- the import quotas, licensing arrangements, or tax incentives -- that produce situations in which the returns to private investors become disconnected from the underlying market realities. The individual investor may be profiting as a consequence of those protections, but only at the cost of overall national efficiency and income. Raising productivity means allowing change It is with those considerations in mind that countries seeking to boost their growth performance look to micro-economic reforms -- to reduced protection, to deregulation, to flatter and broader tax structures, to increased market flexibility -- in order to encourage available resources of labour and capital to move into those areas where private financial returns and national economic returns are similarly high. Of course, encouraging the flow of resources into higher-yielding activities also implies that those same resources, labour and capital, are permitted to move away from activities in which returns are low. So when we see sheep and beef farms being converted into either dairy units, on the one hand, or pine forests on the other, we need to check if there are particular regulatory or taxation reasons encouraging that shift. If there are none, we are entitled to conclude that rational investors are making a judgement that the future returns on investment in dairying or forestry are likely to be superior to the future returns on sheep and beef farming. Moreover, we are entitled to presume that, as a result of that changed land use, our national growth potential will be higher. The efficiency of our capital stock will have increased. Of course, rational investors may be wrong in their judgements. Only time will tell. But so long as those investors are risking their own money, in an efficient regulatory and tax environment, we stand the best possible chance of maximising the performance of the economy overall. One message should be very clear. We cannot lift our economic performance by locking land, labour or capital into low-yielding activities. Lifting our growth performance will inevitably mean continuing change, including the decline of some sectors, in order to free resources for movement to expanding, higher-yielding activities. And in a world of ever-faster innovation, the high performance economies are likely to be the more flexible ones -- the ones most able to quickly take up emerging technologies and production processes and to encourage the shift of resources from one industry or production technique to another. Monetary policy has a background role in facilitating faster growth You will note that so far I have managed to avoid any mention of monetary policy or the role of the Reserve Bank in all of this. Interest rates and exchange rates haven't entered the equation. That's because monetary policy and the Reserve Bank have an important, but essentially "background", role in allowing the economy to achieve its longer-term growth potential. A couple of points are relevant here. What I have discussed so far are the "real" contributors to economic growth -- the quantity and quality of inputs. These are the "supply side" factors. Monetary policy and the Reserve Bank operate on the demand side. The task of monetary policy is to maintain price stability. That involves ensuring that demand in the economy grows roughly in line with the capacity of the economy to meet that demand. The Reserve Bank's Policy Targets Agreement (PTA), signed by the Minister of Finance and the Governor, sets a 0 to 3 percent inflation target as the Governor's sole objective. The PTA establishes that single objective of price stability "... so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy". The rationale for that position is quite straightforward, and is particularly relevant to a sector such as forestry, which involves such long investment horizons. In an inflation-free environment, investors and the public generally get their best shot at reading accurately the signals that markets are delivering -- which goods and services represent best value, where the best returns on investment may be found, how much to consume and how much to save. Simply adopting an easy monetary policy does nothing to increase the supply of labour or its skill level. It does nothing to improve the availability of better technologies. But most importantly, an easy monetary policy that gives rise to a risk of future inflation is likely to divert investment and the flow of resources away from sectors with longer-term investment horizons -- such as forestry -- towards quick-return real estate and similar investments that exploit the tax and other distortions which emerge in an inflationary environment. Once price stability has been achieved, monetary policy is essentially an exercise in smoothing economic cycles -- slowing the economy when it looks likely to overheat, stimulating it as activity slows. That is not a straightforward exercise. Even if we get it right, (and we won't always) there will still be economic cycles. But we should be able to avoid the boom/bust cycles of old. If our longer-term growth potential is around 3 percent, it is probably the case that growth outturns in the 1 percent to 5 percent range will be the norm. Occasional external shocks and surprises -- climate, international events, and so on -- may take us outside that range. But surprises of that sort should be rare. However, a sustained growth performance within a range of that sort would represent a substantial step up from our experience through the 1960s and 1970s, and would place us somewhere near the top end of the OECD growth league. Interest rates are determined by international conditions and local risk factors So what does that mean for interest rates and exchange rates in New Zealand over the longer term? Essentially, in our world of open capital markets, interest rates in New Zealand will tend to settle at some margin above or below a benchmark set in US financial markets. How large that margin is (and whether it is positive or negative) will depend on the risks and returns that savers, both domestic and foreign, associate with New Zealand. There are, of course, many different risks that enter that assessment. But a key one is the risk of future inflation. A firm commitment to the maintenance of price stability is already resulting in substantially lower interest rates in New Zealand. The rate paid by the New Zealand Government on its New Zealand dollar 10-year bonds has fallen from around 10 percentage points above that paid by the US Government on 10-year US dollar bonds in the mid 1980s, to little more than half of one percent above the US rate. Our shorter-term interest rates have also fallen sharply relative to those in other countries over the past decade or so, but they remain high by OECD standards, and high in real terms. That will remain the case so long as the strong demand for borrowing that we have seen over the past several years continues. On that note, it is worth reminding ourselves that the route to consistently lower interest rates lies in allowing both savers and borrowers to become confident that the risk of future inflation is slight. We can't look to the exchange rate to boost international competitiveness A conference examining competitiveness may find it tempting to look to the exchange rate for salvation at some point. Don't bother. The forestry industry, like every other export industry in New Zealand, is going to have to live with an exchange rate that varies. There is nothing you can do about that, and there is nothing the government or the Reserve Bank can do about that. We live in a world of floating exchange rates. While it is conceivable that we could fix our exchange rate to the US dollar, or the Australian dollar, or even the TWI (as we once did) we can't fix to all simultaneously. Inevitably we have to learn to cope with exchange rate variability. In fact, on measures of shorter-term exchange rate volatility, the New Zealand dollar is a surprisingly good performer. Day-to-day volatility of our currency is modest when measured alongside the experience of other developed countries -- even those much larger than New Zealand. To assess the impact of longer-term exchange rate trends, we need to look to measures of the "real" or inflation-adjusted exchange rate -- because that is what matters for exporters. On that basis, we find that the New Zealand dollar moves through the inevitable cycles, but will typically be found within about 15 percent to 20 percent of its longer-term average. Our recent experience has been consistent with that. The real TWI was around 10 percent below its long-term average at its last trough in 1992. At its recent peak, in April of this year, it was around 17 percent above that same longer-term average. While cycles in the real exchange rate of that amplitude can certainly create discomfort for exporters, it is clear that they are well within the range experienced by other currencies. In essence, exporters should be factoring cycles of that sort into their business planning. It is clearly relevant to the variability of their future earnings stream, and therefore, to the value of their assets and to the nature of the capital structure they require to stay in business. Of course, it is also relevant to their balance sheet management and to risk-hedging strategies they may need to adopt. The best contribution that governments and central banks can make to moderating real exchange rate cycles is to embrace policy consistency and transparency -- in monetary policy, fiscal policy, and in tax and regulatory policies. The decline in exchange rate volatility in recent years provides some evidence to support that. One point we should all be clear on. There is no future in thinking we can pursue competitiveness, in forestry or any other sector, through attempts to use monetary policy to engineer a weaker exchange rate. I say that for several reasons: Competitiveness and the productivity improvements that ensure competitiveness are products of • "real" advances in efficiency, technology and management. Lowering the exchange rate makes no one more efficient. • The focus of monetary policy on the single objective of price stability is key to convincing savers and investors that, in taking their decisions, they do not need to factor in a large inflation risk. It is only in that way that we can get sustainably lower interest rates. • As our own history well demonstrates, any short-term gains that may be available to exporters as a result of a one-off depreciation of the exchange rate are quickly eroded as future inflation increases. As a fix for competitiveness problems, exchange rate depreciations are both addictive and ultimately destructive. • Central banks do not determine real exchange rates in the long term. Markets and relative economic efficiency/productivity trends determine real exchange rates. What of the balance of payments deficit? Let me touch on one other issue that is relevant to the longer-term behaviour of the New Zealand dollar and New Zealand interest rates -- the balance of payments. We are currently running a current account deficit of the order of 6 percent of GDP. That puts us amongst the largest external deficits in the OECD. Note also that New Zealand's net foreign debt currently amounts to around 80 percent of GDP -- which puts us at the top end of international experience. To prevent that external debt ratio from increasing further, it is necessary for the current account deficit to decrease to less than the annual growth of GDP -- ie, to something less than about 3 percent. The key issue here is domestic savings behaviour. To the extent that domestic savings are insufficient to fund the nation's investment needs, we must rely on foreign savings. And if we are reliant on foreign savings, we must, by definition, continue to run a current account deficit. That is a simple accounting identity. I note with interest the estimates of some commentators who suggest that the forestry industry alone will require substantial volumes of foreign investment over the next few years. They may be correct in their estimates of investment needs. But if those needs are met from foreign investment, we must accept that that is equivalent to saying that New Zealand must continue to run a current account deficit. Will New Zealand generally, and the forestry sector in particular, have difficulty attracting the investment capital it requires? Probably not. So long as investors have confidence in the quality of our industries, the reliability of future earning streams, and the quality of our future macro and micro economic policies, it is unlikely that we will have difficulty in attracting the necessary investment. We compete in a global market to sell our products. Equally, we compete in a global market to attract savings for investment. The pool of savings available globally is enormous, and New Zealand's needs represent just a minute fraction of that available. New Zealand need not, therefore, regard itself as investment constrained. But to the extent that our domestic savings fall short of the levels required to fund our investment needs, our external debt ratios continue to rise, then the risks perceived by potential investors will also rise. With higher risks come increased interest rate margins. It is probably also the case that those high external debt ratios leave New Zealand a little more vulnerable to shifts in international market sentiment, which may reveal themselves in sharp and sometimes disruptive movements in interest rates and exchange rates. For those reasons, it is our belief that New Zealand would face a more secure future if our dependence on the savings of others were reduced.	['mr. sherwin considers growth, productivity and monetary policy: the address by the deputy governor of the reserve bank of new zealand, longer-term perspective mr. murray sherwin, to the annual conference of the new zealand forest owners association in auckland on 12/11/97.', 'introduction: competitiveness and productivity i have been asked to discuss the new zealand economy in a medium-term context, with particular reference to the place of forestry.', 'i am conscious also of the overall theme of this conference -- the competition gap.', 'i applaud the association for choosing to focus on that theme, because while that is clearly a very relevant issue for the forestry sector to be debating, it is equally relevant to the broader economy.', 'we all wish to raise living standards in new zealand.', 'the reform effort of the past 13 years has been focused on precisely that goal.', 'to achieve it, we require a sustained lift in productivity, across the new zealand economy.', 'improved productivity and "meeting the competition gap" are one and the same thing.', "it is not my intention to provide a substantive projection of new zealand's economic prospects over the growth cycle of a gf17 pine tree.", 'nor do i intend to discuss the likely prospects of the forestry sector.', 'rather, i will try to lay out a few of the very broad factors that will shape the development of the new zealand economy over the medium term, and to reflect a little on the factors that influence interest rates and exchange rates over longer time horizons.', 'the determinants of economic growth last month, governor don brash delivered a speech to the auckland rotary club under the topic "how fast can the new zealand economy grow?"', 'the key theme of that speech was that our growth potential is determined ultimately by quantities and quality.', 'the quantity of people and the quantity of capital -- in the form of factories, forests, trucks, roads, computers and all the tools of a modern economy.', 'and the quality of those same inputs -- how well they work, and how efficiently they are deployed.', "as dr. brash went on to say, the reserve bank believes that new zealand's longer-term growth potential is probably of the order of 3 percent annually at present -- a result of a trend growth in the working age population of around 1.5 percent and trend growth in output per person, or productivity, also of around 1.5 percent.", 'lifting that growth potential requires bigger quantities or better qualities -- of people, attitudes, and equipment.', "on the quantities side, we can't do a great deal in the short term about the size of the working age population.", 'after centuries of diligent practice, it still takes around 9 months to produce a new kiwi and, only a little quicker than pinus radiata -- around 20 years -- to get that new kiwi into the work force.', 'of course, we can import new workers "ready built up".', 'but even then, as we have discovered in recent years, there are limitations on how quickly new immigrants can be absorbed.', 'in any event, while increasing the size of the labour force may enable us to boost overall economic growth, what really matters for living standards is per capita growth.', 'and that means we need to focus on output per person, or the productivity of our work force, not just its raw quantity.', 'in the longer term, and at the risk of doing some violence to the wealth of economic research on the subject, productivity is heavily dependent on one key factor -- the quality of our human resources.', 'living standards rise on the back of overall educational attainment and attitudes.', 'that implies a continuing need to raise the quality of our general educational effort.', 'it means raising the numbers participating in higher education.', 'it means improved on-the-job training.', 'it means better-trained managers able to make smarter decisions and provide improved management of our work force -- in the forest, on the factory floor, in the research laboratories, within both the public and private sectors.', "and it means smarter governance from within the nation's boardrooms.", 'the role of capital investment intertwined with the quality of our work force and how well it is managed is the issue of the quality and quantity of physical capital available to each person.', 'by teaming better-trained people with better technology and working with more and better physical capital we can provide a recipe for making serious progress in raising productivity.', 'and through that, we can make serious advances in our living standards.', "new zealand's history provides some useful insights into the role of capital investment.", 'during our slow growth phase -- through the 1970s and 1980s -- our investment levels were quite respectable by the standards of other developed economies -- somewhere around 25 percent of gdp per annum.', 'what was impeding growth was not so much an inadequate quantity of investment, but poor quality investment -- a persistent tendency to direct capital into low-yielding activities.', 'the sources of that misdirection of capital are not hard to find.', 'they lie with government-led investment decisions -- for example, "think big" projects -- and with investment encouraged into sectors or activities sheltered by protections of various kinds.', 'it is those protections -- the import quotas, licensing arrangements, or tax incentives -- that produce situations in which the returns to private investors become disconnected from the underlying market realities.', 'the individual investor may be profiting as a consequence of those protections, but only at the cost of overall national efficiency and income.', 'raising productivity means allowing change it is with those considerations in mind that countries seeking to boost their growth performance look to micro-economic reforms -- to reduced protection, to deregulation, to flatter and broader tax structures, to increased market flexibility -- in order to encourage available resources of labour and capital to move into those areas where private financial returns and national economic returns are similarly high.', 'of course, encouraging the flow of resources into higher-yielding activities also implies that those same resources, labour and capital, are permitted to move away from activities in which returns are low.', 'so when we see sheep and beef farms being converted into either dairy units, on the one hand, or pine forests on the other, we need to check if there are particular regulatory or taxation reasons encouraging that shift.', 'if there are none, we are entitled to conclude that rational investors are making a judgement that the future returns on investment in dairying or forestry are likely to be superior to the future returns on sheep and beef farming.', 'moreover, we are entitled to presume that, as a result of that changed land use, our national growth potential will be higher.', 'the efficiency of our capital stock will have increased.', 'of course, rational investors may be wrong in their judgements.', 'only time will tell.', 'but so long as those investors are risking their own money, in an efficient regulatory and tax environment, we stand the best possible chance of maximising the performance of the economy overall.', 'one message should be very clear.', 'we cannot lift our economic performance by locking land, labour or capital into low-yielding activities.', 'lifting our growth performance will inevitably mean continuing change, including the decline of some sectors, in order to free resources for movement to expanding, higher-yielding activities.', 'and in a world of ever-faster innovation, the high performance economies are likely to be the more flexible ones -- the ones most able to quickly take up emerging technologies and production processes and to encourage the shift of resources from one industry or production technique to another.', 'monetary policy has a background role in facilitating faster growth you will note that so far i have managed to avoid any mention of monetary policy or the role of the reserve bank in all of this.', "interest rates and exchange rates haven't entered the equation.", 'that\'s because monetary policy and the reserve bank have an important, but essentially "background", role in allowing the economy to achieve its longer-term growth potential.', 'a couple of points are relevant here.', 'what i have discussed so far are the "real" contributors to economic growth -- the quantity and quality of inputs.', 'these are the "supply side" factors.', 'monetary policy and the reserve bank operate on the demand side.', 'the task of monetary policy is to maintain price stability.', 'that involves ensuring that demand in the economy grows roughly in line with the capacity of the economy to meet that demand.', "the reserve bank's policy targets agreement (pta), signed by the minister of finance and the governor, sets a 0 to 3 percent inflation target as the governor's sole objective.", 'the pta establishes that single objective of price stability "... so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the new zealand economy".', 'the rationale for that position is quite straightforward, and is particularly relevant to a sector such as forestry, which involves such long investment horizons.', 'in an inflation-free environment, investors and the public generally get their best shot at reading accurately the signals that markets are delivering -- which goods and services represent best value, where the best returns on investment may be found, how much to consume and how much to save.', 'simply adopting an easy monetary policy does nothing to increase the supply of labour or its skill level.', 'it does nothing to improve the availability of better technologies.', 'but most importantly, an easy monetary policy that gives rise to a risk of future inflation is likely to divert investment and the flow of resources away from sectors with longer-term investment horizons -- such as forestry -- towards quick-return real estate and similar investments that exploit the tax and other distortions which emerge in an inflationary environment.', 'once price stability has been achieved, monetary policy is essentially an exercise in smoothing economic cycles -- slowing the economy when it looks likely to overheat, stimulating it as activity slows.', 'that is not a straightforward exercise.', "even if we get it right, (and we won't always) there will still be economic cycles.", 'but we should be able to avoid the boom/bust cycles of old.', 'if our longer-term growth potential is around 3 percent, it is probably the case that growth outturns in the 1 percent to 5 percent range will be the norm.', 'occasional external shocks and surprises -- climate, international events, and so on -- may take us outside that range.', 'but surprises of that sort should be rare.', 'however, a sustained growth performance within a range of that sort would represent a substantial step up from our experience through the 1960s and 1970s, and would place us somewhere near the top end of the oecd growth league.', 'interest rates are determined by international conditions and local risk factors so what does that mean for interest rates and exchange rates in new zealand over the longer term?', 'essentially, in our world of open capital markets, interest rates in new zealand will tend to settle at some margin above or below a benchmark set in us financial markets.', 'how large that margin is (and whether it is positive or negative) will depend on the risks and returns that savers, both domestic and foreign, associate with new zealand.', 'there are, of course, many different risks that enter that assessment.', 'but a key one is the risk of future inflation.', 'a firm commitment to the maintenance of price stability is already resulting in substantially lower interest rates in new zealand.', 'the rate paid by the new zealand government on its new zealand dollar 10-year bonds has fallen from around 10 percentage points above that paid by the us government on 10-year us dollar bonds in the mid 1980s, to little more than half of one percent above the us rate.', 'our shorter-term interest rates have also fallen sharply relative to those in other countries over the past decade or so, but they remain high by oecd standards, and high in real terms.', 'that will remain the case so long as the strong demand for borrowing that we have seen over the past several years continues.', 'on that note, it is worth reminding ourselves that the route to consistently lower interest rates lies in allowing both savers and borrowers to become confident that the risk of future inflation is slight.', "we can't look to the exchange rate to boost international competitiveness a conference examining competitiveness may find it tempting to look to the exchange rate for salvation at some point.", 'the forestry industry, like every other export industry in new zealand, is going to have to live with an exchange rate that varies.', 'there is nothing you can do about that, and there is nothing the government or the reserve bank can do about that.', 'we live in a world of floating exchange rates.', "while it is conceivable that we could fix our exchange rate to the us dollar, or the australian dollar, or even the twi (as we once did) we can't fix to all simultaneously.", 'inevitably we have to learn to cope with exchange rate variability.', 'in fact, on measures of shorter-term exchange rate volatility, the new zealand dollar is a surprisingly good performer.', 'day-to-day volatility of our currency is modest when measured alongside the experience of other developed countries -- even those much larger than new zealand.', 'to assess the impact of longer-term exchange rate trends, we need to look to measures of the "real" or inflation-adjusted exchange rate -- because that is what matters for exporters.', 'on that basis, we find that the new zealand dollar moves through the inevitable cycles, but will typically be found within about 15 percent to 20 percent of its longer-term average.', 'our recent experience has been consistent with that.', 'the real twi was around 10 percent below its long-term average at its last trough in 1992. at its recent peak, in april of this year, it was around 17 percent above that same longer-term average.', 'while cycles in the real exchange rate of that amplitude can certainly create discomfort for exporters, it is clear that they are well within the range experienced by other currencies.', 'in essence, exporters should be factoring cycles of that sort into their business planning.', 'it is clearly relevant to the variability of their future earnings stream, and therefore, to the value of their assets and to the nature of the capital structure they require to stay in business.', 'of course, it is also relevant to their balance sheet management and to risk-hedging strategies they may need to adopt.', 'the best contribution that governments and central banks can make to moderating real exchange rate cycles is to embrace policy consistency and transparency -- in monetary policy, fiscal policy, and in tax and regulatory policies.', 'the decline in exchange rate volatility in recent years provides some evidence to support that.', 'one point we should all be clear on.', 'there is no future in thinking we can pursue competitiveness, in forestry or any other sector, through attempts to use monetary policy to engineer a weaker exchange rate.', 'i say that for several reasons: competitiveness and the productivity improvements that ensure competitiveness are products of • "real" advances in efficiency, technology and management.', 'lowering the exchange rate makes no one more efficient.', '• the focus of monetary policy on the single objective of price stability is key to convincing savers and investors that, in taking their decisions, they do not need to factor in a large inflation risk.', 'it is only in that way that we can get sustainably lower interest rates.', '• as our own history well demonstrates, any short-term gains that may be available to exporters as a result of a one-off depreciation of the exchange rate are quickly eroded as future inflation increases.', 'as a fix for competitiveness problems, exchange rate depreciations are both addictive and ultimately destructive.', '• central banks do not determine real exchange rates in the long term.', 'markets and relative economic efficiency/productivity trends determine real exchange rates.', 'what of the balance of payments deficit?', 'let me touch on one other issue that is relevant to the longer-term behaviour of the new zealand dollar and new zealand interest rates -- the balance of payments.', 'we are currently running a current account deficit of the order of 6 percent of gdp.', 'that puts us amongst the largest external deficits in the oecd.', "note also that new zealand's net foreign debt currently amounts to around 80 percent of gdp -- which puts us at the top end of international experience.", 'to prevent that external debt ratio from increasing further, it is necessary for the current account deficit to decrease to less than the annual growth of gdp -- ie, to something less than about 3 percent.', 'the key issue here is domestic savings behaviour.', "to the extent that domestic savings are insufficient to fund the nation's investment needs, we must rely on foreign savings.", 'and if we are reliant on foreign savings, we must, by definition, continue to run a current account deficit.', 'that is a simple accounting identity.', 'i note with interest the estimates of some commentators who suggest that the forestry industry alone will require substantial volumes of foreign investment over the next few years.', 'they may be correct in their estimates of investment needs.', 'but if those needs are met from foreign investment, we must accept that that is equivalent to saying that new zealand must continue to run a current account deficit.', 'will new zealand generally, and the forestry sector in particular, have difficulty attracting the investment capital it requires?', 'so long as investors have confidence in the quality of our industries, the reliability of future earning streams, and the quality of our future macro and micro economic policies, it is unlikely that we will have difficulty in attracting the necessary investment.', 'we compete in a global market to sell our products.', 'equally, we compete in a global market to attract savings for investment.', "the pool of savings available globally is enormous, and new zealand's needs represent just a minute fraction of that available.", 'new zealand need not, therefore, regard itself as investment constrained.', 'but to the extent that our domestic savings fall short of the levels required to fund our investment needs, our external debt ratios continue to rise, then the risks perceived by potential investors will also rise.', 'with higher risks come increased interest rate margins.', 'it is probably also the case that those high external debt ratios leave new zealand a little more vulnerable to shifts in international market sentiment, which may reveal themselves in sharp and sometimes disruptive movements in interest rates and exchange rates.', 'for those reasons, it is our belief that new zealand would face a more secure future if our dependence on the savings of others were reduced.']	Murray Sherwin	Reserve Bank of New Zealand	Deputy Governor	New Zealand
https://www.bis.org/review/r971121c.pdf	Mr. Greenspan's remarks at the Center for Financial Studies in Frankfurt (Central Bank Articles and Speeches, 7 Nov 97)	Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Center for Financial Studies in Frankfurt-am-Main, on 7/11/97.	1997-11-07 00:00:00	Mr. Greenspan's remarks at the Center for Financial Studies in Frankfurt Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Center for Financial Studies in Frankfurt-am-Main, on 7/11/97. The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought into sharper focus the issue of price measurement. As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation. In today's advanced economies, allocative decisions are primarily made not by governments but by markets, and the central guide to the efficient allocation of resources in a market economy is prices. Prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use. Of course, this signaling process would work with or without government statistical agencies that measure individual and aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy. Indeed, vibrant market economies existed long before government agencies were established to measure prices. Nonetheless, in a modern monetary economy, accurate price measurement is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability. Accurate price measures are necessary for understanding economic developments, not only involving inflation but also involving real output and productivity. If the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real output and productivity. Real incomes and living standards are rising faster than our published data suggest. Under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid misguided actions that will provoke unintended consequences. Clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth. Moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may nevertheless take such an index into account less formally. If the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will be skewed. The measured price indexes have played an especially prominent role in Germany, both in terms of public perceptions of inflation performance and as a guide for policymakers. The Bundesbank's long-standing commitment to price stability and the public's support for that commitment derive at least to some extent from Germany's experiences with hyperinflation earlier this century. Given this experience with the devastation that such inflation can bring to the economy and to people's lives, it comes as no surprise that your public and your policymakers give such careful scrutiny to the available measures of inflation. Germany has a reputation for special vigilance in guarding the stability of the price level and has achieved an admirable record of success in maintaining low inflation over the postwar period. From the standpoint of monetary policy, this very success makes accurate price measurement all the more important. When measured inflation is high, we can be confident that the proper direction of monetary policy is to bring inflation lower. But when measured inflation is low, the proper direction of monetary policy, as I indicated, could depend crucially on the accuracy of those measurements. The importance of accurate price measurement was particularly apparent during unification, when it became necessary to gauge productivity in East and West Germany on a comparable basis. Initial estimates of East German productivity relative to that of the West were considerably higher than later, more accurate estimates showed to be the case. These differences, we are told, owed largely to - 2 - the difficulties in adjusting the prices of East German products to take into account that they were, on average, of lower quality than the equivalent items produced in the West. In thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other. The notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined. Moreover, in practice, aggregation can be complicated because standard price indexes frequently assume that individuals and businesses purchase the same basket of goods and services over time -- whereas, in fact, people substitute some goods for others when relative prices change and as new goods are introduced. How one aggregates individual prices, of course, depends on the purpose of the measure. Still, the problems of aggregation are well understood by economists, and workable solutions are within reach. Many countries have made progress in utilizing aggregation formulas that do take into account product substitutions, and further progress in this area seems likely in the years ahead. It is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually. At first glance, observing and measuring prices might not appear especially daunting. After all, prices are at the center of virtually all economic transactions. But, in fact, the problem is extraordinarily complex. To be sure, the nominal value -- in dollars or Deutsche Marks, for example -- of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. But dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant over time. Defining such a constant-quality unit of output is the central conceptual difficulty in price measurement. Such a definition may be clear for unalloyed aluminium ingot of 99.7 percent purity for the vast proportion of transactions; consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminium ingot. Similarly, the prices of a ton of cold rolled steel sheet, or of a linear meter of cotton broad woven fabric, can be reasonably compared over a period of years. But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures. One does not have to look to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago. The continual introduction of new goods and services onto the markets creates special challenges for price measurement. In some cases, a new good may best be viewed as an improved version of an old good. But, in many cases, new products may deliver services that simply were not available before. When personal computers were first introduced, the benefits they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique. The introduction of heart bypass operations literally prolonged many lives by decades. And, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives. In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision. The area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery. In an area with such rapid technological change, what is the appropriate unit of output? Is it a procedure, a treatment, or a cure? How does one - 3 - value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis? Although there is considerable uncertainty, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down. How, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete? We must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle. Embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer. A company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present. Furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become. Market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets. The emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level. By necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgement of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation. Eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the price level with some precision. In those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed. They may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components or whether arithmetic or logarithmic weighting of the components is more appropriate. But, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy. In that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve. To be sure, progress will not be easy for estimating the value of quality improvements is a painstaking process. It must be done methodically, item by item. But progress can be made. One improvement that has been made in recent years is a better ability to capture quality differences by pricing the underlying characteristics of complex products. With an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations. A "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on. Computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer. Other examples abound. Advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools. The variety of commercial aircraft is much larger now than it was twenty years ago. And in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world. Although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever. Gone are the days when Henry Ford could say he would sell a car of any color "so long as it's black". - 4 - In such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics and pricing each of them separately. The so-called hedonic technique is designed to do precisely that. This technique associates changes in a product's price with changes in product characteristics. It therefore allows a quality comparison when new products with improved characteristics are introduced. Not surprisingly, one area in which this approach has been especially useful is in computer technology. In the United States, prior to the mid-1980s, computer prices simply were held constant in the national accounts. Now, with the introduction of hedonic techniques, the accounts show computer prices declining at double-digit rates, surely a more accurate estimate of the true quality-adjusted price change. The few other countries that have introduced these techniques -- France being the most recent -- show computer prices declining much more rapidly than in the majority of countries that have not yet done so. But hedonics are by no means a panacea. First of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors. The benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones. In addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value. In the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on. But, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the buyer values. In these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software. The issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products. New generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier. Even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility. Therefore, even in the case of personal computers, where we have made such great strides in measuring quality changes, I suspect that important phenomena still may not be adequately captured by our published price indexes. Despite the advances in price measurement that have been made over the years, there remains considerable room for improvement. In the United States, a group of experts empanelled by the Senate Finance Committee -- the Boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years. About half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated. Researchers at the Federal Reserve and elsewhere have come up with similar figures. Although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist. The Boskin commission, along with most other estimates of bias in the U.S. CPI, have taken a micro-statistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mis-measurement, using a macroeconomic approach that is essentially independent of the - 5 - micro-statistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mis-measured and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries might be considerably stronger than suggested by the published data. Assuming, for example, no change in productivity for these industries would imply a price bias consistent with the Boskin commission findings. Of course, the United States is not the only country that faces challenges in constructing an accurate measure of inflation. Other countries -- Germany among them -- confront similar issues. In a recent survey of consumer price indexes in its member countries, the OECD found that most countries felt that measurement bias was smaller in magnitude in their own countries than in the United States. Certainly regarding quality adjustment, however, I doubt that this is generally the case. Many countries' responses were prepared by the countries' statistical agencies, which tend to take a somewhat more sanguine view of the adequacy of the existing price statistics than do outside economists. But, in any case, the OECD survey did indicate that many countries reported that measurement bias was a concern and that most countries do not adequately adjust their statistics for quality improvements. Indeed, as I noted previously, most European countries still have yet to adopt the most up-to-date techniques for measuring computer prices in their national accounts. As the OECD survey recognized, the challenges presented by rapid technological advances have affected all of us -- not just the United States. Thus, potential sources of measurement bias should be seriously examined in all countries. Indeed, issues of price measurement may be especially important for the European countries entering into monetary union. For a region with a single monetary policy, a single, consistently estimated measure of inflation is necessary to gauge the region's economic performance. Toward that end, as you know, Eurostat publishes harmonized indexes of consumer prices that are constructed using a common basket of goods and services for each EU member state and using similar statistical methodology. These measures should go a long way toward providing a conceptually sound basis for judging convergence of EU member states in the selection of countries to participate in monetary union. Subsequent to monetary union, harmonized consumer prices can be used as the best available measure of inflation in the Euro area. However, as it now stands, the harmonized measures do not contain a broad coverage of consumer services. Most notably, the costs of owner-occupied housing -- a sizable share of consumer expenditures -- are excluded from the harmonized indexes. In the United States, for example, the CPI calculated on this harmonized basis would have increased three or four tenths of a percentage point more slowly than the published CPI, on average, over the past few years, largely because prices of owner-occupied housing have been rising more rapidly than the other components. Arguably, the published index, with broader coverage, is more relevant to assessing inflation trends in the United States than would be the harmonized index. As long as relative prices can and do diverge across countries, the harmonized indexes need to contain as broad a range of items as is practical. As monetary union proceeds, then, it would be to the advantage of monetary authorities in the Euro area to have a consistent measure of inflation defined over a broad basket of goods and services that is measured according to established statistical methods. Most useful would be for the member countries to continue the harmonization process until the national statistical agencies are truly working on a consistent basis. Indeed, measuring prices consistently across countries could be an important step toward making price measurement more accurate everywhere, if harmonization results in each country's best practices being adopted throughout the monetary union. Moreover, different prices of the same tradable good across the community might signal inefficiencies of distribution which were not evident from other sources. - 6 - Harmonization of CPIs in Europe is just one of many examples demonstrating why price measurement techniques cannot be static. With innovation constantly leading to new products, greater variety, and higher quality, the statistical agencies must work ever harder just to stay in place. A government official in the United States once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him. The only way the system can succeed, he said, is to be just as fast and twice as agile. That is the challenge that lies ahead, and it is, indeed, a large one. There are, however, reasons for optimism. The information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, may also play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies. For example, computers might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis. Utilizing data from store checkout scanners, which the United States is now investigating, may be an important first step in that direction. But the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope. Just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology. Such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made. If the challenge for our statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgements about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations.	["mr. greenspan's remarks at the center for financial studies in frankfurt remarks by the chairman of the board of the us federal reserve system, mr. alan greenspan, at the center for financial studies in frankfurt-am-main, on 7/11/97.", 'the remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought into sharper focus the issue of price measurement.', 'as we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge.', 'biases of a few tenths in annual inflation rates do not matter when inflation is high.', 'they do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation.', "in today's advanced economies, allocative decisions are primarily made not by governments but by markets, and the central guide to the efficient allocation of resources in a market economy is prices.", 'prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use.', 'of course, this signaling process would work with or without government statistical agencies that measure individual and aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy.', 'indeed, vibrant market economies existed long before government agencies were established to measure prices.', 'nonetheless, in a modern monetary economy, accurate price measurement is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability.', 'accurate price measures are necessary for understanding economic developments, not only involving inflation but also involving real output and productivity.', 'if the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real output and productivity.', 'real incomes and living standards are rising faster than our published data suggest.', 'under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid misguided actions that will provoke unintended consequences.', 'clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth.', 'moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may nevertheless take such an index into account less formally.', 'if the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will be skewed.', 'the measured price indexes have played an especially prominent role in germany, both in terms of public perceptions of inflation performance and as a guide for policymakers.', "the bundesbank's long-standing commitment to price stability and the public's support for that commitment derive at least to some extent from germany's experiences with hyperinflation earlier this century.", "given this experience with the devastation that such inflation can bring to the economy and to people's lives, it comes as no surprise that your public and your policymakers give such careful scrutiny to the available measures of inflation.", 'germany has a reputation for special vigilance in guarding the stability of the price level and has achieved an admirable record of success in maintaining low inflation over the postwar period.', 'from the standpoint of monetary policy, this very success makes accurate price measurement all the more important.', 'when measured inflation is high, we can be confident that the proper direction of monetary policy is to bring inflation lower.', 'but when measured inflation is low, the proper direction of monetary policy, as i indicated, could depend crucially on the accuracy of those measurements.', 'the importance of accurate price measurement was particularly apparent during unification, when it became necessary to gauge productivity in east and west germany on a comparable basis.', 'initial estimates of east german productivity relative to that of the west were considerably higher than later, more accurate estimates showed to be the case.', 'these differences, we are told, owed largely to - 2 - the difficulties in adjusting the prices of east german products to take into account that they were, on average, of lower quality than the equivalent items produced in the west.', 'in thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other.', 'the notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined.', 'moreover, in practice, aggregation can be complicated because standard price indexes frequently assume that individuals and businesses purchase the same basket of goods and services over time -- whereas, in fact, people substitute some goods for others when relative prices change and as new goods are introduced.', 'how one aggregates individual prices, of course, depends on the purpose of the measure.', 'still, the problems of aggregation are well understood by economists, and workable solutions are within reach.', 'many countries have made progress in utilizing aggregation formulas that do take into account product substitutions, and further progress in this area seems likely in the years ahead.', 'it is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually.', 'at first glance, observing and measuring prices might not appear especially daunting.', 'after all, prices are at the center of virtually all economic transactions.', 'but, in fact, the problem is extraordinarily complex.', 'to be sure, the nominal value -- in dollars or deutsche marks, for example -- of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies.', 'but dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant over time.', 'defining such a constant-quality unit of output is the central conceptual difficulty in price measurement.', 'such a definition may be clear for unalloyed aluminium ingot of 99.7 percent purity for the vast proportion of transactions; consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminium ingot.', 'similarly, the prices of a ton of cold rolled steel sheet, or of a linear meter of cotton broad woven fabric, can be reasonably compared over a period of years.', "but when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult.", 'these problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures.', 'one does not have to look to the most advanced technology to recognize the difficulties that are faced.', 'to take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago.', 'the continual introduction of new goods and services onto the markets creates special challenges for price measurement.', 'in some cases, a new good may best be viewed as an improved version of an old good.', 'but, in many cases, new products may deliver services that simply were not available before.', 'when personal computers were first introduced, the benefits they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique.', 'the introduction of heart bypass operations literally prolonged many lives by decades.', "and, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives.", 'in theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision.', 'the area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices.', 'cures and preventive treatments have become available for previously untreatable diseases.', 'medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery.', 'in an area with such rapid technological change, what is the appropriate unit of output?', 'is it a procedure, a treatment, or a cure?', 'how does one - 3 - value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis?', 'although there is considerable uncertainty, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down.', 'how, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete?', 'we must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle.', 'embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer.', 'a company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present.', 'furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become.', 'market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets.', 'the emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level.', "by necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgement of the future purchasing power of money.", 'to the extent they do not, of course, the implicit real interest rate is biased in the opposite direction.', 'moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation.', 'eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the price level with some precision.', 'in those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed.', 'they may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components or whether arithmetic or logarithmic weighting of the components is more appropriate.', 'but, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy.', 'in that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve.', 'to be sure, progress will not be easy for estimating the value of quality improvements is a painstaking process.', 'it must be done methodically, item by item.', 'but progress can be made.', 'one improvement that has been made in recent years is a better ability to capture quality differences by pricing the underlying characteristics of complex products.', 'with an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations.', 'a "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on.', 'computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer.', 'advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools.', 'the variety of commercial aircraft is much larger now than it was twenty years ago.', 'and in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world.', 'although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever.', 'gone are the days when henry ford could say he would sell a car of any color "so long as it\'s black".', '- 4 - in such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics and pricing each of them separately.', 'the so-called hedonic technique is designed to do precisely that.', "this technique associates changes in a product's price with changes in product characteristics.", 'it therefore allows a quality comparison when new products with improved characteristics are introduced.', 'not surprisingly, one area in which this approach has been especially useful is in computer technology.', 'in the united states, prior to the mid-1980s, computer prices simply were held constant in the national accounts.', 'now, with the introduction of hedonic techniques, the accounts show computer prices declining at double-digit rates, surely a more accurate estimate of the true quality-adjusted price change.', 'the few other countries that have introduced these techniques -- france being the most recent -- show computer prices declining much more rapidly than in the majority of countries that have not yet done so.', 'but hedonics are by no means a panacea.', 'first of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors.', 'the benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones.', 'in addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value.', 'in the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on.', 'but, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the buyer values.', 'in these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software.', 'the issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products.', 'new generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier.', "even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility.", 'therefore, even in the case of personal computers, where we have made such great strides in measuring quality changes, i suspect that important phenomena still may not be adequately captured by our published price indexes.', 'despite the advances in price measurement that have been made over the years, there remains considerable room for improvement.', 'in the united states, a group of experts empanelled by the senate finance committee -- the boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years.', 'about half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated.', 'researchers at the federal reserve and elsewhere have come up with similar figures.', 'although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist.', 'the boskin commission, along with most other estimates of bias in the u.s. cpi, have taken a micro-statistical approach, estimating separately the magnitude of each category of potential bias.', 'recent work by staff economists at the federal reserve board has added corroborating evidence of price mis-measurement, using a macroeconomic approach that is essentially independent of the - 5 - micro-statistical exercises.', 'specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained.', 'indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades.', 'it is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years.', 'much more reasonable is the view that prices have been mis-measured and that the true quality-adjusted prices have been rising more slowly than the published price indexes.', 'properly measured, output and productivity trends in these service industries might be considerably stronger than suggested by the published data.', 'assuming, for example, no change in productivity for these industries would imply a price bias consistent with the boskin commission findings.', 'of course, the united states is not the only country that faces challenges in constructing an accurate measure of inflation.', 'other countries -- germany among them -- confront similar issues.', 'in a recent survey of consumer price indexes in its member countries, the oecd found that most countries felt that measurement bias was smaller in magnitude in their own countries than in the united states.', 'certainly regarding quality adjustment, however, i doubt that this is generally the case.', "many countries' responses were prepared by the countries' statistical agencies, which tend to take a somewhat more sanguine view of the adequacy of the existing price statistics than do outside economists.", 'but, in any case, the oecd survey did indicate that many countries reported that measurement bias was a concern and that most countries do not adequately adjust their statistics for quality improvements.', 'indeed, as i noted previously, most european countries still have yet to adopt the most up-to-date techniques for measuring computer prices in their national accounts.', 'as the oecd survey recognized, the challenges presented by rapid technological advances have affected all of us -- not just the united states.', 'thus, potential sources of measurement bias should be seriously examined in all countries.', 'indeed, issues of price measurement may be especially important for the european countries entering into monetary union.', "for a region with a single monetary policy, a single, consistently estimated measure of inflation is necessary to gauge the region's economic performance.", 'toward that end, as you know, eurostat publishes harmonized indexes of consumer prices that are constructed using a common basket of goods and services for each eu member state and using similar statistical methodology.', 'these measures should go a long way toward providing a conceptually sound basis for judging convergence of eu member states in the selection of countries to participate in monetary union.', 'subsequent to monetary union, harmonized consumer prices can be used as the best available measure of inflation in the euro area.', 'however, as it now stands, the harmonized measures do not contain a broad coverage of consumer services.', 'most notably, the costs of owner-occupied housing -- a sizable share of consumer expenditures -- are excluded from the harmonized indexes.', 'in the united states, for example, the cpi calculated on this harmonized basis would have increased three or four tenths of a percentage point more slowly than the published cpi, on average, over the past few years, largely because prices of owner-occupied housing have been rising more rapidly than the other components.', 'arguably, the published index, with broader coverage, is more relevant to assessing inflation trends in the united states than would be the harmonized index.', 'as long as relative prices can and do diverge across countries, the harmonized indexes need to contain as broad a range of items as is practical.', 'as monetary union proceeds, then, it would be to the advantage of monetary authorities in the euro area to have a consistent measure of inflation defined over a broad basket of goods and services that is measured according to established statistical methods.', 'most useful would be for the member countries to continue the harmonization process until the national statistical agencies are truly working on a consistent basis.', "indeed, measuring prices consistently across countries could be an important step toward making price measurement more accurate everywhere, if harmonization results in each country's best practices being adopted throughout the monetary union.", 'moreover, different prices of the same tradable good across the community might signal inefficiencies of distribution which were not evident from other sources.', '- 6 - harmonization of cpis in europe is just one of many examples demonstrating why price measurement techniques cannot be static.', 'with innovation constantly leading to new products, greater variety, and higher quality, the statistical agencies must work ever harder just to stay in place.', "a government official in the united states once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him.", 'the only way the system can succeed, he said, is to be just as fast and twice as agile.', 'that is the challenge that lies ahead, and it is, indeed, a large one.', 'there are, however, reasons for optimism.', 'the information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, may also play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies.', 'for example, computers might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis.', 'utilizing data from store checkout scanners, which the united states is now investigating, may be an important first step in that direction.', 'but the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope.', 'just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology.', 'such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made.', 'if the challenge for our statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgements about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman	US
https://www.bis.org/review/r971121b.pdf	Mr. George looks at the prospects for the City of London - in or out of EMU (Central Bank Articles and Speeches, 24 Oct 97)	Speech by the Governor of the Bank of England, Mr. E.A.J.George, at the Royal Institute of International Affairs Conference in London, on 24/10/97.	1997-10-24 00:00:00	Mr. George looks at the prospects for the City of London - in or out of EMU Speech by the Governor of the Bank of England, Mr. E.A.J.George, at the Royal Institute of International Affairs Conference in London, on 24/10/97. Prospects for the City -- in or out of EMU Mr. Chairman, you have asked me to speak specifically about "the prospects for the City - or out of EMU". You -- very kindly in recent circumstances -- did not ask me to discuss the wider pros and cons, either of the project as a whole, or of UK membership. But perhaps I might nevertheless begin by making a more general point. Perfectly reasonable people can legitimately disagree about EMU, both in principle and about the appropriate timing and pace of monetary integration. On the project as a whole, most analysts would acknowledge that there are real potential benefits, but that there are also real risks to be set against them; and most would acknowledge that those risks will increase if the politics of EMU are allowed to run ahead of the economics, so that countries are allowed, or even encouraged, to participate, without first having achieved genuine, and sustainable, economic convergence -- in substance and not just some technical accounting form. On the question of British membership the new Labour Government has spoken of 'formidable obstacles' to this country joining EMU in the first wave. But one thing is clear: everyone, in or out, has an unambiguous interest, if EMU does go ahead, in doing everything we can to make it a success. And it is equally clear that those countries that participate in Monetary Union have a similar unambiguous interest in the economic prosperity of countries remaining, at least for the time being, on the outside. Larry Summers, the Deputy Secretary of the US Treasury, writing about EMU in the Financial Times on Wednesday, said: "The US is well served when Europe is vibrant economically and working to open its markets and strengthen its ties with the global economy." He might have been speaking for all of us here in Europe, in or out, recognising that we have a mutual, and reciprocal, self-interest in each other's economic well-being. So my general point is this. Whatever the outcome on EMU, it is vitally important that we continue to maintain, and strengthen, positive and constructive relationships throughout the European Union area -- and indeed beyond -- in our national and collective interests. For the UK, in particular, if we were to opt out of the first wave, that certainly means that during our EU Presidency, over the critical first half of next year, we must -- as I am quite confident we will -- do everything we possibly can to ensure that the procedures leading up to the historic decisions run smoothly and that the decisions themselves are timely and, hopefully, harmonious. But beyond that it certainly means, too, that "outs", or potential "pre-ins", should not attempt to exploit any perceived -- and certainly short-term -- advantage from the additional policy freedoms they might have on the outside, but should, for example, persist in macro-economic, fiscal and monetary, discipline in parallel with the EMU countries. But it also means that the "in" countries, for their part, have an identical self-interest in maintaining an open and constructive relationship with the "outs"/"pre-ins". Otherwise we would all be cutting off our nose to spite our face. I make this general point, Mr. Chairman, because this context seems to me to be relevant to any assessment of the economic prospect, of the economy as a whole or of any particular sector, within or without the euro-area. In the rest of my remarks I assume that, in or out, we will be operating within a constructive, co-operative, environment throughout the EU, for the powerful reason that that is in everyone's interest. - 2 - Against that background let me turn to the prospects for the City. I will, in fact, concentrate on the case in which the UK does not participate in EMU in the first wave, because in the alternative case, the UK in scenario, while there may be uncertainty about the overall macro-economic implications, there is little reason to suppose that there would be any adverse implications for the City in particular. The only possible disadvantage I see would result from the imposition of onerous regulatory or financial burdens -- for example onerous minimum reserve requirements -- which might act to distort activity within the financial sector and/or drive it outside the euro-area altogether. So what then are the prospects for the City if the UK is, initially, out? The current strengths of the City -- as a uniquely international, rather than simply a national or regional European financial centre -- will be familiar to you. They include a vast, critical mass of markets and financial services in commercial and investment banking, securities and derivatives activity, investment and fund management, insurance and commodities and so on, involving an extraordinary concentration of the strongest financial businesses from all around the world. To give just one example, uniquely among the major countries we have more banks which are incorporated abroad operating in the City than domestic banks, and over half of the total deposits of the UK banking system is denominated in foreign currencies, worth over £1 trillion -- that's a one and twelve noughts -- notwithstanding the current strength of sterling. The particular strengths that have contributed to this massive concentration of international business are many and various. They include: the English language; the convenient time zone; the ready availability of the relevant trading and other financial skills as well as professional support services -- in law, accountancy, tax, property, communications and so on. They include effective infrastructure. And they include importantly, too, an adaptive regulatory framework which has in fact been remarkably successful in maintaining confidence in financial institutions and markets without stifling innovation and risk-taking. All of these factors -- and no doubt others -- help to explain why some 600,000 people are estimated to be employed in finance and other business services in Greater London -- a number which I believe is roughly equal to the total population of Frankfurt. Now you will have noticed that none of these factors has anything to do with the question of the national currency used either here in the UK or in Continental Europe. The main impact of the advent of the euro on financial activity, as I see it, is that it will encourage the development of broader and deeper and more liquid markets, in financial instruments of all kinds, where they are currently fragmented because they are denominated in the various individual national European currencies. The City of London thrives on liquid markets regardless of the currency -- and it will thrive on the euro, whether the UK is "in" or "out". Measured in these terms the introduction of the euro represents an opportunity for London rather than a threat. I have no doubt whatever that there will be a vigorous euro-euro market in London, come what may, just as there is a vigorous market in euro-DM or euro-francs as well as euro-$ and euro-yen at present. The reality is that the location of financial activity does not depend upon the local currency. It will continue to be carried on wherever it can most conveniently, efficiently and profitably be carried on. And the fact that foreign-owned institutions -- from Europe itself and from around the world -- continue to build their presence here, despite the near universal assumption that the UK will not in fact participate in EMU from the beginning, suggests that they share this perception. I would hope that the rest of Europe would positively welcome the contribution that the City can, and I am confident will, make to the development of markets and other financial activity in the euro, because it is in their interest too. International or intra-regional trade and investment activity is not, at the macro-economic level, a zero-sum game. It is a positive sum game. And this is true of financial, just as much as of any other kind of economic activity. The prosperity of the City -- whether the UK is "in" or "out" -- is simply a particular case of the general point which I made at the outset. I welcome the - 3 - prospect of increasing financial activity in Frankfurt, Paris, Milan or Amsterdam or wherever because it will result in increased activity here too in London. And the converse is equally true. It is in this sense that the City is a major European, not simply a national asset. Now some people may argue that "offshore" markets in national or regional currencies complicate the conduct of national or regional monetary policy, with the implication that national or regional currencies should somehow be confined to their national or regional space. I must confess that this view seems to ignore the fact that it has in practice over the past twenty or thirty years proved perfectly possible for monetary policy to be conducted successfully despite the existence of the euro-markets. And I do not see how one could realistically expect to contain the use of a major currency, which the euro will certainly be, within territorial borders in any event. But as I have made clear, the UK's interest -- "in" or "out" -- lies unambiguously in doing all that we can to ensure that the single currency succeeds. And in this context we would, of course, co-operate with the ECB in any way we could, to avoid potential disturbance to European monetary policy, were it shown to exist. Mr Chairman, London does not hold its pre-eminent position as Europe's major financial centre as of right. We must continue to earn it. If we are to take advantage -- "in" or "out" -- of the opportunity that the euro will bring, then we must be technically well prepared. We will be. There is increasing evidence that financial institutions in the UK are now taking the steps necessary to ensure that they are ready for the introduction of the euro, whether or not the UK joins EMU. In the early summer, we invited a representative sample of firms to confirm whether their preparations were on track. The response we received was broadly reassuring, though some of their preparations are dependent on decisions about the euro markets which have yet to be taken, as I shall explain in a moment. But the key point is that the urgency of the need to prepare is now widely recognised. The Bank of England is playing a substantive role in the preparations in two complementary ways. Through our very active participation in the work of the EMI, we aim to make sure that the design of EMU, at least so far as the operations of the ECB are concerned, is capable of being delivered in a technical sense. That is the test that we have applied, for example, to the work of the EMI on the implementation of monetary policy and on the so-called changeover scenario. John Townend talked about this yesterday. Our other role is to co-ordinate the preparations for the introduction of the euro in the City of London, to the extent that co-ordination is required. The Bank's role in helping the financial sector to prepare for the euro was recognised and reconfirmed by the Chancellor this summer when he launched his complementary initiative to begin preparing the business community for the euro. In addition to making our own internal preparations at the Bank, we play a co-ordinating role in the financial community in three main ways: First, our job is to ensure that the necessary infrastructure is developed in the UK to allow anyone who wishes to do so to use the euro in wholesale payments and across the financial markets in London from the first day of EMU. Second, we aim to promote discussion between the EMI, national central banks and market participants across Europe about practical issues on which the market is seeking a degree of co-ordination. And third, we provide information: for example, through our quarterly series of editions on Practical Issues Arising from the Introduction of the Euro, which is distributed to around 32,000 - 4 - recipients across the City and beyond, including 4,000 directly abroad. And following the successful symposium we held early this year, we are planning to hold a further symposium, next January at the Bank, on London as the international financial centre for the euro. Our theme will be: 'London will be ready'. I shall now turn to the steps that we are taking to ensure that London will be ready for the euro, whether the UK is "in" or "out". (i) Payments and settlement infrastructure for the euro First of all, the payments and settlement infrastructure. We are constructing payments arrangements in euro in London which we intend to be at least as efficient and cheap as anywhere else in Europe, even if the UK stays "out". In the UK, the real-time gross settlement system which came into operation in the spring of last year is being developed so that it will operate in euro. If the UK joins, the UK sterling system will effectively become a euro system. And, in case the UK is "out", a parallel euro system is under construction to sit alongside the sterling system: it will enable the members of CHAPS to process euro payments as a foreign currency within the UK and across borders within the EU, through its link to the pan-European RTGS system -- TARGET -- which is being developed. The idea behind TARGET is to link together in euro the national RTGS systems of EU Member States so that large-value payments can be made or received between Member States throughout the EU area, with finality in real time, in exactly the same way as they can at present be made and received within Member States with national RTGS systems denominated in their own national currencies. One of the main purposes of TARGET is to support closer European economic and financial integration by reducing the risks in pan-European payments -- just as national RTGS systems reduce the risk in national payment systems. The other main purpose of TARGET is to integrate the euro money market so as to ensure that the same short term euro interest rate -- determined by the single monetary policy of the ECB -- prevails throughout the euro area. TARGET is a project which we strongly support. It has been agreed that all EU Member States may connect their national RTGS systems to TARGET, whether or not they join EMU. The main policy issue outstanding concerns the terms on which the European Central Bank will grant intraday credit to the "outs". We see no monetary -- or other -- grounds for any discrimination against the "outs". If intraday liquidity to the "outs" were to be restricted the effect would be to increase the cost of using TARGET, and to damage the efficiency of the system for both "ins" and "outs". That would simply divert euro payments to alternative mechanisms, including correspondent banking and the EBA's net end-of-day settlement system. It would be unlikely significantly to deter the international use of the euro -- if that were the objective -- any more than lack of direct access to national RTGS systems deters the international use of the dollar or yen or Deutsche Mark now. Its main impact would be to make intra-European payments less secure. We would regret that. Besides payments systems, the preparation of securities settlement systems for the introduction of the euro is a complex task in its own right. One of the reasons for this is that there are different approaches to securities settlement between different Member States and financial institutions. Another is that different approaches may be required to meet issuers' requirements for re-denomination. Even in one market in one country, the introduction of major changes in securities settlement systems can lead to teething problems, both in the central IT infrastructure and for individual institutions as they learn how to apply the changes. Yet in the case of EMU, a number of Member States will switch to the euro more or less simultaneously at the start. That carries considerable risks of confusion and error, unless there is an extensive programme across Europe to explain the changes required in detail first. This is not of course, a particular problem for the UK. (ii) Market framework for the use of the euro - 5 - The second important aspect of preparation is the development of a comprehensive market framework for the use of the euro in London. The euro regulations help to provide the legal part of the framework as I understand you discussed yesterday. To make sure that the euro market in London, as elsewhere in Europe, is as deep and liquid as possible, we also need to harmonise market conventions on new issues of securities in the euro money and bond markets, and conventions in the foreign exchange markets. Market associations now agree on the basis on which conventions in these markets should be harmonised, and the Bank has encouraged their initiative. The problem has been to see how EU-wide decisions will be taken. Harmonised practices may develop spontaneously in the markets, but there is no guarantee of this. So it is very helpful that the EMI Council decided with our encouragement in September to 'welcome and support' harmonised market conventions on the basis proposed by the market associations. We also welcome the EMI Council's decision in September to prepare for the computation by the ESCB of an effective overnight reference rate for the euro area. There remains however a good deal to be done everywhere -- in co-ordinating price sources, for example, as methods of redenomination. But in all of these respects London is well up with the game. Conclusion Mr. Chairman, it is sometimes suggested that a perceived threat to its activity if we were "out" will cause the City to press for early UK membership of EMU, and that this will be an important factor in the Government's decision. I am bound to say that I see very little sign of this. Certainly there are those in the City who advocate our early participation, but there are equally those who are more hesitant -- just as opinions are divided elsewhere within the country. But for the most part, my impression is that City attitudes to EMU, whether for or against, reflect a broader assessment of the respective pros and cons for the country as a whole rather than strong views about the implications for the City in particular. On the whole I find that City opinion is relatively optimistic about its future prospects, "in" or "out". And, provided we do indeed operate within a co-operative framework, and provided we are indeed well prepared, the City has good reason to be optimistic.	['mr. george looks at the prospects for the city of london - in or out of emu speech by the governor of the bank of england, mr. e.a.j.george, at the royal institute of international affairs conference in london, on 24/10/97.', 'prospects for the city -- in or out of emu mr. chairman, you have asked me to speak specifically about "the prospects for the city - or out of emu".', 'you -- very kindly in recent circumstances -- did not ask me to discuss the wider pros and cons, either of the project as a whole, or of uk membership.', 'but perhaps i might nevertheless begin by making a more general point.', 'perfectly reasonable people can legitimately disagree about emu, both in principle and about the appropriate timing and pace of monetary integration.', 'on the project as a whole, most analysts would acknowledge that there are real potential benefits, but that there are also real risks to be set against them; and most would acknowledge that those risks will increase if the politics of emu are allowed to run ahead of the economics, so that countries are allowed, or even encouraged, to participate, without first having achieved genuine, and sustainable, economic convergence -- in substance and not just some technical accounting form.', "on the question of british membership the new labour government has spoken of 'formidable obstacles' to this country joining emu in the first wave.", 'but one thing is clear: everyone, in or out, has an unambiguous interest, if emu does go ahead, in doing everything we can to make it a success.', 'and it is equally clear that those countries that participate in monetary union have a similar unambiguous interest in the economic prosperity of countries remaining, at least for the time being, on the outside.', 'larry summers, the deputy secretary of the us treasury, writing about emu in the financial times on wednesday, said: "the us is well served when europe is vibrant economically and working to open its markets and strengthen its ties with the global economy."', "he might have been speaking for all of us here in europe, in or out, recognising that we have a mutual, and reciprocal, self-interest in each other's economic well-being.", 'so my general point is this.', 'whatever the outcome on emu, it is vitally important that we continue to maintain, and strengthen, positive and constructive relationships throughout the european union area -- and indeed beyond -- in our national and collective interests.', 'for the uk, in particular, if we were to opt out of the first wave, that certainly means that during our eu presidency, over the critical first half of next year, we must -- as i am quite confident we will -- do everything we possibly can to ensure that the procedures leading up to the historic decisions run smoothly and that the decisions themselves are timely and, hopefully, harmonious.', 'but beyond that it certainly means, too, that "outs", or potential "pre-ins", should not attempt to exploit any perceived -- and certainly short-term -- advantage from the additional policy freedoms they might have on the outside, but should, for example, persist in macro-economic, fiscal and monetary, discipline in parallel with the emu countries.', 'but it also means that the "in" countries, for their part, have an identical self-interest in maintaining an open and constructive relationship with the "outs"/"pre-ins".', 'otherwise we would all be cutting off our nose to spite our face.', 'i make this general point, mr. chairman, because this context seems to me to be relevant to any assessment of the economic prospect, of the economy as a whole or of any particular sector, within or without the euro-area.', "in the rest of my remarks i assume that, in or out, we will be operating within a constructive, co-operative, environment throughout the eu, for the powerful reason that that is in everyone's interest.", '- 2 - against that background let me turn to the prospects for the city.', 'i will, in fact, concentrate on the case in which the uk does not participate in emu in the first wave, because in the alternative case, the uk in scenario, while there may be uncertainty about the overall macro-economic implications, there is little reason to suppose that there would be any adverse implications for the city in particular.', 'the only possible disadvantage i see would result from the imposition of onerous regulatory or financial burdens -- for example onerous minimum reserve requirements -- which might act to distort activity within the financial sector and/or drive it outside the euro-area altogether.', 'so what then are the prospects for the city if the uk is, initially, out?', 'the current strengths of the city -- as a uniquely international, rather than simply a national or regional european financial centre -- will be familiar to you.', 'they include a vast, critical mass of markets and financial services in commercial and investment banking, securities and derivatives activity, investment and fund management, insurance and commodities and so on, involving an extraordinary concentration of the strongest financial businesses from all around the world.', "to give just one example, uniquely among the major countries we have more banks which are incorporated abroad operating in the city than domestic banks, and over half of the total deposits of the uk banking system is denominated in foreign currencies, worth over £1 trillion -- that's a one and twelve noughts -- notwithstanding the current strength of sterling.", 'the particular strengths that have contributed to this massive concentration of international business are many and various.', 'they include: the english language; the convenient time zone; the ready availability of the relevant trading and other financial skills as well as professional support services -- in law, accountancy, tax, property, communications and so on.', 'they include effective infrastructure.', 'and they include importantly, too, an adaptive regulatory framework which has in fact been remarkably successful in maintaining confidence in financial institutions and markets without stifling innovation and risk-taking.', 'all of these factors -- and no doubt others -- help to explain why some 600,000 people are estimated to be employed in finance and other business services in greater london -- a number which i believe is roughly equal to the total population of frankfurt.', 'now you will have noticed that none of these factors has anything to do with the question of the national currency used either here in the uk or in continental europe.', 'the main impact of the advent of the euro on financial activity, as i see it, is that it will encourage the development of broader and deeper and more liquid markets, in financial instruments of all kinds, where they are currently fragmented because they are denominated in the various individual national european currencies.', 'the city of london thrives on liquid markets regardless of the currency -- and it will thrive on the euro, whether the uk is "in" or "out".', 'measured in these terms the introduction of the euro represents an opportunity for london rather than a threat.', 'i have no doubt whatever that there will be a vigorous euro-euro market in london, come what may, just as there is a vigorous market in euro-dm or euro-francs as well as euro-$ and euro-yen at present.', 'the reality is that the location of financial activity does not depend upon the local currency.', 'it will continue to be carried on wherever it can most conveniently, efficiently and profitably be carried on.', 'and the fact that foreign-owned institutions -- from europe itself and from around the world -- continue to build their presence here, despite the near universal assumption that the uk will not in fact participate in emu from the beginning, suggests that they share this perception.', 'i would hope that the rest of europe would positively welcome the contribution that the city can, and i am confident will, make to the development of markets and other financial activity in the euro, because it is in their interest too.', 'international or intra-regional trade and investment activity is not, at the macro-economic level, a zero-sum game.', 'it is a positive sum game.', 'and this is true of financial, just as much as of any other kind of economic activity.', 'the prosperity of the city -- whether the uk is "in" or "out" -- is simply a particular case of the general point which i made at the outset.', 'i welcome the - 3 - prospect of increasing financial activity in frankfurt, paris, milan or amsterdam or wherever because it will result in increased activity here too in london.', 'and the converse is equally true.', 'it is in this sense that the city is a major european, not simply a national asset.', 'now some people may argue that "offshore" markets in national or regional currencies complicate the conduct of national or regional monetary policy, with the implication that national or regional currencies should somehow be confined to their national or regional space.', 'i must confess that this view seems to ignore the fact that it has in practice over the past twenty or thirty years proved perfectly possible for monetary policy to be conducted successfully despite the existence of the euro-markets.', 'and i do not see how one could realistically expect to contain the use of a major currency, which the euro will certainly be, within territorial borders in any event.', 'but as i have made clear, the uk\'s interest -- "in" or "out" -- lies unambiguously in doing all that we can to ensure that the single currency succeeds.', 'and in this context we would, of course, co-operate with the ecb in any way we could, to avoid potential disturbance to european monetary policy, were it shown to exist.', "mr chairman, london does not hold its pre-eminent position as europe's major financial centre as of right.", 'we must continue to earn it.', 'if we are to take advantage -- "in" or "out" -- of the opportunity that the euro will bring, then we must be technically well prepared.', 'there is increasing evidence that financial institutions in the uk are now taking the steps necessary to ensure that they are ready for the introduction of the euro, whether or not the uk joins emu.', 'in the early summer, we invited a representative sample of firms to confirm whether their preparations were on track.', 'the response we received was broadly reassuring, though some of their preparations are dependent on decisions about the euro markets which have yet to be taken, as i shall explain in a moment.', 'but the key point is that the urgency of the need to prepare is now widely recognised.', 'the bank of england is playing a substantive role in the preparations in two complementary ways.', 'through our very active participation in the work of the emi, we aim to make sure that the design of emu, at least so far as the operations of the ecb are concerned, is capable of being delivered in a technical sense.', 'that is the test that we have applied, for example, to the work of the emi on the implementation of monetary policy and on the so-called changeover scenario.', 'john townend talked about this yesterday.', 'our other role is to co-ordinate the preparations for the introduction of the euro in the city of london, to the extent that co-ordination is required.', "the bank's role in helping the financial sector to prepare for the euro was recognised and reconfirmed by the chancellor this summer when he launched his complementary initiative to begin preparing the business community for the euro.", 'in addition to making our own internal preparations at the bank, we play a co-ordinating role in the financial community in three main ways: first, our job is to ensure that the necessary infrastructure is developed in the uk to allow anyone who wishes to do so to use the euro in wholesale payments and across the financial markets in london from the first day of emu.', 'second, we aim to promote discussion between the emi, national central banks and market participants across europe about practical issues on which the market is seeking a degree of co-ordination.', 'and third, we provide information: for example, through our quarterly series of editions on practical issues arising from the introduction of the euro, which is distributed to around 32,000 - 4 - recipients across the city and beyond, including 4,000 directly abroad.', 'and following the successful symposium we held early this year, we are planning to hold a further symposium, next january at the bank, on london as the international financial centre for the euro.', "our theme will be: 'london will be ready'.", 'i shall now turn to the steps that we are taking to ensure that london will be ready for the euro, whether the uk is "in" or "out".', '(i) payments and settlement infrastructure for the euro first of all, the payments and settlement infrastructure.', 'we are constructing payments arrangements in euro in london which we intend to be at least as efficient and cheap as anywhere else in europe, even if the uk stays "out".', 'in the uk, the real-time gross settlement system which came into operation in the spring of last year is being developed so that it will operate in euro.', 'if the uk joins, the uk sterling system will effectively become a euro system.', 'and, in case the uk is "out", a parallel euro system is under construction to sit alongside the sterling system: it will enable the members of chaps to process euro payments as a foreign currency within the uk and across borders within the eu, through its link to the pan-european rtgs system -- target -- which is being developed.', 'the idea behind target is to link together in euro the national rtgs systems of eu member states so that large-value payments can be made or received between member states throughout the eu area, with finality in real time, in exactly the same way as they can at present be made and received within member states with national rtgs systems denominated in their own national currencies.', 'one of the main purposes of target is to support closer european economic and financial integration by reducing the risks in pan-european payments -- just as national rtgs systems reduce the risk in national payment systems.', 'the other main purpose of target is to integrate the euro money market so as to ensure that the same short term euro interest rate -- determined by the single monetary policy of the ecb -- prevails throughout the euro area.', 'target is a project which we strongly support.', 'it has been agreed that all eu member states may connect their national rtgs systems to target, whether or not they join emu.', 'the main policy issue outstanding concerns the terms on which the european central bank will grant intraday credit to the "outs".', 'we see no monetary -- or other -- grounds for any discrimination against the "outs".', 'if intraday liquidity to the "outs" were to be restricted the effect would be to increase the cost of using target, and to damage the efficiency of the system for both "ins" and "outs".', "that would simply divert euro payments to alternative mechanisms, including correspondent banking and the eba's net end-of-day settlement system.", 'it would be unlikely significantly to deter the international use of the euro -- if that were the objective -- any more than lack of direct access to national rtgs systems deters the international use of the dollar or yen or deutsche mark now.', 'its main impact would be to make intra-european payments less secure.', 'we would regret that.', 'besides payments systems, the preparation of securities settlement systems for the introduction of the euro is a complex task in its own right.', 'one of the reasons for this is that there are different approaches to securities settlement between different member states and financial institutions.', "another is that different approaches may be required to meet issuers' requirements for re-denomination.", 'even in one market in one country, the introduction of major changes in securities settlement systems can lead to teething problems, both in the central it infrastructure and for individual institutions as they learn how to apply the changes.', 'yet in the case of emu, a number of member states will switch to the euro more or less simultaneously at the start.', 'that carries considerable risks of confusion and error, unless there is an extensive programme across europe to explain the changes required in detail first.', 'this is not of course, a particular problem for the uk.', '(ii) market framework for the use of the euro - 5 - the second important aspect of preparation is the development of a comprehensive market framework for the use of the euro in london.', 'the euro regulations help to provide the legal part of the framework as i understand you discussed yesterday.', 'to make sure that the euro market in london, as elsewhere in europe, is as deep and liquid as possible, we also need to harmonise market conventions on new issues of securities in the euro money and bond markets, and conventions in the foreign exchange markets.', 'market associations now agree on the basis on which conventions in these markets should be harmonised, and the bank has encouraged their initiative.', 'the problem has been to see how eu-wide decisions will be taken.', 'harmonised practices may develop spontaneously in the markets, but there is no guarantee of this.', "so it is very helpful that the emi council decided with our encouragement in september to 'welcome and support' harmonised market conventions on the basis proposed by the market associations.", "we also welcome the emi council's decision in september to prepare for the computation by the escb of an effective overnight reference rate for the euro area.", 'there remains however a good deal to be done everywhere -- in co-ordinating price sources, for example, as methods of redenomination.', 'but in all of these respects london is well up with the game.', 'conclusion mr. chairman, it is sometimes suggested that a perceived threat to its activity if we were "out" will cause the city to press for early uk membership of emu, and that this will be an important factor in the government\'s decision.', 'i am bound to say that i see very little sign of this.', 'certainly there are those in the city who advocate our early participation, but there are equally those who are more hesitant -- just as opinions are divided elsewhere within the country.', 'but for the most part, my impression is that city attitudes to emu, whether for or against, reflect a broader assessment of the respective pros and cons for the country as a whole rather than strong views about the implications for the city in particular.', 'on the whole i find that city opinion is relatively optimistic about its future prospects, "in" or "out".', 'and, provided we do indeed operate within a co-operative framework, and provided we are indeed well prepared, the city has good reason to be optimistic.']	Edward George	Bank of England	Governor	UK
https://www.bis.org/review/r971121a.pdf	Mr. Stals considers the role of monetary policy in stabilising the business cycle during the pre- and post-election period (Central Bank Articles and Speeches, 7 Nov 97)	Address by the Governor of the Reserve Bank of South Africa, Dr. Chris Stals, at the Annual Conference of the Bureau for Economic Research, in Cape Town, on 7/11/97.	1997-11-07 00:00:00	Mr. Stals considers the role of monetary policy in stabilising the business cycle during the pre- and post-election period Address by the Governor of the Reserve Bank of South Africa, Dr. Chris Stals, at the Annual Conference of the Bureau for Economic Research, in Cape Town, on 7/11/97. 1. Introduction In the implementation of monetary policy the Reserve Bank should not be influenced by the fact that an election will take place in South Africa in May 1999. The reference to the "pre- and post-election period" in the title of this address should therefore be regarded as coincidental. As always, monetary policy should be guided by developments in financial aggregates such as the money supply and bank credit extension, with the obvious objective of protecting the value of the currency. In contemporary monetary policy, central banks are normally also not guided by the objective of "stabilising the business cycle". It is the task of monetary policy to promote a stable financial environment at all times, irrespective of the current phase of the business cycle. There is, however, a definite relationship between developments in real economic activity ("the business cycle") and in the financial aggregates relevant for monetary policy. By concentrating on the trends in the financial aggregates, and not in real economic activity, monetary policy, however, has a better chance of maintaining financial stability that will, in the longer term, be conducive for sustainable economic growth at a higher level. A former Governor of the Reserve Bank of Australia once said the following: "There was a recognition that (monetary) policy had to do more than stabilise the cycle: the problem with an exclusive focus on the business cycle was that we may well stabilise the real side of the economy without stabilising the price side of the economy". (Governor M.J. Phillips, When the Music Stops, Reserve Bank of Australia Bulletin, July 1990). A slowdown in the business cycle will normally also include a slowdown in real gross domestic expenditure, incorporating declines in the growth rates of both consumption and investment expenditure. Such slowdowns, however, may not yet at the time of the decline in expenditure justify the relaxation of monetary policy. The slowdown in real expenditure will after some normal time-lags be followed by a decrease in the demand for bank credit, which will also lead to a decline in the rate of growth in the money supply. Timing monetary policy decisions to coincide rather with changes in the monetary aggregates and not with changes in real economic activity reduces the danger of a premature re-stimulation of the demand for bank credit, and a too early injection of excessive amounts of additional money. A monetary policy linked to changes in the business cycle could easily lead to the re-emergence of the harmful stop-go policies so often pursued by central banks in the 1960s. 2. 1997 - A year of macroeconomic consolidation Developments in the South African economy in the early months of 1996, and particularly the currency crisis of February last year, exposed certain weaknesses that were developing in the South African economy at that time, and that needed early correction. The signs were already there in the first half of 1996 that the calendar year of 1997 would turn out to be a year of macroeconomic consolidation. Now, eighteen months later, we can look back with some satisfaction on the progress that has been made in restoring overall economic equilibrium. Firstly, in the area of real economic activity, equilibrium has been restored not only in the growth rates but also in the absolute levels of total gross - 2 - domestic product and total gross domestic expenditure. After increases of about 6 per cent per year in 1994 and 1995, the growth in gross domestic expenditure slowed down to 3 per cent in 1996, and to almost zero so far in 1997. The rate of growth in total production also slowed down marginally, but was still maintained at a positive level of about 2 per cent in the first nine months of 1997. These developments in real economic activity over the past eighteen months were reflected in an improvement in the overall balance of payments. The seasonally adjusted and annualised rate of the current account deficit declined from R13 billion in the second quarter of 1996 to R31⁄2 billion in the second quarter of 1997. This improvement contributed to the adoption of a more positive attitude by foreign investors and the net capital inflow increased from less than R4 billion in the full year of 1996 to more than R16 billion in the first half of 1997. In light of the surplus that emerged on the overall balance of payments, the total gross gold and foreign exchange reserves held by the banking sector increased by R14 billion from about R17 billion at the end of December 1996 to about R31 billion at the end of June 1997. Thirdly, the excessive rates of increase in the money supply and in bank credit extension in 1995 and 1996 also marginally slowed down in 1997. In the third quarter of 1997, the seasonally adjusted amount of the money supply increased at an annual rate of 12.2 per cent, and that of total domestic credit extension by the banking sector by only 6.3 per cent. Finally, in the consolidation process, South Africa succeeded in absorbing the unavoidable increase in inflation in the aftermath of the depreciation of last year. As was expected, the rate of increase in consumer prices accelerated from 5.5 per cent in April 1996 to 9.9 per cent in April 1997 but then declined again to 8 per cent in September 1997. In the third quarter of 1997, inflation was indeed running at an annualised rate of 6.6 per cent, back on track again towards the medium-term objective of bringing the rate of inflation in South Africa more in line with the average rate of inflation in the economies of our major international trading partners and competitors. The parts played by changes in the exchange rate of the rand, and in interest rates, in bringing about better equilibrium should not be underestimated. The average weighted value of the rand against a basket of currencies first depreciated by about 23 per cent during the first ten months of last year, before it appreciated again by 11 per cent from 31 October 1996 to 13 March 1997. Since then it followed a more steady path and depreciated by about 10 per cent in the next seven months. At the end of October 1997, the average weighted value of the rand was only marginally down from its level of 31 December 1996. Liquidity was initially drained from the money market after the foreign capital inflows subsided in February 1996, and the money market shortage gradually increased to reach a peak of more than R10 billion in March 1997. Since then, the situation eased again to an average daily shortage of only about R5 billion in October 1997. Interest rates obviously followed these trends and increased quite sharply during the course of 1996 but then declined again in 1997. The rate on three months bankers' acceptances for example reached a peak of almost 17 per cent at the end of November 1996, before declining to 14.9 per cent at the end of October 1997. The macroeconomic consolidation process therefore without any doubt created a sounder and better balanced overall economic basis on which a next phase of more rapid economic expansion can now develop. 3. The role of monetary policy After the exchange rate crash of February 1996, the monetary policy approach was to let market forces work with some intervention by the Reserve Bank in the foreign exchange and in the money markets, but mainly with the intention of supporting an orderly adjustment in market prices. It - 3 - was never the intention to try and fix the exchange rate of the rand at any predetermined artificial level, neither did the Bank try to keep interest rates unrealistically low. It was furthermore accepted that, after the relatively large depreciation in the exchange rate and taking account also of the "openness" of the South African economy, the rate of inflation would rise. The challenge for monetary policy was, however, to constrain the rate of increase in inflation to a first round effect only, and to prevent prices from going into an uncontrollable and perpetuating inflationary spiral. In retrospect, the policy seemed to have worked quite well. The restrictive monetary policy, and particularly the rise in interest rates, were not received with unanimous support by all sectors of the South African community. Interest rates, however, remain one of the main disciplines of the market economy and countries that are not prepared to bear the effects of this discipline from time to time will be punished by the markets. This basic lesson is now being learned again by a number of countries in the East Asia region where interest rates recently soared to a much higher level than ever experienced by South Africa. Now that the overall macroeconomic consolidation process has made good progress, there are some impatient pressures building up on the Reserve Bank to relax monetary policy quickly and decisively. Some of these pressures are still based on the now defunct Phillips curve or an assumed trade-off between inflation and growth -- an argument that was buried in most countries of the world already in the 1980s when macroeconomic policy switched the emphasis from a demand-management approach to a supply-side solution. The rapid expansion of communications and the increase in electronically driven capacity for economic analyses further contributed to the more effective implementation of pre-empting expectations, and reduced the opportunity for central bankers to stimulate economies in the short term by applying over-expansionary monetary policies. The South African Reserve Bank now follows the lead of many other central banks in the world to base monetary policy decisions on developments in financial or monetary aggregates, and not on changes in real economic activity. Indeed, the latest fashion is for central banks, together with governments, to target inflation more directly. Taking account of typical time-lags that exist between the implementation of monetary policies and their eventual effect on prices, monetary policy adjustments are based on the expectation of what the rate of inflation may turn out to be twelve to eighteen months downstream. Reliable forecasting therefore has become as important for the monetary authorities as they are for private sector operators in the markets. For this purpose, the familiar monetary aggregates such as the money supply, bank credit extension, the level of interest rates and the shape of the yield curve and changes in the exchange rate provide the best indicators available in the short term to guide monetary policy decisions. What will be important for the stance of monetary policy over the next year will not be the approaching election in 1999, but rather current developments in these well-known basic financial aggregates. Apart from contending with the after-effects of the depreciation of the rand last year, the major concern for the Reserve Bank recently has been the continuous increase at a high rate in the total amount of bank credit extended to the private sector. Over the past few months there has been a significant slowdown in the annualised rate of increase in bank credit extended to the private sector which amounted to 21.2 per cent in the second quarter of 1997, before declining to 9.5 per cent in the third quarter. After the recent downward adjustment in the financial markets in South Africa, we may find some further slowdown in the rate of increase in bank credit extension, to reflect more truly the slowdown which already occurred in real economic activity. Recent events in the international currency markets proved once again that the forecasting of possible future developments in financial aggregates can be very perilous. As South Africa liberalises its financial markets further and as the South African financial system gets more integrated into an extremely volatile international environment, the hazards of forecasting will increase. For the central bank, this unfortunately reduces the value of strictly defined monetary policy models, and makes - 4 - the task of implementing policies more discretionary. Market participants prefer a monetary policy based on pre-announced rules and want to be in a position where they can pre-empt important changes in monetary policy for their own advantage, and for the sake of giving good advice to their clients. This, however, is not possible in the present environment where unpredictable events in far-away places such as Thailand can have profound influences on monetary developments in South Africa. Forecasting possible developments in the exchange rate of the rand, for example, must not only take account of developments in South Africa, but also of possible changes in the cross exchange rates of major currencies, developments in international capital markets, economic and political developments in a number of emerging economies and a multitude of other possible global developments. As illustrated over the past year, changes in the effective exchange rate of the rand in turn can have many effects on monetary policy decisions in South Africa. In this multi-complex environment it is just unreasonable to expect of any governor of any central bank anywhere in the world to signal to markets in advance what adjustments in interest rates or other monetary policies could be expected over the next year. 4. A greater reliance on markets In the situation, it is advisable to rely more on market forces for the necessary correction of imbalances that may develop from time to time in the macro economy. Markets must therefore be encouraged to become more flexible, more efficient and more responsive to changes in underlying supply and demand conditions. In the case of South Africa, three important changes will be introduced in the structure of financial markets over the next few months: • Firstly, the existing national payment, clearing and settlement system will be upgraded in March 1998 to pave the way for real-time on-line settlement of large transactions on a gross basis, and for the daily settlement on a net basis of other (smaller) transactions between banking institutions. This versatile new system will provide challenging opportunities for the development of a more active interbank funds market. Secondly, the Reserve Bank will introduce a new system for providing liquidity to banking • institutions through daily repurchase transactions that will establish a floating interest rate for central bank accommodation. Thirdly, the Department of Finance intends to introduce a new system for the primary sale of and • secondary market making in government bonds by the appointment of a number of securities dealers from the private banking sector to operate as authorised dealers on behalf of the Treasury. These changes are all intended to serve the needs of more liberalised and free financial markets in South Africa. At the same time, they should open up the way for further exchange control relaxations and encourage greater integration of the South African financial markets in the global financial system. 5. Concluding remarks Next year holds the prospects for being an interesting one for the South African economy. • Firstly, there is the prospect for better economic growth in South Africa, following upon the macroeconomic consolidation of the past year. - 5 - • Secondly, important structural adjustments, particularly in the financial markets, will introduce interesting new challenges for all participants in the markets. • Thirdly, we shall have to contend with the continuing turmoil in the international currency markets, and possibly also with the adverse effects of the El Nino phenomenon.	['mr. stals considers the role of monetary policy in stabilising the business cycle during the pre- and post-election period address by the governor of the reserve bank of south africa, dr. chris stals, at the annual conference of the bureau for economic research, in cape town, on 7/11/97.', '1. introduction in the implementation of monetary policy the reserve bank should not be influenced by the fact that an election will take place in south africa in may 1999. the reference to the "pre- and post-election period" in the title of this address should therefore be regarded as coincidental.', 'as always, monetary policy should be guided by developments in financial aggregates such as the money supply and bank credit extension, with the obvious objective of protecting the value of the currency.', 'in contemporary monetary policy, central banks are normally also not guided by the objective of "stabilising the business cycle".', 'it is the task of monetary policy to promote a stable financial environment at all times, irrespective of the current phase of the business cycle.', 'there is, however, a definite relationship between developments in real economic activity ("the business cycle") and in the financial aggregates relevant for monetary policy.', 'by concentrating on the trends in the financial aggregates, and not in real economic activity, monetary policy, however, has a better chance of maintaining financial stability that will, in the longer term, be conducive for sustainable economic growth at a higher level.', 'a former governor of the reserve bank of australia once said the following: "there was a recognition that (monetary) policy had to do more than stabilise the cycle: the problem with an exclusive focus on the business cycle was that we may well stabilise the real side of the economy without stabilising the price side of the economy".', '(governor m.j. phillips, when the music stops, reserve bank of australia bulletin, july 1990).', 'a slowdown in the business cycle will normally also include a slowdown in real gross domestic expenditure, incorporating declines in the growth rates of both consumption and investment expenditure.', 'such slowdowns, however, may not yet at the time of the decline in expenditure justify the relaxation of monetary policy.', 'the slowdown in real expenditure will after some normal time-lags be followed by a decrease in the demand for bank credit, which will also lead to a decline in the rate of growth in the money supply.', 'timing monetary policy decisions to coincide rather with changes in the monetary aggregates and not with changes in real economic activity reduces the danger of a premature re-stimulation of the demand for bank credit, and a too early injection of excessive amounts of additional money.', 'a monetary policy linked to changes in the business cycle could easily lead to the re-emergence of the harmful stop-go policies so often pursued by central banks in the 1960s.', '1997 - a year of macroeconomic consolidation developments in the south african economy in the early months of 1996, and particularly the currency crisis of february last year, exposed certain weaknesses that were developing in the south african economy at that time, and that needed early correction.', 'the signs were already there in the first half of 1996 that the calendar year of 1997 would turn out to be a year of macroeconomic consolidation.', 'now, eighteen months later, we can look back with some satisfaction on the progress that has been made in restoring overall economic equilibrium.', 'firstly, in the area of real economic activity, equilibrium has been restored not only in the growth rates but also in the absolute levels of total gross - 2 - domestic product and total gross domestic expenditure.', 'after increases of about 6 per cent per year in 1994 and 1995, the growth in gross domestic expenditure slowed down to 3 per cent in 1996, and to almost zero so far in 1997. the rate of growth in total production also slowed down marginally, but was still maintained at a positive level of about 2 per cent in the first nine months of 1997. these developments in real economic activity over the past eighteen months were reflected in an improvement in the overall balance of payments.', 'the seasonally adjusted and annualised rate of the current account deficit declined from r13 billion in the second quarter of 1996 to r31⁄2 billion in the second quarter of 1997. this improvement contributed to the adoption of a more positive attitude by foreign investors and the net capital inflow increased from less than r4 billion in the full year of 1996 to more than r16 billion in the first half of 1997. in light of the surplus that emerged on the overall balance of payments, the total gross gold and foreign exchange reserves held by the banking sector increased by r14 billion from about r17 billion at the end of december 1996 to about r31 billion at the end of june 1997. thirdly, the excessive rates of increase in the money supply and in bank credit extension in 1995 and 1996 also marginally slowed down in 1997. in the third quarter of 1997, the seasonally adjusted amount of the money supply increased at an annual rate of 12.2 per cent, and that of total domestic credit extension by the banking sector by only 6.3 per cent.', 'finally, in the consolidation process, south africa succeeded in absorbing the unavoidable increase in inflation in the aftermath of the depreciation of last year.', 'as was expected, the rate of increase in consumer prices accelerated from 5.5 per cent in april 1996 to 9.9 per cent in april 1997 but then declined again to 8 per cent in september 1997. in the third quarter of 1997, inflation was indeed running at an annualised rate of 6.6 per cent, back on track again towards the medium-term objective of bringing the rate of inflation in south africa more in line with the average rate of inflation in the economies of our major international trading partners and competitors.', 'the parts played by changes in the exchange rate of the rand, and in interest rates, in bringing about better equilibrium should not be underestimated.', 'the average weighted value of the rand against a basket of currencies first depreciated by about 23 per cent during the first ten months of last year, before it appreciated again by 11 per cent from 31 october 1996 to 13 march 1997. since then it followed a more steady path and depreciated by about 10 per cent in the next seven months.', "at the end of october 1997, the average weighted value of the rand was only marginally down from its level of 31 december 1996. liquidity was initially drained from the money market after the foreign capital inflows subsided in february 1996, and the money market shortage gradually increased to reach a peak of more than r10 billion in march 1997. since then, the situation eased again to an average daily shortage of only about r5 billion in october 1997. interest rates obviously followed these trends and increased quite sharply during the course of 1996 but then declined again in 1997. the rate on three months bankers' acceptances for example reached a peak of almost 17 per cent at the end of november 1996, before declining to 14.9 per cent at the end of october 1997. the macroeconomic consolidation process therefore without any doubt created a sounder and better balanced overall economic basis on which a next phase of more rapid economic expansion can now develop.", '3. the role of monetary policy after the exchange rate crash of february 1996, the monetary policy approach was to let market forces work with some intervention by the reserve bank in the foreign exchange and in the money markets, but mainly with the intention of supporting an orderly adjustment in market prices.', 'it - 3 - was never the intention to try and fix the exchange rate of the rand at any predetermined artificial level, neither did the bank try to keep interest rates unrealistically low.', 'it was furthermore accepted that, after the relatively large depreciation in the exchange rate and taking account also of the "openness" of the south african economy, the rate of inflation would rise.', 'the challenge for monetary policy was, however, to constrain the rate of increase in inflation to a first round effect only, and to prevent prices from going into an uncontrollable and perpetuating inflationary spiral.', 'in retrospect, the policy seemed to have worked quite well.', 'the restrictive monetary policy, and particularly the rise in interest rates, were not received with unanimous support by all sectors of the south african community.', 'interest rates, however, remain one of the main disciplines of the market economy and countries that are not prepared to bear the effects of this discipline from time to time will be punished by the markets.', 'this basic lesson is now being learned again by a number of countries in the east asia region where interest rates recently soared to a much higher level than ever experienced by south africa.', 'now that the overall macroeconomic consolidation process has made good progress, there are some impatient pressures building up on the reserve bank to relax monetary policy quickly and decisively.', 'some of these pressures are still based on the now defunct phillips curve or an assumed trade-off between inflation and growth -- an argument that was buried in most countries of the world already in the 1980s when macroeconomic policy switched the emphasis from a demand-management approach to a supply-side solution.', 'the rapid expansion of communications and the increase in electronically driven capacity for economic analyses further contributed to the more effective implementation of pre-empting expectations, and reduced the opportunity for central bankers to stimulate economies in the short term by applying over-expansionary monetary policies.', 'the south african reserve bank now follows the lead of many other central banks in the world to base monetary policy decisions on developments in financial or monetary aggregates, and not on changes in real economic activity.', 'indeed, the latest fashion is for central banks, together with governments, to target inflation more directly.', 'taking account of typical time-lags that exist between the implementation of monetary policies and their eventual effect on prices, monetary policy adjustments are based on the expectation of what the rate of inflation may turn out to be twelve to eighteen months downstream.', 'reliable forecasting therefore has become as important for the monetary authorities as they are for private sector operators in the markets.', 'for this purpose, the familiar monetary aggregates such as the money supply, bank credit extension, the level of interest rates and the shape of the yield curve and changes in the exchange rate provide the best indicators available in the short term to guide monetary policy decisions.', 'what will be important for the stance of monetary policy over the next year will not be the approaching election in 1999, but rather current developments in these well-known basic financial aggregates.', 'apart from contending with the after-effects of the depreciation of the rand last year, the major concern for the reserve bank recently has been the continuous increase at a high rate in the total amount of bank credit extended to the private sector.', 'over the past few months there has been a significant slowdown in the annualised rate of increase in bank credit extended to the private sector which amounted to 21.2 per cent in the second quarter of 1997, before declining to 9.5 per cent in the third quarter.', 'after the recent downward adjustment in the financial markets in south africa, we may find some further slowdown in the rate of increase in bank credit extension, to reflect more truly the slowdown which already occurred in real economic activity.', 'recent events in the international currency markets proved once again that the forecasting of possible future developments in financial aggregates can be very perilous.', 'as south africa liberalises its financial markets further and as the south african financial system gets more integrated into an extremely volatile international environment, the hazards of forecasting will increase.', 'for the central bank, this unfortunately reduces the value of strictly defined monetary policy models, and makes - 4 - the task of implementing policies more discretionary.', 'market participants prefer a monetary policy based on pre-announced rules and want to be in a position where they can pre-empt important changes in monetary policy for their own advantage, and for the sake of giving good advice to their clients.', 'this, however, is not possible in the present environment where unpredictable events in far-away places such as thailand can have profound influences on monetary developments in south africa.', 'forecasting possible developments in the exchange rate of the rand, for example, must not only take account of developments in south africa, but also of possible changes in the cross exchange rates of major currencies, developments in international capital markets, economic and political developments in a number of emerging economies and a multitude of other possible global developments.', 'as illustrated over the past year, changes in the effective exchange rate of the rand in turn can have many effects on monetary policy decisions in south africa.', 'in this multi-complex environment it is just unreasonable to expect of any governor of any central bank anywhere in the world to signal to markets in advance what adjustments in interest rates or other monetary policies could be expected over the next year.', '4. a greater reliance on markets in the situation, it is advisable to rely more on market forces for the necessary correction of imbalances that may develop from time to time in the macro economy.', 'markets must therefore be encouraged to become more flexible, more efficient and more responsive to changes in underlying supply and demand conditions.', 'in the case of south africa, three important changes will be introduced in the structure of financial markets over the next few months: • firstly, the existing national payment, clearing and settlement system will be upgraded in march 1998 to pave the way for real-time on-line settlement of large transactions on a gross basis, and for the daily settlement on a net basis of other (smaller) transactions between banking institutions.', 'this versatile new system will provide challenging opportunities for the development of a more active interbank funds market.', 'secondly, the reserve bank will introduce a new system for providing liquidity to banking • institutions through daily repurchase transactions that will establish a floating interest rate for central bank accommodation.', 'thirdly, the department of finance intends to introduce a new system for the primary sale of and • secondary market making in government bonds by the appointment of a number of securities dealers from the private banking sector to operate as authorised dealers on behalf of the treasury.', 'these changes are all intended to serve the needs of more liberalised and free financial markets in south africa.', 'at the same time, they should open up the way for further exchange control relaxations and encourage greater integration of the south african financial markets in the global financial system.', '5. concluding remarks next year holds the prospects for being an interesting one for the south african economy.', '• firstly, there is the prospect for better economic growth in south africa, following upon the macroeconomic consolidation of the past year.', '- 5 - • secondly, important structural adjustments, particularly in the financial markets, will introduce interesting new challenges for all participants in the markets.', '• thirdly, we shall have to contend with the continuing turmoil in the international currency markets, and possibly also with the adverse effects of the el nino phenomenon.']	Chris Stals	South African Reserve Bank	Governor	South Africa
https://www.bis.org/review/r971119e.pdf	Mr. Erçel considers the European financial markets and their implications for Turkish institutions (Central Bank Articles and Speeches, 23 Oct 97)	Speech given by the Governor of the Central Bank of the Republic of Turkey, Mr. Gazi Erçel, in Istanbul on 23/10/97.	1997-10-23 00:00:00	Mr. Erçel considers the European financial markets and their implications for Turkish institutions Speech given by the Governor of the Central Bank of the Republic of Turkey, Mr. Gazi Erçel, in Istanbul on 23/10/97. The EMU will be the most important change in the international monetary system since the creation of the IMF at Bretton Woods. The creation of a new currency, the Euro, is in fact a historical event for the European Union (EU). It marks a new quality in the process of European unification because it is the final point and coronation of efforts since 1958 to create one big market in Europe. The success of the Euro area will, of course, depend on the future development of the value of the Euro. The Euro, as we all know, has to compete with two strong international currencies: the US dollar and the Japanese yen. According to one school of thought, the Euro will have a stable value. That is because the high stock of assets in Euro, held by official or private foreign holders and which were converted from national currencies, in particular from Deutsche Mark, will not be switched into other currencies. Besides, once the Euro is introduced, there could be a significant switch of foreign exchange reserves out of US dollars and into Euro. This could give a boost to the exchange rate of the Euro against the US dollar over time. The sheer size of the economy in the monetary union will encourage the use of the Euro instead of the US dollar in trade and foreign exchange transactions. This process would further be accelerated by the fact that the use of a single currency will remove the not negligible cost of transactions. According to a study conducted by the IFO Institute in Munich, "the transaction costs for the inter-European currency management may be in the order of nearly 60 billion ECUs, or nearly 1% the GNP of the European Union". Also it is likely that central banks will use the Euro rather than the US dollar in foreign exchange interventions. In turn, this will encourage non-EU central banks to switch an increasing proportion of their reserves into the Euro. This process will take time and the Euro will not usurp the role of the US dollar in the short term. However, the trend is likely to be persistent and eventually the current importance of the US dollar in the foreign exchange markets should be replaced by the joint importance of the US dollar and the Euro. One factor which will affect the speed of this change is the outlook for the Euro based on the fundamentals of the monetary policy of the European Central Bank (ECB). Moreover, the creation of a monetary union will prevent exchange rate volatility within the united Europe, the reason being that the Euro area as a whole will be much less dependent on foreign trade. It is estimated that the share of foreign trade of the Euro area will be only about 10% of GNP in comparison to about 30% for Germany today. And over the long term, the Euro should become almost as widely used as the US dollar is today. One conclusion to be inferred from this is the following: since Turkey has close trade, service and financial links with Europe, and as the only country connected to Europe in a Customs Union (CU), which I hope will evolve over time towards full membership, the EMU will create completely new conditions in Turkey's international and European relations. Therefore what will happen in Europe will be decisive for Turkey in the years ahead. It will be a challenge for the Turkish authorities, as well as for bankers and businessmen. One of the most important prerequisites for a successful monetary union is a sufficient degree of economic convergence among the potential members. From that standpoint the degree of convergence among the EU countries is remarkable, particularly as regards the convergence criteria; stable prices, stable exchange rates, low long-term interest rates and healthy public finances. In addition to these criteria, the Maastricht Treaty requires that all member countries in the EU must grant independence to their central banks before the Monetary Union and the establishment of the European System of Central Banks (ESCB). The reason behind the requirement of independent national central banks is that fixing exchange rates and unifying currencies requires a common monetary policy. - 2 - For a currency union to function "smoothly and in a sustainable way, it is absolutely necessary that all participants agree on either a single common policy or closely coordinated policies". All costs and benefits of the union must be shared equally. Any member acting with the "free-rider" mentality, and benefiting from the system at the expense of the others, will eventually cause the system to disintegrate. Therefore, a single common currency requires a single monetary policy with a clearly defined target, which is price stability. This basic principle of monetary policy has already been embedded in the Maastricht Treaty. And the European System of Central Banks (ESCB) has been made responsible for achieving it. In order for the ESCB to fulfil the task assigned to it, it must act in full independence from national governments or from European institutions. The ESCB Governing Council, which is composed of the Board of Management of the ESCB and the governors of the participating central banks, will not be representing respective national interests. Although there are some differences between the two systems, the ESCB is like the Federal Reserve System of the US. For the ESCB to act independently, individual national central banks must already be acting independently of their governments, because the ESCB will be built on individual national central banks. That is why the Maastricht Treaty made it obligatory for the national governments to grant independence to their central banks in the period leading to the formation of the ESCB. The EMU is an event with far-reaching consequences; in one way or the other all countries will be affected by it. Unlike the effect of a currency area, a customs union or a free trade area, a monetary union can affect in various degrees all countries, irrespective of whether they are in or out. This general fact, together with the signing a Customs Union (CU) Agreement with the EU, make EMU even more important for Turkey than for other countries outside the EMU. Therefore, I believe that the Turkish Central Bank has a predominant role to play in informing and educating all Turkish entities about the choices and implications of EMU. As you all know, Turkey is one of the potential countries to join the EU. I would say that our country's ultimate aim is to become a full member of the EU; therefore first we need to adapt to European standards in many areas. The steps Turkey took on the way to the CU are also steps taken to ensure full integration in EMU. After these general remarks I would like to look at the issue from Turkey's perspective. So far, the measures taken to support the independence of the Central Bank of Turkey (CBT) are remarkable. Recently, the Central Bank Law was amended and now limits have been set on the so-called "short-term advances" which the Treasury is legally entitled to obtain from the Central Bank. Starting from 1994, the Treasury's annual use of short-term advances is to be reduced gradually over five years from 15 to 3 percent of each year's incremental budget appropriations. By 1998, the Treasury will be entitled to short-term advances totalling not more than 3 percent of that year's incremental budget appropriations over the previous year. In addition to that, the Treasury and the Central Bank have signed a seven-point protocol to cooperate in fighting inflation. The official aim of this accord is also to give the Central Bank more independence. So, an important development towards the full independence of the Central Bank has been initiated, as required in the Maastricht Treaty. However, we have been in the process of preparing a new Central Bank law in parallel with the same institutions in the EU. The work has already been done and we are ready to submit it to the government if and when the political environment is appropriate. On the other hand, in addition to the already installed electronic payments clearing system, the CB has signed a contract to develop and install a modern national securities settlement system. The new system will allow the Bank to increase the efficiency with which government securities can be traded on the capital markets and ensure that the payments system will match the standards of those in the EU and other western nations. The new system will also be capable of being connected to the - 3 - TARGET network. At the same time the system will strengthen Turkey's links with the European member countries and will enable it to trade in the same currency as other members, a requirement for participation in the EMU. As far as the technical infrastructure is concerned, Turkey is ready to integrate itself into the EU. I would like to remind you that Turkey has been pursuing a series of liberalization policies since 1980 which are broadly in line with economic tendencies in the world. A wide range of policy measures were put into effect to achieve the restructuring of the economy. Changes in exchange rate and trade policies were the main instruments in this process. This program has brought a radical change in Turkey's development strategy by increasing its dependence on market forces. In this context, the fixed exchange rate policy was replaced by the flexible one, restrictive control measures on imports were abolished and protection was reduced gradually. Similarly, foreign exchange transactions were thoroughly liberalized, free trade zones were established, foreign investment was further encouraged along with the privatization of public enterprises. As a result of these newly adopted policies, there have been spectacular changes in the Turkish economy, with exports and foreign investments having proved to be responsive to the structural adjustment process; within this process, the Turkish lira has become fully convertible and restrictions on capital movements have been effectively removed. Even though the liberalization policies were adopted independent of the EU perspective, they helped to facilitate Turkey's attempt to apply for full membership, by providing a solid basis for lasting progress. On the other hand, member countries of the EU have tried to make some adaptations in their banking regulations to integrate financial systems. Competition among them has increased. A universal banking system is accepted. Banks either have increased their assets or have merged with other banks in order to be strong in a market where competition is intensified. New financial products are created every day. Technology is used intensively in order to reduce costs and serve customers better. In parallel to these developments many reforms have been made in order to develop the Turkish banking system. Some amendments were made to the Banking Law to harmonize it with European standards, and now we are in the process of preparing a new Banking Law. These changes will require some banks to strengthen their financial situation and bring their credit risk and equity participation ratios closer to the EU norms. Within the process of becoming more deeply integrated with the European financial markets, the Turkish banking system will now face new competition. The CU agreement has naturally affected Turkish banks and changed the dimensions of competition. But Turkish banks seem ready in many ways for this new and larger competitive environment. Today banks in Turkey are made more dynamic by a high-technology electronic infrastructure, high-quality services and well-trained manpower. What we need is to integrate the legal and institutional systems in parallel with the EU banks. With the introduction of the Euro there would arise a number of technical issues which must be immediately tackled. As of today, Turkish banks are allowed to maintain foreign exchange positions in 23 foreign currencies, of which 17, including the ECU, are European currencies. With the Euro the CB and the Turkish banks will no longer have to deal in these currencies, but only in Euro. Of course, initially there will be some currencies, like the British pound and a few others, which will continue to exist for a while. But within this process, all foreign assets and liabilities in the currencies of the countries participating in the monetary union will need to be converted into the Euro. Currently, Turkey follows an exchange rate policy based on a basket consisting of the US dollar and the Deutsche Mark. It is assumed that since other European currencies are related to the Deutsche Mark through the European Exchange Rate Mechanism (ERM), the basket also reflects the weight of other European currencies through the Deutsche Mark. With monetary union the share of the Euro area in Turkey's overall trade in goods or services will be more than 50%. But this will not change the picture from the exchange rate policy point of view. Therefore the Euro could easily be substitute for Deutsche Mark in the present basket. - 4 - Within the CB's foreign reserves, some positions are being held in the currencies of the countries which are candidates for monetary union membership. These positions consist of securities and money market placements. It is expected that security investments will be converted to the Euro as of January 1st, 1999. Money market placements on the other hand will continue to be transacted in their original currencies until July 1st, 2002. The fixing of the Deutsche Mark rate against Euro, the Euro's value against other currencies in the international money markets and the depth and performance of the Euro bond market will be important factors in terms of our reserve management policy. In the Euro market, there will no longer be any cross-currency risk and cross currency-induced interest rate differential. However, it is possible that the country risk-induced differential will become more pronounced. Therefore investors must pay attention to which country's security they are buying when investing in Euro-denominated securities. There are also issues which should be considered by the real sector. In particular those firms which are very active in trades across borders are likely to adopt the value of the Euro in their dealings rather quickly, because firms competing in European markets, in order to make comparison possible, should set their prices in Euro. As I have already mentioned, the CB and the commercial banks have to convert the foreign exchange denominated accounts into the Euro. This is not an easy task and involves changes in accounting systems and data processing. Therefore due attention has to be paid to these infrastructural changes prior to the introduction of the Euro. The fact that the EU is Turkey's most important trading partner increases the implications of EMU for the Turkish economy. On the other hand, the EU has the largest share in foreign investment in Turkey, and invisible earnings in the Turkish balance of payments have a significant European content. Furthermore, most of our correspondent banks are in the Euro zone. Turkey has close trade, service and financial links with Europe, as the only country connected to Europe in a CU which hopefully will evolve over time towards full membership. In conclusion, I would like to point out that time is getting short for launching the Euro. The time remaining must therefore be used efficiently. Those who have prepared and are ready will also be those who will also derive the greatest benefits. I do believe that we are heading in the right direction.	['mr. erçel considers the european financial markets and their implications for turkish institutions speech given by the governor of the central bank of the republic of turkey, mr. gazi erçel, in istanbul on 23/10/97.', 'the emu will be the most important change in the international monetary system since the creation of the imf at bretton woods.', 'the creation of a new currency, the euro, is in fact a historical event for the european union (eu).', 'it marks a new quality in the process of european unification because it is the final point and coronation of efforts since 1958 to create one big market in europe.', 'the success of the euro area will, of course, depend on the future development of the value of the euro.', 'the euro, as we all know, has to compete with two strong international currencies: the us dollar and the japanese yen.', 'according to one school of thought, the euro will have a stable value.', 'that is because the high stock of assets in euro, held by official or private foreign holders and which were converted from national currencies, in particular from deutsche mark, will not be switched into other currencies.', 'besides, once the euro is introduced, there could be a significant switch of foreign exchange reserves out of us dollars and into euro.', 'this could give a boost to the exchange rate of the euro against the us dollar over time.', 'the sheer size of the economy in the monetary union will encourage the use of the euro instead of the us dollar in trade and foreign exchange transactions.', 'this process would further be accelerated by the fact that the use of a single currency will remove the not negligible cost of transactions.', 'according to a study conducted by the ifo institute in munich, "the transaction costs for the inter-european currency management may be in the order of nearly 60 billion ecus, or nearly 1% the gnp of the european union".', 'also it is likely that central banks will use the euro rather than the us dollar in foreign exchange interventions.', 'in turn, this will encourage non-eu central banks to switch an increasing proportion of their reserves into the euro.', 'this process will take time and the euro will not usurp the role of the us dollar in the short term.', 'however, the trend is likely to be persistent and eventually the current importance of the us dollar in the foreign exchange markets should be replaced by the joint importance of the us dollar and the euro.', 'one factor which will affect the speed of this change is the outlook for the euro based on the fundamentals of the monetary policy of the european central bank (ecb).', 'moreover, the creation of a monetary union will prevent exchange rate volatility within the united europe, the reason being that the euro area as a whole will be much less dependent on foreign trade.', 'it is estimated that the share of foreign trade of the euro area will be only about 10% of gnp in comparison to about 30% for germany today.', 'and over the long term, the euro should become almost as widely used as the us dollar is today.', "one conclusion to be inferred from this is the following: since turkey has close trade, service and financial links with europe, and as the only country connected to europe in a customs union (cu), which i hope will evolve over time towards full membership, the emu will create completely new conditions in turkey's international and european relations.", 'therefore what will happen in europe will be decisive for turkey in the years ahead.', 'it will be a challenge for the turkish authorities, as well as for bankers and businessmen.', 'one of the most important prerequisites for a successful monetary union is a sufficient degree of economic convergence among the potential members.', 'from that standpoint the degree of convergence among the eu countries is remarkable, particularly as regards the convergence criteria; stable prices, stable exchange rates, low long-term interest rates and healthy public finances.', 'in addition to these criteria, the maastricht treaty requires that all member countries in the eu must grant independence to their central banks before the monetary union and the establishment of the european system of central banks (escb).', 'the reason behind the requirement of independent national central banks is that fixing exchange rates and unifying currencies requires a common monetary policy.', '- 2 - for a currency union to function "smoothly and in a sustainable way, it is absolutely necessary that all participants agree on either a single common policy or closely coordinated policies".', 'all costs and benefits of the union must be shared equally.', 'any member acting with the "free-rider" mentality, and benefiting from the system at the expense of the others, will eventually cause the system to disintegrate.', 'therefore, a single common currency requires a single monetary policy with a clearly defined target, which is price stability.', 'this basic principle of monetary policy has already been embedded in the maastricht treaty.', 'and the european system of central banks (escb) has been made responsible for achieving it.', 'in order for the escb to fulfil the task assigned to it, it must act in full independence from national governments or from european institutions.', 'the escb governing council, which is composed of the board of management of the escb and the governors of the participating central banks, will not be representing respective national interests.', 'although there are some differences between the two systems, the escb is like the federal reserve system of the us.', 'for the escb to act independently, individual national central banks must already be acting independently of their governments, because the escb will be built on individual national central banks.', 'that is why the maastricht treaty made it obligatory for the national governments to grant independence to their central banks in the period leading to the formation of the escb.', 'the emu is an event with far-reaching consequences; in one way or the other all countries will be affected by it.', 'unlike the effect of a currency area, a customs union or a free trade area, a monetary union can affect in various degrees all countries, irrespective of whether they are in or out.', 'this general fact, together with the signing a customs union (cu) agreement with the eu, make emu even more important for turkey than for other countries outside the emu.', 'therefore, i believe that the turkish central bank has a predominant role to play in informing and educating all turkish entities about the choices and implications of emu.', 'as you all know, turkey is one of the potential countries to join the eu.', "i would say that our country's ultimate aim is to become a full member of the eu; therefore first we need to adapt to european standards in many areas.", 'the steps turkey took on the way to the cu are also steps taken to ensure full integration in emu.', "after these general remarks i would like to look at the issue from turkey's perspective.", 'so far, the measures taken to support the independence of the central bank of turkey (cbt) are remarkable.', 'recently, the central bank law was amended and now limits have been set on the so-called "short-term advances" which the treasury is legally entitled to obtain from the central bank.', "starting from 1994, the treasury's annual use of short-term advances is to be reduced gradually over five years from 15 to 3 percent of each year's incremental budget appropriations.", "by 1998, the treasury will be entitled to short-term advances totalling not more than 3 percent of that year's incremental budget appropriations over the previous year.", 'in addition to that, the treasury and the central bank have signed a seven-point protocol to cooperate in fighting inflation.', 'the official aim of this accord is also to give the central bank more independence.', 'so, an important development towards the full independence of the central bank has been initiated, as required in the maastricht treaty.', 'however, we have been in the process of preparing a new central bank law in parallel with the same institutions in the eu.', 'the work has already been done and we are ready to submit it to the government if and when the political environment is appropriate.', 'on the other hand, in addition to the already installed electronic payments clearing system, the cb has signed a contract to develop and install a modern national securities settlement system.', 'the new system will allow the bank to increase the efficiency with which government securities can be traded on the capital markets and ensure that the payments system will match the standards of those in the eu and other western nations.', 'the new system will also be capable of being connected to the - 3 - target network.', "at the same time the system will strengthen turkey's links with the european member countries and will enable it to trade in the same currency as other members, a requirement for participation in the emu.", 'as far as the technical infrastructure is concerned, turkey is ready to integrate itself into the eu.', 'i would like to remind you that turkey has been pursuing a series of liberalization policies since 1980 which are broadly in line with economic tendencies in the world.', 'a wide range of policy measures were put into effect to achieve the restructuring of the economy.', 'changes in exchange rate and trade policies were the main instruments in this process.', "this program has brought a radical change in turkey's development strategy by increasing its dependence on market forces.", 'in this context, the fixed exchange rate policy was replaced by the flexible one, restrictive control measures on imports were abolished and protection was reduced gradually.', 'similarly, foreign exchange transactions were thoroughly liberalized, free trade zones were established, foreign investment was further encouraged along with the privatization of public enterprises.', 'as a result of these newly adopted policies, there have been spectacular changes in the turkish economy, with exports and foreign investments having proved to be responsive to the structural adjustment process; within this process, the turkish lira has become fully convertible and restrictions on capital movements have been effectively removed.', "even though the liberalization policies were adopted independent of the eu perspective, they helped to facilitate turkey's attempt to apply for full membership, by providing a solid basis for lasting progress.", 'on the other hand, member countries of the eu have tried to make some adaptations in their banking regulations to integrate financial systems.', 'competition among them has increased.', 'a universal banking system is accepted.', 'banks either have increased their assets or have merged with other banks in order to be strong in a market where competition is intensified.', 'new financial products are created every day.', 'technology is used intensively in order to reduce costs and serve customers better.', 'in parallel to these developments many reforms have been made in order to develop the turkish banking system.', 'some amendments were made to the banking law to harmonize it with european standards, and now we are in the process of preparing a new banking law.', 'these changes will require some banks to strengthen their financial situation and bring their credit risk and equity participation ratios closer to the eu norms.', 'within the process of becoming more deeply integrated with the european financial markets, the turkish banking system will now face new competition.', 'the cu agreement has naturally affected turkish banks and changed the dimensions of competition.', 'but turkish banks seem ready in many ways for this new and larger competitive environment.', 'today banks in turkey are made more dynamic by a high-technology electronic infrastructure, high-quality services and well-trained manpower.', 'what we need is to integrate the legal and institutional systems in parallel with the eu banks.', 'with the introduction of the euro there would arise a number of technical issues which must be immediately tackled.', 'as of today, turkish banks are allowed to maintain foreign exchange positions in 23 foreign currencies, of which 17, including the ecu, are european currencies.', 'with the euro the cb and the turkish banks will no longer have to deal in these currencies, but only in euro.', 'of course, initially there will be some currencies, like the british pound and a few others, which will continue to exist for a while.', 'but within this process, all foreign assets and liabilities in the currencies of the countries participating in the monetary union will need to be converted into the euro.', 'currently, turkey follows an exchange rate policy based on a basket consisting of the us dollar and the deutsche mark.', 'it is assumed that since other european currencies are related to the deutsche mark through the european exchange rate mechanism (erm), the basket also reflects the weight of other european currencies through the deutsche mark.', "with monetary union the share of the euro area in turkey's overall trade in goods or services will be more than 50%.", 'but this will not change the picture from the exchange rate policy point of view.', 'therefore the euro could easily be substitute for deutsche mark in the present basket.', "- 4 - within the cb's foreign reserves, some positions are being held in the currencies of the countries which are candidates for monetary union membership.", 'these positions consist of securities and money market placements.', "it is expected that security investments will be converted to the euro as of january 1st, 1999. money market placements on the other hand will continue to be transacted in their original currencies until july 1st, 2002. the fixing of the deutsche mark rate against euro, the euro's value against other currencies in the international money markets and the depth and performance of the euro bond market will be important factors in terms of our reserve management policy.", 'in the euro market, there will no longer be any cross-currency risk and cross currency-induced interest rate differential.', 'however, it is possible that the country risk-induced differential will become more pronounced.', "therefore investors must pay attention to which country's security they are buying when investing in euro-denominated securities.", 'there are also issues which should be considered by the real sector.', 'in particular those firms which are very active in trades across borders are likely to adopt the value of the euro in their dealings rather quickly, because firms competing in european markets, in order to make comparison possible, should set their prices in euro.', 'as i have already mentioned, the cb and the commercial banks have to convert the foreign exchange denominated accounts into the euro.', 'this is not an easy task and involves changes in accounting systems and data processing.', 'therefore due attention has to be paid to these infrastructural changes prior to the introduction of the euro.', "the fact that the eu is turkey's most important trading partner increases the implications of emu for the turkish economy.", 'on the other hand, the eu has the largest share in foreign investment in turkey, and invisible earnings in the turkish balance of payments have a significant european content.', 'furthermore, most of our correspondent banks are in the euro zone.', 'turkey has close trade, service and financial links with europe, as the only country connected to europe in a cu which hopefully will evolve over time towards full membership.', 'in conclusion, i would like to point out that time is getting short for launching the euro.', 'the time remaining must therefore be used efficiently.', 'those who have prepared and are ready will also be those who will also derive the greatest benefits.', 'i do believe that we are heading in the right direction.']	Gazi Erçel	Central Bank of the Republic of Türkiye	Governor	Turkey
https://www.bis.org/review/r971119d.pdf	Mr. Greenspan's testimony before the House of Representatives' Committee on Banking and Financial Services (Central Bank Articles and Speeches, 13 Nov 97)	Testimony of the Chairman of the Governing Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives in Washington DC, on 13/11/97.	1997-11-13 00:00:00	Mr. Greenspan's testimony before the House of Respresentatives' Commmittee on Banking and Financial Services Testimony of the Chairman of the Governing Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives in Washington DC, on 13/11/97. Recent developments in world finance have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. Doubtless, there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth, and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows into these economies, in particular short-term flows, was - 2 - denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about 4 percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there will be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts, and relatively robust financial systems, have experienced severe pressures. One can debate whether the turbulence in Latin American asset values reflects contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the external liabilities of sovereign governments or failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. - 3 - The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.	["mr. greenspan's testimony before the house of respresentatives' commmittee on banking and financial services testimony of the chairman of the governing board of the us federal reserve system, mr. alan greenspan, before the committee on banking and financial services of the us house of representatives in washington dc, on 13/11/97.", 'recent developments in world finance have highlighted growing interactions among national financial markets.', 'the underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems.', 'that improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly.', 'doubtless, there is much to be learned from the recent experience in asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide.', 'while each of the asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them.', 'following the early post-world war ii period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s.', 'by the 1980s most economies in the region were expanding vigorously.', 'foreign net capital inflows grew, but until recent years were relatively modest.', 'the world bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the asia pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996. a major impetus behind this rapid expansion was the global stock market boom of the 1990s.', 'as that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in asia.', 'the resultant diversification induced a sharp increase in capital flows into those economies.', 'to a large extent, they came from investors in the united states and western europe.', 'a substantial amount came from japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country.', 'the rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from japan.', 'in retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk.', 'i suspect that it was inevitable in those conditions of low inflation, rapid growth, and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects.', 'this is an experience, of course, not unknown in the united states on occasion.', 'these real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems.', 'in many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital.', "moreover, in most cases, the currencies of these economies were closely tied to the u.s. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive.", 'in addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses.', 'however, overall gdp growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies.', 'moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows into these economies, in particular short-term flows, was - 2 - denominated by the ultimate borrowers in foreign currencies.', 'this put additional pressure on companies to earn foreign exchange through exports.', 'the pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies.', 'the shifts in perceived future investment risks led to sharp declines in stock markets across asia, often on top of earlier declines or lackluster performances.', 'to date, the direct impact of these developments on the american economy has been modest, but it can be expected not to be negligible.', 'u.s. exports to thailand, the philippines, indonesia, and malaysia (the four countries initially affected) were about 4 percent of total u.s. exports in 1996. however, an additional 12 percent went to hong kong, korea, singapore and taiwan (economies that have been affected more recently).', 'thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted.', 'our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports.', 'the share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead.', 'in addition, there will be indirect effects on the u.s. real economy from countries such as japan that compete even more extensively with the economies in the asian region.', 'particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities.', 'even economies, such as hong kong, with formidable stocks of international reserves, balanced external accounts, and relatively robust financial systems, have experienced severe pressures.', 'one can debate whether the turbulence in latin american asset values reflects contagion effects from asia, the influence of developments in u.s. financial markets, or home-grown causes.', "whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system.", 'perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the asian region would run into a temporary slowdown or pause.', 'but there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time.', 'nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy.', 'private capital flows may temporarily turn adverse.', 'in these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge.', 'similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the external liabilities of sovereign governments or failed domestic businesses.', 'to do otherwise could lead to distorted investments and could ultimately unbalance the world financial system.', 'the recent experience in asia underscores the importance of financially sound domestic banking and other associated financial institutions.', 'while the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with.', 'our unlamented savings and loan crises come to mind.', 'these are trying days for economic policymakers in asia.', 'they must fend off domestic pressures that seek disengagement from the world trading and financial system.', 'the authorities in these countries are working hard, in some cases with substantial assistance from the imf, the world bank, and the asian development bank, to stabilize their financial systems and economies.', '- 3 - the financial disturbances that have afflicted a number of currencies in asia do not at this point, as i indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize.', 'it is in the interest of the united states and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman of the Governing Board	US
https://www.bis.org/review/r971119c.pdf	Remarks by Ms. Phillips at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute (Central Bank Articles and Speeches, 4 Nov 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute, Chicago, on 4/11/97.	1997-11-04 00:00:00	Remarks by Ms. Phillips at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute, Chicago, on 4/11/97. It is a pleasure to be here to discuss the Federal Reserve's perspective on risk management. As you know, advances in the methods and techniques in this area are having wide-ranging effects on the corporate decision making process in all types of business. The effects on banking institutions have been especially profound. Clearly, financial engineering and improvements in risk management have helped banks to expand product lines, offer more efficient services, and control the risks of ever more complex financial instruments and the growing volume of financial transactions. For some institutions, the application of new risk management techniques to specific areas is leading the way to a broader, firm-wide risk consciousness that is completely, and appropriately, transforming the entire corporate culture. This is particularly important since the very essence of banking and financial intermediation is the acceptance and management of risk. Adopting a "risk-focused" corporate culture from the highest levels of senior management down through business line personnel represents the ultimate product quality assurance program for individual customers and the financial system more generally. From the Federal Reserve's perspective, effective risk management at financial institutions plays a critical role in helping to achieve our central bank responsibilities of: 1. promoting an efficient and effective financial system that adequately finances economic growth, and 2. ensuring that financial institutions do not become a source of systemic risk, or pose a threat to the payment system or burden taxpayers with losses arising from the federal safety net. Advances in risk management clearly help reduce potential systemic disruptions. The Federal Reserve, along with other supervisors both here and abroad, has focused increasing resources on encouraging developments in this area. Indeed, just as financial engineering and advances in risk management are changing the operating methods and business cultures of financial institutions, they are also transforming both the operations and the corporate culture of bank supervisors. While ultimate goals and objectives remain the same, over the past several years, supervisors have been moving to more "incentive-compatible" approaches to 1) foster sound risk management within the institution rather than compliance with narrow rules and regulations, 2) minimize burden through the use of new examination approaches and internal risk measurement systems, and 3) reinforce market discipline. Fostering Sound Risk Management Key to almost all of these initiatives has been an increasing effort by supervisors to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. Too often financial engineering has been targeted at regulatory arbitrage -- that is, the exploitation of loopholes in narrow regulatory policies are based on old traditional instruments, activities or business lines. Supervisors are increasingly recognizing that the underlying risk characteristics of a financial instrument, activity or business line are of primary importance and not what they are called or officially labelled. To be sure, financial engineering can create derivative instruments which can combine component risks (including market, credit, liquidity, operational and reputational risks) in complex ways. But seemingly simple traditional cash instruments can actually have higher risk profiles than many instruments that are formally labelled "derivatives." In fact, the categorization of financial instruments and activities without regard to their underlying risk and economic functions can actually handicap sound management. - 2 - Thus, Federal Reserve and other supervisors have increasingly issued supervisory guidance that emphasizes managing the risks involved in bank activities and de-emphasizes the supervisory focus on specific instruments or traditional products. Most recently, the FFIEC published for industry comment a new policy statement that would eliminate the 1992 interagency policy that instituted the FFIEC high risk test. The older policy statement placed significant constraints on a depository institution's holding of certain "high-risk" mortgage securities that met specific market risk sensitivity tests. The new policy would replace the high risk test with broader guidance on sound practices for managing all investment and end-user activities. In essence, the new statement would allow an institution to hold any bank-eligible instrument as an investment as long as the institution had an adequate risk management process commensurate with the scope, complexity, and sophistication of its investment and end-user holdings. The old FFIEC high-risk tests offer an excellent case study of the potential pitfalls of narrow formulaic supervision in an age of dynamic financial engineering. By requiring a pre-purchase price sensitivity analysis, the high risk test successfully helped institutions better understand the interest rate risk of certain mortgage securities. It effectively constrained many smaller financial institutions from acquiring certain types of securities that subsequently created large losses for other investors. However, while protecting some institutions, the tests may also have distorted the investment decision making process at other depository institutions. Concerns about burden and heightened examiner review of all types of mortgage securities may have led institutions to blindly eliminate them as potential investments -- regardless of the merits of their risk/return profiles. Also, by focusing only on certain products, the test provided incentives for institutions to acquire other types of securities with embedded options that required no testing. Such instruments were thought to have a supervisory "stamp of approval", but in fact often had risk characteristics similar to or greater than those designated as "high risk". Assuming positive industry comments, the FFIEC hopes to implement the proposed new policy in early 1998. The comment period extends through November 17, and I encourage all of you to comment. I might mention that the new policy will apply to all investment and end-user derivatives activities. It illustrates that supervisors are increasingly emphasizing risk management on a portfolio rather than an instrument-specific basis. Although this is arguably the first principle of finance and is widely appreciated by bankers and regulators, putting this principle into practice in banking has not been easy. Past banking crises have, in part, reflected a failure to recognize or to prudently limit concentrations of risk. However, technology and financial innovation are now enabling financial theories and conceptual techniques that have been around for decades to be put into practice to manage market, credit and liquidity risks. Moreover, these risks are increasingly being managed across activities and in some cases on a global basis. This move to a broad portfolio or "macro" approach to managing risk has influenced bank supervisory efforts in several ways. All three of the U.S. banking agencies now take a more "risk-focused" approach to bank supervision. Bank exams are no longer exhaustive reviews of all of a bank's specific activities. Instead, they now take a more targeted approach to identifying and reviewing the sources of risk within a bank's "portfolio" of activities. Exam resources are now targeted at evaluating the soundness of a bank's processes for managing risks and our supervisory tools have been enhanced in this direction. Increased Use of Internal Measurement and Management Systems In addition, supervisors increasingly are relying on internal risk management systems, including increasingly sophisticated risk measurement systems used by banks to manage their businesses. - 3 - The objectives here are two-fold -- to help improve the effectiveness of our examinations and to reduce the burden on banking organizations. Examinations now involve significant off-site, pre-planning, analysis and fact finding. Then the on-site examination activities include spot checks to determine the reliability of the bank's internal risk management system. To the extent examiners gain confidence in the bank's risk management process, they will place greater emphasis on the findings of the bank's internal auditors at an earlier stage in the examination process and focus resources in other areas. An area of bank risk management systems that has been particularly useful to supervisors is risk measurement. No better example exists than the banking agencies' adoption of a risk assessment approach for evaluating capital adequacy for interest rate risk. Early on in that rulemaking process, supervisors recognized that a number of banking institutions had internal models for measuring interest rate risk that were much more sophisticated than any possible standardized regulatory model. However, at the same time, supervisors were acutely aware that many other institutions had limited capabilities in this area and that many banks may have been hesitant to develop more sophisticated internal measurement systems prior to the determination of a supervisory approach. Accordingly, in 1993, supervisors proposed to use the results of internal models for evaluating the quantitative level of interest rate risk exposure at individual institutions. While the rulemaking process was ultimately longer than desired, it did demonstrate the clear intent of supervisors to encourage and provide incentives for improvements in risk management and to take full advantage of such advances when possible. I think most banks would agree that the discovery process and comment periods supervisors convened from 1993 through 1995, and the ensuing dialogue, spurred significant industry development and refinement of interest rate risk models. A similar process evolved in developing the international capital standard for market risk in the trading activities of internationally active banks. Beginning next January, banks that meet certain qualitative and quantitative standards for risk management will calculate market risk capital charges for their trading activities on the basis of their own internal Value at Risk (VaR) measures. Here again, supervisors recognized early developments in the quantitative measurement of market risks, encouraged industry progress, and sought to build on the VaR concept when developing a supervisory approach. During the discovery and rulemaking process the supervisory attention paid to VaR techniques led to more robust modelling and has helped spread the use of VaR techniques worldwide. Moving forward, perhaps such supervisory/private sector synergies can be gained in other areas of risk management, as well. The quantification of credit risks, by far the most important risk in banking, may be a candidate. At present, some institutions are making significant strides on a number of fronts to better quantify and manage credit risk. In addition to major developments in credit scoring and the use of artificial intelligence in underwriting various types of consumer loans, a few banks are beginning to use historical data to estimate probability loss distributions for the credit risk of different quality commercial loans. In some banks, credit risk-adjusted returns to capital are being used to construct a portfolio management framework for credit risk. This, in turn, is providing a proving ground for a risk-adjusted pricing of loans as well as a myriad of new instruments such as credit derivatives. While industry efforts to quantify credit risks are still in the early stages of evolution, recent progress holds promise for reducing both institutional and systemic risks. Indeed, these efforts might eventually lead to new supervisory regimes for addressing credit risk. Better methods of quantifying credit risk have significant potential for reducing the time examiners spend in on-site examinations. Moreover, advances in credit risk measurement may ultimately allow supervisors to design regulatory capital standards around internal models. We recognize the inadequacy of the existing risk-based capital regime where such assets as loans are all treated as having the same risk. We are actively encouraging the development of more quantitative approaches to credit risk management. However, better regulatory tools are not yet available. While supervisors can prod - 4 - developments in risk management, ultimately it will be up to the industry to find other ways to better measure and manage credit risk. Strengthening Market Discipline Harnessing market forces to reinforce supervisory objectives is another important goal in the changing culture of supervisors. Reliable financial information and adequate disclosure of risk exposures is an essential ingredient to achieving this goal. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess fundamental financial strength. It is this desire to see market discipline play a greater role in influencing banking activities that has prompted the Federal Reserve Board to join the debate about the derivative accounting standards that are being developed by the Financial Accounting Standards Board (FASB). Everyone agrees that a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm as well as the economic substance of its activities. However, the Board believes that the application of market value accounting to business strategies where not appropriate, and particularly when applied on a piecemeal basis, or when market prices are not readily available, may lead to increased volatility or fluctuation in reported results. Such accounting practices may actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with business strategies can cause them to incur significant costs to provide information that may not realistically reflect way underlying circumstances or trends in performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of meaningless accounting volatility from income statements and balance sheets can also impose significant costs without offsetting benefits. The Board believes that these problems can be minimized by having large firms with active trading portfolios place market values in supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing costs on an unnecessarily wide range of firms and without imposing the broader costs of having to reverse or "back out" the distorting effects of the proposed accounting standard. Emerging Challenges to Risk Management Without a doubt, banking institutions have made significant progress in implementing new techniques and methods in risk management. To date, most work in this area has centered around the "science" of risk management -- that is, the quantitative measurement of risk. However, quantitative measurement is only one element of the overall process of financial risk management. Other elements such as board and senior management oversight, internal controls, and the role of internal and external audits are just as important. Given the pace of technological and financial innovation, inadequate internal controls can expose an institution to significant risk. Indeed, inadequate management oversight, combined with a lack of internal controls, has been the primary cause of the losses experienced by several high profile major international banking organizations. In some cases basic time-honored internal controls such as segmentation of duties and independent risk assessment had been ignored. In others, internal management processes have failed to keep pace with technological development, financial innovation, and global expansion. It is these "low tech" areas that pose continued challenges to risk management. - 5 - Some institutions are beginning to address these challenges in their attempts to identify, monitor and control the operating risks of various business lines. Indeed, operating risk is quickly emerging as the next frontier of risk management. While no clear standardized definition of operating risk has yet emerged, several progressive institutions are expending significant resources to address the operating risks inherent in particular business lines. For some, this involves conducting extensive risk assessments throughout business and product lines to identify both the types of processing, information, and personnel risks that exist and the potential measures that can be taken to mitigate them. Others are buttressing these assessments with attempts actually to quantify and charge internal capital for operating risk exposures. Supervisors can also be expected to more closely monitor banks' efforts to identify and manage operating risks. One very important operating risk that all banking institutions face is the challenge of addressing the Year 2000 issue. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. Meeting the demands of this review and ensuring proper remedies both before and after the Year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Banks and others need to address Year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. Summary In summary, advances in computerization and communications have created a paradigm shift for financial markets, the financial services industry, and the management of financial risks. In response, supervisors are also moving to a new, more "incentive-compatible" regime of greater reliance on banks' own risk measures and internal controls. This transformation may be slow and will be challenging for all. Supervisors can encourage innovation, but the private sector must do much of the development work. As always, a transition to an improved framework will work best with cooperative, open dialogue between the financial industry and its regulators, so that compatible and efficient answers are found. In today's markets, institutions and financial systems are linked as never before, and such connections are likely to grow in the years ahead. How effectively institutions manage their risks and allocate their capital will have substantial consequences for economic growth. We have seen significant progress in measuring market risk, and the groundwork is being laid for future gains in measuring credit risk, but those are only two risks. Operating risks such as fraud, human misjudgments, and the failure of information systems, processing operations and basic internal controls must be addressed comprehensively. At this point, we can take satisfaction in the risk management strides we have made. But I am confident that opportunities for even greater progress lie ahead.	['remarks by ms. phillips at the asset/liability and treasury management conference of the bank administration institute remarks by ms. susan m. phillips, a member of the board of governors of the us federal reserve system, at the asset/liability and treasury management conference of the bank administration institute, chicago, on 4/11/97.', "it is a pleasure to be here to discuss the federal reserve's perspective on risk management.", 'as you know, advances in the methods and techniques in this area are having wide-ranging effects on the corporate decision making process in all types of business.', 'the effects on banking institutions have been especially profound.', 'clearly, financial engineering and improvements in risk management have helped banks to expand product lines, offer more efficient services, and control the risks of ever more complex financial instruments and the growing volume of financial transactions.', 'for some institutions, the application of new risk management techniques to specific areas is leading the way to a broader, firm-wide risk consciousness that is completely, and appropriately, transforming the entire corporate culture.', 'this is particularly important since the very essence of banking and financial intermediation is the acceptance and management of risk.', 'adopting a "risk-focused" corporate culture from the highest levels of senior management down through business line personnel represents the ultimate product quality assurance program for individual customers and the financial system more generally.', "from the federal reserve's perspective, effective risk management at financial institutions plays a critical role in helping to achieve our central bank responsibilities of: 1. promoting an efficient and effective financial system that adequately finances economic growth, and 2. ensuring that financial institutions do not become a source of systemic risk, or pose a threat to the payment system or burden taxpayers with losses arising from the federal safety net.", 'advances in risk management clearly help reduce potential systemic disruptions.', 'the federal reserve, along with other supervisors both here and abroad, has focused increasing resources on encouraging developments in this area.', 'indeed, just as financial engineering and advances in risk management are changing the operating methods and business cultures of financial institutions, they are also transforming both the operations and the corporate culture of bank supervisors.', 'while ultimate goals and objectives remain the same, over the past several years, supervisors have been moving to more "incentive-compatible" approaches to 1) foster sound risk management within the institution rather than compliance with narrow rules and regulations, 2) minimize burden through the use of new examination approaches and internal risk measurement systems, and 3) reinforce market discipline.', 'fostering sound risk management key to almost all of these initiatives has been an increasing effort by supervisors to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation.', 'too often financial engineering has been targeted at regulatory arbitrage -- that is, the exploitation of loopholes in narrow regulatory policies are based on old traditional instruments, activities or business lines.', 'supervisors are increasingly recognizing that the underlying risk characteristics of a financial instrument, activity or business line are of primary importance and not what they are called or officially labelled.', 'to be sure, financial engineering can create derivative instruments which can combine component risks (including market, credit, liquidity, operational and reputational risks) in complex ways.', 'but seemingly simple traditional cash instruments can actually have higher risk profiles than many instruments that are formally labelled "derivatives."', 'in fact, the categorization of financial instruments and activities without regard to their underlying risk and economic functions can actually handicap sound management.', '- 2 - thus, federal reserve and other supervisors have increasingly issued supervisory guidance that emphasizes managing the risks involved in bank activities and de-emphasizes the supervisory focus on specific instruments or traditional products.', 'most recently, the ffiec published for industry comment a new policy statement that would eliminate the 1992 interagency policy that instituted the ffiec high risk test.', 'the older policy statement placed significant constraints on a depository institution\'s holding of certain "high-risk" mortgage securities that met specific market risk sensitivity tests.', 'the new policy would replace the high risk test with broader guidance on sound practices for managing all investment and end-user activities.', 'in essence, the new statement would allow an institution to hold any bank-eligible instrument as an investment as long as the institution had an adequate risk management process commensurate with the scope, complexity, and sophistication of its investment and end-user holdings.', 'the old ffiec high-risk tests offer an excellent case study of the potential pitfalls of narrow formulaic supervision in an age of dynamic financial engineering.', 'by requiring a pre-purchase price sensitivity analysis, the high risk test successfully helped institutions better understand the interest rate risk of certain mortgage securities.', 'it effectively constrained many smaller financial institutions from acquiring certain types of securities that subsequently created large losses for other investors.', 'however, while protecting some institutions, the tests may also have distorted the investment decision making process at other depository institutions.', 'concerns about burden and heightened examiner review of all types of mortgage securities may have led institutions to blindly eliminate them as potential investments -- regardless of the merits of their risk/return profiles.', 'also, by focusing only on certain products, the test provided incentives for institutions to acquire other types of securities with embedded options that required no testing.', 'such instruments were thought to have a supervisory "stamp of approval", but in fact often had risk characteristics similar to or greater than those designated as "high risk".', 'assuming positive industry comments, the ffiec hopes to implement the proposed new policy in early 1998. the comment period extends through november 17, and i encourage all of you to comment.', 'i might mention that the new policy will apply to all investment and end-user derivatives activities.', 'it illustrates that supervisors are increasingly emphasizing risk management on a portfolio rather than an instrument-specific basis.', 'although this is arguably the first principle of finance and is widely appreciated by bankers and regulators, putting this principle into practice in banking has not been easy.', 'past banking crises have, in part, reflected a failure to recognize or to prudently limit concentrations of risk.', 'however, technology and financial innovation are now enabling financial theories and conceptual techniques that have been around for decades to be put into practice to manage market, credit and liquidity risks.', 'moreover, these risks are increasingly being managed across activities and in some cases on a global basis.', 'this move to a broad portfolio or "macro" approach to managing risk has influenced bank supervisory efforts in several ways.', 'all three of the u.s. banking agencies now take a more "risk-focused" approach to bank supervision.', "bank exams are no longer exhaustive reviews of all of a bank's specific activities.", 'instead, they now take a more targeted approach to identifying and reviewing the sources of risk within a bank\'s "portfolio" of activities.', "exam resources are now targeted at evaluating the soundness of a bank's processes for managing risks and our supervisory tools have been enhanced in this direction.", 'increased use of internal measurement and management systems in addition, supervisors increasingly are relying on internal risk management systems, including increasingly sophisticated risk measurement systems used by banks to manage their businesses.', '- 3 - the objectives here are two-fold -- to help improve the effectiveness of our examinations and to reduce the burden on banking organizations.', 'examinations now involve significant off-site, pre-planning, analysis and fact finding.', "then the on-site examination activities include spot checks to determine the reliability of the bank's internal risk management system.", "to the extent examiners gain confidence in the bank's risk management process, they will place greater emphasis on the findings of the bank's internal auditors at an earlier stage in the examination process and focus resources in other areas.", 'an area of bank risk management systems that has been particularly useful to supervisors is risk measurement.', "no better example exists than the banking agencies' adoption of a risk assessment approach for evaluating capital adequacy for interest rate risk.", 'early on in that rulemaking process, supervisors recognized that a number of banking institutions had internal models for measuring interest rate risk that were much more sophisticated than any possible standardized regulatory model.', 'however, at the same time, supervisors were acutely aware that many other institutions had limited capabilities in this area and that many banks may have been hesitant to develop more sophisticated internal measurement systems prior to the determination of a supervisory approach.', 'accordingly, in 1993, supervisors proposed to use the results of internal models for evaluating the quantitative level of interest rate risk exposure at individual institutions.', 'while the rulemaking process was ultimately longer than desired, it did demonstrate the clear intent of supervisors to encourage and provide incentives for improvements in risk management and to take full advantage of such advances when possible.', 'i think most banks would agree that the discovery process and comment periods supervisors convened from 1993 through 1995, and the ensuing dialogue, spurred significant industry development and refinement of interest rate risk models.', 'a similar process evolved in developing the international capital standard for market risk in the trading activities of internationally active banks.', 'beginning next january, banks that meet certain qualitative and quantitative standards for risk management will calculate market risk capital charges for their trading activities on the basis of their own internal value at risk (var) measures.', 'here again, supervisors recognized early developments in the quantitative measurement of market risks, encouraged industry progress, and sought to build on the var concept when developing a supervisory approach.', 'during the discovery and rulemaking process the supervisory attention paid to var techniques led to more robust modelling and has helped spread the use of var techniques worldwide.', 'moving forward, perhaps such supervisory/private sector synergies can be gained in other areas of risk management, as well.', 'the quantification of credit risks, by far the most important risk in banking, may be a candidate.', 'at present, some institutions are making significant strides on a number of fronts to better quantify and manage credit risk.', 'in addition to major developments in credit scoring and the use of artificial intelligence in underwriting various types of consumer loans, a few banks are beginning to use historical data to estimate probability loss distributions for the credit risk of different quality commercial loans.', 'in some banks, credit risk-adjusted returns to capital are being used to construct a portfolio management framework for credit risk.', 'this, in turn, is providing a proving ground for a risk-adjusted pricing of loans as well as a myriad of new instruments such as credit derivatives.', 'while industry efforts to quantify credit risks are still in the early stages of evolution, recent progress holds promise for reducing both institutional and systemic risks.', 'indeed, these efforts might eventually lead to new supervisory regimes for addressing credit risk.', 'better methods of quantifying credit risk have significant potential for reducing the time examiners spend in on-site examinations.', 'moreover, advances in credit risk measurement may ultimately allow supervisors to design regulatory capital standards around internal models.', 'we recognize the inadequacy of the existing risk-based capital regime where such assets as loans are all treated as having the same risk.', 'we are actively encouraging the development of more quantitative approaches to credit risk management.', 'however, better regulatory tools are not yet available.', 'while supervisors can prod - 4 - developments in risk management, ultimately it will be up to the industry to find other ways to better measure and manage credit risk.', 'strengthening market discipline harnessing market forces to reinforce supervisory objectives is another important goal in the changing culture of supervisors.', 'reliable financial information and adequate disclosure of risk exposures is an essential ingredient to achieving this goal.', 'market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of counterparties and competitors.', "investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential.", 'sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles.', 'inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess fundamental financial strength.', 'it is this desire to see market discipline play a greater role in influencing banking activities that has prompted the federal reserve board to join the debate about the derivative accounting standards that are being developed by the financial accounting standards board (fasb).', 'everyone agrees that a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm as well as the economic substance of its activities.', 'however, the board believes that the application of market value accounting to business strategies where not appropriate, and particularly when applied on a piecemeal basis, or when market prices are not readily available, may lead to increased volatility or fluctuation in reported results.', "such accounting practices may actually obscure underlying trends or developments affecting a firm's condition and performance.", 'requiring companies to adopt market value accounting where it is not consistent with business strategies can cause them to incur significant costs to provide information that may not realistically reflect way underlying circumstances or trends in performance.', 'moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of meaningless accounting volatility from income statements and balance sheets can also impose significant costs without offsetting benefits.', 'the board believes that these problems can be minimized by having large firms with active trading portfolios place market values in supplemental disclosures rather than by forcing their use in the primary financial statements.', 'such an approach would give analysts the information they need, without imposing costs on an unnecessarily wide range of firms and without imposing the broader costs of having to reverse or "back out" the distorting effects of the proposed accounting standard.', 'emerging challenges to risk management without a doubt, banking institutions have made significant progress in implementing new techniques and methods in risk management.', 'to date, most work in this area has centered around the "science" of risk management -- that is, the quantitative measurement of risk.', 'however, quantitative measurement is only one element of the overall process of financial risk management.', 'other elements such as board and senior management oversight, internal controls, and the role of internal and external audits are just as important.', 'given the pace of technological and financial innovation, inadequate internal controls can expose an institution to significant risk.', 'indeed, inadequate management oversight, combined with a lack of internal controls, has been the primary cause of the losses experienced by several high profile major international banking organizations.', 'in some cases basic time-honored internal controls such as segmentation of duties and independent risk assessment had been ignored.', 'in others, internal management processes have failed to keep pace with technological development, financial innovation, and global expansion.', 'it is these "low tech" areas that pose continued challenges to risk management.', '- 5 - some institutions are beginning to address these challenges in their attempts to identify, monitor and control the operating risks of various business lines.', 'indeed, operating risk is quickly emerging as the next frontier of risk management.', 'while no clear standardized definition of operating risk has yet emerged, several progressive institutions are expending significant resources to address the operating risks inherent in particular business lines.', 'for some, this involves conducting extensive risk assessments throughout business and product lines to identify both the types of processing, information, and personnel risks that exist and the potential measures that can be taken to mitigate them.', 'others are buttressing these assessments with attempts actually to quantify and charge internal capital for operating risk exposures.', "supervisors can also be expected to more closely monitor banks' efforts to identify and manage operating risks.", 'one very important operating risk that all banking institutions face is the challenge of addressing the year 2000 issue.', 'u.s. banks appear to be taking this matter seriously and are generally well underway toward identifying individual needs and developing action plans.', 'the federal reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made.', 'meeting the demands of this review and ensuring proper remedies both before and after the year 2000 will be a significant and costly task to both the industry and the banking agencies.', 'however, even within the context of banking, the scope of the year 2000 problem extends far beyond u.s. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties.', 'banks and others need to address year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability.', 'at a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium.', 'if nothing else, it is simply good business.', 'summary in summary, advances in computerization and communications have created a paradigm shift for financial markets, the financial services industry, and the management of financial risks.', 'in response, supervisors are also moving to a new, more "incentive-compatible" regime of greater reliance on banks\' own risk measures and internal controls.', 'this transformation may be slow and will be challenging for all.', 'supervisors can encourage innovation, but the private sector must do much of the development work.', 'as always, a transition to an improved framework will work best with cooperative, open dialogue between the financial industry and its regulators, so that compatible and efficient answers are found.', "in today's markets, institutions and financial systems are linked as never before, and such connections are likely to grow in the years ahead.", 'how effectively institutions manage their risks and allocate their capital will have substantial consequences for economic growth.', 'we have seen significant progress in measuring market risk, and the groundwork is being laid for future gains in measuring credit risk, but those are only two risks.', 'operating risks such as fraud, human misjudgments, and the failure of information systems, processing operations and basic internal controls must be addressed comprehensively.', 'at this point, we can take satisfaction in the risk management strides we have made.', 'but i am confident that opportunities for even greater progress lie ahead.']	Susan M Phillips	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r971119b.pdf	Ms. Phillips discusses trends and challenges in Federal Reserve bank supervision (Central Bank Articles and Speeches, 30 Oct 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Houston Baptist University, Houston, Texas on 30/10/97.	1997-10-30 00:00:00	Ms. Phillips discusses trends and challenges in Federal Reserve bank supervision Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Houston Baptist University, Houston, Texas on 30/10/97. Trends and Challenges in Federal Reserve Bank Supervision I am pleased to be here today to talk with you about some of the important, fundamental changes taking place within the U.S. banking system and the effects those changes are having on the Federal Reserve's supervisory process. As you know, the U.S. economy and banking system have enjoyed more than half a decade of improving strength and prosperity in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While this situation is a vast improvement over conditions in earlier years, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. That's what makes supervising banks so interesting and such a challenge. When the economy and the banking industry are in difficulty, supervisors must identify and address immediate problems in an effort to protect the U.S. taxpayer and the federal safety net. When conditions are good, as they are today, supervisors have the opportunity to review their oversight process and promote sound practices for managing banking risks in an effort to avert or mitigate future problems. This and keeping up with the pace of financial innovation and industry change that has occurred in the past 5 to 10 years has been a challenge, indeed. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Any process that prevents all banking problems would be extremely invasive to banking organizations and would likely inhibit economic growth. As financial intermediaries, banks must take risks if they and their communities are to grow. As risk-takers, some banks will necessarily incur losses, and some will eventually fail. The objective is to contain the costs of risk-taking, both to individual institutions and to the safety net, more generally. Therefore, our goal as regulators is to help identify weak banking practices so that small or emerging problems can be addressed before they become large and costly. To do that in today's markets, and in an environment in which technology and financial innovation can lead to rapid change, the Federal Reserve is pursuing a more risk-focused supervisory approach. We are well underway toward implementing this new supervisory framework, and initial indications about it -- from both examiners and bankers -- have been favorable. This risk-focused approach to supervision is seen as a necessary response to a variety of factors: the growing complexity and pace of change within the industry, the increasingly global nature of U.S. and world financial markets, and the methods available today for managing and controlling risk. As banking practices and markets continue to evolve, I believe this emphasis on risk-focused supervision will be even more necessary in the years to come. What is "Risk-Focused" Supervision? With that introduction, let me clarify what I mean by risk-focused supervision. How does it differ from the way supervisors have traditionally done their job? What does it mean to the banking system? What is it? In short, risk-focused supervision simply means that in conducting bank examinations and other supervisory activities, we will seek to direct our attention and resources to the areas that we perceive pose the greatest risk to banks. In many respects, that would seem rather obvious and hardly earth shaking, and in many ways it is, indeed, nothing new. The Federal Reserve and the other banking agencies have long sought to identify exceptions and to prioritize examination activities. In the past, though, the business of bank supervision has focused on validating bank balance sheets, particularly the value of loan portfolios, which have been historically the principal source of problems for banks. Much of the prior emphasis was on determining the condition of a bank at a point in time. In the process, we would go through the balance sheet, assuring ourselves that a bank's assets and liabilities were essentially as stated and that its reserves and net worth were real. As part of the process, there was a review of sound management practices, internal controls, and strong internal audit activities, but that review was not the initial or primary focus. In earlier times that approach was adequate, since bank balance sheets were generally slow to change. Banks held their loans to maturity; they acquired deposits locally and at a pace similar to local economic growth; their product lines were stable; and management turnover, itself, was typically low. By tracking the quality of loans and other assets, examiners could generally detect deterioration and other business problems through their periodic on-site examinations. If done often enough, those examinations typically gave authorities sufficient time to take action and to either close or sell a bank before the losses became significant to the deposit insurance fund. Developments Driving Change During the past decade, though, the U.S. banking system experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with energy and agricultural sector difficulties or accumulating commercial real estate problems. I am sure that many of you here today can easily recall those times, and that these and other difficulties took a heavy toll -- if not in your own banks, in those of your competitors. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 banks on the FDIC problem list. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to rebuild their capital and reserves, strengthen their internal controls, diversify their risks, and improve their practices for identifying, underwriting, and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these mostly domestic events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought about an endless variety of derivative instruments, increased securitization, ATMs, and a broader range of banking products. By lowering information costs, they have also led to dramatic improvements in risk management and have expanded the marketing and service capabilities of banks and their competitors. In large part, these changes and innovations are unequivocally good for society and have produced more efficient markets and, in turn, greater international trade and economic growth. They have also, however, greatly increased the complexity of banking and bank supervision. In both cases, these developments have spurred the demand for highly trained and qualified personnel. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, due not only to technology and financial innovation, but also to legislative changes allowing interstate banking. The number of independent commercial banking organizations has declined 40 percent since 1980 to 7,400 in June of this year. While possibly stressful to many bankers and bank customers, this dramatic structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. A challenge now for many institutions may be to manage their growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand into more diverse or nontraditional banking activities, particularly through acquisitions. Growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers, while competing effectively with other regulated and unregulated firms. As you know, the Congress has been wrestling with the issue of banking powers for years and -- with the exception of interstate branching -- has yet to make much progress. The Federal Reserve has long believed that legislation is needed and that the industry can best move forward if this issue is resolved by lawmakers, rather than by regulators in a piecemeal fashion. Nevertheless, with or without legislation, we must all deal with changing markets and with the opportunities and pressures they present. Utilizing existing legislative authority, regulators have been able to approve new banking products that were not available a decade ago, as financial markets and products have evolved. However, whether future expansion comes through new laws or merely through new interpretations of current laws and regulations, it is important that the banking industry use its powers wisely and that its performance remain sound. Supervisory Challenges Ahead In supervising this "industry-in-transition", the Federal Reserve has no shortage of tasks, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of improving technology and financial techniques so that our oversight is not only effective, but also as unobtrusive and as appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach such issues as measuring capital adequacy and international convergence of supervisory standards. Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, the development of new financial products and the greater depth and liquidity of financial markets have enabled banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's on-going process for managing risk. The risk-focused approach, by definition, entails a more formal planning phase that identifies those areas and activities at risk that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and then, through off-site analysis, target areas of the portfolio for review. This revised process should be less disruptive to the daily activities of banks than earlier examination procedures and has the further advantage of reducing our own travel costs and improving examiner morale. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of bank information systems. The review of a bank's information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding their appetite for risk. As in the past, performance of substantive checks on the reliability of a bank's controls remains an important element of the examination process, albeit in a more automated and advanced form. For example, we are pursuing ways to make greater use of loan sampling in order to generate statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is providing itself with an accurate indication of the bank's condition. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and Federal Reserve examiners occurs between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18-month examination cycle. It also strengthens our ability to respond promptly if conditions deteriorate. Importantly, the Federal Reserve's examination staff indicates that this risk-focused process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Reserve Bank personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked our examiners to provide a specific supervisory rating for a bank's risk management process. This Fed initiative preceded, but is quite consistent with, the more recent interagency decision to add an "S" to the end of the CAMEL rating. That "S", as you know, addresses sensitivity to market risk and reflects in large part a bank's ability to manage that risk. Any managers in the audience who are with U.S. offices of foreign banks may appreciate that these rating changes simply highlight the importance of risk management that the Federal Reserve has for some time emphasized in its review of foreign banks. How effective is the risk-focused process? Since economic and industry conditions have been so favorable in recent years, there has not been a sufficiently stressful economic downturn to provide a robust test. The market volatility beginning in 1994 offered some insights about supervisory judgements of the risk management systems of large trading banks, but there have been few other indications. Even the rise to record levels of delinquencies and defaults on credit card debt may reflect factors other than the ability of supervisors to ensure that management has all the important bases covered. The real test, of course, would come with a major economic downturn. Even then, though, it will be hard to know what might have occurred had our oversight procedures not changed. Nevertheless, there are indications that both banking and supervisory practices are materially better now than they were in the 1980s and early 1990s. Because of technology and lower computer and communications costs, information is much more readily available than in earlier decades, and sound management practices are more widespread. Risk measurement and portfolio management techniques that were largely theoretical when some of us were in college are now fully operational in many banks. Moreover, the costly experience with bank and thrift failures in the early 1990s has not been forgotten. As a result, most bankers and business managers today have a greater appreciation, I believe, for the value of risk management and internal controls. To that point, we are finding, with increased frequency, that banks are designing personnel compensation systems to provide managers with greater incentives to control risk. Implementing a risk-focused supervisory approach has not been an easy task. It has required significant revisions to our broad and specialized training programs, including expansion of capital markets, risk assessment information technology, and global trading activities as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion examiners now have to focus their efforts on areas of highest risk, it has also become more important that we ensure the consistency and overall quality of our examinations. To address that point, we have developed automated examination tools, based on a decision-tree framework, that will help guide examiners through the procedures most relevant to individual banks, given their specific circumstances and risk profiles. Moreover, both domestically and abroad, the Federal Reserve is working with other bank supervisors and with the banking industry to develop sound practices for management for a variety of bank activities. Initiatives in recent years include guidance on disclosure and on managing interest rate risk and derivative activities. Such efforts, and the growing worldwide recognition of the value of market forces, should lead to clearer expectations of supervisors, greater reliance on market discipline, and less intrusive regulation. In that connection, the Federal Reserve in recent years has worked closely with the FDIC and with state banking departments to coordinate our examination procedures and supervisory practices. A prime example of these efforts is the adoption last year of the State and Federal Protocol, through which we all seek to achieve a relatively seamless supervisory process for banks operating across state lines. We are also working together on a variety of automation efforts, some of which I have referred to already. The Year 2000 Under the category of "problems we don't need", I find it difficult to talk with bankers these days without raising the "Year 2000" problem. Fortunately, most U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. Nevertheless, the Federal Reserve and the other federal banking agencies are actively reviewing the efforts of banks to address this vital issue. Some banks, particularly large ones, have stated, themselves, that if an institution is not already well underway toward resolving this problem, then it is already too late. I hope that all of you are giving this matter adequate attention, and are taking the steps necessary to ensure that changes are being made within your banks, and also by your vendors and customers. A critical aspect of the year 2000 problem is that we are all so inter-linked. Not only are we exposed to our own internal computer problems, but also to those with whom we do business. This matter has far-reaching implications for banks, covering not only operating risk, but also credit risk, liquidity risk, reputational risk, and others if material problems emerge. This is yet another illustration of the many challenges faced by bankers today. Conclusion In conclusion, the history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection that reflects the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. In many ways, however, the banking and financial system has changed dramatically in the past decade both in terms of its structure and the diversity of its activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years, specifically about the need to actively monitor, manage, and control risks. Through its supervisory process, the Federal Reserve seeks to maintain a proper balance: permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Maintaining responsible banking and responsible bank supervision is the key. We must all work to identify risks and to ensure they are adequately monitored and controlled. That result will lead to better banking practices, to more stable earnings and asset quality for the industry, and to less regulatory and legislative risk. These are goals we all share.	['ms. phillips discusses trends and challenges in federal reserve bank supervision remarks by ms. susan m. phillips, a member of the board of governors of the us federal reserve system, at houston baptist university, houston, texas on 30/10/97.', "trends and challenges in federal reserve bank supervision i am pleased to be here today to talk with you about some of the important, fundamental changes taking place within the u.s. banking system and the effects those changes are having on the federal reserve's supervisory process.", 'as you know, the u.s. economy and banking system have enjoyed more than half a decade of improving strength and prosperity in which u.s. banks have become better capitalized and more profitable than they have been in generations.', 'moreover, in the past 13 months not a single insured bank has failed, and the bank insurance fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance.', 'while this situation is a vast improvement over conditions in earlier years, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems.', "that's what makes supervising banks so interesting and such a challenge.", 'when the economy and the banking industry are in difficulty, supervisors must identify and address immediate problems in an effort to protect the u.s. taxpayer and the federal safety net.', 'when conditions are good, as they are today, supervisors have the opportunity to review their oversight process and promote sound practices for managing banking risks in an effort to avert or mitigate future problems.', 'this and keeping up with the pace of financial innovation and industry change that has occurred in the past 5 to 10 years has been a challenge, indeed.', 'as i begin my remarks, i would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail.', 'any process that prevents all banking problems would be extremely invasive to banking organizations and would likely inhibit economic growth.', 'as financial intermediaries, banks must take risks if they and their communities are to grow.', 'as risk-takers, some banks will necessarily incur losses, and some will eventually fail.', 'the objective is to contain the costs of risk-taking, both to individual institutions and to the safety net, more generally.', 'therefore, our goal as regulators is to help identify weak banking practices so that small or emerging problems can be addressed before they become large and costly.', "to do that in today's markets, and in an environment in which technology and financial innovation can lead to rapid change, the federal reserve is pursuing a more risk-focused supervisory approach.", 'we are well underway toward implementing this new supervisory framework, and initial indications about it -- from both examiners and bankers -- have been favorable.', 'this risk-focused approach to supervision is seen as a necessary response to a variety of factors: the growing complexity and pace of change within the industry, the increasingly global nature of u.s. and world financial markets, and the methods available today for managing and controlling risk.', 'as banking practices and markets continue to evolve, i believe this emphasis on risk-focused supervision will be even more necessary in the years to come.', 'what is "risk-focused" supervision?', 'with that introduction, let me clarify what i mean by risk-focused supervision.', 'how does it differ from the way supervisors have traditionally done their job?', 'what does it mean to the banking system?', 'in short, risk-focused supervision simply means that in conducting bank examinations and other supervisory activities, we will seek to direct our attention and resources to the areas that we perceive pose the greatest risk to banks.', 'in many respects, that would seem rather obvious and hardly earth shaking, and in many ways it is, indeed, nothing new.', 'the federal reserve and the other banking agencies have long sought to identify exceptions and to prioritize examination activities.', 'in the past, though, the business of bank supervision has focused on validating bank balance sheets, particularly the value of loan portfolios, which have been historically the principal source of problems for banks.', 'much of the prior emphasis was on determining the condition of a bank at a point in time.', "in the process, we would go through the balance sheet, assuring ourselves that a bank's assets and liabilities were essentially as stated and that its reserves and net worth were real.", 'as part of the process, there was a review of sound management practices, internal controls, and strong internal audit activities, but that review was not the initial or primary focus.', 'in earlier times that approach was adequate, since bank balance sheets were generally slow to change.', 'banks held their loans to maturity; they acquired deposits locally and at a pace similar to local economic growth; their product lines were stable; and management turnover, itself, was typically low.', 'by tracking the quality of loans and other assets, examiners could generally detect deterioration and other business problems through their periodic on-site examinations.', 'if done often enough, those examinations typically gave authorities sufficient time to take action and to either close or sell a bank before the losses became significant to the deposit insurance fund.', 'developments driving change during the past decade, though, the u.s. banking system experienced a great deal of turmoil, stress, and change.', "ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans.", 'at the same time, many of these institutions and smaller regional banks were struggling with energy and agricultural sector difficulties or accumulating commercial real estate problems.', 'i am sure that many of you here today can easily recall those times, and that these and other difficulties took a heavy toll -- if not in your own banks, in those of your competitors.', 'by the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 banks on the fdic problem list.', 'this experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs.', 'for their part, bankers recognized the need to rebuild their capital and reserves, strengthen their internal controls, diversify their risks, and improve their practices for identifying, underwriting, and managing risk.', 'supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well.', 'the fdic improvement act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge.', 'beyond these mostly domestic events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets.', 'these technologies have brought about an endless variety of derivative instruments, increased securitization, atms, and a broader range of banking products.', 'by lowering information costs, they have also led to dramatic improvements in risk management and have expanded the marketing and service capabilities of banks and their competitors.', 'in large part, these changes and innovations are unequivocally good for society and have produced more efficient markets and, in turn, greater international trade and economic growth.', 'they have also, however, greatly increased the complexity of banking and bank supervision.', 'in both cases, these developments have spurred the demand for highly trained and qualified personnel.', 'within the united states, our banking system has also experienced a dramatic consolidation in the number of banking institutions, due not only to technology and financial innovation, but also to legislative changes allowing interstate banking.', 'the number of independent commercial banking organizations has declined 40 percent since 1980 to 7,400 in june of this year.', 'while possibly stressful to many bankers and bank customers, this dramatic structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs.', 'a challenge now for many institutions may be to manage their growth and the continuing process of industry consolidation.', 'this challenge may be greatest as banking organizations expand into more diverse or nontraditional banking activities, particularly through acquisitions.', 'growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers, while competing effectively with other regulated and unregulated firms.', 'as you know, the congress has been wrestling with the issue of banking powers for years and -- with the exception of interstate branching -- has yet to make much progress.', 'the federal reserve has long believed that legislation is needed and that the industry can best move forward if this issue is resolved by lawmakers, rather than by regulators in a piecemeal fashion.', 'nevertheless, with or without legislation, we must all deal with changing markets and with the opportunities and pressures they present.', 'utilizing existing legislative authority, regulators have been able to approve new banking products that were not available a decade ago, as financial markets and products have evolved.', 'however, whether future expansion comes through new laws or merely through new interpretations of current laws and regulations, it is important that the banking industry use its powers wisely and that its performance remain sound.', 'supervisory challenges ahead in supervising this "industry-in-transition", the federal reserve has no shortage of tasks, despite the virtually unprecedented strong condition of the u.s. banking system today.', 'we, too, must deal with the evolving financial markets and advances in technology.', 'at the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of improving technology and financial techniques so that our oversight is not only effective, but also as unobtrusive and as appropriate as possible.', 'these tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach such issues as measuring capital adequacy and international convergence of supervisory standards.', 'constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the federal reserve and an objective we have sought to advance with our emphasis on risk-focused examinations.', 'particularly in the past decade, the development of new financial products and the greater depth and liquidity of financial markets have enabled banking organizations to change their risk profiles more rapidly than ever before.', "that possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's on-going process for managing risk.", 'the risk-focused approach, by definition, entails a more formal planning phase that identifies those areas and activities at risk that warrant the most extensive review.', "this pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and then, through off-site analysis, target areas of the portfolio for review.", 'this revised process should be less disruptive to the daily activities of banks than earlier examination procedures and has the further advantage of reducing our own travel costs and improving examiner morale.', "once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems.", "as a result, the federal reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of bank information systems.", "the review of a bank's information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding their appetite for risk.", "as in the past, performance of substantive checks on the reliability of a bank's controls remains an important element of the examination process, albeit in a more automated and advanced form.", "for example, we are pursuing ways to make greater use of loan sampling in order to generate statistically valid conclusions about the accuracy of a bank's internal loan review process.", "to the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is providing itself with an accurate indication of the bank's condition.", "moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high priority aspects of the institution's operations.", "a significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and federal reserve examiners occurs between examinations.", 'that approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18-month examination cycle.', 'it also strengthens our ability to respond promptly if conditions deteriorate.', "importantly, the federal reserve's examination staff indicates that this risk-focused process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of reserve bank personnel by perhaps 10 percent.", 'while those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications.', "complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management.", "since 1995, we have asked our examiners to provide a specific supervisory rating for a bank's risk management process.", 'this fed initiative preceded, but is quite consistent with, the more recent interagency decision to add an "s" to the end of the camel rating.', 'that "s", as you know, addresses sensitivity to market risk and reflects in large part a bank\'s ability to manage that risk.', 'any managers in the audience who are with u.s. offices of foreign banks may appreciate that these rating changes simply highlight the importance of risk management that the federal reserve has for some time emphasized in its review of foreign banks.', 'how effective is the risk-focused process?', 'since economic and industry conditions have been so favorable in recent years, there has not been a sufficiently stressful economic downturn to provide a robust test.', 'the market volatility beginning in 1994 offered some insights about supervisory judgements of the risk management systems of large trading banks, but there have been few other indications.', 'even the rise to record levels of delinquencies and defaults on credit card debt may reflect factors other than the ability of supervisors to ensure that management has all the important bases covered.', 'the real test, of course, would come with a major economic downturn.', 'even then, though, it will be hard to know what might have occurred had our oversight procedures not changed.', 'nevertheless, there are indications that both banking and supervisory practices are materially better now than they were in the 1980s and early 1990s.', 'because of technology and lower computer and communications costs, information is much more readily available than in earlier decades, and sound management practices are more widespread.', 'risk measurement and portfolio management techniques that were largely theoretical when some of us were in college are now fully operational in many banks.', 'moreover, the costly experience with bank and thrift failures in the early 1990s has not been forgotten.', 'as a result, most bankers and business managers today have a greater appreciation, i believe, for the value of risk management and internal controls.', 'to that point, we are finding, with increased frequency, that banks are designing personnel compensation systems to provide managers with greater incentives to control risk.', 'implementing a risk-focused supervisory approach has not been an easy task.', 'it has required significant revisions to our broad and specialized training programs, including expansion of capital markets, risk assessment information technology, and global trading activities as well as courses devoted exclusively to internal controls.', 'these education programs will, of course, need to be continually updated as industry activities and conditions evolve.', 'with the greater discretion examiners now have to focus their efforts on areas of highest risk, it has also become more important that we ensure the consistency and overall quality of our examinations.', 'to address that point, we have developed automated examination tools, based on a decision-tree framework, that will help guide examiners through the procedures most relevant to individual banks, given their specific circumstances and risk profiles.', 'moreover, both domestically and abroad, the federal reserve is working with other bank supervisors and with the banking industry to develop sound practices for management for a variety of bank activities.', 'initiatives in recent years include guidance on disclosure and on managing interest rate risk and derivative activities.', 'such efforts, and the growing worldwide recognition of the value of market forces, should lead to clearer expectations of supervisors, greater reliance on market discipline, and less intrusive regulation.', 'in that connection, the federal reserve in recent years has worked closely with the fdic and with state banking departments to coordinate our examination procedures and supervisory practices.', 'a prime example of these efforts is the adoption last year of the state and federal protocol, through which we all seek to achieve a relatively seamless supervisory process for banks operating across state lines.', 'we are also working together on a variety of automation efforts, some of which i have referred to already.', 'the year 2000 under the category of "problems we don\'t need", i find it difficult to talk with bankers these days without raising the "year 2000" problem.', 'fortunately, most u.s. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans.', 'nevertheless, the federal reserve and the other federal banking agencies are actively reviewing the efforts of banks to address this vital issue.', 'some banks, particularly large ones, have stated, themselves, that if an institution is not already well underway toward resolving this problem, then it is already too late.', 'i hope that all of you are giving this matter adequate attention, and are taking the steps necessary to ensure that changes are being made within your banks, and also by your vendors and customers.', 'a critical aspect of the year 2000 problem is that we are all so inter-linked.', 'not only are we exposed to our own internal computer problems, but also to those with whom we do business.', 'this matter has far-reaching implications for banks, covering not only operating risk, but also credit risk, liquidity risk, reputational risk, and others if material problems emerge.', 'this is yet another illustration of the many challenges faced by bankers today.', 'conclusion in conclusion, the history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection that reflects the role of banks in the credit intermediation process.', 'we can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change.', 'in many ways, however, the banking and financial system has changed dramatically in the past decade both in terms of its structure and the diversity of its activities.', 'risk management practices have also advanced, helped by technological and financial innovations.', 'i believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years, specifically about the need to actively monitor, manage, and control risks.', 'through its supervisory process, the federal reserve seeks to maintain a proper balance: permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability.', 'maintaining responsible banking and responsible bank supervision is the key.', 'we must all work to identify risks and to ensure they are adequately monitored and controlled.', 'that result will lead to better banking practices, to more stable earnings and asset quality for the industry, and to less regulatory and legislative risk.', 'these are goals we all share.']	Susan M Phillips	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r971119a.pdf	Mr. Kelley's testimony to the US House of Representatives Committee on Banking and Financial Services (Central Bank Articles and Speeches, 4 Nov 97)	Testimony by Mr. Edward W. Kelley Jr., a member of the Board of Governors of the US Federal Reserve System, before the Committee on Banking and Financial Services of the US House of Representatives, in Washington DC, on 4/11/97.	1997-11-04 00:00:00	Mr. Kelley's testimony to the US House of Representatives Committee on Testimony by Mr. Edward W. Kelley Jr., a member of the Board Banking and Financial Services of Governors of the US Federal Reserve System, before the Committee on Banking and Financial Services of the US House of Representatives, in Washington DC, on 4/11/97. I am pleased to appear before the Committee today to discuss the Federal Reserve's efforts to address the Year 2000 computer systems issue. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This afternoon I will focus on actions being taken by the Federal Reserve System to address our internal systems, coordination with the industry, and contingency planning. Background The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications are the Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) applications. The first two applications are large-value payments mechanisms for U.S. dollar interbank funds transfers and U.S. government securities transfers. Users of the applications are primarily depository institutions and government agencies. The Fedwire funds transfer system is a real-time credit transfer system used primarily for payments related to interbank funds transfers such as Fed funds transactions, interbank settlement transactions, and "third-party" payments between the customers of depository institutions. Funds transferred over Fedwire are immediately final; they cannot be revoked after they have been accepted and processed by the Federal Reserve. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $280 trillion. The current average total daily value of Fedwire funds transfers is approximately $1.1 trillion. The Fedwire securities transfer system supports the safekeeping, clearing, and settlement of U.S. government securities in both the primary and secondary markets. It provides custody of U.S. government securities in book-entry form, as well as the transfer of securities ownership among market participants. On the custody side, the system calculates and credits interest and principal payments to the holders of securities, reconciles outstanding securities balances with issuers, and performs other record keeping and collateral safekeeping functions. On the transfer side, the system delivers book-entry securities against a simultaneous payment, called delivery-versus-payment, thus reducing the settlement risks of market participants. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $160 trillion. The average total daily value of Fedwire securities transfers is about $650 billion. The ACH is an electronic payment service that supports both credit and debit transactions and is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Typical credit transactions include direct deposit of payroll and corporate payments to suppliers. Typical debit transactions include the collection of mortgage and loan payments and corporate cash concentration transactions. The ACH processes transactions in batches one or two days before they are scheduled to settle. ACH transactions are settled through depository institutions' accounts at the Federal Reserve Banks. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $12 trillion. About 3.3 billion of these payments were commercial transactions; 625 million payments were originated by the Federal government. The Reserve Banks' critical applications, such as Fedwire funds and securities transfer, ACH, and supporting accounting systems, run on mainframe computer systems operated by Federal Reserve Automation Services (FRAS), the internal organizational unit that processes applications on behalf of the Federal Reserve Banks and operates the Federal Reserve's national network. These critical applications are "centralized", that is, one copy of the application is used by all twelve Reserve Banks. In addition to centralized applications on the mainframe, the Federal Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as cash distribution, banking supervision and regulation, research, public information, and human resources. The Reserve Banks also operate check processing systems that provide check services to depository institutions and the U.S. government. A national communications network, called FEDNET, supports the exchange of information among the Reserve Banks, FRAS, and external organizations. The scope of the Federal Reserve's Year 2000 activities includes all of these processing environments and the supporting telecommunications network. Year 2000 Readiness It is crucial that the Federal Reserve provide reliable services to the nation's banking system and financial markets. The Federal Reserve is giving the Year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. We are taking a comprehensive approach to our preparedness which includes assessments of readiness, remediation, and testing. The Federal Reserve has completed application assessments and internal test plans, and we are currently renovating and testing software. We are also updating proven plans and techniques used during other times of operational stress in order to be prepared to address potential century date change difficulties. All Federal Reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. Further, critical financial services systems that interface with the depository institutions will be Year 2000-ready by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. A large cadre of top personnel in the Federal Reserve System have been assigned to this task. Our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated problems with internal systems, and enhancing our ability to respond to possible Year 2000-related operating failures of depository institutions. Assuring compliance internally is requiring review of approximately 90 million lines of computer code. While there are challenges and a great deal of work before us, I can report that we expect to be fully prepared for the century date change. The Federal Reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations. Our new centralized mission-critical applications, such as Fedwire funds transfer, Fedwire securities transfer, and ACH, were designed from inception with Year 2000 compliance in mind. The mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation. Like our counterparts in the private sector, the Federal Reserve System still faces substantial challenges in achieving Year 2000 readiness. These challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our Year 2000 activities. CDC Project Management According to industry experts, up to one-quarter of an organization's Year 2000 compliance efforts are devoted to project management. Managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements. In addition, Year 2000 preparations must address many computerized environmental and facilities management systems such as power, heating and cooling, voice communications, elevators, and vaults. Our Year 2000 project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. In 1995, a Federal Reserve System-wide project was initiated, referred to as the Century Date Change (CDC) project, to coordinate the efforts of the Reserve Banks, FRAS, and the Board of Governors. Our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, communication, and monitoring. Our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met. The readiness process involves performing risk assessments, modifying automated systems, and testing both internally and with depository institutions, service providers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. Some of our most senior executives are leading the project, and the Board and senior Bank management are now receiving formal, detailed status reports at least every 60 days. Any significant compliance issues will be reported to the Board immediately. The Reserve Banks' internal audit departments and the Board's oversight staff are also closely monitoring progress. A significant challenge in meeting our Year 2000 readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure is comprised of hardware and software products from third-party vendors. Additionally, the Federal Reserve utilizes commercial application software products and services for certain administrative functions and other operations. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000-ready. In many cases, compliance will require upgrading, or even replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well. These preparations also include careful attention to the Year 2000 readiness of telecommunications providers. Testing As we continue to assess our systems for Year 2000 readiness, we are well along in preparing a special central environment for testing our payment system applications. We are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies. These environments will enable testing for high-risk dates, such as the rollover to the year 2000 and leap year processing. Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Our test environments will be configured to provide flexible and nearly continuous access by customers. Network communications components are also being tested and certified in a special test lab environment at FRAS. The testing effort for Year 2000 readiness within the Federal Reserve will be extensive and complex. Industry experts estimate that testing for readiness will consume more than half of total Year 2000 project resources. To leverage existing resources and processes, we are modelling our Year 2000 testing on proven testing methods and processes. Our customers are already familiar with these processes and the testing environment. We shared our testing strategy with depository institutions in October of this year, and we are currently developing a coordinated test schedule. As I noted earlier, the Reserve Banks are targeting June 1998 to commence testing with their depository institution customers, which allows an 18-month time period for depository institutions to test their systems with the Federal Reserve. All of these activities require that we retain highly skilled staff critical to the success of the project. As I mentioned earlier, we have placed the highest priority on our CDC project, and, as such, have allocated many of the best managers and technical staff in the Federal Reserve System to work on the project. The information technology industry is already experiencing market pressures due to the increased demand for technical talent. As the millennium draws closer, the global market requirements for qualified personnel will intensify even further. We are responding as necessary to these market-induced pressures by implementing programs to retain staff members in critical, high-demand positions. Our focus at the Board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure. We are also working hard to address the supervisory issues raised by Year 2000 and are developing contingency plans which I will discuss later. Bank Supervision As a bank supervisor, the Federal Reserve has worked closely with the other supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise so that we can identify early and address problems that arise. Comptroller of the Currency Ludwig is testifying today as Chairman of the FFIEC to describe the interagency Year 2000 supervisory initiatives of all of the five member agencies (Federal Reserve, OCC, FDIC, OTS and NCUA), so I will limit my comments on the Federal Reserve's supervisory efforts. In May of this year, the Federal Reserve and the other regulatory agencies developed a uniform Year 2000 assessment questionnaire to collect information on a national basis. Based on the responses and other information, we believe the banking industry's awareness level improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated. Generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change. Many larger banks are already renovating their operating systems and have commenced testing of their critical applications. Large organizations seem generally capable of renovating their critical operating systems by year-end 1998, and will have their testing well underway by then. Smaller banks, including the U.S. offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less measurable and is being carefully monitored. We are directing significant attention to ensure that these banks intensify their efforts to prepare for the Year 2000. Major third-party service providers and software vendors serving the banking industry are acutely aware of the issue and are working diligently to address it. Most of these suppliers consider their Year 2000 capability to be a business survival issue, as it is of critical importance to their ability to remain competitive in an aggressive industry. By mid-year 1998 we will have conducted a thorough Year 2000 preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. As we proceed through the examination process, we are identifying any institutions that require intensified supervisory attention and establishing our priorities for subsequent examinations. International Awareness With regard to the international aspects of the Year 2000 issue, U.S. offices of foreign banks pose a unique set of challenges. We are concerned about the possibility that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem, and may not as yet have committed the resources necessary to address the issues effectively. This is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems. In addition, we are increasingly concerned that the foreign branches of U.S. banks may be adversely affected if counterparties in foreign markets are not ready for the Year 2000. Therefore, we are working through the Bank for International Settlements' (BIS) Committee on Banking Supervision, composed of many of the international supervisory agencies responsible for the foreign banks that operate in the United States. Through formal and informal discussions, the distribution of several interagency statements and advisories, and the Federal Reserve's Year 2000 video (see below) to the BIS supervisors committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by the century date change. The G-10 governors issued an advisory in September that included a paper by the bank supervisors committee on the Year 2000 challenge to banks and bank supervisors around the world to ensure a higher level of awareness and activity on their part. The BIS supervisors committee has developed a survey sent to about 40 countries to collect better information on the state of readiness of banks in those countries and the extent of the efforts of the bank supervisors to address the issues locally and internationally. The surveys will be evaluated and the findings distributed early next year. Also on the international front, William McDonough, President of the Federal Reserve Bank of New York, in a keynote address to the annual meeting of the Institute of International Finance in Hong Kong, emphasized the importance of planning for the century date change on an international basis and the significant risk to financial markets posed by the Year 2000. We also participated in the BIS meeting sponsored by the Committee on Payments and Settlement Systems and the Group of Computer Experts for G-10 and major non-G-10 central banks in September which provided a forum to share views on and approaches to dealing with Year 2000 issues, and we have been active in various private sector forums. The majority of foreign central banks are confident that payment and settlement applications under their management will be Year 2000-ready. Like the Federal Reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication service providers. The approach of foreign central banks toward raising bank industry awareness varies widely. Information garnered from this meeting and similar meetings planned for the future will assist the BIS Committee on Payment and Settlement Systems, as well as the Federal Reserve, in understanding the state of preparedness of payment systems on a global level. Public Awareness We are mindful that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We continue to advise our bank customers of the Federal Reserve's plans and time frames for making our software Year 2000-ready. We have inaugurated a Year 2000 industry newsletter and have just published our first bulletin addressing specific technical issues. We would be glad to provide you with copies of our recent newsletter and the bulletin. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. The FFIEC Year 2000 Web site can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness" intended for viewing by a bank's board of directors and senior management. The video presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In my introductory remarks on the video, I note that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video can be ordered through the Board's Web site. Contingency Planning While we will continue our public outreach efforts, our main focus is preparedness. Because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is on our readiness and the avoidance of problems. But we know from experience that upon occasion, things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. In this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions. Moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be appropriately positioned to deal with similar problems in the financial sector that might arise as a result of CDC. However, CDC presents many unique situations. For example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option. We are, of course, developing specific CDC contingency plans to address various operational scenarios, and our contingency planning includes preparation to address unanticipated problems when we bring our systems into production as Year 2000 begins. Key technical staff will be ready to respond quickly to problems with our computer and network systems. We are establishing procedures with our primary vendors to ensure direct communication and appropriate recourse should their products fail at Federal Reserve installations during Year 2000 date processing. Our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry. We already have arrangements in place to assist financial institutions in the event they are unable to access their own systems. For example, we are able to provide financial institutions with access to Federal Reserve computer terminals on a limited basis for the processing of critical funds transfers. This contingency arrangement has proven highly effective when used from time to time by depository institutions experiencing major hardware/software outages or that have had their operations disrupted due to natural disasters such as the Los Angeles earthquake, hurricane Hugo in the Carolinas, and hurricane Andrew in south Florida. In these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community, and we arranged for our operations to function virtually without interruptions for 24 hours a day during the crisis period. We feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by the century date change. We are formulating responses for augmenting certain functions, such as computer help desk services and off-line funds transfers, to respond to short-term needs for these services. Beyond reliance on a sound plan and effective execution of the plan, the Federal Reserve provides several different payment services, such as Fedwire, ACH, check, and cash; therefore, the banking industry is not totally dependent upon any single system for executing payments. Alternatives are available in the event of a disruption in a segment of the electronic payment system. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and would not necessarily involve funding shortfalls. Nevertheless, the Federal Reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The Federal Reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall. Our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the U.S. that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall. Closing Remarks As I indicated at the outset, the Federal Reserve views its Year 2000 preparations with great seriousness. As such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. We believe that we are well-positioned to meet our objectives and will remain vigilant throughout the process. As a bank supervisor, the Federal Reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance. Lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of Year 2000 issues and provide for the sharing of experiences, ideas, and best practices.	["mr. kelley's testimony to the us house of representatives committee on testimony by mr. edward w. kelley jr., a member of the board banking and financial services of governors of the us federal reserve system, before the committee on banking and financial services of the us house of representatives, in washington dc, on 4/11/97.", "i am pleased to appear before the committee today to discuss the federal reserve's efforts to address the year 2000 computer systems issue.", 'the federal reserve system has developed and is executing a comprehensive plan to ensure its own year 2000 readiness and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry.', 'this afternoon i will focus on actions being taken by the federal reserve system to address our internal systems, coordination with the industry, and contingency planning.', 'background the federal reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the united states.', 'three of these applications are the fedwire funds transfer, fedwire securities transfer, and automated clearing house (ach) applications.', 'the first two applications are large-value payments mechanisms for u.s. dollar interbank funds transfers and u.s. government securities transfers.', 'users of the applications are primarily depository institutions and government agencies.', 'the fedwire funds transfer system is a real-time credit transfer system used primarily for payments related to interbank funds transfers such as fed funds transactions, interbank settlement transactions, and "third-party" payments between the customers of depository institutions.', 'funds transferred over fedwire are immediately final; they cannot be revoked after they have been accepted and processed by the federal reserve.', 'about 10,000 depository institutions use the fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $280 trillion.', 'the current average total daily value of fedwire funds transfers is approximately $1.1 trillion.', 'the fedwire securities transfer system supports the safekeeping, clearing, and settlement of u.s. government securities in both the primary and secondary markets.', 'it provides custody of u.s. government securities in book-entry form, as well as the transfer of securities ownership among market participants.', 'on the custody side, the system calculates and credits interest and principal payments to the holders of securities, reconciles outstanding securities balances with issuers, and performs other record keeping and collateral safekeeping functions.', 'on the transfer side, the system delivers book-entry securities against a simultaneous payment, called delivery-versus-payment, thus reducing the settlement risks of market participants.', 'about 8,000 depository institutions use the fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $160 trillion.', 'the average total daily value of fedwire securities transfers is about $650 billion.', 'the ach is an electronic payment service that supports both credit and debit transactions and is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers.', 'typical credit transactions include direct deposit of payroll and corporate payments to suppliers.', 'typical debit transactions include the collection of mortgage and loan payments and corporate cash concentration transactions.', 'the ach processes transactions in batches one or two days before they are scheduled to settle.', "ach transactions are settled through depository institutions' accounts at the federal reserve banks.", 'approximately 4 billion ach transactions were processed in 1996 with a total value of approximately $12 trillion.', 'about 3.3 billion of these payments were commercial transactions; 625 million payments were originated by the federal government.', "the reserve banks' critical applications, such as fedwire funds and securities transfer, ach, and supporting accounting systems, run on mainframe computer systems operated by federal reserve automation services (fras), the internal organizational unit that processes applications on behalf of the federal reserve banks and operates the federal reserve's national network.", 'these critical applications are "centralized", that is, one copy of the application is used by all twelve reserve banks.', 'in addition to centralized applications on the mainframe, the federal reserve banks operate a range of applications in a distributed computing environment, supporting business functions such as cash distribution, banking supervision and regulation, research, public information, and human resources.', 'the reserve banks also operate check processing systems that provide check services to depository institutions and the u.s. government.', 'a national communications network, called fednet, supports the exchange of information among the reserve banks, fras, and external organizations.', "the scope of the federal reserve's year 2000 activities includes all of these processing environments and the supporting telecommunications network.", "year 2000 readiness it is crucial that the federal reserve provide reliable services to the nation's banking system and financial markets.", "the federal reserve is giving the year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations.", 'we are taking a comprehensive approach to our preparedness which includes assessments of readiness, remediation, and testing.', 'the federal reserve has completed application assessments and internal test plans, and we are currently renovating and testing software.', 'we are also updating proven plans and techniques used during other times of operational stress in order to be prepared to address potential century date change difficulties.', 'all federal reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. further, critical financial services systems that interface with the depository institutions will be year 2000-ready by mid-1998.', 'this schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources.', 'a large cadre of top personnel in the federal reserve system have been assigned to this task.', 'our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated problems with internal systems, and enhancing our ability to respond to possible year 2000-related operating failures of depository institutions.', 'assuring compliance internally is requiring review of approximately 90 million lines of computer code.', 'while there are challenges and a great deal of work before us, i can report that we expect to be fully prepared for the century date change.', 'the federal reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations.', 'our new centralized mission-critical applications, such as fedwire funds transfer, fedwire securities transfer, and ach, were designed from inception with year 2000 compliance in mind.', 'the mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation.', 'like our counterparts in the private sector, the federal reserve system still faces substantial challenges in achieving year 2000 readiness.', 'these challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, and establishing contingency plans.', 'we are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our year 2000 activities.', "cdc project management according to industry experts, up to one-quarter of an organization's year 2000 compliance efforts are devoted to project management.", 'managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements.', 'in addition, year 2000 preparations must address many computerized environmental and facilities management systems such as power, heating and cooling, voice communications, elevators, and vaults.', 'our year 2000 project is being closely coordinated among the reserve banks, the board of governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies.', 'in 1995, a federal reserve system-wide project was initiated, referred to as the century date change (cdc) project, to coordinate the efforts of the reserve banks, fras, and the board of governors.', 'our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, communication, and monitoring.', 'our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met.', 'the readiness process involves performing risk assessments, modifying automated systems, and testing both internally and with depository institutions, service providers, and government agencies.', 'we are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally.', 'some of our most senior executives are leading the project, and the board and senior bank management are now receiving formal, detailed status reports at least every 60 days.', 'any significant compliance issues will be reported to the board immediately.', "the reserve banks' internal audit departments and the board's oversight staff are also closely monitoring progress.", 'a significant challenge in meeting our year 2000 readiness objectives is our reliance on commercial hardware and software products and services.', 'much of our information processing and communications infrastructure is comprised of hardware and software products from third-party vendors.', 'additionally, the federal reserve utilizes commercial application software products and services for certain administrative functions and other operations.', 'as a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are year 2000-ready.', 'in many cases, compliance will require upgrading, or even replacing, equipment and software.', 'we have a complete inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well.', 'these preparations also include careful attention to the year 2000 readiness of telecommunications providers.', 'testing as we continue to assess our systems for year 2000 readiness, we are well along in preparing a special central environment for testing our payment system applications.', 'we are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies.', 'these environments will enable testing for high-risk dates, such as the rollover to the year 2000 and leap year processing.', 'testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions.', 'our test environments will be configured to provide flexible and nearly continuous access by customers.', 'network communications components are also being tested and certified in a special test lab environment at fras.', 'the testing effort for year 2000 readiness within the federal reserve will be extensive and complex.', 'industry experts estimate that testing for readiness will consume more than half of total year 2000 project resources.', 'to leverage existing resources and processes, we are modelling our year 2000 testing on proven testing methods and processes.', 'our customers are already familiar with these processes and the testing environment.', 'we shared our testing strategy with depository institutions in october of this year, and we are currently developing a coordinated test schedule.', 'as i noted earlier, the reserve banks are targeting june 1998 to commence testing with their depository institution customers, which allows an 18-month time period for depository institutions to test their systems with the federal reserve.', 'all of these activities require that we retain highly skilled staff critical to the success of the project.', 'as i mentioned earlier, we have placed the highest priority on our cdc project, and, as such, have allocated many of the best managers and technical staff in the federal reserve system to work on the project.', 'the information technology industry is already experiencing market pressures due to the increased demand for technical talent.', 'as the millennium draws closer, the global market requirements for qualified personnel will intensify even further.', 'we are responding as necessary to these market-induced pressures by implementing programs to retain staff members in critical, high-demand positions.', 'our focus at the board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure.', 'we are also working hard to address the supervisory issues raised by year 2000 and are developing contingency plans which i will discuss later.', 'bank supervision as a bank supervisor, the federal reserve has worked closely with the other supervisory agencies that are part of the federal financial institutions examination council (ffiec) to alert the industry to our concerns and to monitor year 2000 preparations of the institutions we supervise so that we can identify early and address problems that arise.', "comptroller of the currency ludwig is testifying today as chairman of the ffiec to describe the interagency year 2000 supervisory initiatives of all of the five member agencies (federal reserve, occ, fdic, ots and ncua), so i will limit my comments on the federal reserve's supervisory efforts.", 'in may of this year, the federal reserve and the other regulatory agencies developed a uniform year 2000 assessment questionnaire to collect information on a national basis.', "based on the responses and other information, we believe the banking industry's awareness level improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated.", "generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change.", 'many larger banks are already renovating their operating systems and have commenced testing of their critical applications.', 'large organizations seem generally capable of renovating their critical operating systems by year-end 1998, and will have their testing well underway by then.', 'smaller banks, including the u.s. offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less measurable and is being carefully monitored.', 'we are directing significant attention to ensure that these banks intensify their efforts to prepare for the year 2000. major third-party service providers and software vendors serving the banking industry are acutely aware of the issue and are working diligently to address it.', 'most of these suppliers consider their year 2000 capability to be a business survival issue, as it is of critical importance to their ability to remain competitive in an aggressive industry.', 'by mid-year 1998 we will have conducted a thorough year 2000 preparedness examination of every bank, u.s. branch and agency of a foreign bank, and service provider that we supervise.', "our examination program includes a review of each organization's year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan.", 'as we proceed through the examination process, we are identifying any institutions that require intensified supervisory attention and establishing our priorities for subsequent examinations.', 'international awareness with regard to the international aspects of the year 2000 issue, u.s. offices of foreign banks pose a unique set of challenges.', 'we are concerned about the possibility that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem, and may not as yet have committed the resources necessary to address the issues effectively.', 'this is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems.', "in addition, we are increasingly concerned that the foreign branches of u.s. banks may be adversely affected if counterparties in foreign markets are not ready for the year 2000. therefore, we are working through the bank for international settlements' (bis) committee on banking supervision, composed of many of the international supervisory agencies responsible for the foreign banks that operate in the united states.", "through formal and informal discussions, the distribution of several interagency statements and advisories, and the federal reserve's year 2000 video (see below) to the bis supervisors committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by the century date change.", 'the g-10 governors issued an advisory in september that included a paper by the bank supervisors committee on the year 2000 challenge to banks and bank supervisors around the world to ensure a higher level of awareness and activity on their part.', 'the bis supervisors committee has developed a survey sent to about 40 countries to collect better information on the state of readiness of banks in those countries and the extent of the efforts of the bank supervisors to address the issues locally and internationally.', 'the surveys will be evaluated and the findings distributed early next year.', 'also on the international front, william mcdonough, president of the federal reserve bank of new york, in a keynote address to the annual meeting of the institute of international finance in hong kong, emphasized the importance of planning for the century date change on an international basis and the significant risk to financial markets posed by the year 2000. we also participated in the bis meeting sponsored by the committee on payments and settlement systems and the group of computer experts for g-10 and major non-g-10 central banks in september which provided a forum to share views on and approaches to dealing with year 2000 issues, and we have been active in various private sector forums.', 'the majority of foreign central banks are confident that payment and settlement applications under their management will be year 2000-ready.', 'like the federal reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication service providers.', 'the approach of foreign central banks toward raising bank industry awareness varies widely.', 'information garnered from this meeting and similar meetings planned for the future will assist the bis committee on payment and settlement systems, as well as the federal reserve, in understanding the state of preparedness of payment systems on a global level.', 'public awareness we are mindful that extensive communication with the industry and the public is crucial to the success of century date change efforts.', "our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness.", "we continue to advise our bank customers of the federal reserve's plans and time frames for making our software year 2000-ready.", 'we have inaugurated a year 2000 industry newsletter and have just published our first bulletin addressing specific technical issues.', 'we would be glad to provide you with copies of our recent newsletter and the bulletin.', "we have also established an internet web site to provide depository institutions with information regarding the federal reserve system's cdc project.", 'this site can be accessed at the following internet address: http://www.frbsf.org/fiservices/cdc.', 'on behalf of the ffiec, the federal reserve has developed a year 2000 information distribution system, including an internet web site and a toll free fax back service (888-882-0982).', 'the web site provides easy access to policy statements, guidance to examiners, and paths to other year 2000 web sites available from numerous other sources.', 'the ffiec year 2000 web site can be accessed at the following internet address: http://www.ffiec.gov/y2k.', 'the federal reserve has also produced a ten-minute video entitled "year 2000 executive awareness" intended for viewing by a bank\'s board of directors and senior management.', 'the video presents a summary of the year 2000 five-phase project management plan outlined in the interagency policy statement.', 'in my introductory remarks on the video, i note that senior bank officials should be directly involved in managing the year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis.', "the video can be ordered through the board's web site.", 'contingency planning while we will continue our public outreach efforts, our main focus is preparedness.', 'because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is on our readiness and the avoidance of problems.', 'but we know from experience that upon occasion, things can go wrong.', "given our unique role as the nation's central bank, the federal reserve has always stressed contingency planning -- for both systemic risks as well as operational failures.", 'in this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions.', 'moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be appropriately positioned to deal with similar problems in the financial sector that might arise as a result of cdc.', 'however, cdc presents many unique situations.', 'for example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option.', 'we are, of course, developing specific cdc contingency plans to address various operational scenarios, and our contingency planning includes preparation to address unanticipated problems when we bring our systems into production as year 2000 begins.', 'key technical staff will be ready to respond quickly to problems with our computer and network systems.', 'we are establishing procedures with our primary vendors to ensure direct communication and appropriate recourse should their products fail at federal reserve installations during year 2000 date processing.', 'our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry.', 'we already have arrangements in place to assist financial institutions in the event they are unable to access their own systems.', 'for example, we are able to provide financial institutions with access to federal reserve computer terminals on a limited basis for the processing of critical funds transfers.', 'this contingency arrangement has proven highly effective when used from time to time by depository institutions experiencing major hardware/software outages or that have had their operations disrupted due to natural disasters such as the los angeles earthquake, hurricane hugo in the carolinas, and hurricane andrew in south florida.', 'in these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community, and we arranged for our operations to function virtually without interruptions for 24 hours a day during the crisis period.', 'we feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by the century date change.', 'we are formulating responses for augmenting certain functions, such as computer help desk services and off-line funds transfers, to respond to short-term needs for these services.', 'beyond reliance on a sound plan and effective execution of the plan, the federal reserve provides several different payment services, such as fedwire, ach, check, and cash; therefore, the banking industry is not totally dependent upon any single system for executing payments.', 'alternatives are available in the event of a disruption in a segment of the electronic payment system.', 'we recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others.', 'these problems could be manifested in a number of ways and would not necessarily involve funding shortfalls.', 'nevertheless, the federal reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market.', 'the federal reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available.', 'the terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall.', 'our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the u.s. that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank.', 'such circumstances would necessitate coordination with the home country supervisor.', 'moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall.', 'closing remarks as i indicated at the outset, the federal reserve views its year 2000 preparations with great seriousness.', 'as such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial systems we operate.', 'while we have made significant progress and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using federal reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion.', 'in particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience.', 'we believe that we are well-positioned to meet our objectives and will remain vigilant throughout the process.', "as a bank supervisor, the federal reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance.", 'lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of year 2000 issues and provide for the sharing of experiences, ideas, and best practices.']	Edward W Kelley, Jr	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r971112b.pdf	Mr. Macfarlane's statement to the House of Representatives Standing Committee on Financial Institutions and Public Administration (Central Bank Articles and Speeches, 6 Nov 97)	Statement by the Governor of the Reserve Bank of Australia, Mr. Ian Macfarlane, to the House of Representatives Standing Committee on Financial Institutions and Public Administration in Sydney on 6/11/97.	1997-11-06 00:00:00	Mr. Macfarlane's statement to the House of Representatives Standing Committee on Financial Institutions and Public Administration Statement by the Governor of the Reserve Bank of Australia, Mr. Ian Macfarlane, to the House of Representatives Standing Committee on Financial Institutions and Public Administration in Sydney on 6/11/97. Thank you, Mr Chairman. It is a pleasure to be here in front of your Committee for the second time under the new arrangements set out in the Statement on the Conduct of Monetary Policy. On the basis of the first hearing, we think the new arrangements are working very well. On that occasion, we received some very penetrating and constructive questioning from Committee members, and there seemed to be quite a lot of public interest in the proceedings. Of course, we should always be trying to improve our procedures, but the only improvement we have been able to make on this occasion is to get our half-yearly report to the Committee two hours ahead of the hearing, compared with one hour last time. You will appreciate that in order to follow due process we cannot finalise the document until after our Board Meeting which was on Tuesday. I should also say that I was hoping that we might have been able to have this hearing somewhere other than Sydney. While it is very convenient for us to be meeting again in the New South Wales Parliament House about 100 metres from my office, we see merit in this hearing moving to other State capitals and Canberra on a regular basis if that is possible. The main reason for these hearings is to improve the accountability of the Reserve Bank, both directly to Parliament, and via the press coverage to the public more generally. In the spirit of increased accountability, I should, I suppose, be accountable for what I said to this Committee at the previous hearing, as well as for what I am going to say today. I covered a number of subjects at the previous hearing which I thought were important for an understanding of how the economy was going to perform over coming years. I also mentioned a couple of outcomes we expected for 1997. It is those which will probably be of the most immediate interest. I said that, after a sluggish 1996 where GDP had grown at about 3 per cent -- at one point, it got to not much more than 2 per cent on a 12-months-ended basis, we should expect it to pick up to about 4 per cent in 1997. I also said that I expected inflation to stay at the bottom of the 2-3 per cent range, with the possibility that it could go a little lower for a while. Now I think I could be excused for wanting to walk away from earlier forecasts as a result of the current turmoil in Asian and world financial markets. While I intend to say quite a lot about those events later on, I do not propose to invoke that excuse at this stage, because they have not had any effect on the economy to date. They have affected financial markets, but not the economy yet. Instead, I want to start by saying that the baseline we have to work from, i.e., the growth of the economy in the first three quarters of 1997, has been at least as good as I was pointing to in May, if not a little better. • We now have the GDP growth rates for the first two quarters of 1997, which show the economy grew at an annual rate of nearly 4 per cent during that time. And we have further monthly figures for the September quarter which are somewhat stronger than those recorded during the first half of the year. This is true for the major monthly indicators such as retail trade, imports and exports. It is also true for the labour market, especially for vacancies, and to some extent also for employment. There is also evidence from the business surveys that confidence is picking up, but these surveys were generally compiled before the Asian headlines of a fortnight ago. • On inflation, the outlook changed a little. New figures brought underlying inflation below 2 per cent, and our on-going assessment caused us to lower our forecasts. As a result, we have had two further easings of monetary policy -- one in May and one in July. An important reason for the lower inflation forecasts was the better outlook for wages. You may recall that shortly after the previous hearing in May we received revised figures on earnings from the ABS that suggested not only that they were lower in the quarter in question -- the March quarter of 1997 -- but that an upward trend had been revised away. This better picture was confirmed again in the June quarter figures, but the picture has been muddied somewhat by the recent September quarter figures which show an unexpectedly strong rise. On balance, therefore, we at the Bank judged that the information becoming available over the past six months was tending to confirm this relatively benign view of the future -- GDP growth of about 4 per cent (enough for some further reduction in unemployment from the 8.8 per cent we had at the time of the last hearing) and inflation a little below 2 per cent (enough to justify the May and July easings in monetary policy). The picture was not all rosy -- the slower output growth of 1996 was still making its presence felt in the form of sluggish employment growth in the first half of 1997, there were some doubts about the strength of investment, and the effects of El Niño were around the corner. But economies nearly always present a mixed picture, and this mixture was a lot better than most. In addition, financial conditions had become clearly easier than in May. The overnight cash rate had come down from 6 per cent to 5 per cent as a result of the two easings of monetary policy, and yields on 10-year bonds were down from 73⁄4 per cent to 6 per cent. The exchange rate against the US dollar has come down from 77.7 US cents to 70.3 US cents; against the trade-weighted index, it has come down from 60.2 to 57.0. I come now to the point where I should say a few things about what has been happening in Asia and the rest of the world. I will do my best to be specific, but you should bear in mind that the ground is constantly changing. The first thing I would like to say is that in the long run I am still very optimistic about Asian growth prospects. These countries still retain a set of characteristics that are conducive to long-run growth: • they can still achieve rapid productivity growth through technology transfer, i.e., they have started from a long way behind and have a fair way to go; • they are oriented towards international trade; • they have high savings rates and high investment and a relatively small government sector; they have generally sound fiscal and monetary policies -- although they have got some • way to go in terms of the soundness of their banking and financial sectors; and • they have great respect for, and devote considerable effort to, education. I do not see the end of the Asian miracle, partly because I do not think it ever was a miracle; it was just the application of some tried and tested rules of good economic policy. It is still fortunate for our long-run prosperity that we have strong links to Asia. Having declared my optimism about the long run, I should now turn to the short run. Clearly, there are going to be difficulties here, in particular among four ASEAN countries -- Thailand, Malaysia, Indonesia and the Philippines. From the moment the Thai baht was floated on 2 July, attention quickly broadened to encompass these four. Their currencies have fallen sharply, as have their stock markets and property prices. These countries are battening down the hatches -- in two cases with the help of the IMF -- to sort out their problems. The principal problem, it is now apparent, concerns how to handle the fall of previously over-inflated asset prices, undisciplined lending by local banks and foreigners, and some very opaque inter-relationships between business and government which have obscured the true financial position of a lot of companies and banks. There also appears to have been over-investment in some areas. Property played its usual major role, but on this occasion there were also more contemporary avenues, particularly electronics and semi-conductors, where there is clear over-capacity and intense competition among these countries (and with Korea and Taiwan). Of course, these problems have been around for years -- they did not just start on 2 July. A part of this adjustment must inevitably involve a sharp curtailment of growth in the short run and a contraction of credit. Imports will fall, and so the effects will be spread to other countries. The good news for Australia is that these four countries account for only 10 per cent of Australia's exports. If the difficulties remain confined to these four countries, the effect on Australia's exports, and hence our growth, would be modest. The rest of Asia is, in fact, a lot more important to Australia. Japan -- our largest market -- has been limping along at an average annual growth rate of about 1 per cent now for about five years. Our exports to Japan have virtually not increased at all during that period. The other big Asian markets for Australia are Korea, China, Taiwan and Hong Kong. These are collectively much more important than the ASEAN four. Of course, some of the underlying problems that afflict the ASEAN four also apply, although more modestly, to some of these countries. For a time, it looked as though the ASEAN problems would spill over to these in a big way, but that seems less likely now, although we should not speak too soon. Even so, we should build in the assumption of some slowing in aggregate for these countries. To judge the effects on Australia, we should, in principle, have a view on how each country will fare in regard to economic growth, imports and the health of their banking systems (and we should look outside Asia, which I will do later). It is never easy and some sure bets turn out to be wrong. For example, virtually everyone thought the simultaneous share market crash of 1987 and associated company failures would presage at least a slowdown, if not a recession. In the event, 1988 turned out to be a boom year for the OECD economy and for Australia. Let us hope we can be a little closer to the mark this time. Most analysis to date has consisted of a relatively mechanical application of lower growth and lower imports among the ASEAN four to lower Australian exports and lower Australian GDP growth. The orders of magnitudes are quite small and the most commonly cited figure for GDP growth in Australia is a reduction of about a quarter of a percentage point. According to press reports, the OECD has recently suggested figures of 0.3 per cent for Australia in 1997 and 0.4 per cent in 1998. Quite how they got an effect on 1997, which we are already 80 per cent through, I do not know, but, as I said, I am only relying on newspaper reports. These sorts of figures can become considerably larger if we also bring in lower growth rates for Korea, China, etc., but we are getting into the realms of speculation if we do so. The only guide that we have is that this will not be the first time that it has happened. In 1984 and 1985 we saw a big drop in Asian currencies and a big drop in their growth rates. It had the predicted effect and our exports to Asia for a time were quite weak. Again, last year -- in calendar 1996 -- there was zero growth of imports in the ASEAN four, and our exports to them slowed. I think we will have to put up with a period of weakness again. Frustrating as this instability may be, it seems to be an inevitable part of an open competitive economic system which is the only type capable of achieving strong growth in the long run. So far I have only talked about Asia, but the outcome for the world economy will depend on more than Asia. We have to bring in two bigger regions -- North America and Europe. North America (mainly the United States but also including Canada and Mexico) is growing quite strongly. The recent disturbances in financial markets which were imported into North America from Asia do not seem to have had a lasting impact. If anything, their main effect seems to have been to hose down some overheated asset markets slightly, and hence to reduce the likelihood of an imminent tightening of US monetary policy. Such a tightening in the next six months cannot be ruled out, however. Europe is finally recording some gains after years of disappointingly slow recovery from the early 1990s recession. In fact, European growth has picked up to the point where six European central banks recently tightened monetary policy slightly to head off possible inflationary pressures down the track. So far, I have talked about Asian and world economic events as though their only effect on Australia was via our exports. Of course, that is only part of the story. The other important part is that we now have to face the possibility of further financial market instability. For better or for worse, through knowledge or through fear, the international investment community is taking a more sceptical look at things Asian, and that includes all countries in the Asian region, including Australia. That means they have become more risk-averse, and more likely to judge countries and their policies harshly. We have already seen some of the effects on some Asian countries: • falling exchange rates; • falling share prices; • rising risk margins in interest rates; • downgrades by rating agencies. We are in a better position to handle this financial instability than we have been at any stage in the last 30 years. We formerly had a reputation as a boom-bust economy, and investors used to build in quite a large premium for risk when holding Australian assets. We have come a long way in convincing investors that this is largely a thing of the past. A good example of this is that our bond yields are now virtually the same as US bond yields, whereas five years or ten years ago it was not uncommon for the gap to be as high as five percentage points; some of this was a risk premium and some of it reflected our higher inflation. Another example is that the Australian dollar used to be one of the most volatile currencies in the world, whereas in the 1990s it has been no more volatile than the major currencies such as the US dollar, the yen or the Deutsche Mark. Over the past four or five months, this has served us well. While the Australian dollar has gone down a fair amount against the US dollar, it remained relatively steady in trade-weighted terms. It is true that over the last fortnight the Australian dollar has declined in trade-weighted terms, but it has done this in a relatively orderly fashion, and it is not an unreasonable market response given that our export markets have weakened. This new-found reputation for stability may surprise some people, because there is still a tendency to read so much into the small month-by-month or quarter-by-quarter variations in economic statistics. But if we take a longer sweep, we can see how many of the economic problems that used to concern us have now been eliminated, or are at least under some reasonable sort of control. The headlines are no longer full of stories about the current account deficit or the level of foreign debt. The budget deficit is small. High inflation and its inevitable twin, high interest rates, no longer fill the papers. This does not mean, of course, that we have solved all our economic problems, but we have clearly narrowed them down. This has also tended to concentrate minds on the one that remains -- namely, the level of unemployment. This is a reasonable priority because less progress has been achieved on unemployment than on the other imbalances in the economy that came to the fore in the mid-1970s and persisted through the 1980s. It is not as though no progress has been made -- the unemployment rate has come down from a peak of 11.2 per cent to its present 8.6 per cent -- but it has been disappointing progress. With six years of the expansion now behind us at an average growth rate of 3.6 per cent per annum -- the third highest in the OECD area -- we could have hoped for more. I think some further progress can be made over the next year, although we have to accept that it will probably be slow, and monetary policy will only be part of the story -- in the long run, only a small part. History suggests this will remain the case. Australia moved from 2 per cent unemployment to over 10 per cent in the decade from 1973 to 1983. The damage was really done during that period. Despite good output and employment growth in the 1980s expansion, the unemployment rate was back to 11 per cent following the 1990 recession. So in net terms no progress had been made in a decade. What we want this time is good growth in output and employment, with a difference -- we want it to last a lot longer. The six-and-a-half years that the previous two economic expansions lasted was not good enough. Although progress was made in reducing unemployment -- particularly in the second one -- it was all lost in the ensuing recession. This time around we must make sure we have a much longer expansion, reducing the likelihood and severity of any future slowdown as much as possible. I do not know how that will be possible, but the surest way of ameliorating the business cycle in this way is to avoid the imbalances occurring during the later stages of the expansion. The main imbalance in Australia, as elsewhere, has always been the emergence of inflation. The story is never exactly the same -- inflation can be accompanied by a wage push, an asset price boom or an external imbalance -- but the result has been the same following each of the past three booms. That is why we need to have a more medium-term focus in our monetary policy and why the inflation target is such a central part of it. The inflation target is not anti-growth; low inflation is not an end in itself, we are interested in sustaining a good inflation performance because we are interested in growth and employment. Keeping inflation in check is the key to longer expansions. It has sometimes been said that we are too cautious in following this policy. I think that is a little unfair. Of course, we are cautious in that we like to look at a range of information and think carefully before we make a move on monetary policy. But we try to be forward looking and pre-emptive. For example, we did not wait till measured inflation was below 2 per cent before easing -- in fact, it was 3.1 per cent when we first eased in July last year. Similarly, there have been suggestions that the Reserve Bank has a speed limit above which the economy cannot be allowed to grow (the figure usually cited was 31⁄2 per cent). Such a suggestion is, of course, incorrect and I have pointed this out on several occasions. In case there is still any doubt, you only have to look at our behaviour in 1997. As I said earlier, the economy has been growing at 4 per cent per annum so far in 1997, yet it did not stop us easing monetary policy twice this year. If we are getting reasonable news on inflation and our inflation forecasts are in good shape, we have no objection to the economy growing by 4 per cent or 4 per cent plus. When looking at the whole picture of employment and unemployment, monetary policy is only a small part of the story, and it mainly concerns the cyclical aspect of unemployment. If you look at the really big changes in employment or unemployment over decades, rather than years, monetary policy plays a very small role. The biggest change in employment performance of which I am aware is the contrast between the United States and continental Europe. In the United States, the unemployment rate is back to its 1960s level, whereas in Europe it is about five times as high as it was in the 1960s. A few European countries have done better than that -- including the United Kingdom -- but others have done worse. If you try to explain the superior US employment result by faster economic growth you get nowhere. Europe has grown as fast as the United States over three decades -- it just has not generated jobs. The explanations for the poor European performance on jobs all centre around various types of rigidities, especially in wages and conditions of employment, but also the social security system and the difficulties involved in starting businesses and the subsequent lack of entrepreneurship. I do not intend to go into this in any depth because it is a huge topic. I only raise it to point out that there is much more to the story than the growth of demand, and the role that monetary policy plays in it. In other words, even if we succeed in having good economic growth and sustaining it for a longer period than in earlier expansions, it will not solve all our unemployment problems. We will make some progress, but it is too optimistic to think that we will be able to emulate the Americans and return to the 1960s level of unemployment through macro-economic policies alone. I saw in the paper yesterday someone from ACOSS saying that the big challenge for Australia was to achieve US-style economic growth and low unemployment without US-style inequality and poverty. I think this is a realistic way of looking at it. It shows an awareness of the current trade-off, and I suspect a hope that, with some ingenuity, we might be able to improve on it somewhat. My only quibble is that we already have achieved US growth rates -- in fact, exceeded them -- it is the US unemployment rate that has eluded us. This is something that people like myself, who studied economics in the 1960s, find surprising. In the 1960s it was the United States that was always criticised by countries like Australia and most of Europe for their high unemployment. Now the boot is on the other foot. There is a lot more that I could talk about, but I will confine myself to only one further topic. That is the subject of bank lending and bank margins, particularly bank lending to small business. This is a subject that this Committee has taken a particular interest in. In fact, the first large-scale inter-country study of Australian banks' margins and banks' profitability was undertaken by the Reserve Bank at the request of this Committee in August 1994. We did another study at the Committee's request recently which was published in our October Bulletin. As Committee members also know, the Reserve Bank has been meeting with its Small Business Finance Advisory Panel since 1993 to discuss the provision of finance to that sector. We formed this Panel because we were worried that banks had become excessively risk-averse and were reluctant to lend to small business in the early part of the recovery from the 1990/91 recession. It has been a slow process, but competitive pressures have been gradually working their way into banks' margins, i.e., the difference between the average rate they earn on their loans and the average rate they pay on their deposits. These margins are now lower than at any time since we have been collecting the statistics, and the biggest fall has occurred over the past two years. Clearly, the entry of mortgage originators into the housing market was a very important development, and it led to the margin on housing lending falling from a level which was high by international standards to one which is about average. We are now beginning to see hotter competition in lending to small and medium-sized businesses. Partly this is a result of the need felt by many banks, particularly the regional ones, to reduce their reliance on the now much less profitable mortgage market. In this sense, it shows how competition slowly works its way through the system. I confess that it has taken longer than I expected, and longer than I hoped, but we are finally getting there. That brings me to the end of my introductory remarks. We have certainly had a very eventful period in the month leading up to this meeting and we have all been working hard to keep up with events, particularly in the international scene.	["mr. macfarlane's statement to the house of representatives standing committee on financial institutions and public administration statement by the governor of the reserve bank of australia, mr. ian macfarlane, to the house of representatives standing committee on financial institutions and public administration in sydney on 6/11/97.", 'thank you, mr chairman.', 'it is a pleasure to be here in front of your committee for the second time under the new arrangements set out in the statement on the conduct of monetary policy.', 'on the basis of the first hearing, we think the new arrangements are working very well.', 'on that occasion, we received some very penetrating and constructive questioning from committee members, and there seemed to be quite a lot of public interest in the proceedings.', 'of course, we should always be trying to improve our procedures, but the only improvement we have been able to make on this occasion is to get our half-yearly report to the committee two hours ahead of the hearing, compared with one hour last time.', 'you will appreciate that in order to follow due process we cannot finalise the document until after our board meeting which was on tuesday.', 'i should also say that i was hoping that we might have been able to have this hearing somewhere other than sydney.', 'while it is very convenient for us to be meeting again in the new south wales parliament house about 100 metres from my office, we see merit in this hearing moving to other state capitals and canberra on a regular basis if that is possible.', 'the main reason for these hearings is to improve the accountability of the reserve bank, both directly to parliament, and via the press coverage to the public more generally.', 'in the spirit of increased accountability, i should, i suppose, be accountable for what i said to this committee at the previous hearing, as well as for what i am going to say today.', 'i covered a number of subjects at the previous hearing which i thought were important for an understanding of how the economy was going to perform over coming years.', 'i also mentioned a couple of outcomes we expected for 1997. it is those which will probably be of the most immediate interest.', 'i said that, after a sluggish 1996 where gdp had grown at about 3 per cent -- at one point, it got to not much more than 2 per cent on a 12-months-ended basis, we should expect it to pick up to about 4 per cent in 1997. i also said that i expected inflation to stay at the bottom of the 2-3 per cent range, with the possibility that it could go a little lower for a while.', 'now i think i could be excused for wanting to walk away from earlier forecasts as a result of the current turmoil in asian and world financial markets.', 'while i intend to say quite a lot about those events later on, i do not propose to invoke that excuse at this stage, because they have not had any effect on the economy to date.', 'they have affected financial markets, but not the economy yet.', 'instead, i want to start by saying that the baseline we have to work from, i.e., the growth of the economy in the first three quarters of 1997, has been at least as good as i was pointing to in may, if not a little better.', '• we now have the gdp growth rates for the first two quarters of 1997, which show the economy grew at an annual rate of nearly 4 per cent during that time.', 'and we have further monthly figures for the september quarter which are somewhat stronger than those recorded during the first half of the year.', 'this is true for the major monthly indicators such as retail trade, imports and exports.', 'it is also true for the labour market, especially for vacancies, and to some extent also for employment.', 'there is also evidence from the business surveys that confidence is picking up, but these surveys were generally compiled before the asian headlines of a fortnight ago.', '• on inflation, the outlook changed a little.', 'new figures brought underlying inflation below 2 per cent, and our on-going assessment caused us to lower our forecasts.', 'as a result, we have had two further easings of monetary policy -- one in may and one in july.', 'an important reason for the lower inflation forecasts was the better outlook for wages.', 'you may recall that shortly after the previous hearing in may we received revised figures on earnings from the abs that suggested not only that they were lower in the quarter in question -- the march quarter of 1997 -- but that an upward trend had been revised away.', 'this better picture was confirmed again in the june quarter figures, but the picture has been muddied somewhat by the recent september quarter figures which show an unexpectedly strong rise.', 'on balance, therefore, we at the bank judged that the information becoming available over the past six months was tending to confirm this relatively benign view of the future -- gdp growth of about 4 per cent (enough for some further reduction in unemployment from the 8.8 per cent we had at the time of the last hearing) and inflation a little below 2 per cent (enough to justify the may and july easings in monetary policy).', 'the picture was not all rosy -- the slower output growth of 1996 was still making its presence felt in the form of sluggish employment growth in the first half of 1997, there were some doubts about the strength of investment, and the effects of el niño were around the corner.', 'but economies nearly always present a mixed picture, and this mixture was a lot better than most.', 'in addition, financial conditions had become clearly easier than in may.', 'the overnight cash rate had come down from 6 per cent to 5 per cent as a result of the two easings of monetary policy, and yields on 10-year bonds were down from 73⁄4 per cent to 6 per cent.', 'the exchange rate against the us dollar has come down from 77.7 us cents to 70.3 us cents; against the trade-weighted index, it has come down from 60.2 to 57.0. i come now to the point where i should say a few things about what has been happening in asia and the rest of the world.', 'i will do my best to be specific, but you should bear in mind that the ground is constantly changing.', 'the first thing i would like to say is that in the long run i am still very optimistic about asian growth prospects.', 'these countries still retain a set of characteristics that are conducive to long-run growth: • they can still achieve rapid productivity growth through technology transfer, i.e., they have started from a long way behind and have a fair way to go; • they are oriented towards international trade; • they have high savings rates and high investment and a relatively small government sector; they have generally sound fiscal and monetary policies -- although they have got some • way to go in terms of the soundness of their banking and financial sectors; and • they have great respect for, and devote considerable effort to, education.', 'i do not see the end of the asian miracle, partly because i do not think it ever was a miracle; it was just the application of some tried and tested rules of good economic policy.', 'it is still fortunate for our long-run prosperity that we have strong links to asia.', 'having declared my optimism about the long run, i should now turn to the short run.', 'clearly, there are going to be difficulties here, in particular among four asean countries -- thailand, malaysia, indonesia and the philippines.', 'from the moment the thai baht was floated on 2 july, attention quickly broadened to encompass these four.', 'their currencies have fallen sharply, as have their stock markets and property prices.', 'these countries are battening down the hatches -- in two cases with the help of the imf -- to sort out their problems.', 'the principal problem, it is now apparent, concerns how to handle the fall of previously over-inflated asset prices, undisciplined lending by local banks and foreigners, and some very opaque inter-relationships between business and government which have obscured the true financial position of a lot of companies and banks.', 'there also appears to have been over-investment in some areas.', 'property played its usual major role, but on this occasion there were also more contemporary avenues, particularly electronics and semi-conductors, where there is clear over-capacity and intense competition among these countries (and with korea and taiwan).', 'of course, these problems have been around for years -- they did not just start on 2 july.', 'a part of this adjustment must inevitably involve a sharp curtailment of growth in the short run and a contraction of credit.', 'imports will fall, and so the effects will be spread to other countries.', "the good news for australia is that these four countries account for only 10 per cent of australia's exports.", "if the difficulties remain confined to these four countries, the effect on australia's exports, and hence our growth, would be modest.", 'the rest of asia is, in fact, a lot more important to australia.', 'japan -- our largest market -- has been limping along at an average annual growth rate of about 1 per cent now for about five years.', 'our exports to japan have virtually not increased at all during that period.', 'the other big asian markets for australia are korea, china, taiwan and hong kong.', 'these are collectively much more important than the asean four.', 'of course, some of the underlying problems that afflict the asean four also apply, although more modestly, to some of these countries.', 'for a time, it looked as though the asean problems would spill over to these in a big way, but that seems less likely now, although we should not speak too soon.', 'even so, we should build in the assumption of some slowing in aggregate for these countries.', 'to judge the effects on australia, we should, in principle, have a view on how each country will fare in regard to economic growth, imports and the health of their banking systems (and we should look outside asia, which i will do later).', 'it is never easy and some sure bets turn out to be wrong.', 'for example, virtually everyone thought the simultaneous share market crash of 1987 and associated company failures would presage at least a slowdown, if not a recession.', 'in the event, 1988 turned out to be a boom year for the oecd economy and for australia.', 'let us hope we can be a little closer to the mark this time.', 'most analysis to date has consisted of a relatively mechanical application of lower growth and lower imports among the asean four to lower australian exports and lower australian gdp growth.', 'the orders of magnitudes are quite small and the most commonly cited figure for gdp growth in australia is a reduction of about a quarter of a percentage point.', 'according to press reports, the oecd has recently suggested figures of 0.3 per cent for australia in 1997 and 0.4 per cent in 1998. quite how they got an effect on 1997, which we are already 80 per cent through, i do not know, but, as i said, i am only relying on newspaper reports.', 'these sorts of figures can become considerably larger if we also bring in lower growth rates for korea, china, etc., but we are getting into the realms of speculation if we do so.', 'the only guide that we have is that this will not be the first time that it has happened.', 'in 1984 and 1985 we saw a big drop in asian currencies and a big drop in their growth rates.', 'it had the predicted effect and our exports to asia for a time were quite weak.', 'again, last year -- in calendar 1996 -- there was zero growth of imports in the asean four, and our exports to them slowed.', 'i think we will have to put up with a period of weakness again.', 'frustrating as this instability may be, it seems to be an inevitable part of an open competitive economic system which is the only type capable of achieving strong growth in the long run.', 'so far i have only talked about asia, but the outcome for the world economy will depend on more than asia.', 'we have to bring in two bigger regions -- north america and europe.', 'north america (mainly the united states but also including canada and mexico) is growing quite strongly.', 'the recent disturbances in financial markets which were imported into north america from asia do not seem to have had a lasting impact.', 'if anything, their main effect seems to have been to hose down some overheated asset markets slightly, and hence to reduce the likelihood of an imminent tightening of us monetary policy.', 'such a tightening in the next six months cannot be ruled out, however.', 'europe is finally recording some gains after years of disappointingly slow recovery from the early 1990s recession.', 'in fact, european growth has picked up to the point where six european central banks recently tightened monetary policy slightly to head off possible inflationary pressures down the track.', 'so far, i have talked about asian and world economic events as though their only effect on australia was via our exports.', 'of course, that is only part of the story.', 'the other important part is that we now have to face the possibility of further financial market instability.', 'for better or for worse, through knowledge or through fear, the international investment community is taking a more sceptical look at things asian, and that includes all countries in the asian region, including australia.', 'that means they have become more risk-averse, and more likely to judge countries and their policies harshly.', 'we have already seen some of the effects on some asian countries: • falling exchange rates; • falling share prices; • rising risk margins in interest rates; • downgrades by rating agencies.', 'we are in a better position to handle this financial instability than we have been at any stage in the last 30 years.', 'we formerly had a reputation as a boom-bust economy, and investors used to build in quite a large premium for risk when holding australian assets.', 'we have come a long way in convincing investors that this is largely a thing of the past.', 'a good example of this is that our bond yields are now virtually the same as us bond yields, whereas five years or ten years ago it was not uncommon for the gap to be as high as five percentage points; some of this was a risk premium and some of it reflected our higher inflation.', 'another example is that the australian dollar used to be one of the most volatile currencies in the world, whereas in the 1990s it has been no more volatile than the major currencies such as the us dollar, the yen or the deutsche mark.', 'over the past four or five months, this has served us well.', 'while the australian dollar has gone down a fair amount against the us dollar, it remained relatively steady in trade-weighted terms.', 'it is true that over the last fortnight the australian dollar has declined in trade-weighted terms, but it has done this in a relatively orderly fashion, and it is not an unreasonable market response given that our export markets have weakened.', 'this new-found reputation for stability may surprise some people, because there is still a tendency to read so much into the small month-by-month or quarter-by-quarter variations in economic statistics.', 'but if we take a longer sweep, we can see how many of the economic problems that used to concern us have now been eliminated, or are at least under some reasonable sort of control.', 'the headlines are no longer full of stories about the current account deficit or the level of foreign debt.', 'the budget deficit is small.', 'high inflation and its inevitable twin, high interest rates, no longer fill the papers.', 'this does not mean, of course, that we have solved all our economic problems, but we have clearly narrowed them down.', 'this has also tended to concentrate minds on the one that remains -- namely, the level of unemployment.', 'this is a reasonable priority because less progress has been achieved on unemployment than on the other imbalances in the economy that came to the fore in the mid-1970s and persisted through the 1980s.', 'it is not as though no progress has been made -- the unemployment rate has come down from a peak of 11.2 per cent to its present 8.6 per cent -- but it has been disappointing progress.', 'with six years of the expansion now behind us at an average growth rate of 3.6 per cent per annum -- the third highest in the oecd area -- we could have hoped for more.', 'i think some further progress can be made over the next year, although we have to accept that it will probably be slow, and monetary policy will only be part of the story -- in the long run, only a small part.', 'history suggests this will remain the case.', 'australia moved from 2 per cent unemployment to over 10 per cent in the decade from 1973 to 1983. the damage was really done during that period.', 'despite good output and employment growth in the 1980s expansion, the unemployment rate was back to 11 per cent following the 1990 recession.', 'so in net terms no progress had been made in a decade.', 'what we want this time is good growth in output and employment, with a difference -- we want it to last a lot longer.', 'the six-and-a-half years that the previous two economic expansions lasted was not good enough.', 'although progress was made in reducing unemployment -- particularly in the second one -- it was all lost in the ensuing recession.', 'this time around we must make sure we have a much longer expansion, reducing the likelihood and severity of any future slowdown as much as possible.', 'i do not know how that will be possible, but the surest way of ameliorating the business cycle in this way is to avoid the imbalances occurring during the later stages of the expansion.', 'the main imbalance in australia, as elsewhere, has always been the emergence of inflation.', 'the story is never exactly the same -- inflation can be accompanied by a wage push, an asset price boom or an external imbalance -- but the result has been the same following each of the past three booms.', 'that is why we need to have a more medium-term focus in our monetary policy and why the inflation target is such a central part of it.', 'the inflation target is not anti-growth; low inflation is not an end in itself, we are interested in sustaining a good inflation performance because we are interested in growth and employment.', 'keeping inflation in check is the key to longer expansions.', 'it has sometimes been said that we are too cautious in following this policy.', 'i think that is a little unfair.', 'of course, we are cautious in that we like to look at a range of information and think carefully before we make a move on monetary policy.', 'but we try to be forward looking and pre-emptive.', 'for example, we did not wait till measured inflation was below 2 per cent before easing -- in fact, it was 3.1 per cent when we first eased in july last year.', 'similarly, there have been suggestions that the reserve bank has a speed limit above which the economy cannot be allowed to grow (the figure usually cited was 31⁄2 per cent).', 'such a suggestion is, of course, incorrect and i have pointed this out on several occasions.', 'in case there is still any doubt, you only have to look at our behaviour in 1997. as i said earlier, the economy has been growing at 4 per cent per annum so far in 1997, yet it did not stop us easing monetary policy twice this year.', 'if we are getting reasonable news on inflation and our inflation forecasts are in good shape, we have no objection to the economy growing by 4 per cent or 4 per cent plus.', 'when looking at the whole picture of employment and unemployment, monetary policy is only a small part of the story, and it mainly concerns the cyclical aspect of unemployment.', 'if you look at the really big changes in employment or unemployment over decades, rather than years, monetary policy plays a very small role.', 'the biggest change in employment performance of which i am aware is the contrast between the united states and continental europe.', 'in the united states, the unemployment rate is back to its 1960s level, whereas in europe it is about five times as high as it was in the 1960s.', 'a few european countries have done better than that -- including the united kingdom -- but others have done worse.', 'if you try to explain the superior us employment result by faster economic growth you get nowhere.', 'europe has grown as fast as the united states over three decades -- it just has not generated jobs.', 'the explanations for the poor european performance on jobs all centre around various types of rigidities, especially in wages and conditions of employment, but also the social security system and the difficulties involved in starting businesses and the subsequent lack of entrepreneurship.', 'i do not intend to go into this in any depth because it is a huge topic.', 'i only raise it to point out that there is much more to the story than the growth of demand, and the role that monetary policy plays in it.', 'in other words, even if we succeed in having good economic growth and sustaining it for a longer period than in earlier expansions, it will not solve all our unemployment problems.', 'we will make some progress, but it is too optimistic to think that we will be able to emulate the americans and return to the 1960s level of unemployment through macro-economic policies alone.', 'i saw in the paper yesterday someone from acoss saying that the big challenge for australia was to achieve us-style economic growth and low unemployment without us-style inequality and poverty.', 'i think this is a realistic way of looking at it.', 'it shows an awareness of the current trade-off, and i suspect a hope that, with some ingenuity, we might be able to improve on it somewhat.', 'my only quibble is that we already have achieved us growth rates -- in fact, exceeded them -- it is the us unemployment rate that has eluded us.', 'this is something that people like myself, who studied economics in the 1960s, find surprising.', 'in the 1960s it was the united states that was always criticised by countries like australia and most of europe for their high unemployment.', 'now the boot is on the other foot.', 'there is a lot more that i could talk about, but i will confine myself to only one further topic.', 'that is the subject of bank lending and bank margins, particularly bank lending to small business.', 'this is a subject that this committee has taken a particular interest in.', "in fact, the first large-scale inter-country study of australian banks' margins and banks' profitability was undertaken by the reserve bank at the request of this committee in august 1994. we did another study at the committee's request recently which was published in our october bulletin.", 'as committee members also know, the reserve bank has been meeting with its small business finance advisory panel since 1993 to discuss the provision of finance to that sector.', 'we formed this panel because we were worried that banks had become excessively risk-averse and were reluctant to lend to small business in the early part of the recovery from the 1990/91 recession.', "it has been a slow process, but competitive pressures have been gradually working their way into banks' margins, i.e., the difference between the average rate they earn on their loans and the average rate they pay on their deposits.", 'these margins are now lower than at any time since we have been collecting the statistics, and the biggest fall has occurred over the past two years.', 'clearly, the entry of mortgage originators into the housing market was a very important development, and it led to the margin on housing lending falling from a level which was high by international standards to one which is about average.', 'we are now beginning to see hotter competition in lending to small and medium-sized businesses.', 'partly this is a result of the need felt by many banks, particularly the regional ones, to reduce their reliance on the now much less profitable mortgage market.', 'in this sense, it shows how competition slowly works its way through the system.', 'i confess that it has taken longer than i expected, and longer than i hoped, but we are finally getting there.', 'that brings me to the end of my introductory remarks.', 'we have certainly had a very eventful period in the month leading up to this meeting and we have all been working hard to keep up with events, particularly in the international scene.']	Ian J Macfarlane	Reserve Bank of Australia	Governor	Australia
https://www.bis.org/review/r971112a.pdf	M. Roth s'interroge sur la relation entre le franc suisse et l'euro (Central Bank Articles and Speeches, 27 Oct 97)	Exposé de M. Jean-Pierre Roth, Vice-président de la Direction générale de la Banque nationale suisse, à la Chambre de Commerce Suisse en Italie, à Milan, le 27/10/97.	1997-10-27 00:00:00	M. Roth s'interroge sur la relation entre le franc suisse et l'euro Exposé de M. Jean-Pierre Roth, Vice-président de la Direction générale de la Banque nationale suisse, à la Chambre de Commerce Suisse en Italie, à Milan, le 27/10/97. 1. Introduction Les échéances fixées par le Traité de Maastricht se rapprochent à grands pas. Au printemps prochain seront désignés les pays qui participeront à la première phase d'intégration monétaire. Tout porte à penser, sur la base des indicateurs de convergence observables actuellement, que l'Union monétaire sera plus large que ce que l'on imaginait il y a douze mois seulement. Dans moins d'un an, donc, il se pourrait que tous les pays entourant la Suisse aient uni leur destin monétaire. Que devons-nous attendre, en Suisse, de ce profond changement d'horizon monétaire? Quelles en seront les conséquences pour le franc suisse et pour la politique de la Banque nationale suisse? Je suis heureux de pouvoir développer ces thèmes devant vous et de m'exprimer sur sol italien et lombard, une terre si proche, géographiquement et économiquement, de la Suisse et si proche aussi de notre coeur. 2. Un changement profond d'environnement 2.1. .... en Europe Si, d'un point de vue suisse, l'Union monétaire entraînera un profond bouleversement de l'environnement européen, le choc sera encore plus marqué pour les membres de l'Union eux-mêmes. Avec la monnaie unique, les marchés européens franchiront un nouveau et très important pas dans leur intégration. Non seulement les biens, les capitaux et les personnes circuleront librement, mais il n'y aura plus qu'une seule monnaie -- l'euro -- donc une seule politique monétaire et une seule structure des taux d'intérêt. L'apparition d'un taux d'intérêt unique et d'un marché financier intégré marquera fortement l'économie européenne du 21ème siècle. Songez que, il y a cinq ans seulement, l'écart entre les taux à long terme en Allemagne et en Italie était de 660 points de base. Aujourd'hui, à la veille de l'Union, ce différentiel est tombé à 80 points, demain, il aura disparu. La convergence des taux d'intérêt à long terme a été le signe le plus concret des progrès vers l'Union monétaire. L'exemple le plus frappant est celui de la parfaite coïncidence qui existe maintenant entre les taux français et allemands, la France et l'Allemagne étant les deux pays sans lesquels l'Union ne pourra se faire. Une bonne part de la convergence financière observée ces derniers mois tient à l'anticipation de progrès substantiels dans la correction des déficits publics et le respect de la norme des 3 %. Les récentes estimations effectuées à ce sujet par la Commission de Bruxelles l'ont encore renforcée. Mais il ne faut pas oublier non plus que la décrue spectaculaire des taux d'inflation dans les pays du sud de l'Europe a grandement aidé à rapprocher les situations des marchés financiers. Personne ne peut dire à quel niveau se situeraient aujourd'hui les taux d'intérêt dans les différents pays européens s'ils n'étaient pas engagés dans le processus d'intégration monétaire. Aujourd'hui déjà, certains d'entre eux bénéficient certainement d'un effet d'entraînement favorable, d'autres doivent compter peut-être avec une prime nouvelle d'insécurité. A mes yeux, l'économie italienne profite déjà et profitera encore plus demain de son ancrage plus ferme dans l'édifice européen. Son dynamisme pourra s'appuyer sur des conditions de financement bien plus favorables que par le passé. La seconde révolution entraînée par la monnaie unique sera celle de l'unification des marchés financiers européens. Avec la disparition des monnaies nationales, les banques se trouveront en situation de plus grande concurrence, leurs clients étant en mesure de comparer rapidement la qualité des produits offerts. Les grandes manoeuvres ont déjà commencé dans le secteur bancaire depuis l'introduction de la liberté des mouvements de capitaux; elles vont se poursuivre et même s'intensifier. Sous la pression de la monnaie unique, mais aussi sous celle de la globalisation des marchés et des progrès technologiques, l'industrie bancaire européenne va devoir procéder à un assainissement de ses structures. Notre continent est clairement „over-banked"; peu de chose s'opposera encore aux ajustements structurels lorsque la monnaie unique sera en place. 2.2. .... et en Suisse 2.2.1. Un environnement plus homogène Avec l'apparition de l'euro, l'Europe passera donc d'un espace à devises multiples, à marchés financiers fragmentés, à une zone uniforme aux dimensions de celles des Etats-Unis. Si les Européens gagnent leur pari de mettre en place une monnaie saine, la Suisse bénéficiera alors d'un environnement beaucoup plus homogène et stable que par le passé. Nous avons derrière nous l'expérience de plus de vingt ans de franc suisse flottant. Cette expérience s'est révélée positive sur de nombreux plans, notamment sur celui de la maîtrise de l'inflation et des taux d'intérêt bas dont nous jouissons. Mais les changes flottants -- ou plus concrètement l'absence d'ordre monétaire international -- comportent aussi des inconvénients pour les petits pays. Le plus grave est celui de l'absence de discipline imposée aux politiques économiques nationales. Avec la monnaie unique et l'application d'une seule politique monétaire, notre environnement gagnera en homogénéité et des sources de perturbation disparaîtront. Evidemment, cette situation pourra attrister quelques salles de change, mais c'est sans aucun doute un point positif pour l'économie suisse dans son ensemble. Pour illustrer ce point, permettez-moi de prendre deux exemples: Considérez tout d'abord la relation entre le franc suisse et le mark allemand au cours des quinze dernières années. Si les choses sont mesurées en terme réel, on constate que la relation franc -- DM a oscillé dans une bande de fluctuation relativement étroite, de 5 %, ± autour d'un trend d'appréciation du franc de l'ordre de 0,5 % par an. Vue sous cet angle, la relation entre le franc et le mark, deux monnaies qui n'étaient liées par aucun accord monétaire et dont les cours n'étaient pas influencés par des interventions sur les marchés des changes, s'est révélée être extraordinairement stable. Les changes flottants n'ont donc pas généré les cours irrationnels que certains annonçaient. Pourquoi cette stabilité relative entre le franc et le mark? Parce qu'il existait entre la Suisse et l'Allemagne une grande convergence des objectifs de politique économique et des situations conjoncturelles. Considérez maintenant la relation entre le franc suisse et la lire italienne, pour la même période et sur les mêmes bases. L'image que l'on en retire est fort différente. La volatilité est beaucoup plus forte. La lire connaît une longue période d'appréciation jusqu'en 1992, puis chute dans un retournement dramatique de situation, suivi d'une nouvelle normalisation. Vous connaissez les raisons qui se trouvent en arrière-plan de ces fluctuations de la lire. Elles tiennent aux situations souvent difficiles rencontrées par la politique économique italienne durant ces années. Pour l'économie suisse, de telles variations de cours sont extrêmement douloureuses. Le degré de compétitivité de son industrie d'exportation se modifie dramatiquement, et ceci dans des périodes relativement brèves. Il s'ensuivit des coûts élevés d'ajustement au plan économique et social. La relation entre le franc et le mark et celle entre le franc et la lire révèlent donc deux aspects bien différents de notre histoire financière récente. D'un côté, une relative stabilité, de l'autre, une volatilité marquée. C'est dans ce domaine qu'un progrès considérable sera réalisé grâce à l'intégration monétaire européenne. Avec la fixation irrémédiable des parités, puis l'introduction de l'euro, une seule politique monétaire sera appliquée. Le continent aura gagné en homogénéité financière. Si l'euro disposait, demain, des mêmes caractéristiques que le mark allemand, la relation entre le franc suisse et les monnaies européennes sera beaucoup plus stable que par le passé. Les progrès de la stabilité monétaire profiteront donc non seulement aux Européens mais aussi à ceux qui vivent à leur côté. 2.2.2. Une intégration accélérée Au-delà du changement de l'environnement financier, je m'attends aussi à ce que la monnaie unique accélère l'intégration de fait de l'économie suisse dans l'économie européenne. Aujourd'hui déjà, 80 % de nos importations proviennent de l'Union européenne, qui absorbe à son tour 60 % de nos exportations. De par nos flux commerciaux, notre conjoncture dépend fortement de ce qui se passe chez nos voisins. Les retournements conjoncturels en Suisse coïncident avec ceux de la France et de l'Allemagne. Demain, avec une politique macro-économique unifiée autour de nous, tout porte à croire que les pulsions économiques qui s'exerceront sur nous seront de plus en plus synchronisées. Notre rythme de production deviendra ainsi encore plus dépendant de ce qui se passe sur le continent. Parallèlement à l'homogénéité économique croissante de l'Union européenne on constatera que la Suisse aura de plus en plus un profil européen. Cette intégration accrue de la Suisse dans l'Europe nous demandera évidemment de vivre étroitement avec la future monnaie européenne. Tous les secteurs de notre économie qui commercent avec l'étranger se trouveront concernés. En premier lieu, le marché européen va devenir effectivement un „grand marché" dans lequel une monnaie -- l'euro -- sera l'instrument de transaction. Nous devons en tenir compte. Les pratiques européennes en matière de contrats, de conditions, de normes s'imposeront encore plus à nous que par le passé. Il sera toujours plus difficile d'utiliser le franc comme monnaie de facturation pour nos exportations et les touristes qui passeront la frontière comprendront mal qu'ils ne puissent utiliser leurs euros pour effectuer leurs paiements. La réalité d'une grande zone monétaire à notre porte nous demandera de la souplesse et de l'imagination. L'Europe, qui jusqu'ici n'était qu'une mosaïque monétaire, deviendra un ensemble monolithique. Ceci ne peut rester sans conséquence sur notre manière de commercer. Un autre aspect important de l'impact de l'euro sur l'économie suisse est celui de la mise en place d'un système de paiement interbancaire en euros. Cette question est délicate car elle n'est pas encore résolue au sein de l'Union européenne elle-même. De quoi s'agit-il? Au sein de l'Union monétaire, les systèmes nationaux de paiements interbancaires seront reliés entre eux. Il sera aussi possible de faire un paiement, valeur du jour même, de Paris à Francfort alors qu'aujourd'hui une telle opération s'exécute en 48 heures. Le système européen des paiements ainsi créé bénéficiera de l'appui de la Banque centrale européenne s'il devait être en manque de liquidités. Au niveau européen existera donc ce qui existe déjà au niveau national. La difficulté vient du fait qu'un certain nombre de pays de l'UE ne participeront pas à la première phase d'intégration monétaire. Pourront-ils se connecter au système des paiements, et à quelles conditions? Cette question n'est pas encore réglée au sein de l'Union. Dans ces conditions, la récente décision des banques suisses de créer en Allemagne une banque de clearing qui sera chargée d'exécuter leurs paiements mutuels en euros et d'établir un pont avec la Banque centrale européenne me paraît adéquate. Il conviendra d'examiner si la Banque nationale peut jouer un rôle utile dans ce cadre lorsque les conditions de coopération entre les „ins" et les „outs" au sein de l'Union européenne auront été arrêtées. 3. Les conséquences pour la Banque nationale J'en viens ainsi tout naturellement à la troisième partie de cet exposé: les conséquences de l'intégration monétaire pour la politique de la Banque nationale. A mon sens, deux types de questions se posent: • les implications à long terme de l'intégration monétaire sur la politique de la BNS, • les influences de court terme. A long terme, l'Union monétaire européenne est pour nous synonyme d'imbrication accrue de l'économie suisse dans la scène monétaire européenne. La situation du marché des changes, qui est déjà aujourd'hui un facteur important dans notre appréciation de la situation, le sera plus encore. Le fait qu'une grande partie de notre commerce s'effectuera avec la zone euro, le fait aussi que la conjoncture européenne s'imposera toujours plus à la nôtre créeront forcément une communauté de destin entre le franc et l'euro. Une trop grande volatilité de l'euro par rapport au franc pourrait devenir extrêmement douloureuse pour l'économie suisse. Nous en sommes conscients. J'ai toutefois confiance, et je base ma confiance sur l'expérience de la cohabitation du franc suisse et du mark au cours des quinze dernières années. Si les objectifs et les situations économiques convergent entre la Suisse et l'Union européenne, tout porte à penser que la volatilité de la relation franc -- euro se maintiendra dans des limites acceptables. Cette convergence des options fondamentales me paraît acquise puisque la Banque centrale européenne, tout comme la BNS, fera de la stabilité des prix l'objectif prioritaire de sa politique. Au fil des années, le franc et l'euro reposeront donc sur des éléments fondamentaux fort semblables. Cela aura également pour conséquence de permettre un rapprochement progressif des taux d'intérêt sur ces devises. Aujourd'hui, l'écart entre les taux suisses et allemands (représentant les taux sur l'euro) est de plus de 200 points de base. Cet écart me semble biaisé par les incertitudes liées à l'introduction de la monnaie unique. Une fois celles-ci dissipées, un rapprochement devrait se manifester. Ce ne seront pas seulement les taux suisses qui monteront mais aussi les taux sur l'euro qui baisseront. Ce rapprochement n'est pas pour demain, il se manifestera lorsque les marchés seront convaincus de la stabilité de la nouvelle monnaie européenne. Dans le court terme, la phase d'introduction de l'euro est marquée par une forte incertitude. Pourtant, tout a été mis en place au niveau institutionnel comme au niveau des critères de convergence pour convaincre les marchés que l'euro sera une monnaie de qualité. Mais tant que les marchés ne pourront pas juger sur pièce, une incertitude existera, incertitude qui pourrait être source d'instabilité des marchés et qui pourrait maintenir les taux d'intérêt à un niveau plus élevé que ce qui serait souhaitable d'un point de vue conjoncturel. Cette volatilité potentielle de l'euro pourrait créer des difficultés pour le franc suisse, monnaie de refuge. Comment neutraliser de telles perturbations pour l'économie suisse? Il n'y a pas de réponse simple et évidente à cette question. Certains pensent qu'il conviendrait, à l'image de ce qu'avait fait l'Autriche, que la Suisse décide de se lier unilatéralement à l'euro afin d'éliminer le risque de change. Il lui suffirait pour cela de mener une politique de taux d'intérêt appropriée, voire de la renforcer par des interventions sur le marché des changes. Ce n'est malheureusement pas si facile! Si nous fixions une parité entre le franc et l'euro, nous courrions deux risques majeurs: -soit les marchés nous croiraient et nous provoquerions alors une sortie massive de capitaux qui quitteraient le franc pour se placer dans la zone euro où les rémunérations sont nettement plus élevées; -soit les marchés ne considéreraient pas cette parité comme définitive et spéculeraient à sa révision à la hausse. Notre stratégie stimulerait alors la spéculation au lieu de la calmer. Nous devrons donc vivre avec un franc flottant, mais nous devrons aussi nous comporter de telle sorte que „la bataille de l'euro n'ait pas lieu". Dans ce domaine, comme dans bien d'autres, il vaut mieux prévenir une situation que la corriger. Nous nous sommes efforcés ces douze derniers mois d'éviter une appréciation du franc suisse face au mark. Nous l'avons fait en menant une politique monétaire accommodante. Cette stratégie a été, je crois, couronnée de succès. La faiblesse du mark engendrée par les incertitudes l'euro s'est reportée avant tout sur le dollar et la livre sterling, le franc suisse n'a été atteint que marginalement. Nous devons continuer sur cette ligne tant que les doutes sur l'euro n'auront pas disparu. Mettons-nous ainsi en danger la stabilité des prix à moyen terme? Je ne le crois pas. La croissance de nos agrégats monétaires se ralentit maintenant et le dépassement de la monnaie centrale -- notre indicateur principal -- par rapport à son trend d'équilibre exagère vraisemblablement le degré d'expansion de notre action. Enfin, n'oublions pas que dans un environnement marqué par le risque d'un franc fort, la probabilité d'une résurgence marquée de l'inflation est faible. Conclusion Les mois qui nous séparent de la première phase d'interprétation monétaire peuvent encore comporter des surprises. Le calme relatif du marché des changes au cours des douze derniers mois est rassurant, il indique que les risques de perturbation futurs sont limités. Une fois la zone monétaire définie, la convergence des taux d'intérêt s'imposera d'elle-même et l'Union monétaire deviendra réalité. C'est une nouvelle phase de l'histoire européenne qui commencera alors. Pour la Suisse également, bien qu'elle ne participe pas à l'intégration monétaire. Nous aurons à vivre avec un environnement plus homogène, dont les taux d'intérêt seront peut-être relativement élevés dans une phase initiale, tant que la monnaie unique n'aura fait preuve de ses qualités. Sur la durée, en revanche, il apparaîtra toujours plus de manière évidente que le franc suisse et l'euro sont des monnaies comparables, ce qui entraînera une convergence des taux entre la Suisse et l'Europe. Personne ne peut dire, aujourd'hui, à quel rythme ces ajustements s'effectueront. La révolution monétaire, comme toute révolution, comporte de nombreuses incertitudes. Nous en avons déjà vécues, nous en vivrons encore jusqu'à la fin de ce siècle. Cela demandera aux entreprises une grande capacité d'adaptation au nouvel environnement. Je ne parle pas seulement des établissements financiers mais aussi de tous ceux qui commercent avec l'Europe. Mais sur la durée, notre industrie d'exportation pourra compter avec un environnement monétaire plus homogène, moins volatil que par le passé. L'Union monétaire demandera aussi beaucoup de pragmatisme dans la conduite de la politique monétaire. Le „pragmatisme" est souvent attrayant mais ne nous cachons pas qu'il est synonyme de prise de décision dans des conditions particulièrement difficiles où les points de repère sont moins évidents que d'habitude. Nous avons bon espoir, Mesdames et Messieurs, que le nouvel ordre monétaire européen ne créera pas de handicap majeur pour la Suisse et le franc suisse. Il s'agit au contraire d'une chance pour notre pays, celle de clore le chapitre de vingt-cinq années de désordres monétaires en Europe, pour déboucher sur une période où les politiques seront plus convergentes et stables. Nous en attendons plus de calme dans les changes, ce qui sera dans l'intérêt du développement de notre commerce extérieur et aussi dans celui d'un retour à la croissance économique dans notre pays. _____________________________	["m. roth s'interroge sur la relation entre le franc suisse et l'euro exposé de m. jean-pierre roth, vice-président de la direction générale de la banque nationale suisse, à la chambre de commerce suisse en italie, à milan, le 27/10/97.", '1. introduction les échéances fixées par le traité de maastricht se rapprochent à grands pas.', "au printemps prochain seront désignés les pays qui participeront à la première phase d'intégration monétaire.", "tout porte à penser, sur la base des indicateurs de convergence observables actuellement, que l'union monétaire sera plus large que ce que l'on imaginait il y a douze mois seulement.", "dans moins d'un an, donc, il se pourrait que tous les pays entourant la suisse aient uni leur destin monétaire.", "que devons-nous attendre, en suisse, de ce profond changement d'horizon monétaire?", 'quelles en seront les conséquences pour le franc suisse et pour la politique de la banque nationale suisse?', "je suis heureux de pouvoir développer ces thèmes devant vous et de m'exprimer sur sol italien et lombard, une terre si proche, géographiquement et économiquement, de la suisse et si proche aussi de notre coeur.", "2. un changement profond d'environnement 2.1.", ".... en europe si, d'un point de vue suisse, l'union monétaire entraînera un profond bouleversement de l'environnement européen, le choc sera encore plus marqué pour les membres de l'union eux-mêmes.", 'avec la monnaie unique, les marchés européens franchiront un nouveau et très important pas dans leur intégration.', "non seulement les biens, les capitaux et les personnes circuleront librement, mais il n'y aura plus qu'une seule monnaie -- l'euro -- donc une seule politique monétaire et une seule structure des taux d'intérêt.", "l'apparition d'un taux d'intérêt unique et d'un marché financier intégré marquera fortement l'économie européenne du 21ème siècle.", "songez que, il y a cinq ans seulement, l'écart entre les taux à long terme en allemagne et en italie était de 660 points de base.", "aujourd'hui, à la veille de l'union, ce différentiel est tombé à 80 points, demain, il aura disparu.", "la convergence des taux d'intérêt à long terme a été le signe le plus concret des progrès vers l'union monétaire.", "l'exemple le plus frappant est celui de la parfaite coïncidence qui existe maintenant entre les taux français et allemands, la france et l'allemagne étant les deux pays sans lesquels l'union ne pourra se faire.", "une bonne part de la convergence financière observée ces derniers mois tient à l'anticipation de progrès substantiels dans la correction des déficits publics et le respect de la norme des 3 %.", "les récentes estimations effectuées à ce sujet par la commission de bruxelles l'ont encore renforcée.", "mais il ne faut pas oublier non plus que la décrue spectaculaire des taux d'inflation dans les pays du sud de l'europe a grandement aidé à rapprocher les situations des marchés financiers.", "personne ne peut dire à quel niveau se situeraient aujourd'hui les taux d'intérêt dans les différents pays européens s'ils n'étaient pas engagés dans le processus d'intégration monétaire.", "aujourd'hui déjà, certains d'entre eux bénéficient certainement d'un effet d'entraînement favorable, d'autres doivent compter peut-être avec une prime nouvelle d'insécurité.", "a mes yeux, l'économie italienne profite déjà et profitera encore plus demain de son ancrage plus ferme dans l'édifice européen.", "son dynamisme pourra s'appuyer sur des conditions de financement bien plus favorables que par le passé.", "la seconde révolution entraînée par la monnaie unique sera celle de l'unification des marchés financiers européens.", 'avec la disparition des monnaies nationales, les banques se trouveront en situation de plus grande concurrence, leurs clients étant en mesure de comparer rapidement la qualité des produits offerts.', "les grandes manoeuvres ont déjà commencé dans le secteur bancaire depuis l'introduction de la liberté des mouvements de capitaux; elles vont se poursuivre et même s'intensifier.", "sous la pression de la monnaie unique, mais aussi sous celle de la globalisation des marchés et des progrès technologiques, l'industrie bancaire européenne va devoir procéder à un assainissement de ses structures.", 'notre continent est clairement „over-banked"; peu de chose s\'opposera encore aux ajustements structurels lorsque la monnaie unique sera en place.', ".... et en suisse 2.2.1. un environnement plus homogène avec l'apparition de l'euro, l'europe passera donc d'un espace à devises multiples, à marchés financiers fragmentés, à une zone uniforme aux dimensions de celles des etats-unis.", "si les européens gagnent leur pari de mettre en place une monnaie saine, la suisse bénéficiera alors d'un environnement beaucoup plus homogène et stable que par le passé.", "nous avons derrière nous l'expérience de plus de vingt ans de franc suisse flottant.", "cette expérience s'est révélée positive sur de nombreux plans, notamment sur celui de la maîtrise de l'inflation et des taux d'intérêt bas dont nous jouissons.", "mais les changes flottants -- ou plus concrètement l'absence d'ordre monétaire international -- comportent aussi des inconvénients pour les petits pays.", "le plus grave est celui de l'absence de discipline imposée aux politiques économiques nationales.", "avec la monnaie unique et l'application d'une seule politique monétaire, notre environnement gagnera en homogénéité et des sources de perturbation disparaîtront.", "evidemment, cette situation pourra attrister quelques salles de change, mais c'est sans aucun doute un point positif pour l'économie suisse dans son ensemble.", "pour illustrer ce point, permettez-moi de prendre deux exemples: considérez tout d'abord la relation entre le franc suisse et le mark allemand au cours des quinze dernières années.", "si les choses sont mesurées en terme réel, on constate que la relation franc -- dm a oscillé dans une bande de fluctuation relativement étroite, de 5 %, ± autour d'un trend d'appréciation du franc de l'ordre de 0,5 % par an.", "vue sous cet angle, la relation entre le franc et le mark, deux monnaies qui n'étaient liées par aucun accord monétaire et dont les cours n'étaient pas influencés par des interventions sur les marchés des changes, s'est révélée être extraordinairement stable.", "les changes flottants n'ont donc pas généré les cours irrationnels que certains annonçaient.", 'pourquoi cette stabilité relative entre le franc et le mark?', "parce qu'il existait entre la suisse et l'allemagne une grande convergence des objectifs de politique économique et des situations conjoncturelles.", 'considérez maintenant la relation entre le franc suisse et la lire italienne, pour la même période et sur les mêmes bases.', "l'image que l'on en retire est fort différente.", 'la volatilité est beaucoup plus forte.', "la lire connaît une longue période d'appréciation jusqu'en 1992, puis chute dans un retournement dramatique de situation, suivi d'une nouvelle normalisation.", 'vous connaissez les raisons qui se trouvent en arrière-plan de ces fluctuations de la lire.', 'elles tiennent aux situations souvent difficiles rencontrées par la politique économique italienne durant ces années.', "pour l'économie suisse, de telles variations de cours sont extrêmement douloureuses.", "le degré de compétitivité de son industrie d'exportation se modifie dramatiquement, et ceci dans des périodes relativement brèves.", "il s'ensuivit des coûts élevés d'ajustement au plan économique et social.", 'la relation entre le franc et le mark et celle entre le franc et la lire révèlent donc deux aspects bien différents de notre histoire financière récente.', "d'un côté, une relative stabilité, de l'autre, une volatilité marquée.", "c'est dans ce domaine qu'un progrès considérable sera réalisé grâce à l'intégration monétaire européenne.", "avec la fixation irrémédiable des parités, puis l'introduction de l'euro, une seule politique monétaire sera appliquée.", 'le continent aura gagné en homogénéité financière.', "si l'euro disposait, demain, des mêmes caractéristiques que le mark allemand, la relation entre le franc suisse et les monnaies européennes sera beaucoup plus stable que par le passé.", 'les progrès de la stabilité monétaire profiteront donc non seulement aux européens mais aussi à ceux qui vivent à leur côté.', "2.2.2. une intégration accélérée au-delà du changement de l'environnement financier, je m'attends aussi à ce que la monnaie unique accélère l'intégration de fait de l'économie suisse dans l'économie européenne.", "aujourd'hui déjà, 80 % de nos importations proviennent de l'union européenne, qui absorbe à son tour 60 % de nos exportations.", 'de par nos flux commerciaux, notre conjoncture dépend fortement de ce qui se passe chez nos voisins.', "les retournements conjoncturels en suisse coïncident avec ceux de la france et de l'allemagne.", "demain, avec une politique macro-économique unifiée autour de nous, tout porte à croire que les pulsions économiques qui s'exerceront sur nous seront de plus en plus synchronisées.", 'notre rythme de production deviendra ainsi encore plus dépendant de ce qui se passe sur le continent.', "parallèlement à l'homogénéité économique croissante de l'union européenne on constatera que la suisse aura de plus en plus un profil européen.", "cette intégration accrue de la suisse dans l'europe nous demandera évidemment de vivre étroitement avec la future monnaie européenne.", "tous les secteurs de notre économie qui commercent avec l'étranger se trouveront concernés.", 'en premier lieu, le marché européen va devenir effectivement un „grand marché" dans lequel une monnaie -- l\'euro -- sera l\'instrument de transaction.', 'nous devons en tenir compte.', "les pratiques européennes en matière de contrats, de conditions, de normes s'imposeront encore plus à nous que par le passé.", "il sera toujours plus difficile d'utiliser le franc comme monnaie de facturation pour nos exportations et les touristes qui passeront la frontière comprendront mal qu'ils ne puissent utiliser leurs euros pour effectuer leurs paiements.", "la réalité d'une grande zone monétaire à notre porte nous demandera de la souplesse et de l'imagination.", "l'europe, qui jusqu'ici n'était qu'une mosaïque monétaire, deviendra un ensemble monolithique.", 'ceci ne peut rester sans conséquence sur notre manière de commercer.', "un autre aspect important de l'impact de l'euro sur l'économie suisse est celui de la mise en place d'un système de paiement interbancaire en euros.", "cette question est délicate car elle n'est pas encore résolue au sein de l'union européenne elle-même.", "au sein de l'union monétaire, les systèmes nationaux de paiements interbancaires seront reliés entre eux.", "il sera aussi possible de faire un paiement, valeur du jour même, de paris à francfort alors qu'aujourd'hui une telle opération s'exécute en 48 heures.", "le système européen des paiements ainsi créé bénéficiera de l'appui de la banque centrale européenne s'il devait être en manque de liquidités.", 'au niveau européen existera donc ce qui existe déjà au niveau national.', "la difficulté vient du fait qu'un certain nombre de pays de l'ue ne participeront pas à la première phase d'intégration monétaire.", 'pourront-ils se connecter au système des paiements, et à quelles conditions?', "cette question n'est pas encore réglée au sein de l'union.", "dans ces conditions, la récente décision des banques suisses de créer en allemagne une banque de clearing qui sera chargée d'exécuter leurs paiements mutuels en euros et d'établir un pont avec la banque centrale européenne me paraît adéquate.", 'il conviendra d\'examiner si la banque nationale peut jouer un rôle utile dans ce cadre lorsque les conditions de coopération entre les „ins" et les „outs" au sein de l\'union européenne auront été arrêtées.', "3. les conséquences pour la banque nationale j'en viens ainsi tout naturellement à la troisième partie de cet exposé: les conséquences de l'intégration monétaire pour la politique de la banque nationale.", "a mon sens, deux types de questions se posent: • les implications à long terme de l'intégration monétaire sur la politique de la bns, • les influences de court terme.", "a long terme, l'union monétaire européenne est pour nous synonyme d'imbrication accrue de l'économie suisse dans la scène monétaire européenne.", "la situation du marché des changes, qui est déjà aujourd'hui un facteur important dans notre appréciation de la situation, le sera plus encore.", "le fait qu'une grande partie de notre commerce s'effectuera avec la zone euro, le fait aussi que la conjoncture européenne s'imposera toujours plus à la nôtre créeront forcément une communauté de destin entre le franc et l'euro.", "une trop grande volatilité de l'euro par rapport au franc pourrait devenir extrêmement douloureuse pour l'économie suisse.", 'nous en sommes conscients.', "j'ai toutefois confiance, et je base ma confiance sur l'expérience de la cohabitation du franc suisse et du mark au cours des quinze dernières années.", "si les objectifs et les situations économiques convergent entre la suisse et l'union européenne, tout porte à penser que la volatilité de la relation franc -- euro se maintiendra dans des limites acceptables.", "cette convergence des options fondamentales me paraît acquise puisque la banque centrale européenne, tout comme la bns, fera de la stabilité des prix l'objectif prioritaire de sa politique.", "au fil des années, le franc et l'euro reposeront donc sur des éléments fondamentaux fort semblables.", "cela aura également pour conséquence de permettre un rapprochement progressif des taux d'intérêt sur ces devises.", "aujourd'hui, l'écart entre les taux suisses et allemands (représentant les taux sur l'euro) est de plus de 200 points de base.", "cet écart me semble biaisé par les incertitudes liées à l'introduction de la monnaie unique.", 'une fois celles-ci dissipées, un rapprochement devrait se manifester.', "ce ne seront pas seulement les taux suisses qui monteront mais aussi les taux sur l'euro qui baisseront.", "ce rapprochement n'est pas pour demain, il se manifestera lorsque les marchés seront convaincus de la stabilité de la nouvelle monnaie européenne.", "dans le court terme, la phase d'introduction de l'euro est marquée par une forte incertitude.", "pourtant, tout a été mis en place au niveau institutionnel comme au niveau des critères de convergence pour convaincre les marchés que l'euro sera une monnaie de qualité.", "mais tant que les marchés ne pourront pas juger sur pièce, une incertitude existera, incertitude qui pourrait être source d'instabilité des marchés et qui pourrait maintenir les taux d'intérêt à un niveau plus élevé que ce qui serait souhaitable d'un point de vue conjoncturel.", "cette volatilité potentielle de l'euro pourrait créer des difficultés pour le franc suisse, monnaie de refuge.", "comment neutraliser de telles perturbations pour l'économie suisse?", "il n'y a pas de réponse simple et évidente à cette question.", "certains pensent qu'il conviendrait, à l'image de ce qu'avait fait l'autriche, que la suisse décide de se lier unilatéralement à l'euro afin d'éliminer le risque de change.", "il lui suffirait pour cela de mener une politique de taux d'intérêt appropriée, voire de la renforcer par des interventions sur le marché des changes.", "ce n'est malheureusement pas si facile!", "si nous fixions une parité entre le franc et l'euro, nous courrions deux risques majeurs: -soit les marchés nous croiraient et nous provoquerions alors une sortie massive de capitaux qui quitteraient le franc pour se placer dans la zone euro où les rémunérations sont nettement plus élevées; -soit les marchés ne considéreraient pas cette parité comme définitive et spéculeraient à sa révision à la hausse.", 'notre stratégie stimulerait alors la spéculation au lieu de la calmer.', 'nous devrons donc vivre avec un franc flottant, mais nous devrons aussi nous comporter de telle sorte que „la bataille de l\'euro n\'ait pas lieu".', "dans ce domaine, comme dans bien d'autres, il vaut mieux prévenir une situation que la corriger.", "nous nous sommes efforcés ces douze derniers mois d'éviter une appréciation du franc suisse face au mark.", "nous l'avons fait en menant une politique monétaire accommodante.", 'cette stratégie a été, je crois, couronnée de succès.', "la faiblesse du mark engendrée par les incertitudes l'euro s'est reportée avant tout sur le dollar et la livre sterling, le franc suisse n'a été atteint que marginalement.", "nous devons continuer sur cette ligne tant que les doutes sur l'euro n'auront pas disparu.", 'mettons-nous ainsi en danger la stabilité des prix à moyen terme?', 'je ne le crois pas.', "la croissance de nos agrégats monétaires se ralentit maintenant et le dépassement de la monnaie centrale -- notre indicateur principal -- par rapport à son trend d'équilibre exagère vraisemblablement le degré d'expansion de notre action.", "enfin, n'oublions pas que dans un environnement marqué par le risque d'un franc fort, la probabilité d'une résurgence marquée de l'inflation est faible.", "conclusion les mois qui nous séparent de la première phase d'interprétation monétaire peuvent encore comporter des surprises.", 'le calme relatif du marché des changes au cours des douze derniers mois est rassurant, il indique que les risques de perturbation futurs sont limités.', "une fois la zone monétaire définie, la convergence des taux d'intérêt s'imposera d'elle-même et l'union monétaire deviendra réalité.", "c'est une nouvelle phase de l'histoire européenne qui commencera alors.", "pour la suisse également, bien qu'elle ne participe pas à l'intégration monétaire.", "nous aurons à vivre avec un environnement plus homogène, dont les taux d'intérêt seront peut-être relativement élevés dans une phase initiale, tant que la monnaie unique n'aura fait preuve de ses qualités.", "sur la durée, en revanche, il apparaîtra toujours plus de manière évidente que le franc suisse et l'euro sont des monnaies comparables, ce qui entraînera une convergence des taux entre la suisse et l'europe.", "personne ne peut dire, aujourd'hui, à quel rythme ces ajustements s'effectueront.", 'la révolution monétaire, comme toute révolution, comporte de nombreuses incertitudes.', "nous en avons déjà vécues, nous en vivrons encore jusqu'à la fin de ce siècle.", "cela demandera aux entreprises une grande capacité d'adaptation au nouvel environnement.", "je ne parle pas seulement des établissements financiers mais aussi de tous ceux qui commercent avec l'europe.", "mais sur la durée, notre industrie d'exportation pourra compter avec un environnement monétaire plus homogène, moins volatil que par le passé.", "l'union monétaire demandera aussi beaucoup de pragmatisme dans la conduite de la politique monétaire.", 'le „pragmatisme" est souvent attrayant mais ne nous cachons pas qu\'il est synonyme de prise de décision dans des conditions particulièrement difficiles où les points de repère sont moins évidents que d\'habitude.', 'nous avons bon espoir, mesdames et messieurs, que le nouvel ordre monétaire européen ne créera pas de handicap majeur pour la suisse et le franc suisse.', "il s'agit au contraire d'une chance pour notre pays, celle de clore le chapitre de vingt-cinq années de désordres monétaires en europe, pour déboucher sur une période où les politiques seront plus convergentes et stables.", "nous en attendons plus de calme dans les changes, ce qui sera dans l'intérêt du développement de notre commerce extérieur et aussi dans celui d'un retour à la croissance économique dans notre pays."]	Jean-Pierre Roth	Swiss National Bank	Vice-president of the Directorate	Switzerland
https://www.bis.org/review/r971107c.pdf	M. Tietmeyer explique la politique de stabilité dans la future UEM (Central Bank Articles and Speeches, 27 Oct 97)	Exposé de Prof. Dr. Hans Tietmeyer, Président de la Deutsche Bundesbank, au Club de l'Expansion, à Paris, le 27/10/97.	1997-10-27 00:00:00	M. Tietmeyer explique la politique de stabilité dans la future UEM Exposé de Prof. Dr. Hans Tietmeyer, Président de la Deutsche Bundesbank, au Club de l'Expansion, à Paris, le 27/10/97. I A la veille d'entrer dans un nouveau millénaire, nombreux sont ceux qui en Europe attendent avec une certaine fébrilité une "nouvelle ère monétaire" qui doit commencer début 1999 déjà avec la monnaie européenne commune. Pendant longtemps, l'UEM n'a représenté qu'une vision générale. Après avoir été inscrite pour la première fois -officiellement -- dans le calendrier européen au sommet de La Haye en 1969, puis avoir été concrétisée par le plan Werner, l'Union monétaire a disparu de la scène politique durant les deux décennies suivantes. Avec la signature du traité de Maastricht en 1992, l'UEM est toutefois devenue un objectif obligé s'inscrivant dans un plan fixé par contrat et comportant des échéances précises. Or, ce plan doit être réalisé de façon à ce que l'on puisse ériger une construction durablement stable qui ne soit pas un échafaudage fragile donnant lieu à des conflits. En effet, l'UEM ne pourra faire progresser l'intégration économique et politique et éviter les conflits que si elle repose sur des fondations vraiment stables et si les lois économiques sont continuellement observées. Voilà en quoi consiste notre objectif commun. L'Union monétaire est le couronnement d'un long processus historique. La France et l'Allemagne en ont été dès le début les forces motrices. Depuis la fin de la deuxième guerre mondiale, ces deux pays se sont fixé comme objectif la coopération économique et politique et ont cherché à établir des bases solides permettant de garantir la prospérité et la paix en Europe. Ils ont été le moteur de l'intégration, même si par moments leurs motivations et positions étaient différentes. Mais c'est surtout dans le domaine de la politique monétaire que s'est produit, durant la dernière décennie, un rapprochement fondamental. II En conformité avec la mission qui leur est assignée, les banques centrales de nos deux pays ont, aujourd'hui, comme objectif prioritaire la stabilité monétaire. Actuellement, le taux d'augmentation annuel des prix à la consommation en France et en Allemagne oscille entre un peu moins de 11⁄2% et 2%. Les taux directeurs, de 3,3% dans les deux pays, sont pour le moment au même niveau. Sur le compartiment du long terme, c'est-à-dire sur les marchés des capitaux où se négocient par exemple les emprunts d'Etat à long terme, les taux sont également plus ou moins identiques. Mais ce qui est encore bien plus important dans ce contexte, c'est qu'il y ait conformité entre les positions des deux pays sur le plan de la politique monétaire. Ainsi, les responsables de la Banque de France et de la Bundesbank sont convaincues que la stabilité des prix est la condition essentielle pour assurer la croissance, un bon niveau d'emploi et la stabilité monétaire externe. Mais elles savent aussi que la stabilité des prix ne suffit pas, elle seule, à la longue. Elle doit s'accompagner également d'une réorientation des politiques financière, fiscale, sociale et salariale, qui doit stimuler le dynamisme économique et, partant, encourager l'emploi. La stratégie à long terme de nos deux instituts, qui diverge fondamentalement de la politique de réglage en finesse du processus économique pratiquée autrefois dans les pays anglo-saxons, devrait également être adoptée, à mon avis, par la future banque centrale européenne. Le fait que les politiques menées par la Banque de France et la Deutsche Bundesbank soient semblables, en théorie comme en pratique, n'est pas dû au seul hasard. C'est l'aboutissement d'un processus de rapprochement lancé depuis assez longtemps déjà. Le facteur décisif a certainement été le fait qu'au printemps 1983 la France a opté pour une politique économique et financière axée sur la stabilité et qu'elle n'a pas dévié de cette voie durant les années suivantes, malgré toutes les difficultés qu'elle a rencontrées. Le résultat est que les taux de change se sont stabilisés dans une mesure croissante au sein du SME, tout comme le niveau des prix en Europe. Avec le traité de Maastricht qui prévoit que les banques centrales nationales n'ont aucune instruction à recevoir des gouvernements, la France et l'Allemagne ont délibérément recherché aussi la convergence au niveau institutionnel et, à présent, elles ont largement réalisé cet objectif. III Etant donné que les dangers menaçant la stabilité se sont accrus et que la politique monétaire exerce, depuis une assez longue période, des effets de plus en plus expansifs même si les taux directeurs n'ont pas bougé, la Bundesbank a légèrement resserré les rênes monétaires début octobre. Plusieurs autres banques centrales européennes -- dont la Banque de France -- ont elles aussi relevé quelque peu leurs taux. Dans nos deux pays, la loi stipule aujourd'hui que les décisions de politique monétaire sont du seul ressort des banques centrales et ne peuvent en aucun cas être influencées par le gouvernement et la politique. Cette règle est également conforme au traité de Maastricht. Et l'indépendance de la future banque centrale européenne a encore une fois été réaffirmée lors de la réunion informelle de l'Ecofin à Mondorf-les-Bains et à l'occasion du Conseil économique et financier franco-allemand de Münster. Cela implique également que la responsabilité sera désormais assumée, au niveau européen, seulement à travers le rapport présenté par le président de la Banque centrale européenne et non pas par les divers membres du future Système européen de banques centrales. Le relèvement de 0,3 point de pourcentage du troisième taux directeur vise à contrecarrer d'éventuelles pressions inflationnistes. Ainsi, la politique monétaire contribue à ce que les taux à long terme du marché -- qui sont d'une grande importance pour l'économie en Allemagne tout comme en France -- continuent à se situer à un niveau aussi bas que possible. Si, depuis, les taux d'intérêt à long terme ont subi une légère hausse dans nos deux pays, c'est parce que l'évolution observée sur les marchés américains a gagné notre continent. De nombreux analystes des milieux bancaires sont d'avis que le relèvement des taux directeurs favorise aussi la convergence des taux à court terme en Europe. J'estime qu'il faut faire preuve, là, de circonspection. Il est certain que les taux à court terme des pays de l'Union se rapprocheront progressivement les uns des autres à partir du printemps 1998, une fois que les taux de conversion bilatéraux auront été fixés. J'espère qu'ils le feront au niveau le plus bas possible et non pas au niveau qui constituera la moyenne des taux directeurs pratiqués jusque-là en Europe. Mais ce niveau dépendra bien entendu de la situation économique du moment ainsi que du choix des pays qui participeront à l'UEM, qui restent pour l'heure deux inconnues. IV Actuellement, presque tous les pays de l'Union européenne sont confrontés à un chômage record. Mais ce n'est pas en pratiquant une politique monétaire laxiste qu'ils pourront résoudre ce problème puisque le sous-emploi a essentiellement une origine structurelle, tout au moins en Allemagne. Jean-Claude Trichet a indiqué récemment que les banques centrales ne pouvaient -- et ne devaient -- fournir à l'économie que le meilleur environnement monétaire possible. Mais elles ne peuvent pas "prescrire" croissance et emploi. C'est aux partenaires sociaux de faire le nécessaire -- par le biais d'une plus grande flexibilité et mobilité -- pour qu'il n'y ait pas de suppressions de postes et que de nouveaux emplois soient créés. Il est certain que la politique économique, financière et sociale de l'Etat doit également renforcer la dynamique de l'économie en créant des conditions propices et en contribuant, surtout dans nos deux pays, à réduire le chômage. Récemment, le FMI a exhorté, à juste titre, les Européens à tout faire pour que l'euro puisse bien démarrer. Il a rappelé l'urgence de réformer les marchés du travail et les systèmes d'assurance sociale et de retraite. Car, de lui-même, l'euro ne pourra pas résoudre ces problèmes. La politique de stabilité n'est pas au demeurant une invention allemande. Il faudrait à ce propos éliminer les préjugés qui existent encore dans nos deux pays. En France aussi, il s'est toujours trouvé quelqu'un pour réclamer une économie stable non inflationniste. Rappelez-vous ce qu'a écrit Jacques Rueff à la fin des années cinquante sur l'âge de l'inflation. Pour Rueff, les revendications excessives adressées à l'Etat mettent en péril la stabilité des prix et le système économique et social libéral. L'histoire est riche en exemples montrant comment, à la longue, des comptes publics non ordonnés peuvent ébranler la monnaie et l'économie. En France surtout, l'assainissement des budgets publics a toujours revêtu une grande importance. C'est ainsi que jusqu'au début des années quatre-vingt, le déficit budgétaire a été bien inférieur à la limite de 3% fixée par le traité de Maastricht. L'endettement est resté jusqu'à maintenant au-dessous du seuil de 60 % imposé par les critères de convergence. La limite de 3% n'a d'ailleurs pas été inscrite dans le traité de Maastricht à la demande des Allemands, mais sur l'initiative des Français. Il faudra aussi impérativement que les finances publiques soient durablement stables lorsque l'Union monétaire européenne (et sa politique monétaire unique) aura été mise en place. En effet, des dettes publiques élevées -- en particulier lorsqu'elles sont financées à court terme -- peuvent sérieusement compliquer la mise en application de la politique monétaire unique et être source de conflits. V Avant de conclure, j'aimerais encore parler brièvement du développement de l'intégration politique dans l'Union, domaine qui à vrai dire n'entre pas tout à fait dans les attributions d'un banquier central. Me référant à une phrase de Voltaire qui a dit que "les paroles sont aux pensées ce que l'or est aux diamants; il est nécessaire pour les mettre en oeuvre, mais il en faut peu", je résumerai ma pensée. La question de l'intégration monétaire à trouvé une réponse dans le traité de Maastricht. Cependant, en dépit des efforts déployés avant et pendant le conseil d'Amsterdam, aucune solution n'a été trouvée pour une grande partie des interrogations suscitées par la question de la finalité politique de l'intégration européenne. Je suppose que pour certains points très importants comme l'organisation institutionnelle ou la définition exacte des compétences nationales ou supranationales dans les differénts domaines politiques, ces questions ne pourront pas être résolues dans l'immédiat. Mais toutes les nations concernées doivent être conscientes de ce que l'Union monétaire sera, dès le départ, une communauté monétaire solidaire qui ne pourra plus être résiliée. Non seulement il n'y aura plus de taux directeurs différents dans l'Union monétaire, mais une importante partie de la politique cessera de relever de la compétance des pays pour être exercée à l'échelon supranational, et ce de façon définitive. Il ne sera en effet plus possible de sortir de l'Union monétaire. C'est pourquoi il faut qu'il y ait aussi une volonté politique de s'engager durablement en formant une union politique. Cela vaut en particulier à la veille de l'élargissement de l'Union européenne. Valéry Giscard d'Estaing et Helmut Schmidt ont rappelé, à juste titre, dans un article commun publié il y a quelques jours, que "le succès de la monnaie unique dépend, à terme, de l'accomplissement de nouveaux pas sur le plan politique. Sans cela, les changements de gouvernement intervenant dans l'un ou l'autre des pays membres risqueraient de remettre en cause la solidité de l'Union. (...) On aurait pu s'attendre à ce que le traité d'Amsterdam contienne des décisions prises par les pays participants, mais ceux-ci n'étaient pas capables de s'accorder sur des réformes. (...) L'Union monétaire est un projet fédéral qui doit être accompagné et soutenu par d'autres mesures. Elle n'a jamais été faite pour rester un îlot isolé dans l'oeil d'un cyclone d'intérêts nationaux." Pour toutes ces raisons, il est nécessaire que la coopération franco-allemande devienne encore plus intense, afin que le dynamisme de l'intégration ne faiblisse pas après l'entrée dans l'Union monétaire. L'unification européenne est et reste un objectif porteur.	["m. tietmeyer explique la politique de stabilité dans la future uem exposé de prof. dr. hans tietmeyer, président de la deutsche bundesbank, au club de l'expansion, à paris, le 27/10/97.", 'i a la veille d\'entrer dans un nouveau millénaire, nombreux sont ceux qui en europe attendent avec une certaine fébrilité une "nouvelle ère monétaire" qui doit commencer début 1999 déjà avec la monnaie européenne commune.', "pendant longtemps, l'uem n'a représenté qu'une vision générale.", "après avoir été inscrite pour la première fois -officiellement -- dans le calendrier européen au sommet de la haye en 1969, puis avoir été concrétisée par le plan werner, l'union monétaire a disparu de la scène politique durant les deux décennies suivantes.", "avec la signature du traité de maastricht en 1992, l'uem est toutefois devenue un objectif obligé s'inscrivant dans un plan fixé par contrat et comportant des échéances précises.", "or, ce plan doit être réalisé de façon à ce que l'on puisse ériger une construction durablement stable qui ne soit pas un échafaudage fragile donnant lieu à des conflits.", "en effet, l'uem ne pourra faire progresser l'intégration économique et politique et éviter les conflits que si elle repose sur des fondations vraiment stables et si les lois économiques sont continuellement observées.", 'voilà en quoi consiste notre objectif commun.', "l'union monétaire est le couronnement d'un long processus historique.", "la france et l'allemagne en ont été dès le début les forces motrices.", 'depuis la fin de la deuxième guerre mondiale, ces deux pays se sont fixé comme objectif la coopération économique et politique et ont cherché à établir des bases solides permettant de garantir la prospérité et la paix en europe.', "ils ont été le moteur de l'intégration, même si par moments leurs motivations et positions étaient différentes.", "mais c'est surtout dans le domaine de la politique monétaire que s'est produit, durant la dernière décennie, un rapprochement fondamental.", "ii en conformité avec la mission qui leur est assignée, les banques centrales de nos deux pays ont, aujourd'hui, comme objectif prioritaire la stabilité monétaire.", "actuellement, le taux d'augmentation annuel des prix à la consommation en france et en allemagne oscille entre un peu moins de 11⁄2% et 2%.", 'les taux directeurs, de 3,3% dans les deux pays, sont pour le moment au même niveau.', "sur le compartiment du long terme, c'est-à-dire sur les marchés des capitaux où se négocient par exemple les emprunts d'etat à long terme, les taux sont également plus ou moins identiques.", "mais ce qui est encore bien plus important dans ce contexte, c'est qu'il y ait conformité entre les positions des deux pays sur le plan de la politique monétaire.", "ainsi, les responsables de la banque de france et de la bundesbank sont convaincues que la stabilité des prix est la condition essentielle pour assurer la croissance, un bon niveau d'emploi et la stabilité monétaire externe.", 'mais elles savent aussi que la stabilité des prix ne suffit pas, elle seule, à la longue.', "elle doit s'accompagner également d'une réorientation des politiques financière, fiscale, sociale et salariale, qui doit stimuler le dynamisme économique et, partant, encourager l'emploi.", 'la stratégie à long terme de nos deux instituts, qui diverge fondamentalement de la politique de réglage en finesse du processus économique pratiquée autrefois dans les pays anglo-saxons, devrait également être adoptée, à mon avis, par la future banque centrale européenne.', "le fait que les politiques menées par la banque de france et la deutsche bundesbank soient semblables, en théorie comme en pratique, n'est pas dû au seul hasard.", "c'est l'aboutissement d'un processus de rapprochement lancé depuis assez longtemps déjà.", "le facteur décisif a certainement été le fait qu'au printemps 1983 la france a opté pour une politique économique et financière axée sur la stabilité et qu'elle n'a pas dévié de cette voie durant les années suivantes, malgré toutes les difficultés qu'elle a rencontrées.", 'le résultat est que les taux de change se sont stabilisés dans une mesure croissante au sein du sme, tout comme le niveau des prix en europe.', "avec le traité de maastricht qui prévoit que les banques centrales nationales n'ont aucune instruction à recevoir des gouvernements, la france et l'allemagne ont délibérément recherché aussi la convergence au niveau institutionnel et, à présent, elles ont largement réalisé cet objectif.", "iii etant donné que les dangers menaçant la stabilité se sont accrus et que la politique monétaire exerce, depuis une assez longue période, des effets de plus en plus expansifs même si les taux directeurs n'ont pas bougé, la bundesbank a légèrement resserré les rênes monétaires début octobre.", 'plusieurs autres banques centrales européennes -- dont la banque de france -- ont elles aussi relevé quelque peu leurs taux.', "dans nos deux pays, la loi stipule aujourd'hui que les décisions de politique monétaire sont du seul ressort des banques centrales et ne peuvent en aucun cas être influencées par le gouvernement et la politique.", 'cette règle est également conforme au traité de maastricht.', "et l'indépendance de la future banque centrale européenne a encore une fois été réaffirmée lors de la réunion informelle de l'ecofin à mondorf-les-bains et à l'occasion du conseil économique et financier franco-allemand de münster.", 'cela implique également que la responsabilité sera désormais assumée, au niveau européen, seulement à travers le rapport présenté par le président de la banque centrale européenne et non pas par les divers membres du future système européen de banques centrales.', "le relèvement de 0,3 point de pourcentage du troisième taux directeur vise à contrecarrer d'éventuelles pressions inflationnistes.", "ainsi, la politique monétaire contribue à ce que les taux à long terme du marché -- qui sont d'une grande importance pour l'économie en allemagne tout comme en france -- continuent à se situer à un niveau aussi bas que possible.", "si, depuis, les taux d'intérêt à long terme ont subi une légère hausse dans nos deux pays, c'est parce que l'évolution observée sur les marchés américains a gagné notre continent.", "de nombreux analystes des milieux bancaires sont d'avis que le relèvement des taux directeurs favorise aussi la convergence des taux à court terme en europe.", "j'estime qu'il faut faire preuve, là, de circonspection.", "il est certain que les taux à court terme des pays de l'union se rapprocheront progressivement les uns des autres à partir du printemps 1998, une fois que les taux de conversion bilatéraux auront été fixés.", "j'espère qu'ils le feront au niveau le plus bas possible et non pas au niveau qui constituera la moyenne des taux directeurs pratiqués jusque-là en europe.", "mais ce niveau dépendra bien entendu de la situation économique du moment ainsi que du choix des pays qui participeront à l'uem, qui restent pour l'heure deux inconnues.", "iv actuellement, presque tous les pays de l'union européenne sont confrontés à un chômage record.", "mais ce n'est pas en pratiquant une politique monétaire laxiste qu'ils pourront résoudre ce problème puisque le sous-emploi a essentiellement une origine structurelle, tout au moins en allemagne.", "jean-claude trichet a indiqué récemment que les banques centrales ne pouvaient -- et ne devaient -- fournir à l'économie que le meilleur environnement monétaire possible.", 'mais elles ne peuvent pas "prescrire" croissance et emploi.', "c'est aux partenaires sociaux de faire le nécessaire -- par le biais d'une plus grande flexibilité et mobilité -- pour qu'il n'y ait pas de suppressions de postes et que de nouveaux emplois soient créés.", "il est certain que la politique économique, financière et sociale de l'etat doit également renforcer la dynamique de l'économie en créant des conditions propices et en contribuant, surtout dans nos deux pays, à réduire le chômage.", "récemment, le fmi a exhorté, à juste titre, les européens à tout faire pour que l'euro puisse bien démarrer.", "il a rappelé l'urgence de réformer les marchés du travail et les systèmes d'assurance sociale et de retraite.", "car, de lui-même, l'euro ne pourra pas résoudre ces problèmes.", "la politique de stabilité n'est pas au demeurant une invention allemande.", 'il faudrait à ce propos éliminer les préjugés qui existent encore dans nos deux pays.', "en france aussi, il s'est toujours trouvé quelqu'un pour réclamer une économie stable non inflationniste.", "rappelez-vous ce qu'a écrit jacques rueff à la fin des années cinquante sur l'âge de l'inflation.", "pour rueff, les revendications excessives adressées à l'etat mettent en péril la stabilité des prix et le système économique et social libéral.", "l'histoire est riche en exemples montrant comment, à la longue, des comptes publics non ordonnés peuvent ébranler la monnaie et l'économie.", "en france surtout, l'assainissement des budgets publics a toujours revêtu une grande importance.", "c'est ainsi que jusqu'au début des années quatre-vingt, le déficit budgétaire a été bien inférieur à la limite de 3% fixée par le traité de maastricht.", "l'endettement est resté jusqu'à maintenant au-dessous du seuil de 60 % imposé par les critères de convergence.", "la limite de 3% n'a d'ailleurs pas été inscrite dans le traité de maastricht à la demande des allemands, mais sur l'initiative des français.", "il faudra aussi impérativement que les finances publiques soient durablement stables lorsque l'union monétaire européenne (et sa politique monétaire unique) aura été mise en place.", "en effet, des dettes publiques élevées -- en particulier lorsqu'elles sont financées à court terme -- peuvent sérieusement compliquer la mise en application de la politique monétaire unique et être source de conflits.", "v avant de conclure, j'aimerais encore parler brièvement du développement de l'intégration politique dans l'union, domaine qui à vrai dire n'entre pas tout à fait dans les attributions d'un banquier central.", 'me référant à une phrase de voltaire qui a dit que "les paroles sont aux pensées ce que l\'or est aux diamants; il est nécessaire pour les mettre en oeuvre, mais il en faut peu", je résumerai ma pensée.', "la question de l'intégration monétaire à trouvé une réponse dans le traité de maastricht.", "cependant, en dépit des efforts déployés avant et pendant le conseil d'amsterdam, aucune solution n'a été trouvée pour une grande partie des interrogations suscitées par la question de la finalité politique de l'intégration européenne.", "je suppose que pour certains points très importants comme l'organisation institutionnelle ou la définition exacte des compétences nationales ou supranationales dans les differénts domaines politiques, ces questions ne pourront pas être résolues dans l'immédiat.", "mais toutes les nations concernées doivent être conscientes de ce que l'union monétaire sera, dès le départ, une communauté monétaire solidaire qui ne pourra plus être résiliée.", "non seulement il n'y aura plus de taux directeurs différents dans l'union monétaire, mais une importante partie de la politique cessera de relever de la compétance des pays pour être exercée à l'échelon supranational, et ce de façon définitive.", "il ne sera en effet plus possible de sortir de l'union monétaire.", "c'est pourquoi il faut qu'il y ait aussi une volonté politique de s'engager durablement en formant une union politique.", "cela vaut en particulier à la veille de l'élargissement de l'union européenne.", 'valéry giscard d\'estaing et helmut schmidt ont rappelé, à juste titre, dans un article commun publié il y a quelques jours, que "le succès de la monnaie unique dépend, à terme, de l\'accomplissement de nouveaux pas sur le plan politique.', "sans cela, les changements de gouvernement intervenant dans l'un ou l'autre des pays membres risqueraient de remettre en cause la solidité de l'union.", "(...) on aurait pu s'attendre à ce que le traité d'amsterdam contienne des décisions prises par les pays participants, mais ceux-ci n'étaient pas capables de s'accorder sur des réformes.", "(...) l'union monétaire est un projet fédéral qui doit être accompagné et soutenu par d'autres mesures.", 'elle n\'a jamais été faite pour rester un îlot isolé dans l\'oeil d\'un cyclone d\'intérêts nationaux."', "pour toutes ces raisons, il est nécessaire que la coopération franco-allemande devienne encore plus intense, afin que le dynamisme de l'intégration ne faiblisse pas après l'entrée dans l'union monétaire.", "l'unification européenne est et reste un objectif porteur."]	Hans Tietmeyer	Deutsche Bundesbank	Président	Germany
https://www.bis.org/review/r971107b.pdf	Mr. Tietmeyer asks whether the euro can assume the role of a major international currency (Central Bank Articles and Speeches, 28 Oct 97)	Speech given by the President of the Deutsche Bundesbank, Prof. Hans Tietmeyer, at a luncheon at the American Express Company in Paris on 28/10/97.	1997-10-28 00:00:00	Mr. Tietmeyer asks whether the euro can assume the role of a major Speech given by the President of the Deutsche Bundesbank, Prof. Hans international currency Tietmeyer, at a luncheon at the American Express Company in Paris on 28/10/97. I. The "American Express Company" is not only a financial institution, but also a brandname familiar throughout the world. The "American Express credit card" and "American Express travellers' cheque" are acknowledged in most countries as safe and convenient means of payment, which facilitate not just travel. For decades past, therefore, "American Express" has been a symbol of increasing globalisation. There are not many other enterprises that can claim that. Today, however, I do not want to talk about payment instruments. Even so, my reference to the travellers' cheque takes us straight to our topic: alongside the "greenback", the travellers' cheque is likewise a symbol of the dollar's status as the absolute Number One among the currencies of the world. II. A currency which serves at the same time as a unit of account, a medium of exchange and a store of value -- for private investors and public monetary authorities alike -- is known as an international key currency. What are the pre-requisites that a national payment medium needs, in order to assume these functions? Monetary history teaches us that the international role of a currency may often develop spontaneously with the country's political and economic significance. Hence it is not surprising that, besides gold, the pound sterling played the overriding role in the international monetary system for many decades. A well-functioning banking system and efficient capital markets had evolved in the United Kingdom at an early date. The industrial revolution began in Great Britain, and helped the British economy to gain an edge over all other countries. The role of sterling was primarily based on the UK's position as a great power, in both economic and political terms. What is more, over a period of two centuries sterling did not depreciate against other currencies. Once the significance of sterling started to decline, the dollar took the stage as the principal international currency. This was due not only to the US' rise to the status of a world power. Another important factor was that, for a long period, the dollar was far less exposed to inflationary pressures than other currencies. By virtue of the Bretton Woods system, the US dollar became the official key currency in 1944. It served national central banks as a benchmark currency, an intervention currency and a reserve currency alike. Following the collapse of the Bretton Woods system, and given the domestic stability problems in the United States, the dollar forfeited that formal function. Even so, it retained a leading role. As before, the United States remains the world's leading industrial and trading nation. That is why dollars are so highly acceptable worldwide. Moreover, the magnitude of the US financial market ensures a wide variety of investment options. The decontrol of exchange rates, the increasing freedom of capital movements and diverging stability records are the reason why other currencies, such as the Deutsche Mark, have been able to establish themselves alongside the dollar -- albeit on a far more modest scale. After all, currencies, too, compete to an increasing extent for the favour of the international transactor. Besides economic significance, a dynamic economy and a sufficiently large economic area (duly integrated in world trade), it is primarily monetary conditions that must be met. An international key currency must be able to exhibit a successful stability record over a lengthy period. While the markets may forgive short-lived slips, long-term failures are penalised. The markets' memory often stretches back a surprisingly long way. They heed the faintest signs that a currency's stability may be at risk. It is that which makes the credibility that the responsible monetary authority enjoys all the more important. It has transpired that such credibility increases with the degree of independence from government instructions. If a central bank has to serve two masters, namely monetary stability and the promotion of economic activity, it usually comes to grief in both areas. Then its credibility is compromised for a long while. III. The introduction of the euro marks a watershed, not only for the monetary situation in Europe but also for the global monetary system. Little more than a year before its planned introduction, the world's financial markets are now wondering: will the new currency be strong or weak? Can it become a serious alternative to the dollar as a reserve, investment and transaction currency? In Europe, great economic and political hopes are being pinned on the euro. The old continent is to be strengthened as a global economic power, European integration is to be fostered. It is hoped that it will be possible to cope more effectively with the challenges posed by globalisation. Moreover, many people are hoping that the euro will constitute a significant counterweight to the pre-eminent dollar. That is what Jacques Chirac, the French President, said recently in an interview he gave to a German news magazine. But the crucial factor will be whether the euro turns out to be sustainably stable, and what the market expectations in that respect are. The institutional conditions for a stability-oriented monetary policy in Europe are pretty well assured, thanks to the Maastricht Treaty and the independent central bank envisaged therein. However, a good deal will also depend on the appointments to the Executive Board of the European Central Bank. Independence chiefly means the independence of individuals. Among the European central bank governors in the European Monetary Institute, there is a broad consensus today about monetary policy objectives and strategy. That consensus must be preserved in the European Central Bank. That applies also to the view that internal stability has priority over external stability. The external value of the euro is inseparably associated with the precondition of internal stability: "stability begins at home". But the crucial event for the new currency will be the convergence examination in the spring of 1998, and the selection of the participating countries. Only countries with virtually identical stability orientations and sufficiently sound public financial positions right from the start can accede to a durably stable monetary union. The selection of the participating countries is therefore a matter of paramount importance. The vital issue is the sustainability of the convergence achieved and the necessary adaptability of the participating economies to the constantly changing challenges. In this connection, special attention will be focused on Germany and France, since monetary union is almost inconceivable without the participation of either of these countries. However, the task of achieving and maintaining convergence in anti-inflation policy does not apply merely at the time of entry into monetary union. Even after that, the policy mix must be right. This is because, in the monetary union, we shall be pursuing a single monetary policy, but at the same time largely national economic, financial and social policies. When adopting the Stability and Growth Pact in Amsterdam in June 1997, the participating states undertook "immediately to take corrective budgetary action if there are signs of any considerable departure from the objectives of the stability and convergence programmes, and particularly from the medium-term budgetary target of a nearly balanced or in-surplus budget, or if an excessive deficit is in prospect." That is a far-reaching undertaking. In the event of excessive deficits, the Stability and Growth Pact provides that the European Council should automatically impose sanctions. The sanction mechanism is designed not only to foster confidence but also to protect the single currency from unbridled public deficits and to prevent conflicts between monetary and fiscal policy. It sets strict limits to national financial policy. IV. An international key currency generally has to assume the function of an anchor currency. The markets expect it. In the present EMS this function has been, and is being, performed by the Deutsche Mark. In the case of EMS II, the exchange rate arrangement for those countries which are not participating in the single currency from the outset, the euro is to perform this function of an anchor currency. Furthermore, in future a strong orientation towards the euro is to be expected, particularly in central and eastern European countries. The euro will exert a strong attraction, especially on potential candidates for admission to the monetary union -- at any rate, if it proves stable. V. In themselves, however, the future larger economic area and credible compliance with the convergence criteria will not guarantee that the euro actually, and above all globally, develops into a serious alternative to the dollar. Ultimately, the real economic environment in Europe must likewise be right. The former Chairman of the Executive Board of the Deutsche Bank, Alfred Herrhausen, once said: "A currency becomes good if its underlying economy is also good". At present the European continent is being handicapped, above all, by the high degree of official regulation and the manifold inflexibilities on the labour market. In Germany, in particular, a confusing tax system with a high tax ratio is crippling economic dynamism. With respect to competitiveness, if Europe's economy loses touch with other regions in the long run, this is bound to have adverse effects on the euro as well. At all events, the euro will not in itself solve the structural problems besetting Europe. Worldwide locational competition calls for flexibility and the willingness to undertake structural reforms. Nowadays these characteristics are distinctly more marked in the United States than in most European countries. But there are some examples, on the old continent as well, which warrant hope. VI. In some quarters, the planned European monetary union is being viewed with concern through American eyes. That is understandable, for a soft euro -- let alone a failure of the monetary union -- is in the interest neither of Europe nor of the United States. But there are a number of reasons for hoping for a stable euro that can play a leading role in the international monetary system: • In Europe international investors find sophisticated financial markets encompassing a broad range of products and maturities. Structural changes in the international financial markets over the last fifteen years have worked to the detriment of the dollar. They have resulted in a rising market share of European currencies. Given roughly equal economic potential, the European Union is more closely integrated in the • international division of labour than the United States. That suggests that the demand for euros as a transaction currency will be strong. • The European Central Bank will be independent of political instructions. It is committed solely to the priority of internal monetary stability. The potential for excessive budget deficits is strictly limited by the Treaty of Maastricht and the • Stability and Growth Pact. • The Maastricht Treaty has noticeably fostered stability-consciousness in Europe. Inflation performance here is better than ever before. Only countries which can show evidence of long-standing stability are supposed to participate in monetary union. The euro can take up the torch from some illustrious currencies. That applies particularly to the • Deutsche Mark -- today the world's second biggest reserve currency, after the dollar. Of course, ultimately the development of the euro will hinge on whether it proves lastingly stable and to that extent can assume the legacy of those currencies which are already stable today. But all those involved are quite convinced: the euro has to be a success. Despite all the headway made up to now, however, a great deal remains to be done. In the forefront are the sustained consolidation of public finance and the dismantling of structural rigidities. I am sure these needs are increasingly being recognised. Anyway, there is certainly a good prospect of the euro duly playing its role of being an international investment, reserve and transaction currency alongside the dollar. That is, after all, in the best interests of Europe, the United States and third countries alike.	['mr. tietmeyer asks whether the euro can assume the role of a major speech given by the president of the deutsche bundesbank, prof. hans international currency tietmeyer, at a luncheon at the american express company in paris on 28/10/97.', 'i. the "american express company" is not only a financial institution, but also a brandname familiar throughout the world.', 'the "american express credit card" and "american express travellers\' cheque" are acknowledged in most countries as safe and convenient means of payment, which facilitate not just travel.', 'for decades past, therefore, "american express" has been a symbol of increasing globalisation.', 'there are not many other enterprises that can claim that.', 'today, however, i do not want to talk about payment instruments.', 'even so, my reference to the travellers\' cheque takes us straight to our topic: alongside the "greenback", the travellers\' cheque is likewise a symbol of the dollar\'s status as the absolute number one among the currencies of the world.', 'a currency which serves at the same time as a unit of account, a medium of exchange and a store of value -- for private investors and public monetary authorities alike -- is known as an international key currency.', 'what are the pre-requisites that a national payment medium needs, in order to assume these functions?', "monetary history teaches us that the international role of a currency may often develop spontaneously with the country's political and economic significance.", 'hence it is not surprising that, besides gold, the pound sterling played the overriding role in the international monetary system for many decades.', 'a well-functioning banking system and efficient capital markets had evolved in the united kingdom at an early date.', 'the industrial revolution began in great britain, and helped the british economy to gain an edge over all other countries.', "the role of sterling was primarily based on the uk's position as a great power, in both economic and political terms.", 'what is more, over a period of two centuries sterling did not depreciate against other currencies.', 'once the significance of sterling started to decline, the dollar took the stage as the principal international currency.', "this was due not only to the us' rise to the status of a world power.", 'another important factor was that, for a long period, the dollar was far less exposed to inflationary pressures than other currencies.', 'by virtue of the bretton woods system, the us dollar became the official key currency in 1944. it served national central banks as a benchmark currency, an intervention currency and a reserve currency alike.', 'following the collapse of the bretton woods system, and given the domestic stability problems in the united states, the dollar forfeited that formal function.', 'even so, it retained a leading role.', "as before, the united states remains the world's leading industrial and trading nation.", 'that is why dollars are so highly acceptable worldwide.', 'moreover, the magnitude of the us financial market ensures a wide variety of investment options.', 'the decontrol of exchange rates, the increasing freedom of capital movements and diverging stability records are the reason why other currencies, such as the deutsche mark, have been able to establish themselves alongside the dollar -- albeit on a far more modest scale.', 'after all, currencies, too, compete to an increasing extent for the favour of the international transactor.', 'besides economic significance, a dynamic economy and a sufficiently large economic area (duly integrated in world trade), it is primarily monetary conditions that must be met.', 'an international key currency must be able to exhibit a successful stability record over a lengthy period.', 'while the markets may forgive short-lived slips, long-term failures are penalised.', "the markets' memory often stretches back a surprisingly long way.", "they heed the faintest signs that a currency's stability may be at risk.", 'it is that which makes the credibility that the responsible monetary authority enjoys all the more important.', 'it has transpired that such credibility increases with the degree of independence from government instructions.', 'if a central bank has to serve two masters, namely monetary stability and the promotion of economic activity, it usually comes to grief in both areas.', 'then its credibility is compromised for a long while.', 'the introduction of the euro marks a watershed, not only for the monetary situation in europe but also for the global monetary system.', "little more than a year before its planned introduction, the world's financial markets are now wondering: will the new currency be strong or weak?", 'can it become a serious alternative to the dollar as a reserve, investment and transaction currency?', 'in europe, great economic and political hopes are being pinned on the euro.', 'the old continent is to be strengthened as a global economic power, european integration is to be fostered.', 'it is hoped that it will be possible to cope more effectively with the challenges posed by globalisation.', 'moreover, many people are hoping that the euro will constitute a significant counterweight to the pre-eminent dollar.', 'that is what jacques chirac, the french president, said recently in an interview he gave to a german news magazine.', 'but the crucial factor will be whether the euro turns out to be sustainably stable, and what the market expectations in that respect are.', 'the institutional conditions for a stability-oriented monetary policy in europe are pretty well assured, thanks to the maastricht treaty and the independent central bank envisaged therein.', 'however, a good deal will also depend on the appointments to the executive board of the european central bank.', 'independence chiefly means the independence of individuals.', 'among the european central bank governors in the european monetary institute, there is a broad consensus today about monetary policy objectives and strategy.', 'that consensus must be preserved in the european central bank.', 'that applies also to the view that internal stability has priority over external stability.', 'the external value of the euro is inseparably associated with the precondition of internal stability: "stability begins at home".', 'but the crucial event for the new currency will be the convergence examination in the spring of 1998, and the selection of the participating countries.', 'only countries with virtually identical stability orientations and sufficiently sound public financial positions right from the start can accede to a durably stable monetary union.', 'the selection of the participating countries is therefore a matter of paramount importance.', 'the vital issue is the sustainability of the convergence achieved and the necessary adaptability of the participating economies to the constantly changing challenges.', 'in this connection, special attention will be focused on germany and france, since monetary union is almost inconceivable without the participation of either of these countries.', 'however, the task of achieving and maintaining convergence in anti-inflation policy does not apply merely at the time of entry into monetary union.', 'even after that, the policy mix must be right.', 'this is because, in the monetary union, we shall be pursuing a single monetary policy, but at the same time largely national economic, financial and social policies.', 'when adopting the stability and growth pact in amsterdam in june 1997, the participating states undertook "immediately to take corrective budgetary action if there are signs of any considerable departure from the objectives of the stability and convergence programmes, and particularly from the medium-term budgetary target of a nearly balanced or in-surplus budget, or if an excessive deficit is in prospect."', 'that is a far-reaching undertaking.', 'in the event of excessive deficits, the stability and growth pact provides that the european council should automatically impose sanctions.', 'the sanction mechanism is designed not only to foster confidence but also to protect the single currency from unbridled public deficits and to prevent conflicts between monetary and fiscal policy.', 'it sets strict limits to national financial policy.', 'an international key currency generally has to assume the function of an anchor currency.', 'the markets expect it.', 'in the present ems this function has been, and is being, performed by the deutsche mark.', 'in the case of ems ii, the exchange rate arrangement for those countries which are not participating in the single currency from the outset, the euro is to perform this function of an anchor currency.', 'furthermore, in future a strong orientation towards the euro is to be expected, particularly in central and eastern european countries.', 'the euro will exert a strong attraction, especially on potential candidates for admission to the monetary union -- at any rate, if it proves stable.', 'v. in themselves, however, the future larger economic area and credible compliance with the convergence criteria will not guarantee that the euro actually, and above all globally, develops into a serious alternative to the dollar.', 'ultimately, the real economic environment in europe must likewise be right.', 'the former chairman of the executive board of the deutsche bank, alfred herrhausen, once said: "a currency becomes good if its underlying economy is also good".', 'at present the european continent is being handicapped, above all, by the high degree of official regulation and the manifold inflexibilities on the labour market.', 'in germany, in particular, a confusing tax system with a high tax ratio is crippling economic dynamism.', "with respect to competitiveness, if europe's economy loses touch with other regions in the long run, this is bound to have adverse effects on the euro as well.", 'at all events, the euro will not in itself solve the structural problems besetting europe.', 'worldwide locational competition calls for flexibility and the willingness to undertake structural reforms.', 'nowadays these characteristics are distinctly more marked in the united states than in most european countries.', 'but there are some examples, on the old continent as well, which warrant hope.', 'in some quarters, the planned european monetary union is being viewed with concern through american eyes.', 'that is understandable, for a soft euro -- let alone a failure of the monetary union -- is in the interest neither of europe nor of the united states.', 'but there are a number of reasons for hoping for a stable euro that can play a leading role in the international monetary system: • in europe international investors find sophisticated financial markets encompassing a broad range of products and maturities.', 'structural changes in the international financial markets over the last fifteen years have worked to the detriment of the dollar.', 'they have resulted in a rising market share of european currencies.', 'given roughly equal economic potential, the european union is more closely integrated in the • international division of labour than the united states.', 'that suggests that the demand for euros as a transaction currency will be strong.', '• the european central bank will be independent of political instructions.', 'it is committed solely to the priority of internal monetary stability.', 'the potential for excessive budget deficits is strictly limited by the treaty of maastricht and the • stability and growth pact.', '• the maastricht treaty has noticeably fostered stability-consciousness in europe.', 'inflation performance here is better than ever before.', 'only countries which can show evidence of long-standing stability are supposed to participate in monetary union.', 'the euro can take up the torch from some illustrious currencies.', "that applies particularly to the • deutsche mark -- today the world's second biggest reserve currency, after the dollar.", 'of course, ultimately the development of the euro will hinge on whether it proves lastingly stable and to that extent can assume the legacy of those currencies which are already stable today.', 'but all those involved are quite convinced: the euro has to be a success.', 'despite all the headway made up to now, however, a great deal remains to be done.', 'in the forefront are the sustained consolidation of public finance and the dismantling of structural rigidities.', 'i am sure these needs are increasingly being recognised.', 'anyway, there is certainly a good prospect of the euro duly playing its role of being an international investment, reserve and transaction currency alongside the dollar.', 'that is, after all, in the best interests of europe, the united states and third countries alike.']	Hans Tietmeyer	Deutsche Bundesbank	President	Germany
https://www.bis.org/review/r971107a.pdf	Mr. Bäckström discusses the current situation for monetary policy in Sweden (Central Bank Articles and Speeches, 23 Oct 97)	Remarks by the Governor of the Swedish Central Bank, Mr. Urban Bäckström, to the Standing Committee on Finance, in Stockholm, on 23/10/97.	1997-10-23 00:00:00	Mr. Bäckström discusses the current situation for monetary policy in Sweden Remarks by the Governor of the Swedish Central Bank, Mr. Urban Bäckström, to the Standing Committee on Finance, in Stockholm, on 23/10/97. I should like to thank the Committee for the invitation to discuss the Swedish economy and the current situation for monetary policy. In my opening remarks today I shall begin by briefly summarising the recent years' economic tendencies and then consider the present construction of monetary policy. A look into the future will conclude. What I have to say is based on the latest inflation report and events since it was published. From a dual situation to broader expansion Sweden's economy is now entering the fifth year of expansion since the profound crisis at the beginning of the decade. Since GDP turned upwards in the summer of 1993, annual growth has averaged over 2.5 per cent. Annual inflation in this period has averaged only about 2 per cent. This is a marked contrast with the 1970s and 1980s, when annual growth averaged approximately 2 per cent and inflation about 8 per cent. In one respect, however, the situation to date is still dismal, namely as regards the labour market and employment. If an economy is growing well but employment remains weak and unemployment high, there is a strong probability that the labour market is affected by structural problems. Although growth in recent years has been satisfactory, the generation of a broader upswing in the economy has proved difficult. Initially, about three-quarters of the GDP's increase came from manufacturing, which represents only about 20 per cent of Sweden's economy. This meant that bottlenecks occurred fairly quickly, accompanied by various types of inflationary impulses. Our relatively small industrial sector cannot be expected to sustain a growth rate that is higher than the total economy achieved in the 1970s and 1980s. The problem with the dual economy -- a flourishing export-related industrial sector and a rather weak recovery in sectors with a more domestic orientation -- stemmed in part from low confidence in economic policy's determination and ability to keep inflation low in the longer run. This in turn was a consequence of Sweden's poor record in this respect, coupled with serious problems with government finances. Long bond rates fluctuated widely and in 1994 and 1995 they actually climbed to the levels of the years of high inflation. The exchange rate continued along its depreciating path from the 1970s and 1980s. For the Riksbank, the lack of confidence in the direction of economic policy left little room for manoeuvre. Although the instrumental rate was lowered during the spring of 1994, virtually all the market rates and particularly those for longer maturities rose. Sweden was approaching a point where economic policy had to demonstrate that the focus on stability was a firm commitment. The monetary tightening and, perhaps to an even greater extent, the fiscal consolidation gradually generated increased confidence in Sweden's readiness and ability to achieve low long-term inflation. Against this background, during 1996 it was possible to cut the repo rate to its lowest level since the early 1960s. Low inflation and decreased inflation expectations also contributed to falling bond rates, accompanied by an appreciation of the krona from the earlier lows. Since December 1996 the repo rate has been unchanged at 4.10 per cent. All in all, conditions were gradually created for a broader economic upswing. With the time lag that generally applies in economic policy, during 1997 we have observed a mood swing among households, leading for instance to increased private consumption, while export growth has been maintained. The Swedish economy is entering a phase of high activity with a combination of strong domestic demand and strong export growth. The impact of the Riksbank's current monetary stance will take about two years to materialise in full. We therefore have to assess the outlook for inflation as far ahead as in 1999. Such an analysis was presented some weeks ago in the inflation report. I shall be returning shortly to that report and subsequent developments but first I want to discuss the approach in principle to the conduct of monetary policy over the complete economic cycle. Monetary policy in a cyclical perspective A matter that savers and investors are currently discussing is not whether but when the Riksbank will raise the instrumental rate. An expected increase in the repo rate is also indicated by the structure of market rates. The general impression among financial agents seems to be that a repo rate increase is probable some time in the coming winter. The timing of a change in the monetary stance is determined by the Riksbank's assessment of inflation. The simple rule of thumb for the Riksbank can be formulated as follows: if the assessment of inflation, given an unchanged instrumental rate, points to a rate of inflation one to two years ahead that is in line with the target, then the monetary stance is well balanced. If the assessment indicates a risk of inflation rising above (falling below) the target, then the monetary stance is too expansive (contractive) and the repo rate should therefore be raised (lowered). The time has not yet come for an increase in the repo rate, but when it does, our action will hopefully be seen as a natural ingredient of a monetary policy for price stability. Our ambition is to take predictable and timely measures so that sizeable interest rate movements can be avoided. Still, it is hardly surprising that the direction of monetary policy is being discussed. At present Swedish monetary policy's overall impact can be described as expansionary at a time when activity is becoming stronger. The short-term real interest rate is between 2 and 2.5 per cent, depending on the exact maturity and how inflation expectations are measured. How a neutral monetary stance translates into the short real rate is difficult to determine precisely but it can be said that the current rate is comparatively low, with an impact on total demand that should be stimulatory. In addition, the level of the real exchange rate is weak in relation to a reasonable long-term equilibrium. This means that its effect is stimulatory, too. The combined effect of the short interest rate and the exchange rate is therefore tending to support the economic upswing. All else equal, an monetary stance leads to a successive acceleration of expansionary demand. In time, this may generate a growth rate that exceeds the economy's long-term potential. The ability of the economy to cope with a high demand trend is not unlimited. As unutilised resources are activated and the output gap closes, bottlenecks of various kinds arise in the labour market or in real capital. It is in such a situation that inflation may accelerate. In order to avoid the occurrence of shortages and accelerating inflation, the monetary stance must not remain too expansive for too long in an upward phase. Instead, a timely adjustment -- bearing in mind the lag associated with monetary policy -- must be made to a more neutral position before the output gap closes. This promotes a continued growth of demand at a rate the economy can absorb -- for instance with the help of new investment, improved efficiency and labour supply -- without generating inflationary bottlenecks. The purpose of such a monetary adjustment is not to break the expansionary trend but to achieve growth that is more sustainable. In other words, a shift from an expansionary stance to one that is more neutral is designed to bring the economy onto the growth path that matches its structure -- not to bring growth to a halt. Neither should this be described as a contractive turn; it is rather a move that yields a less expansionary stance. In the public debate the Riksbank's monetary policy is sometimes described as though repo rate adjustments were a form of "punishment" or "reward", aimed at measures that have been taken either by the political system or by labour market organisations in connection with wage negotiations. My point here has been that interest rate adjustments are a natural feature of monetary policy's path over the economic cycle. Of course this does not mean that the construction of monetary policy is not affected by fiscal expansion or contraction, or by low or high wage settlements. What I want to make clear is that adjustments to the instrumental rate in the course of the economic cycle are a natural phenomenon and their purpose is to create conditions for sustained growth and low inflation. If a central bank waits too long before shifting from an expansive to a more neutral monetary stance, problems with bottlenecks are liable to become more widespread and the economy may become overheated. Besides entailing rising inflation, this causes firms and households to start accustoming themselves to a high level of inflation. Monetary policy may then be forced to adopt a contractive stance in order to bring inflation back to the target rate. So if the central bank waits too long, the interest rate increases may be all the larger. In the meantime, moreover, economic imbalances and tensions may become so great that they lead to economic setbacks. We are familiar with such a course of events from the 1970s and 1980s, and perhaps not least from the early 1990s. Against this background, in situations when capacity is coming under pressure, it is clearly better for a central bank to act at an early stage. Future inflation The assessment in the inflation report, published just over a month ago, is that growth in the Swedish economy will be about 2 per cent in 1997 and around 3 per cent in 1998. In 1999, the rate is expected to go on accelerating to just over 3 per cent. This assessment envisages that, in an expanding world market, export growth remains relatively high. This is accompanied by an accelerating increase in private consumption, while public consumption at least stops falling. Economic growth in Sweden in 1998 and 1999 would then most probably exceed the potential rate, which is estimated to be just over 2 per cent in annual terms. The broad rise in all the major demand components will therefore gradually exert pressure on the available resources. This successive increase in resource utilisation is already evident in some indicators. A growing proportion of firms are reporting, for example, that output is being restricted by productive factors rather than by demand. The gap between total demand and total resources for production is an important but elusive indicator of inflationary pressure. The Riksbank considers that the output gap, which is an attempt to measure the degree of unutilised resources in the total economy, is 2 per cent of GDP. With the GDP forecast from the inflation report, this means that the gap will narrow by degrees and close some time during 1999, in any event towards the end of that year. In the light of the assessments of resource utilisation and other factors, in the inflation report the Riksbank forecast that the annual increase in the CPI will be around 1 per cent in 1997 and around 2 per cent in both 1998 and 1999, with some upward tendency in the latter two years. This is our main scenario. Like most other forecasts, however, inflation assessments are subject to uncertainty. Our forecasts as a foundation for monetary policy therefore do not consist of single point estimates of future inflation. In practice we construct a number of alternative outcomes and assess their probabilities. Normally there is one main scenario and two alternatives. Economic activity could be stronger than we have envisaged, so that inflation is somewhat higher; but it could also be weaker, giving lower inflation. Most of the evidence suggests, however, that since the inflation report, an outcome which is appreciably weaker than the main scenario has become less likely. The forecasts for all the demand components are naturally uncertain. It is, however, particularly worth discussing the forecast for private consumption, since this component represents about one-half of total demand. Some factors suggest that the growth of private consumption could become stronger than most observers count on today. The background here is that for a number years the growth of household disposable income has been held back by fiscal consolidation. After 1998, however, the direct restrictive fiscal impact on household finances is expected to diminish. But in spite of the weak or negative income trend, private consumption has already been rising for a number of years, albeit rather slowly. The reason is that, besides the effect of income on private consumption, spending by households, as well as their view of the future, is influenced by the increase in wealth. Households have recently become appreciably more optimistic about the future. House prices and share prices have been rising markedly for some years. The realised and latent capital gains of households in 1997 add up to the equivalent of about 25 per cent of their income, a figure that is as high as in the late 1980s. It would be surprising if such an increase in wealth did not contribute sooner or later to higher consumer demand. The key question, however, is how rapidly private consumption will grow. The above applies provided the increase in asset prices is maintained. Since share prices turned upwards in the autumn of 1992, the increase on the Stockholm Exchange has been one of the largest since the early 1920s, which is as far back as the statistics go. The overall valuation of corporate profits is also historically high. The present level of share prices calls for a further rapid increase in profits for several years to come. Minor changes in this picture of the future could affect current share prices. Another element of uncertainty concerns the economy's supply side. We cannot be sure of just how much the economy can produce without an increase in inflation. Moreover, it is not only the total reserve of resources that may affect inflation. The rate at which resource utilisation rises may also be important. A rapid activation of the unutilised resources could generate stronger inflationary impulses even if surplus capacity still exists at total level. CPI inflation has moved up sharply during 1997. The 12-month change was down around 0 per cent for a couple of months last spring but after that it moved up fairly quickly to 1.9 per cent for September. In September alone the CPI rose 0.9 per cent, which was more than most observers had expected. The figure also aroused some uncertainty among savers and investors. The question is whether the increase in inflation represents a new and unforeseen tendency. The main features of this development are not unexpected. One factor behind the rising CPI is increased indirect taxes, for instance for tobacco, and higher administered prices. Another explanation is that the impact on the CPI from the falling interest rates in 1996-1997 is diminishing. All in all, this means that the CPI is closing in on underlying inflation as measured in various ways by the Riksbank. Still, the CPI outcome for September is somewhat higher than the Riksbank had counted on. Figures for a single month admittedly do not warrant definite conclusions but it is certainly important to pay heightened attention to price movements in the coming months. Normally it is underlying or trend inflation that is primarily of interest for monetary policy. This holds unless transitory price effects influence inflation expectations. In a setting where inflation expectations are firmly anchored to the inflation target, monetary policy has some room for manoeuvre. But if expected inflation starts to rise, we must be on the alert, particularly in that the current monetary stance is stimulatory. The importance of expected inflation for price and wage formation was evident not least in connection with the 1995 round of wage negotiations. At that time, expectations of future inflation seem to have been a bit above 4 per cent, which probably contributed to the excessively high level of the ensuing wage agreements. Now that the Swedish economy is on the threshold of very important wage negotiations, there must be no doubt that the Riksbank is truly serious about the inflation target. Future wage formation is yet another risk factor that the Riksbank has to consider. There are some encouraging signs that wage formation is moving in the right direction, even though the parties have gone in for a certain amount of bidding. This tends to be a process that conveys a varying degree of realism. It is important to bear in mind that wage formation is not just a matter of the level of wage agreements. The outcome for wages is also conditioned by the wage drift that mirrors labour supply and demand. The less efficiently the labour market works, the sooner bottlenecks arise that generate increased wage drift. Tendencies to labour shortages in certain sectors are already discernible, despite the high unemployment. Conclusion: monetary stance well balanced; changes in the spectrum of risks A monetary policy that aims for sustained price stability is not at odds with good economic growth. This presupposes that the supply side functions so well that growth does not give rise to inflationary impulses. But if the structure of the economy is such that only moderate growth is feasible, demand and accordingly the monetary stance must be adjusted accordingly. The alternative is demand growth that exceeds what the economy is capable of producing without inflationary bottlenecks. Accelerating inflation is a threat to sustainable growth and may even result in serious economic setbacks, as history has taught us. As economic activity becomes stronger and monetary policy adjusts its sights on the future picture, the Riksbank's monetary stance will have to gradually move away from its current expansionary position. The timing of such a move has to be assessed in the light of new information and today one cannot say when it will happen. Our present assessment is that the monetary stance is well balanced. There has been some shift in the spectrum of risks but our inflation forecast for the coming years is unchanged.	['mr. bäckström discusses the current situation for monetary policy in sweden remarks by the governor of the swedish central bank, mr. urban bäckström, to the standing committee on finance, in stockholm, on 23/10/97.', 'i should like to thank the committee for the invitation to discuss the swedish economy and the current situation for monetary policy.', "in my opening remarks today i shall begin by briefly summarising the recent years' economic tendencies and then consider the present construction of monetary policy.", 'a look into the future will conclude.', 'what i have to say is based on the latest inflation report and events since it was published.', "from a dual situation to broader expansion sweden's economy is now entering the fifth year of expansion since the profound crisis at the beginning of the decade.", 'since gdp turned upwards in the summer of 1993, annual growth has averaged over 2.5 per cent.', 'annual inflation in this period has averaged only about 2 per cent.', 'this is a marked contrast with the 1970s and 1980s, when annual growth averaged approximately 2 per cent and inflation about 8 per cent.', 'in one respect, however, the situation to date is still dismal, namely as regards the labour market and employment.', 'if an economy is growing well but employment remains weak and unemployment high, there is a strong probability that the labour market is affected by structural problems.', 'although growth in recent years has been satisfactory, the generation of a broader upswing in the economy has proved difficult.', "initially, about three-quarters of the gdp's increase came from manufacturing, which represents only about 20 per cent of sweden's economy.", 'this meant that bottlenecks occurred fairly quickly, accompanied by various types of inflationary impulses.', 'our relatively small industrial sector cannot be expected to sustain a growth rate that is higher than the total economy achieved in the 1970s and 1980s.', "the problem with the dual economy -- a flourishing export-related industrial sector and a rather weak recovery in sectors with a more domestic orientation -- stemmed in part from low confidence in economic policy's determination and ability to keep inflation low in the longer run.", "this in turn was a consequence of sweden's poor record in this respect, coupled with serious problems with government finances.", 'long bond rates fluctuated widely and in 1994 and 1995 they actually climbed to the levels of the years of high inflation.', 'the exchange rate continued along its depreciating path from the 1970s and 1980s.', 'for the riksbank, the lack of confidence in the direction of economic policy left little room for manoeuvre.', 'although the instrumental rate was lowered during the spring of 1994, virtually all the market rates and particularly those for longer maturities rose.', 'sweden was approaching a point where economic policy had to demonstrate that the focus on stability was a firm commitment.', "the monetary tightening and, perhaps to an even greater extent, the fiscal consolidation gradually generated increased confidence in sweden's readiness and ability to achieve low long-term inflation.", 'against this background, during 1996 it was possible to cut the repo rate to its lowest level since the early 1960s.', 'low inflation and decreased inflation expectations also contributed to falling bond rates, accompanied by an appreciation of the krona from the earlier lows.', 'since december 1996 the repo rate has been unchanged at 4.10 per cent.', 'all in all, conditions were gradually created for a broader economic upswing.', 'with the time lag that generally applies in economic policy, during 1997 we have observed a mood swing among households, leading for instance to increased private consumption, while export growth has been maintained.', 'the swedish economy is entering a phase of high activity with a combination of strong domestic demand and strong export growth.', "the impact of the riksbank's current monetary stance will take about two years to materialise in full.", 'we therefore have to assess the outlook for inflation as far ahead as in 1999. such an analysis was presented some weeks ago in the inflation report.', 'i shall be returning shortly to that report and subsequent developments but first i want to discuss the approach in principle to the conduct of monetary policy over the complete economic cycle.', 'monetary policy in a cyclical perspective a matter that savers and investors are currently discussing is not whether but when the riksbank will raise the instrumental rate.', 'an expected increase in the repo rate is also indicated by the structure of market rates.', 'the general impression among financial agents seems to be that a repo rate increase is probable some time in the coming winter.', "the timing of a change in the monetary stance is determined by the riksbank's assessment of inflation.", 'the simple rule of thumb for the riksbank can be formulated as follows: if the assessment of inflation, given an unchanged instrumental rate, points to a rate of inflation one to two years ahead that is in line with the target, then the monetary stance is well balanced.', 'if the assessment indicates a risk of inflation rising above (falling below) the target, then the monetary stance is too expansive (contractive) and the repo rate should therefore be raised (lowered).', 'the time has not yet come for an increase in the repo rate, but when it does, our action will hopefully be seen as a natural ingredient of a monetary policy for price stability.', 'our ambition is to take predictable and timely measures so that sizeable interest rate movements can be avoided.', 'still, it is hardly surprising that the direction of monetary policy is being discussed.', "at present swedish monetary policy's overall impact can be described as expansionary at a time when activity is becoming stronger.", 'the short-term real interest rate is between 2 and 2.5 per cent, depending on the exact maturity and how inflation expectations are measured.', 'how a neutral monetary stance translates into the short real rate is difficult to determine precisely but it can be said that the current rate is comparatively low, with an impact on total demand that should be stimulatory.', 'in addition, the level of the real exchange rate is weak in relation to a reasonable long-term equilibrium.', 'this means that its effect is stimulatory, too.', 'the combined effect of the short interest rate and the exchange rate is therefore tending to support the economic upswing.', 'all else equal, an monetary stance leads to a successive acceleration of expansionary demand.', "in time, this may generate a growth rate that exceeds the economy's long-term potential.", 'the ability of the economy to cope with a high demand trend is not unlimited.', 'as unutilised resources are activated and the output gap closes, bottlenecks of various kinds arise in the labour market or in real capital.', 'it is in such a situation that inflation may accelerate.', 'in order to avoid the occurrence of shortages and accelerating inflation, the monetary stance must not remain too expansive for too long in an upward phase.', 'instead, a timely adjustment -- bearing in mind the lag associated with monetary policy -- must be made to a more neutral position before the output gap closes.', 'this promotes a continued growth of demand at a rate the economy can absorb -- for instance with the help of new investment, improved efficiency and labour supply -- without generating inflationary bottlenecks.', 'the purpose of such a monetary adjustment is not to break the expansionary trend but to achieve growth that is more sustainable.', 'in other words, a shift from an expansionary stance to one that is more neutral is designed to bring the economy onto the growth path that matches its structure -- not to bring growth to a halt.', 'neither should this be described as a contractive turn; it is rather a move that yields a less expansionary stance.', 'in the public debate the riksbank\'s monetary policy is sometimes described as though repo rate adjustments were a form of "punishment" or "reward", aimed at measures that have been taken either by the political system or by labour market organisations in connection with wage negotiations.', "my point here has been that interest rate adjustments are a natural feature of monetary policy's path over the economic cycle.", 'of course this does not mean that the construction of monetary policy is not affected by fiscal expansion or contraction, or by low or high wage settlements.', 'what i want to make clear is that adjustments to the instrumental rate in the course of the economic cycle are a natural phenomenon and their purpose is to create conditions for sustained growth and low inflation.', 'if a central bank waits too long before shifting from an expansive to a more neutral monetary stance, problems with bottlenecks are liable to become more widespread and the economy may become overheated.', 'besides entailing rising inflation, this causes firms and households to start accustoming themselves to a high level of inflation.', 'monetary policy may then be forced to adopt a contractive stance in order to bring inflation back to the target rate.', 'so if the central bank waits too long, the interest rate increases may be all the larger.', 'in the meantime, moreover, economic imbalances and tensions may become so great that they lead to economic setbacks.', 'we are familiar with such a course of events from the 1970s and 1980s, and perhaps not least from the early 1990s.', 'against this background, in situations when capacity is coming under pressure, it is clearly better for a central bank to act at an early stage.', 'future inflation the assessment in the inflation report, published just over a month ago, is that growth in the swedish economy will be about 2 per cent in 1997 and around 3 per cent in 1998. in 1999, the rate is expected to go on accelerating to just over 3 per cent.', 'this assessment envisages that, in an expanding world market, export growth remains relatively high.', 'this is accompanied by an accelerating increase in private consumption, while public consumption at least stops falling.', 'economic growth in sweden in 1998 and 1999 would then most probably exceed the potential rate, which is estimated to be just over 2 per cent in annual terms.', 'the broad rise in all the major demand components will therefore gradually exert pressure on the available resources.', 'this successive increase in resource utilisation is already evident in some indicators.', 'a growing proportion of firms are reporting, for example, that output is being restricted by productive factors rather than by demand.', 'the gap between total demand and total resources for production is an important but elusive indicator of inflationary pressure.', 'the riksbank considers that the output gap, which is an attempt to measure the degree of unutilised resources in the total economy, is 2 per cent of gdp.', 'with the gdp forecast from the inflation report, this means that the gap will narrow by degrees and close some time during 1999, in any event towards the end of that year.', 'in the light of the assessments of resource utilisation and other factors, in the inflation report the riksbank forecast that the annual increase in the cpi will be around 1 per cent in 1997 and around 2 per cent in both 1998 and 1999, with some upward tendency in the latter two years.', 'this is our main scenario.', 'like most other forecasts, however, inflation assessments are subject to uncertainty.', 'our forecasts as a foundation for monetary policy therefore do not consist of single point estimates of future inflation.', 'in practice we construct a number of alternative outcomes and assess their probabilities.', 'normally there is one main scenario and two alternatives.', 'economic activity could be stronger than we have envisaged, so that inflation is somewhat higher; but it could also be weaker, giving lower inflation.', 'most of the evidence suggests, however, that since the inflation report, an outcome which is appreciably weaker than the main scenario has become less likely.', 'the forecasts for all the demand components are naturally uncertain.', 'it is, however, particularly worth discussing the forecast for private consumption, since this component represents about one-half of total demand.', 'some factors suggest that the growth of private consumption could become stronger than most observers count on today.', 'the background here is that for a number years the growth of household disposable income has been held back by fiscal consolidation.', 'after 1998, however, the direct restrictive fiscal impact on household finances is expected to diminish.', 'but in spite of the weak or negative income trend, private consumption has already been rising for a number of years, albeit rather slowly.', 'the reason is that, besides the effect of income on private consumption, spending by households, as well as their view of the future, is influenced by the increase in wealth.', 'households have recently become appreciably more optimistic about the future.', 'house prices and share prices have been rising markedly for some years.', 'the realised and latent capital gains of households in 1997 add up to the equivalent of about 25 per cent of their income, a figure that is as high as in the late 1980s.', 'it would be surprising if such an increase in wealth did not contribute sooner or later to higher consumer demand.', 'the key question, however, is how rapidly private consumption will grow.', 'the above applies provided the increase in asset prices is maintained.', 'since share prices turned upwards in the autumn of 1992, the increase on the stockholm exchange has been one of the largest since the early 1920s, which is as far back as the statistics go.', 'the overall valuation of corporate profits is also historically high.', 'the present level of share prices calls for a further rapid increase in profits for several years to come.', 'minor changes in this picture of the future could affect current share prices.', "another element of uncertainty concerns the economy's supply side.", 'we cannot be sure of just how much the economy can produce without an increase in inflation.', 'moreover, it is not only the total reserve of resources that may affect inflation.', 'the rate at which resource utilisation rises may also be important.', 'a rapid activation of the unutilised resources could generate stronger inflationary impulses even if surplus capacity still exists at total level.', 'cpi inflation has moved up sharply during 1997. the 12-month change was down around 0 per cent for a couple of months last spring but after that it moved up fairly quickly to 1.9 per cent for september.', 'in september alone the cpi rose 0.9 per cent, which was more than most observers had expected.', 'the figure also aroused some uncertainty among savers and investors.', 'the question is whether the increase in inflation represents a new and unforeseen tendency.', 'the main features of this development are not unexpected.', 'one factor behind the rising cpi is increased indirect taxes, for instance for tobacco, and higher administered prices.', 'another explanation is that the impact on the cpi from the falling interest rates in 1996-1997 is diminishing.', 'all in all, this means that the cpi is closing in on underlying inflation as measured in various ways by the riksbank.', 'still, the cpi outcome for september is somewhat higher than the riksbank had counted on.', 'figures for a single month admittedly do not warrant definite conclusions but it is certainly important to pay heightened attention to price movements in the coming months.', 'normally it is underlying or trend inflation that is primarily of interest for monetary policy.', 'this holds unless transitory price effects influence inflation expectations.', 'in a setting where inflation expectations are firmly anchored to the inflation target, monetary policy has some room for manoeuvre.', 'but if expected inflation starts to rise, we must be on the alert, particularly in that the current monetary stance is stimulatory.', 'the importance of expected inflation for price and wage formation was evident not least in connection with the 1995 round of wage negotiations.', 'at that time, expectations of future inflation seem to have been a bit above 4 per cent, which probably contributed to the excessively high level of the ensuing wage agreements.', 'now that the swedish economy is on the threshold of very important wage negotiations, there must be no doubt that the riksbank is truly serious about the inflation target.', 'future wage formation is yet another risk factor that the riksbank has to consider.', 'there are some encouraging signs that wage formation is moving in the right direction, even though the parties have gone in for a certain amount of bidding.', 'this tends to be a process that conveys a varying degree of realism.', 'it is important to bear in mind that wage formation is not just a matter of the level of wage agreements.', 'the outcome for wages is also conditioned by the wage drift that mirrors labour supply and demand.', 'the less efficiently the labour market works, the sooner bottlenecks arise that generate increased wage drift.', 'tendencies to labour shortages in certain sectors are already discernible, despite the high unemployment.', 'conclusion: monetary stance well balanced; changes in the spectrum of risks a monetary policy that aims for sustained price stability is not at odds with good economic growth.', 'this presupposes that the supply side functions so well that growth does not give rise to inflationary impulses.', 'but if the structure of the economy is such that only moderate growth is feasible, demand and accordingly the monetary stance must be adjusted accordingly.', 'the alternative is demand growth that exceeds what the economy is capable of producing without inflationary bottlenecks.', 'accelerating inflation is a threat to sustainable growth and may even result in serious economic setbacks, as history has taught us.', "as economic activity becomes stronger and monetary policy adjusts its sights on the future picture, the riksbank's monetary stance will have to gradually move away from its current expansionary position.", 'the timing of such a move has to be assessed in the light of new information and today one cannot say when it will happen.', 'our present assessment is that the monetary stance is well balanced.', 'there has been some shift in the spectrum of risks but our inflation forecast for the coming years is unchanged.']	Urban Bäckström	Sveriges Riksbank	Governor	Sweden
https://www.bis.org/review/r971105g.pdf	Mr. Wellink discusses recent developments in the Dutch economy (Central Bank Articles and Speeches, 25 Oct 97)	Address given by the President of the Netherlands Bank, Dr. A.H.E.M. Wellink, at the XXI European meeting of the Trilateral Commission in The Hague on 25/10/97.	1997-10-25 00:00:00	Mr. Wellink discusses recent developments in the Dutch economy Address given by the President of the Netherlands Bank, Dr. A.H.E.M. Wellink, at the XXIst European meeting of the Trilateral Commission in The Hague on 25/10/97. Recent success As you all know, the Dutch economy has been doing remarkably well lately. Over the past three years, Dutch GDP has grown by an annual average of 3%, i.e., considerably more than was the case in most major continental European countries. For this year and the next, the prospects for growth are even better. Growth has furthermore been attended by considerable job creation, averaging nearly 100,000 man-years per annum, or 1.8%, since 1995. The Dutch unemployment figure has consequently dropped to around 6%. All this is in sharp contrast to the picture presented by most countries on the continent of Europe. Until very recently, they were seeing no more than a moderate cyclical recovery. Still, this year the growth of output in these countries would seem to be accelerating substantially. This has not yet, unfortunately, fed through to the employment situation. In Germany and France, for instance, unemployment is expected to rise even further this year. The unemployment figure there is about twice that in the Netherlands. The Dutch upturn has drawn widespread attention, and has come to be known in some circles as the Dutch model. In my speech today, I will guide you through the roots of the Dutch success. Let me start by saying that the recent favourable economic development is definitely not a miracle. It simply boils down to sound macro-economic policies and deregulation, in particular of labour markets (including some country-specific deregulation policies). Every country in the world can effectively copy it. The implementation of these policies was possible because of a broad consensus in the Netherlands on their necessity. This is lacking in many of our neighbouring countries. But to my mind this consensus among all relevant parties was not caused by the so-called consensus model -- on the contrary. The consensus emerged after the consultative framework -- which had led to paralysis in the 1970s -- was made much leaner. I will come back to that later. Let my first give you an overview of the facts and figures surrounding the so-called "Dutch miracle". Making up for lost ground To see the developments of the last few years in their proper perspective, we must take a look at the situation in the early 1980s. In those years, Dutch business was in serious trouble. The international recession, when it struck, hit the Netherlands much harder than its neighbours, because in the 1970s business sector profitability here had been structurally eroded by excessive rises in wage costs and the consequent deterioration of competitiveness. A vicious circle of labour shake-out set in, leading -- via the social security system -- to higher social insurance contributions and thus contributing to further job destruction. The problem was compounded by an inappropriate policy reaction to the two oil crises, in the form of an expansive budget leading to unsustainable deficits (of over 10% of GDP) and, after some delay, to soaring central government indebtedness. The figures show only too clearly that in those years the Netherlands was much worse off than other countries. In 1970, the Netherlands had still held the sixth place in Europe in terms of per capita GDP (10% above the European average). But by 1988 it had fallen to below that average, and the Netherlands had dropped to the eleventh place. Looking at the figures for subsequent years, we see that the Netherlands has since regained some of the ground which it had lost earlier. In 1996, per capita GDP held the seventh place (at nearly 5% above the European average). A similar pattern is in evidence for the employment situation; between 1972 and 1983, job losses were much worse than in the rest of Europe. But here the relative recovery set in around 1985. In other words, the Dutch success has until now been no more than an exercise in making up for ground lost earlier. In fact, we still have not caught up with Europe in all respects. Explanatory factors In my view, the turnaround which began in 1982-1983 can be ascribed to a combination of sound macroeconomic policy, as well as specific measures aimed at improving the operation of markets. • The gradual restructuring of public finance, starting in 1982 and resulting in a deficit of 2.1% of GDP in 1997, compares favourably with those of most countries in the vicinity. The introduction of real expenditure ceilings at the start of this Cabinet has proved instrumental to this success. Also, the better control of the budgetary process contributed to the outcome. It is gratifying that our efforts to achieve healthier public finances have mainly taken the form of expenditure cuts. The cuts have also made it possible to alleviate the burden of taxation and social insurance contributions. The positive evaluation made by the ECOFIN Council this spring is a good incentive to strive over the next few years for a balanced budget. I will be going into the need for that later. • The fact that since 1983 monetary policy has given absolute priority to stability of the guilder/Deutsche mark exchange rate is another contributing factor. That has enabled us to import, as it were, the usually favourable price climate prevailing in Germany. Because of moderate wage developments at home, this exchange rate policy provided for real exchange rate stability as well, resulting in a favourable competitive position of our business sector. This contrasted sharply with Germany, where excessive wage increases during the reunification boom contributed to a substantial real appreciation of the German mark of about 12% between 1990 and 1995. The real guilder appreciation was instead negligible. The policy also enhanced confidence in the financial markets, which in turn contributed to a sustained decline of (the risk premium contained in) interest rates. For over a decade, Dutch capital market rates have been among the lowest in Europe, making for an improved investment climate as well. • The wage restraint -- I mentioned it already -- ensuing from the much cited accord of Wassenaar (1982) was the third factor. This entailed a trade-off between the employers' organizations and the trade unions, the latter relinquishing automatic price compensation for a shorter working week. A condition was that business costs should not increase. It was furthermore agreed that wage negotiations would be decentralized. The process of wage moderation was boosted further by the government-initiated alleviation of taxation and social insurance contributions. In the longer term, the results can be seen to be truly impressive. Over the past fifteen years, unit wage costs have remained well-nigh stable in the Netherlands, allowing a recovery of profitability, and an improvement of the business sector's competitiveness. • The economy has moved towards greater market orientation, a goal which has been high on the political agenda since the beginning of the 1990s. The labour market was the first to be targeted, with social security legislation being amended to give the market mechanism greater leeway. In the period from 1983 to 1990, minimum wages and social insurance benefits had been delinked from the general development of wages. A wide range of measures was directed at the lower end of the labour market, the aim being to stimulate businesses to employ low-skilled personnel by way of a reduction of social insurance contributions payable by employers, wage cost subsidies and subsidized jobs. Furthermore, society has come to accept flexible forms of labour, such as part-time working and temporary staffing, which have boosted the expansion of the number of jobs in the services sector. In this respect, the Netherlands holds a vanguard position internationally, with 40% of all work now being done on flexible contracts. Not only does this greater flexibility meet the needs of the business sector, employees, too, seem to find it suits their changing preferences. Global calculations show that the potential employment gains for other countries, if part-time jobs had developed to the same extent as in the Netherlands, could be sizeable (around 3 million jobs in both Germany and France). These calculations are highly mechanical and therefore one should be cautious in interpreting the outcome. Nevertheless, I think that part-time work arrangements could be helpful in addressing a serious unemployment situation, under strict conditions, i.e., they are applied tailor-made and do not increase businesses' operating costs. So far the main result in the area of product market improvement has been the 1996 liberalization of the statutory establishment rules for businesses. With boundaries disappearing and new technology being developed all the time, we cannot but go with the grain of the market on an increasing scale. We must always keep in mind that all countries around us are doing exactly the same thing. Introducing new rules and amending old ones may be painful at first, apart from being time-consuming, but there seems to be nothing for it but to go on doing so, if we wish to maintain our prosperity in the longer term. With so much praise being heaped on the Netherlands and its consensus economy, people tend to forget that consensus about how a recovery should be brought about did not materialize out of the blue; in fact, it was enforced by the unfavourable economic developments during the 1980-81 recession, which, as I noted before, hit us much harder than others. Ultimately, it was that very fact which compelled the employers' organizations and the trade unions to give up their entrenched views, views which had been characteristic of the 1970s. That episode illustrates only too vividly that having a consultative framework for employers and employees does not guarantee fruitful negotiations. The consultative process has been streamlined in the meantime. One could say that the "consensus model" of the 1970s has given way to the consensus of the 1990s. Where do we go from here? For all our fifteen years of conducting a policy aimed at recovery, we cannot afford to indulge in complacency. Things may be going in the right direction, but we still have several major long-standing problems to see to: • First, there is the continued high rate of economic inactivity. The low participation rate of our population in general is a major factor underlying our internationally modest position in terms of prosperity. This applies especially to the older members of the labour force. More than half of those aged between 50 and 65 do not hold a job. We should really be seeking to reduce our rate of economic inactivity to the levels prevailing in neighbouring countries. • Secondly, there is our considerable public debt. Although it has been falling in recent years, our debt ratio (of over 70% of GDP) continues to be more than 10 percentage points above the EMU criterion. A rapid further reduction to well below 60% is called for if we wish to be able to cope with the growing burden which the imminent ageing of the population will impose on public finance. In addition, as we have seen in the past, high debts make us more vulnerable in the event of interest rate rises. European interest rates are currently low, but they will not stay that way for ever. Our fundamentals are favourable. One major advantage is our structurally high savings surplus, indicating that macro-economically there are no financial impediments to higher growth. Furthermore, we seem to have scope for further growth, provided we succeed in harnessing the current labour reserve. To complete our recovery, we will need further budgetary restructuring and continue on the path toward greater market orientation. Policy conclusions This brings me to the concluding part of my speech: what can we learn from the Dutch experience? There are five lessons which can be drawn from it. Firstly, monetary stability is an important ingredient of a stable economic climate. However, not only nominal but also real exchange rate stability matters. If relative price and labour cost developments are out of line, a country's competitiveness is seriously affected, even if the nominal exchange rate remains stable. This is an important lesson with a view to EMU when nominal exchange rate stability is a given factor. Secondly, sound budgetary policy is not only about deficit reduction and cutting expenditure. It is about redefining the role of the public sector in an economy. Thirdly, more market pays off. We should not forget that the private sector is the engine of our economy. So why not give the market sector more leeway? Of course, always on the basis of a good analysis of what can and can't be done by the market. The fourth lesson is related to the latter. Policies geared at increasing labour market flexibility work. However, it is important to note that -- as far as labour market policies is concerned -- there is no overall recipe which can be applied. Policies should be tailor-made depending on frictions on certain parts of the labour market. Last, but not least -- and related to the fourth lesson -- reduction in working hours can, under conditions, play an important role in an economy. In the short term, it simply boils down to a redistribution of work, without affecting the performance of an economy. However, redistribution of work can (in return for moderate wage claims) contribute to the necessary consensus between employee and employers organizations in an economy. And the latter does improve the performance of the economy in the longer run, as the Dutch experiences teach us. To conclude, there is not really anything new under the sun. The combination of economic policies which the Netherlands have opted for have been advised by -- for instance -- the International Monetary Fund for a long period. The issue is how to make society embark on these policies; in other words, how to create consensus. Not by forcing all relevant parties into a stalemate, but by creating an awareness that a certain combination of policies -- the five lessons which I mentioned before -- is beneficial for all parties involved.	['mr. wellink discusses recent developments in the dutch economy address given by the president of the netherlands bank, dr. a.h.e.m.', 'wellink, at the xxist european meeting of the trilateral commission in the hague on 25/10/97.', 'recent success as you all know, the dutch economy has been doing remarkably well lately.', 'over the past three years, dutch gdp has grown by an annual average of 3%, i.e., considerably more than was the case in most major continental european countries.', 'for this year and the next, the prospects for growth are even better.', 'growth has furthermore been attended by considerable job creation, averaging nearly 100,000 man-years per annum, or 1.8%, since 1995. the dutch unemployment figure has consequently dropped to around 6%.', 'all this is in sharp contrast to the picture presented by most countries on the continent of europe.', 'until very recently, they were seeing no more than a moderate cyclical recovery.', 'still, this year the growth of output in these countries would seem to be accelerating substantially.', 'this has not yet, unfortunately, fed through to the employment situation.', 'in germany and france, for instance, unemployment is expected to rise even further this year.', 'the unemployment figure there is about twice that in the netherlands.', 'the dutch upturn has drawn widespread attention, and has come to be known in some circles as the dutch model.', 'in my speech today, i will guide you through the roots of the dutch success.', 'let me start by saying that the recent favourable economic development is definitely not a miracle.', 'it simply boils down to sound macro-economic policies and deregulation, in particular of labour markets (including some country-specific deregulation policies).', 'every country in the world can effectively copy it.', 'the implementation of these policies was possible because of a broad consensus in the netherlands on their necessity.', 'this is lacking in many of our neighbouring countries.', 'but to my mind this consensus among all relevant parties was not caused by the so-called consensus model -- on the contrary.', 'the consensus emerged after the consultative framework -- which had led to paralysis in the 1970s -- was made much leaner.', 'i will come back to that later.', 'let my first give you an overview of the facts and figures surrounding the so-called "dutch miracle".', 'making up for lost ground to see the developments of the last few years in their proper perspective, we must take a look at the situation in the early 1980s.', 'in those years, dutch business was in serious trouble.', 'the international recession, when it struck, hit the netherlands much harder than its neighbours, because in the 1970s business sector profitability here had been structurally eroded by excessive rises in wage costs and the consequent deterioration of competitiveness.', 'a vicious circle of labour shake-out set in, leading -- via the social security system -- to higher social insurance contributions and thus contributing to further job destruction.', 'the problem was compounded by an inappropriate policy reaction to the two oil crises, in the form of an expansive budget leading to unsustainable deficits (of over 10% of gdp) and, after some delay, to soaring central government indebtedness.', 'the figures show only too clearly that in those years the netherlands was much worse off than other countries.', 'in 1970, the netherlands had still held the sixth place in europe in terms of per capita gdp (10% above the european average).', 'but by 1988 it had fallen to below that average, and the netherlands had dropped to the eleventh place.', 'looking at the figures for subsequent years, we see that the netherlands has since regained some of the ground which it had lost earlier.', 'in 1996, per capita gdp held the seventh place (at nearly 5% above the european average).', 'a similar pattern is in evidence for the employment situation; between 1972 and 1983, job losses were much worse than in the rest of europe.', 'but here the relative recovery set in around 1985. in other words, the dutch success has until now been no more than an exercise in making up for ground lost earlier.', 'in fact, we still have not caught up with europe in all respects.', 'explanatory factors in my view, the turnaround which began in 1982-1983 can be ascribed to a combination of sound macroeconomic policy, as well as specific measures aimed at improving the operation of markets.', '• the gradual restructuring of public finance, starting in 1982 and resulting in a deficit of 2.1% of gdp in 1997, compares favourably with those of most countries in the vicinity.', 'the introduction of real expenditure ceilings at the start of this cabinet has proved instrumental to this success.', 'also, the better control of the budgetary process contributed to the outcome.', 'it is gratifying that our efforts to achieve healthier public finances have mainly taken the form of expenditure cuts.', 'the cuts have also made it possible to alleviate the burden of taxation and social insurance contributions.', 'the positive evaluation made by the ecofin council this spring is a good incentive to strive over the next few years for a balanced budget.', 'i will be going into the need for that later.', '• the fact that since 1983 monetary policy has given absolute priority to stability of the guilder/deutsche mark exchange rate is another contributing factor.', 'that has enabled us to import, as it were, the usually favourable price climate prevailing in germany.', 'because of moderate wage developments at home, this exchange rate policy provided for real exchange rate stability as well, resulting in a favourable competitive position of our business sector.', 'this contrasted sharply with germany, where excessive wage increases during the reunification boom contributed to a substantial real appreciation of the german mark of about 12% between 1990 and 1995. the real guilder appreciation was instead negligible.', 'the policy also enhanced confidence in the financial markets, which in turn contributed to a sustained decline of (the risk premium contained in) interest rates.', 'for over a decade, dutch capital market rates have been among the lowest in europe, making for an improved investment climate as well.', '• the wage restraint -- i mentioned it already -- ensuing from the much cited accord of wassenaar (1982) was the third factor.', "this entailed a trade-off between the employers' organizations and the trade unions, the latter relinquishing automatic price compensation for a shorter working week.", 'a condition was that business costs should not increase.', 'it was furthermore agreed that wage negotiations would be decentralized.', 'the process of wage moderation was boosted further by the government-initiated alleviation of taxation and social insurance contributions.', 'in the longer term, the results can be seen to be truly impressive.', "over the past fifteen years, unit wage costs have remained well-nigh stable in the netherlands, allowing a recovery of profitability, and an improvement of the business sector's competitiveness.", '• the economy has moved towards greater market orientation, a goal which has been high on the political agenda since the beginning of the 1990s.', 'the labour market was the first to be targeted, with social security legislation being amended to give the market mechanism greater leeway.', 'in the period from 1983 to 1990, minimum wages and social insurance benefits had been delinked from the general development of wages.', 'a wide range of measures was directed at the lower end of the labour market, the aim being to stimulate businesses to employ low-skilled personnel by way of a reduction of social insurance contributions payable by employers, wage cost subsidies and subsidized jobs.', 'furthermore, society has come to accept flexible forms of labour, such as part-time working and temporary staffing, which have boosted the expansion of the number of jobs in the services sector.', 'in this respect, the netherlands holds a vanguard position internationally, with 40% of all work now being done on flexible contracts.', 'not only does this greater flexibility meet the needs of the business sector, employees, too, seem to find it suits their changing preferences.', 'global calculations show that the potential employment gains for other countries, if part-time jobs had developed to the same extent as in the netherlands, could be sizeable (around 3 million jobs in both germany and france).', 'these calculations are highly mechanical and therefore one should be cautious in interpreting the outcome.', "nevertheless, i think that part-time work arrangements could be helpful in addressing a serious unemployment situation, under strict conditions, i.e., they are applied tailor-made and do not increase businesses' operating costs.", 'so far the main result in the area of product market improvement has been the 1996 liberalization of the statutory establishment rules for businesses.', 'with boundaries disappearing and new technology being developed all the time, we cannot but go with the grain of the market on an increasing scale.', 'we must always keep in mind that all countries around us are doing exactly the same thing.', 'introducing new rules and amending old ones may be painful at first, apart from being time-consuming, but there seems to be nothing for it but to go on doing so, if we wish to maintain our prosperity in the longer term.', 'with so much praise being heaped on the netherlands and its consensus economy, people tend to forget that consensus about how a recovery should be brought about did not materialize out of the blue; in fact, it was enforced by the unfavourable economic developments during the 1980-81 recession, which, as i noted before, hit us much harder than others.', "ultimately, it was that very fact which compelled the employers' organizations and the trade unions to give up their entrenched views, views which had been characteristic of the 1970s.", 'that episode illustrates only too vividly that having a consultative framework for employers and employees does not guarantee fruitful negotiations.', 'the consultative process has been streamlined in the meantime.', 'one could say that the "consensus model" of the 1970s has given way to the consensus of the 1990s.', 'where do we go from here?', 'for all our fifteen years of conducting a policy aimed at recovery, we cannot afford to indulge in complacency.', 'things may be going in the right direction, but we still have several major long-standing problems to see to: • first, there is the continued high rate of economic inactivity.', 'the low participation rate of our population in general is a major factor underlying our internationally modest position in terms of prosperity.', 'this applies especially to the older members of the labour force.', 'more than half of those aged between 50 and 65 do not hold a job.', 'we should really be seeking to reduce our rate of economic inactivity to the levels prevailing in neighbouring countries.', '• secondly, there is our considerable public debt.', 'although it has been falling in recent years, our debt ratio (of over 70% of gdp) continues to be more than 10 percentage points above the emu criterion.', 'a rapid further reduction to well below 60% is called for if we wish to be able to cope with the growing burden which the imminent ageing of the population will impose on public finance.', 'in addition, as we have seen in the past, high debts make us more vulnerable in the event of interest rate rises.', 'european interest rates are currently low, but they will not stay that way for ever.', 'our fundamentals are favourable.', 'one major advantage is our structurally high savings surplus, indicating that macro-economically there are no financial impediments to higher growth.', 'furthermore, we seem to have scope for further growth, provided we succeed in harnessing the current labour reserve.', 'to complete our recovery, we will need further budgetary restructuring and continue on the path toward greater market orientation.', 'policy conclusions this brings me to the concluding part of my speech: what can we learn from the dutch experience?', 'there are five lessons which can be drawn from it.', 'firstly, monetary stability is an important ingredient of a stable economic climate.', 'however, not only nominal but also real exchange rate stability matters.', "if relative price and labour cost developments are out of line, a country's competitiveness is seriously affected, even if the nominal exchange rate remains stable.", 'this is an important lesson with a view to emu when nominal exchange rate stability is a given factor.', 'secondly, sound budgetary policy is not only about deficit reduction and cutting expenditure.', 'it is about redefining the role of the public sector in an economy.', 'thirdly, more market pays off.', 'we should not forget that the private sector is the engine of our economy.', 'so why not give the market sector more leeway?', "of course, always on the basis of a good analysis of what can and can't be done by the market.", 'the fourth lesson is related to the latter.', 'policies geared at increasing labour market flexibility work.', 'however, it is important to note that -- as far as labour market policies is concerned -- there is no overall recipe which can be applied.', 'policies should be tailor-made depending on frictions on certain parts of the labour market.', 'last, but not least -- and related to the fourth lesson -- reduction in working hours can, under conditions, play an important role in an economy.', 'in the short term, it simply boils down to a redistribution of work, without affecting the performance of an economy.', 'however, redistribution of work can (in return for moderate wage claims) contribute to the necessary consensus between employee and employers organizations in an economy.', 'and the latter does improve the performance of the economy in the longer run, as the dutch experiences teach us.', 'to conclude, there is not really anything new under the sun.', 'the combination of economic policies which the netherlands have opted for have been advised by -- for instance -- the international monetary fund for a long period.', 'the issue is how to make society embark on these policies; in other words, how to create consensus.', 'not by forcing all relevant parties into a stalemate, but by creating an awareness that a certain combination of policies -- the five lessons which i mentioned before -- is beneficial for all parties involved.']	Nout Wellink	De Nederlandsche Bank	President	Netherlands
https://www.bis.org/review/r971105f.pdf	Mr. Issing considers the future role of the euro in the international financial system (Central Bank Articles and Speeches, 24 Oct 97)	Speech delivered by a member of the Directorate of the Deutsche Bundesbank, Professor Otmar Issing, at the conference of the Royal Institute of International Affairs in London on 24/10/97.	1997-10-24 00:00:00	Mr. Issing considers the future role of the euro in the international financial system Speech delivered by a member of the Directorate of the Deutsche Bundesbank, Professor Otmar Issing, at the conference of the Royal Institute of Interntional Affairs in London on 24/10/97. 1. Momentous changes in the financial markets The introduction of the euro is increasingly affecting expectations in the financial markets worldwide. We are little more than a year away from the start of the third stage of EMU on January 1, 1999, as laid down in the Maastricht Treaty; and in about six months' time the participating countries are to be selected. From the viewpoint of financial market players, a multitude of questions arise: What will be the role of the euro as an international currency? How strong (or how weak) will the future European currency be? And what changes will there be in the business environment of market players owing to the advent of the euro? Expecting reliable answers to these questions implies greatly overrating an economist's capabilities. Trustworthy forecasts at times of a change of regime -- and the monetary union in Europe undoubtedly constitutes such a change - are, to say the least, extremely problematic, if not utterly impossible. Even so, the economist finds it appealing "to gaze into the future" and to ponder over possible patterns of development in terms of "informed guesses". A conceivable starting point for such "brain-teasers" is the status quo: the role of the euro, as measured by the present position of potential EMU participants in the international financial markets and relative to the dollar. But the analysis must not stop at that point. EMU will trigger changes in the financial markets which have to be taken into account in any dynamic survey. The single currency will eliminate market fragmentation in Europe in the important area of currencies, and will enhance the intensity of competition in the financial sector. That will have a major impact on the position of the euro. But it is not only economic considerations that are of significance here, since the international role of a currency also depends crucially on political factors. It was not least political (i.e., foreign policy) considerations that prompted a fresh start in the direction of EMU in the late 1980s. The very aim of monetary union was to "reduce dependency on the dollar" and "strengthen (the member states') scope for monetary policy action".1 A tripolar currency world is evidently what many people had (and some still have) in mind. The aim is for the euro to "compete as an international vehicular currency with the dollar and the yen on an equal footing".2 The single currency will, it is claimed, finally give Europe its due weight in the concert of world powers. A rather cautious approach to the "key currency role", such as was still widespread in Germany in the seventies, is not discernible in Europe at the political level. 2. The euro as an international currency Claiming a prominent role for a currency, even before it comes into being, is one part -- the easier one. The other, unquestionably much more difficult part, is realising that claim. What role the euro will actually play in the concert of major currencies will be decided, first and foremost, in the international financial markets. It is only when the economic preconditions are right that investors will be prepared to hold assets denominated in euros, only then that cross-border transactions outside the EU will be settled in euros on a significant scale, and only then that the euro will become an international currency. Expectations of the euro playing a major role in the international monetary system are chiefly predicated on the stability of the new currency. The euro must earn its position in the portfolios of public and private investors in competition with other currencies. That will hinge crucially on expected exchange rate movements relative to its major competitors -- above all, the US dollar. The key variables for exchange rate expectations are -- in the longer term -- anticipated inflation differentials, since a tendency for exchange rate movements to 3 match purchasing power parity prevails in the long run. Those wishing to establish the euro as an international currency would therefore do well to make the maintenance of price stability their primary goal. The external trend of the euro is inseparably linked to the prerequisite of internal stability -- stability begins at home. On the (often tacit) assumption that the anti-inflationary pre-conditions are met, widespread speculation is thriving at present about which market shares the euro might capture and whether there may be major portfolio shifts in the course of adjustment to the new conditions. Far-reaching conclusions are being drawn, in turn, as to the potential exchange rate trend of the euro. The starting point of these notions is the various functions performed by an international currency and the quantitative dimensions involved in the international financial markets. Specifically, this concerns the role of the euro - as a reserve currency - as an investment currency - as a transaction currency, and - as an anchor currency for exchange rate arrangements 2.1 The euro as a reserve currency World foreign currency reserves amounted to around US$1,500 billion at the end of June 1997. The lion's share was accounted for by US dollar reserves (65%), followed at a considerable distance by reserves denominated in Deutsche Mark (13%). Smaller shares were also accounted for by the yen and the currencies of other EU member states. Upon entry into the third stage of monetary union (by 2002 at the latest), all assets that are still denominated in currencies participating in EMU will be converted into euro assets; that will apply, in principle, to central banks' asset holdings, too. From the point of view of the participating countries, "foreign currency reserves" denominated in these "in" currencies will become domestic euro assets. Considered in isolation, the euro's potential as a reserve currency will therefore initially be lower than the market share of all "in" currencies taken together. Will third countries be able to fill that "gap"? For the "immediate neighbours" of the euro area, a major role will be played by the precise nature of the currency arrangement (i.e., EMS II). The more closely the exchange rate is pegged to the euro, and the greater the recourse to intervention is, the higher the demand for euro reserves is likely to be in the countries in question -- at least during the period up to their entry into EMU. From the present perspective, it is not possible to make a definite prediction as to whether other countries outside the monetary union will, in future, hold part of their reserves in euros. Portfolio-theoretical considerations argue, in principle, for a diversification of foreign exchange reserves. That would open up opportunities for the euro. Ultimately, the investment decisions of central banks will hinge chiefly on their assessment of the future European currency's stability. The question of how the roles of the US dollar or the yen as reserve currencies will be affected by the euro's entry into the international financial markets is not all that easy to answer, either. On the one hand, shifts out of Deutsche Mark assets into US dollar assets are possible; that will apply -- as some anticipate -- to the introductory period in particular, when the euro's reputation still has to be established. On the other hand, the overall global demand for currency reserves might fall, because some of the EMS-related need for currency reserves will no longer exist, and because the degree of openness of those economies which are linked to one another by monetary integration will decline in purely arithmetical terms.4 That is because part of what was previously foreign trade -- already characterised separately as "intra-trade" in the single market -- will then durably become internal trade from the monetary point of view. It is possible to conjecture that, for the group of participating countries, the "need" for currency reserves to cushion unforeseen events will not be as great as it is under the status quo of different currencies; this fall in demand is likely to affect the US dollar, in particular, primarily because the dollar has repeatedly played a major role in interventions in the EMS, too. It is not possible to state a priori what the ultimate outcome of these various effects will be on balance. In that respect, whether the other reserve currencies will benefit from the introduction of the euro, or not, must remain an open question. This applies all the more since a steeply rising share of global currency reserves is meanwhile being held by Asian central banks, which (at least up to now) have shown a preference for the US dollar. 2.2 The euro as an investment currency Although the reserve holdings of monetary authorities are certainly a major factor, trends in the financial markets are determined to a much greater extent by the decisions of private investors. Currency reserves are accompanied by international bank loans which are (in net terms) more than three times as large and by international debt securities amounting to twice their size;5 on top of these, there are direct cross-border lending operations between non-banks that are not included in the above-mentioned international financial market data. The US dollar is the dominant investment currency, too. The Deutsche Mark accounts for less than 15% of international financial assets. It is precisely in the international financial markets that a large number of other potential participating currencies in EMU, taken together, have a significant share, too. (The share of the pound sterling, for example, is about 5%.) The structural changes in the international financial markets over the past 15 years, however, have been to the detriment of the US dollar, and have afforded the European currencies a rising market share. Theoretical considerations seem to suggest that this process might actually be reinforced by monetary union. A crucial factor determining the widespread international use of a currency is the degree of sophistication and openness of its financial markets. Financial markets that guarantee a wide range of products, a broad maturity range and a high level of market liquidity exercise a magnetic attraction internationally. If cross-border capital transactions are free of restrictions, funds are attracted, on the one hand, and, on the other, the currency concerned becomes available for borrowing by non-residents, too. In short, the international use of that currency is fostered. In that respect, the introduction of the euro is likely to have a further positive impact on capital markets within EMU. The currency-related segmentation of the markets will be eliminated, there will be a broader range of investment opportunities available, and the liquidity of the individual products will increase. Already, in the run-up to EMU, member states are gearing themselves to intensifying competition, and are "updating" both their financial markets and their financial instruments. In terms of its total volume, the euro bond market will probably be the second largest after the US dollar bond market; if all the EU member states ultimately participate in EMU, bonds denominated in euros will amount to around 60% of the volume of the US market. Even if the third stage starts with only a limited number of participants, the increase in the financial market's efficiency will be important in fostering the euro. This effect would be reinforced if the larger euro currency area succeeded in dissociating itself more than previously from developments in the United States. On the other hand, the euro will face greater problems than the US dollar inasmuch as the euro will not have the backing of a centralised European government, and as it therefore still remains to be seen which securities will be able to perform a benchmark function in the euro bond market. 2.3 The euro as a transaction currency An international payment medium's function as a transaction currency plays a role in transactions in goods and in foreign exchange trading. There are no up-to-date and reliable figures on the worldwide invoicing shares of individual currencies in foreign trade. Estimates (for 1992) assume that about one-half of aggregate global exports are settled in US dollars, just over 15% in Deutsche Mark and around 6% each in French francs and pounds sterling.6 These figures should be put into perspective, however, since they are influenced to a great extent by individual countries' respective shares in world trade; in general, every country has a comparatively large invoicing share of its own exports in domestic currency. If the figures are adjusted to allow for that effect, only the US dollar and the Deutsche Mark can be classed as "international invoicing currencies". Since, as explained above, a considerable part of what is now foreign trade will become internal trade in the euro area under EMU, the euro is likely, if anything, to account for smaller market shares in "genuine foreign trade" in the first few years than the participating currencies do at present. In the longer term, however, it is quite possible to foresee the euro assuming growing importance, since it will be backed by a large economic area -- particularly as it is precisely in the case of invoicing currencies that market size is obviously a major factor.7 The economic advantages of invoicing in one's own currency should not be overrated, however. Given short-term exchange rate fluctuations, it may be an advantage to settle in one's own currency than in a foreign one. In the medium to long term, however, any exchange risks are to be borne by the counterparties, irrespective of the invoicing currency, in line with market conditions. Transaction currencies are often referred to in connection with their use in international foreign exchange trading. In order to facilitate bilateral transactions between different currencies in narrow markets, "vehicle currencies" have developed, through which foreign exchange market transactions are settled. After the US dollar, the Deutsche Mark is the most frequently employed currency in the foreign exchange markets -- in particular, as a vehicle in transactions between European currencies.8 How important the euro is in foreign exchange trading will hinge crucially on its market shares as an investment and reserve currency, as well as on its role as a potential anchor currency in Europe. If it does establish itself in those areas, it certainly has the potential to go on to become a major transaction currency in foreign exchange trading, albeit without being able to deprive the US dollar of significant market shares in the short term. Under those conditions, it is likewise predestined to become a vehicle currency for transactions in other European currencies. It is also clear, however, that a major segment of European foreign exchange trading will cease to exist as a result of the merging of currencies. 2.4 The euro as an anchor currency The last function of the euro which is to be scrutinised -- and to which I have already referred -- is that of being an anchor in the international monetary system. There is no longer merely speculation to rely on in that area, as some of the broad outlines are already taking shape. An exchange rate arrangement with the euro at its centre is envisaged for those EU countries which are not going to participate in the single currency from the outset. Above and beyond that, orientation to the euro is to be expected, above all, in the countries of central and eastern Europe, either in the form of unilateral pegging exclusively to the euro or by gearing exchange rate policy to a basket of currencies in which the euro has a heavy weighting. The euro will be highly attractive to potential candidates for accession to monetary union, in particular. 3. Some reflections on the external value of the Euro The introduction of the euro represents a radical change in the international monetary system. It will call into question positions in world financial markets which have developed over a period of decades; the conditions which obtain at present in global financial markets can serve, at most, as rough guidelines for the moment of conversion to euros. Which direction future trends will take -- and this is an important implication of the preceding section -- cannot be readily predicted in every case, as different forces are at work. That applies to monetary reserves and to private financial assets alike. And it also applies to the external value of the euro. The analysis has shown that, especially in the initial stages, the euro will have to build up a reputation of being a trustworthy currency. This is occasionally interpreted as implying that a weakness of the euro is to be expected initially. Diametrically opposed to this hypothesis are the forecasts which prophesy a considerable appreciation potential for the euro on account of expected massive shifts in international portfolios owing to the increasing efficiency of the financial markets in Europe and possible diversification advantages, with interest rates being only weakly correlated with other currencies. Both these arguments seem to me to fall short of the truth. Certainly, a high degree of uncertainty can be expected in the early stages of EMU. However, the ECB, given its independence and single-minded commitment to the objective of price stability, deserves a measure of confidence in advance. That applies all the more as -- viewed from the present vantage point -- the starting conditions for EMU, with low inflation rates in virtually all potential participating countries, are decidedly favourable. Risks to the euro are to be seen, rather, in the general political environment, where in some quarters -- with an eye on the high level of unemployment in Europe -- talk of a weak euro is widespread. However, (verbal) exchange rate manipulations will serve neither to solve the serious employment problems nor to establish the euro as an internationally respected currency. The high level of unemployment in Europe is largely structural and can only be overcome by energetic, far-reaching reforms -- for which responsibility lies more or less entirely at the national level. The hope that EMU will make a lasting contribution to reducing unemployment should rest on the expectation of low interest rates and a high level of investment. These, in turn, depend crucially on investors' confidence in the long-term stability of the euro. The misuse of the currency for employment (or trade) policy purposes would not only jeopardise price stability in the euro area, it might also provoke retaliation from other countries. This, after all, would be of no use to anybody. Some commentators are inferring from an expected substitution of euro for dollar-denominated assets that the single currency will have a substantial appreciation potential. Such thinking is predicated on a portfolio structure that is in line with other macroeconomic benchmarks, such as the ratio to GDP or the share of the euro area in world trade. In my view, these rather mechanistic approaches take too little account of the supply side in the financial markets. The broader and deeper European financial market will not only attract investment capital, it will also result in enhanced cross-border borrowing in euros, which, in itself, tends to dampen rates.9 Which effect will prevail in the end, and what the consequent time profile will be for the movement of the euro rate relative to other currencies, can hardly be forecast reliably a priori. In the long run -- as already stated -- relative inflation differentials will largely determine the nominal euro rate. 4. Concluding remarks The statute of the ECB -- above all, central bank independence and the priority given to the objective of price stability -- establishes crucial prerequisites for a stable euro at the institutional level. It is now up to those responsible to fill this monetary constitution with life, to implement its targets in the real world. Especially in the difficult start-up phase, it will be important to appoint the right people -- people who are regarded in the public eye, and particularly in the financial markets, as guarantors of a stability-oriented monetary policy. Any lack of confidence in the management of the ECB would be reflected in corresponding risk premiums on interest rates, and hence might cost the participants in EMU dear. Thus we come full circle: the political objective of establishing the euro as an international currency will be attained only if the market accepts the newcomer. Investors, for their part, will prefer a strong euro, which presupposes stability within EMU. That is a challenge to the ECB, but the other economic policy players, especially the fiscal policy makers, must likewise do their bit to (continue to) keep inflationary risks as low as possible.	['mr. issing considers the future role of the euro in the international financial system speech delivered by a member of the directorate of the deutsche bundesbank, professor otmar issing, at the conference of the royal institute of interntional affairs in london on 24/10/97.', '1. momentous changes in the financial markets the introduction of the euro is increasingly affecting expectations in the financial markets worldwide.', "we are little more than a year away from the start of the third stage of emu on january 1, 1999, as laid down in the maastricht treaty; and in about six months' time the participating countries are to be selected.", 'from the viewpoint of financial market players, a multitude of questions arise: what will be the role of the euro as an international currency?', 'how strong (or how weak) will the future european currency be?', 'and what changes will there be in the business environment of market players owing to the advent of the euro?', "expecting reliable answers to these questions implies greatly overrating an economist's capabilities.", 'trustworthy forecasts at times of a change of regime -- and the monetary union in europe undoubtedly constitutes such a change - are, to say the least, extremely problematic, if not utterly impossible.', 'even so, the economist finds it appealing "to gaze into the future" and to ponder over possible patterns of development in terms of "informed guesses".', 'a conceivable starting point for such "brain-teasers" is the status quo: the role of the euro, as measured by the present position of potential emu participants in the international financial markets and relative to the dollar.', 'but the analysis must not stop at that point.', 'emu will trigger changes in the financial markets which have to be taken into account in any dynamic survey.', 'the single currency will eliminate market fragmentation in europe in the important area of currencies, and will enhance the intensity of competition in the financial sector.', 'that will have a major impact on the position of the euro.', 'but it is not only economic considerations that are of significance here, since the international role of a currency also depends crucially on political factors.', 'it was not least political (i.e., foreign policy) considerations that prompted a fresh start in the direction of emu in the late 1980s.', 'the very aim of monetary union was to "reduce dependency on the dollar" and "strengthen (the member states\') scope for monetary policy action".1 a tripolar currency world is evidently what many people had (and some still have) in mind.', 'the aim is for the euro to "compete as an international vehicular currency with the dollar and the yen on an equal footing".2 the single currency will, it is claimed, finally give europe its due weight in the concert of world powers.', 'a rather cautious approach to the "key currency role", such as was still widespread in germany in the seventies, is not discernible in europe at the political level.', '2. the euro as an international currency claiming a prominent role for a currency, even before it comes into being, is one part -- the easier one.', 'the other, unquestionably much more difficult part, is realising that claim.', 'what role the euro will actually play in the concert of major currencies will be decided, first and foremost, in the international financial markets.', 'it is only when the economic preconditions are right that investors will be prepared to hold assets denominated in euros, only then that cross-border transactions outside the eu will be settled in euros on a significant scale, and only then that the euro will become an international currency.', 'expectations of the euro playing a major role in the international monetary system are chiefly predicated on the stability of the new currency.', 'the euro must earn its position in the portfolios of public and private investors in competition with other currencies.', 'that will hinge crucially on expected exchange rate movements relative to its major competitors -- above all, the us dollar.', 'the key variables for exchange rate expectations are -- in the longer term -- anticipated inflation differentials, since a tendency for exchange rate movements to 3 match purchasing power parity prevails in the long run.', 'those wishing to establish the euro as an international currency would therefore do well to make the maintenance of price stability their primary goal.', 'the external trend of the euro is inseparably linked to the prerequisite of internal stability -- stability begins at home.', 'on the (often tacit) assumption that the anti-inflationary pre-conditions are met, widespread speculation is thriving at present about which market shares the euro might capture and whether there may be major portfolio shifts in the course of adjustment to the new conditions.', 'far-reaching conclusions are being drawn, in turn, as to the potential exchange rate trend of the euro.', 'the starting point of these notions is the various functions performed by an international currency and the quantitative dimensions involved in the international financial markets.', "specifically, this concerns the role of the euro - as a reserve currency - as an investment currency - as a transaction currency, and - as an anchor currency for exchange rate arrangements 2.1 the euro as a reserve currency world foreign currency reserves amounted to around us$1,500 billion at the end of june 1997. the lion's share was accounted for by us dollar reserves (65%), followed at a considerable distance by reserves denominated in deutsche mark (13%).", 'smaller shares were also accounted for by the yen and the currencies of other eu member states.', "upon entry into the third stage of monetary union (by 2002 at the latest), all assets that are still denominated in currencies participating in emu will be converted into euro assets; that will apply, in principle, to central banks' asset holdings, too.", 'from the point of view of the participating countries, "foreign currency reserves" denominated in these "in" currencies will become domestic euro assets.', 'considered in isolation, the euro\'s potential as a reserve currency will therefore initially be lower than the market share of all "in" currencies taken together.', 'will third countries be able to fill that "gap"?', 'for the "immediate neighbours" of the euro area, a major role will be played by the precise nature of the currency arrangement (i.e., ems ii).', 'the more closely the exchange rate is pegged to the euro, and the greater the recourse to intervention is, the higher the demand for euro reserves is likely to be in the countries in question -- at least during the period up to their entry into emu.', 'from the present perspective, it is not possible to make a definite prediction as to whether other countries outside the monetary union will, in future, hold part of their reserves in euros.', 'portfolio-theoretical considerations argue, in principle, for a diversification of foreign exchange reserves.', 'that would open up opportunities for the euro.', "ultimately, the investment decisions of central banks will hinge chiefly on their assessment of the future european currency's stability.", "the question of how the roles of the us dollar or the yen as reserve currencies will be affected by the euro's entry into the international financial markets is not all that easy to answer, either.", "on the one hand, shifts out of deutsche mark assets into us dollar assets are possible; that will apply -- as some anticipate -- to the introductory period in particular, when the euro's reputation still has to be established.", 'on the other hand, the overall global demand for currency reserves might fall, because some of the ems-related need for currency reserves will no longer exist, and because the degree of openness of those economies which are linked to one another by monetary integration will decline in purely arithmetical terms.4 that is because part of what was previously foreign trade -- already characterised separately as "intra-trade" in the single market -- will then durably become internal trade from the monetary point of view.', 'it is possible to conjecture that, for the group of participating countries, the "need" for currency reserves to cushion unforeseen events will not be as great as it is under the status quo of different currencies; this fall in demand is likely to affect the us dollar, in particular, primarily because the dollar has repeatedly played a major role in interventions in the ems, too.', 'it is not possible to state a priori what the ultimate outcome of these various effects will be on balance.', 'in that respect, whether the other reserve currencies will benefit from the introduction of the euro, or not, must remain an open question.', 'this applies all the more since a steeply rising share of global currency reserves is meanwhile being held by asian central banks, which (at least up to now) have shown a preference for the us dollar.', '2.2 the euro as an investment currency although the reserve holdings of monetary authorities are certainly a major factor, trends in the financial markets are determined to a much greater extent by the decisions of private investors.', 'currency reserves are accompanied by international bank loans which are (in net terms) more than three times as large and by international debt securities amounting to twice their size;5 on top of these, there are direct cross-border lending operations between non-banks that are not included in the above-mentioned international financial market data.', 'the us dollar is the dominant investment currency, too.', 'the deutsche mark accounts for less than 15% of international financial assets.', 'it is precisely in the international financial markets that a large number of other potential participating currencies in emu, taken together, have a significant share, too.', '(the share of the pound sterling, for example, is about 5%.)', 'the structural changes in the international financial markets over the past 15 years, however, have been to the detriment of the us dollar, and have afforded the european currencies a rising market share.', 'theoretical considerations seem to suggest that this process might actually be reinforced by monetary union.', 'a crucial factor determining the widespread international use of a currency is the degree of sophistication and openness of its financial markets.', 'financial markets that guarantee a wide range of products, a broad maturity range and a high level of market liquidity exercise a magnetic attraction internationally.', 'if cross-border capital transactions are free of restrictions, funds are attracted, on the one hand, and, on the other, the currency concerned becomes available for borrowing by non-residents, too.', 'in short, the international use of that currency is fostered.', 'in that respect, the introduction of the euro is likely to have a further positive impact on capital markets within emu.', 'the currency-related segmentation of the markets will be eliminated, there will be a broader range of investment opportunities available, and the liquidity of the individual products will increase.', 'already, in the run-up to emu, member states are gearing themselves to intensifying competition, and are "updating" both their financial markets and their financial instruments.', 'in terms of its total volume, the euro bond market will probably be the second largest after the us dollar bond market; if all the eu member states ultimately participate in emu, bonds denominated in euros will amount to around 60% of the volume of the us market.', "even if the third stage starts with only a limited number of participants, the increase in the financial market's efficiency will be important in fostering the euro.", 'this effect would be reinforced if the larger euro currency area succeeded in dissociating itself more than previously from developments in the united states.', 'on the other hand, the euro will face greater problems than the us dollar inasmuch as the euro will not have the backing of a centralised european government, and as it therefore still remains to be seen which securities will be able to perform a benchmark function in the euro bond market.', "2.3 the euro as a transaction currency an international payment medium's function as a transaction currency plays a role in transactions in goods and in foreign exchange trading.", 'there are no up-to-date and reliable figures on the worldwide invoicing shares of individual currencies in foreign trade.', "estimates (for 1992) assume that about one-half of aggregate global exports are settled in us dollars, just over 15% in deutsche mark and around 6% each in french francs and pounds sterling.6 these figures should be put into perspective, however, since they are influenced to a great extent by individual countries' respective shares in world trade; in general, every country has a comparatively large invoicing share of its own exports in domestic currency.", 'if the figures are adjusted to allow for that effect, only the us dollar and the deutsche mark can be classed as "international invoicing currencies".', 'since, as explained above, a considerable part of what is now foreign trade will become internal trade in the euro area under emu, the euro is likely, if anything, to account for smaller market shares in "genuine foreign trade" in the first few years than the participating currencies do at present.', "in the longer term, however, it is quite possible to foresee the euro assuming growing importance, since it will be backed by a large economic area -- particularly as it is precisely in the case of invoicing currencies that market size is obviously a major factor.7 the economic advantages of invoicing in one's own currency should not be overrated, however.", "given short-term exchange rate fluctuations, it may be an advantage to settle in one's own currency than in a foreign one.", 'in the medium to long term, however, any exchange risks are to be borne by the counterparties, irrespective of the invoicing currency, in line with market conditions.', 'transaction currencies are often referred to in connection with their use in international foreign exchange trading.', 'in order to facilitate bilateral transactions between different currencies in narrow markets, "vehicle currencies" have developed, through which foreign exchange market transactions are settled.', 'after the us dollar, the deutsche mark is the most frequently employed currency in the foreign exchange markets -- in particular, as a vehicle in transactions between european currencies.8 how important the euro is in foreign exchange trading will hinge crucially on its market shares as an investment and reserve currency, as well as on its role as a potential anchor currency in europe.', 'if it does establish itself in those areas, it certainly has the potential to go on to become a major transaction currency in foreign exchange trading, albeit without being able to deprive the us dollar of significant market shares in the short term.', 'under those conditions, it is likewise predestined to become a vehicle currency for transactions in other european currencies.', 'it is also clear, however, that a major segment of european foreign exchange trading will cease to exist as a result of the merging of currencies.', '2.4 the euro as an anchor currency the last function of the euro which is to be scrutinised -- and to which i have already referred -- is that of being an anchor in the international monetary system.', 'there is no longer merely speculation to rely on in that area, as some of the broad outlines are already taking shape.', 'an exchange rate arrangement with the euro at its centre is envisaged for those eu countries which are not going to participate in the single currency from the outset.', 'above and beyond that, orientation to the euro is to be expected, above all, in the countries of central and eastern europe, either in the form of unilateral pegging exclusively to the euro or by gearing exchange rate policy to a basket of currencies in which the euro has a heavy weighting.', 'the euro will be highly attractive to potential candidates for accession to monetary union, in particular.', '3. some reflections on the external value of the euro the introduction of the euro represents a radical change in the international monetary system.', 'it will call into question positions in world financial markets which have developed over a period of decades; the conditions which obtain at present in global financial markets can serve, at most, as rough guidelines for the moment of conversion to euros.', 'which direction future trends will take -- and this is an important implication of the preceding section -- cannot be readily predicted in every case, as different forces are at work.', 'that applies to monetary reserves and to private financial assets alike.', 'and it also applies to the external value of the euro.', 'the analysis has shown that, especially in the initial stages, the euro will have to build up a reputation of being a trustworthy currency.', 'this is occasionally interpreted as implying that a weakness of the euro is to be expected initially.', 'diametrically opposed to this hypothesis are the forecasts which prophesy a considerable appreciation potential for the euro on account of expected massive shifts in international portfolios owing to the increasing efficiency of the financial markets in europe and possible diversification advantages, with interest rates being only weakly correlated with other currencies.', 'both these arguments seem to me to fall short of the truth.', 'certainly, a high degree of uncertainty can be expected in the early stages of emu.', 'however, the ecb, given its independence and single-minded commitment to the objective of price stability, deserves a measure of confidence in advance.', 'that applies all the more as -- viewed from the present vantage point -- the starting conditions for emu, with low inflation rates in virtually all potential participating countries, are decidedly favourable.', 'risks to the euro are to be seen, rather, in the general political environment, where in some quarters -- with an eye on the high level of unemployment in europe -- talk of a weak euro is widespread.', 'however, (verbal) exchange rate manipulations will serve neither to solve the serious employment problems nor to establish the euro as an internationally respected currency.', 'the high level of unemployment in europe is largely structural and can only be overcome by energetic, far-reaching reforms -- for which responsibility lies more or less entirely at the national level.', 'the hope that emu will make a lasting contribution to reducing unemployment should rest on the expectation of low interest rates and a high level of investment.', "these, in turn, depend crucially on investors' confidence in the long-term stability of the euro.", 'the misuse of the currency for employment (or trade) policy purposes would not only jeopardise price stability in the euro area, it might also provoke retaliation from other countries.', 'this, after all, would be of no use to anybody.', 'some commentators are inferring from an expected substitution of euro for dollar-denominated assets that the single currency will have a substantial appreciation potential.', 'such thinking is predicated on a portfolio structure that is in line with other macroeconomic benchmarks, such as the ratio to gdp or the share of the euro area in world trade.', 'in my view, these rather mechanistic approaches take too little account of the supply side in the financial markets.', 'the broader and deeper european financial market will not only attract investment capital, it will also result in enhanced cross-border borrowing in euros, which, in itself, tends to dampen rates.9 which effect will prevail in the end, and what the consequent time profile will be for the movement of the euro rate relative to other currencies, can hardly be forecast reliably a priori.', 'in the long run -- as already stated -- relative inflation differentials will largely determine the nominal euro rate.', '4. concluding remarks the statute of the ecb -- above all, central bank independence and the priority given to the objective of price stability -- establishes crucial prerequisites for a stable euro at the institutional level.', 'it is now up to those responsible to fill this monetary constitution with life, to implement its targets in the real world.', 'especially in the difficult start-up phase, it will be important to appoint the right people -- people who are regarded in the public eye, and particularly in the financial markets, as guarantors of a stability-oriented monetary policy.', 'any lack of confidence in the management of the ecb would be reflected in corresponding risk premiums on interest rates, and hence might cost the participants in emu dear.', 'thus we come full circle: the political objective of establishing the euro as an international currency will be attained only if the market accepts the newcomer.', 'investors, for their part, will prefer a strong euro, which presupposes stability within emu.', 'that is a challenge to the ecb, but the other economic policy players, especially the fiscal policy makers, must likewise do their bit to (continue to) keep inflationary risks as low as possible.']	Otmar Issing	Deutsche Bundesbank	Member of the Directorate	Germany
https://www.bis.org/review/r971105e.pdf	Mr. Gaddum discusses Germany as a financial centre and the strengths of the German capital market of today (Central Bank Articles and Speeches, 14 Oct 97)	Speech by the Vice-President of the Deutsche Bundesbank, Mr. Johann Wilhelm Gaddum, at the Financial Centre Roadshow in New York on 14/10/97.	1997-10-14 00:00:00	Mr. Gaddum discusses Germany as a financial centre and the strengths of the German capital market of today Speech by the Vice-President of the Deutsche Bundesbank, Mr. Johann Wilhelm Gaddum, at the Financial Centre Roadshow in New York on 14/10/97. 1. Strengths of the German capital market of today Finanzplatz Deutschland -- the financial centre Germany, which is the "home port" of the D-Mark -- is characterised by the long-standing stability culture of the Deutsche Bundesbank. And the financial centre Germany has benefited considerably from the currency's stability. With the introduction of the euro everything will change. The financial centre Germany will lose its D-Mark bonus. However, it will gain the opportunity to display its competitiveness with the euro in a larger market. The banks, the German parliament and the Bundesbank have been working for years to increase the attractiveness of Germany as a financial centre. With a view to the introduction of the euro, it is important to further strengthen the competitiveness reached so far through additional innovations. It is essential to prepare for competition in the large European market. But we can say with some satisfaction that even today the financial centre Germany, which is the biggest and most dynamic financial market in continental Europe, is in a good position. Germany is currently the third-largest industrial nation in the world and, since German reunification, it has had the highest population of any country in the European Union; in the wake of reunification, however, it has also changed from a capital-exporting country into a capital-importing one. The large current account surpluses which had prevailed until 1990 have turned into sizeable deficits. But the era of Germany's current account deficits could soon be a thing of the past. After a seasonally adjusted positive balance was recorded in the second quarter of this year, I expect the German current account will show an annual surplus again in 1998 at the latest. - 2 - The deficit on current account was covered in part by sales of fixed-rate bonds -- especially Federal securities -- abroad. In view of the D-Mark's role as a reserve currency and the high creditworthiness of the Federal Republic of Germany as a borrower (triple A rating), it is not -- and never has been -- a problem for Germany to raise funds abroad. German banks are among the premier credit institutions worldwide in all sectors of traditional banking business. In only a short period of time they have diversified into new areas of business (investment banking, derivatives, etc.); here, too, they have meanwhile established professional and efficient lines of business. This trend has been and is being accompanied by modernisations undertaken at the German stock exchanges, which are acquiring new structures, opening up new markets and, in doing so, consistently put their faith in the use of electronic systems. Concerning the speed, security and cost-effectiveness of securities trading, the German stock exchange Deutsche Börse leads the field. It has made rapid progress towards full computerisation and soon will offer a trading platform which will be trend-setting in the European context. The tool needed for this -- XETRA (Exchange Electronic Trading) is currently being implemented. The aim of XETRA is to facilitate full electronic handling of stock exchange trading with up to 40,000 securities -- with a worldwide remote membership facility. This will mean lower costs, more efficiency and a high degree of liquidity. In this context the centralised securities settlement system of Deutsche Börse Clearing AG, the leading German stock exchange clearing house, deserves a mention. Its functionality and speed, together with its cost-effective settlement procedures, are unmatched internationally. In Germany, settlement is generally completed within just two days (T+2) -- if necessary, even on the same day; that is faster than anywhere else. And, for the sake of security, they are working on cutting the time even further. The question of deregulation proved to be a less pressing problem in the traditionally liberal German financial market than in other countries; however, in Germany, too, further steps in this direction were necessary. Thus -- to cite just a few examples -- the securities transfer tax was abolished in 1990. Since 1992, foreign non-banks have been able to issue commercial paper denominated in D-Mark. - 3 - In 1994 investors' protection was reinforced by the establishment of the Federal Supervisory Office for Securities Trading and the legal ban on insider dealing. In 1994, too, genuine money market funds were admitted. In January 1997 minimum reserve requirements on repo transactions were abolished. In March 1997 the new stock exchange segment "New Market" was introduced for small and medium-sized fast-growing enterprises. Since May 1997, banks have been allowed to collateralise and sell loans in the form of asset-backed securities. Measured by the volume of securities outstanding, the German bond market is currently the third-largest debt securities market in the world. Within Europe it leads the field. Approximately 40 per cent of the German government bonds outstanding are held by foreign investors. This shows that the long-standing benchmark position of German Federal bonds rests on a sound real base. And it is surely not surprising either that, with a 42% market share, the trade in D-Mark-denominated interest-related products is the leading business in the European financial futures exchanges. Annual net sales of fixed-rate bonds issued by German borrowers amounted to the equivalent of more than US$ 100 billion in each of the past few years. The primary and the secondary markets exhibit a very high degree of liquidity, especially in respect of Federal securities. In order to maintain its leading position in the market, the Federal Government has gradually streamlined its array of issue instruments. Thus, the maturity range was complemented both at the short end ("Bubills") and at the long end of the market (30-year bonds). The further fixing of issue dates has meanwhile led in effect to a regular issuance calendar over the entire year. The concentration on standardised instruments and regular issue dates, in combination with re-openings of issues, ensures large and liquid issue amounts. The introduction of stripping for Federal bonds is likewise part of the strategy to protect the Federal Government's benchmark position. Whereas in the primary market the Government focuses on certain maturity segments, by allowing the stripping of government bonds it offers international institutional investors facilities for investment along the entire yield curve. - 4 - Some regional Land governments in Germany have meanwhile started to combine their issues into joint bonds, which has proved to be rather successful. Another important segment of the German debt securities market is constituted by mortgage bonds (Pfandbriefe) which, as "jumbo" issues, have met with a positive response in the international capital market for some time now. The picture is complemented by the German Financial Futures Exchange (DTB). Although it was established relatively late, it has already conquered a major market position. In conjunction with MATIF in Paris and SOFFEX in Zurich, the DTB is seeking to build a joint continental European trading and clearing platform. Not least because of its efficient settlement and its electronic access facilities installed in foreign financial centres, the DTB offers global capital market players access to all derivative business. In its efforts to catch up with the longer-established futures exchanges, it has already made ground especially with the introduction of the Bobl future; in this respect, it has even surpassed LIFFE. The DTB's range of products meanwhile cover maturities from one month to ten years. Contracts such as the 1-month and the 3-month Euro-Mark future and the future on 2-year Federal Treasury notes are the most recent examples of the DTB's market orientation. 2. Further capital market improvements in the pipeline The launch of European monetary union will change the operating framework in Europe. Thus, the D-Mark will cease to exist as an internationally renowned reserve currency. For the emerging single currency area and the larger single financial market, a number of European Union directives will have to be incorporated into national law. You may rest assured that in doing so we will endeavour to further strengthen Germany as a financial centre. These measures are being supported by practical considerations aimed at smoothing the transition from the D-Mark to the euro for capital market players. The Federal Government will do justice to its leading position as an issuer also by converting its marketable old issues to euros right at the - 5 - start of monetary union on January 1, 1999. That will prevent any split in the market between D-Mark and euro-denominated Federal Government bonds. In other words, large and liquid euro issues covering the entire maturity range will be available from the outset. With regard to the conversion procedures, due consideration has to be given, among other things, to avoiding costs and to agreeing general practical rules in the interest of ensuring a smoothly functioning capital market. This includes a simple and relatively cost-effective concept for bonds in respect of the conversion of (even) D-Mark nominal amounts into (odd) euro amounts, i.e. the so-called 1-cent method. As far as equities are concerned, conversion is likely to be facilitated by the introduction of stock based not on par values, but on divisible units. Thus an instrument which has long been common in the United States will be established in Germany, too. To put it in a nutshell: the German capital market is itself in excellent shape and is or will be very well prepared for the future challenges. 3. Trends in other market sectors 3.1. Foreign exchange market The launch of monetary union in Europe will definitely have far-reaching consequences for the foreign exchange market, too. Monetary union will lead to the elimination of dealings in currencies belonging to the European Monetary System. On the other hand, the odds are that the remaining foreign exchange dealings will concentrate further within continental Europe in favour of Frankfurt. - 6 - At a roughly constant level of trade in US dollars, German banks have been able to increase their operations in sterling, Swiss francs and yen distinctly already during the past few years. And further growth prospects look likely. Another cause of optimism is undoubtedly that Frankfurt will continue to be the location of one of the three central banks which issue the major international currencies, i.e. the US dollar, yen and euro. 3.2. Money market In the German money market, too, progress has been recorded in the past few years. And the Bundesbank has made a major contribution to that. The list is headed by the drastic lowering of the minimum reserve ratios to a level of 1.5% to 2.0% in several stages up to 1995. That has lessened the incentives to circumvent the regulations while preserving the instrument's functional effectiveness. Since then the growth of short-term D-Mark-denominated deposits in the Euro-market has come to a halt. This effect has been reinforced by the exemption from minimum reserve requirements of liabilities under repo transactions with maturities of up to one year, which came into force at the beginning of this year. Within a short period of time this measure fostered the growth of a repo market in Germany and led to a shift of D-Mark-denominated repo business from the Euro-market, particularly London, back to Germany. The set of monetary policy instruments of the future European Central Bank are expected to incorporate key elements of the Bundesbank's tried and tested toolkit. And I am convinced that even if the minimum reserve instrument is likewise employed, solutions will be found which exclude any negative effects on financial markets in the euro area, especially shifts to offshore financial centres. In comparison to the existing national markets, the money market in the euro area is likely to become considerably wider and deeper. The harmonisation of market practices which is currently being vigorously pursued will create a level playing field conducive to boosting competition. A European Interbank Offered Rate (EURIBOR) is to be determined by a representative selection of banks from the euro area as the benchmark interest rate for the financial markets. It will enhance the profile of the European continent and of Frankfurt against London's Euro-Libor. The EURIBOR will establish itself as a major benchmark for derivative financial instruments such as options, futures, floating-rate notes, etc. The fast, smooth and secure settlement of money market transactions is ensured by efficient payment systems. One of the linchpins of the Bundesbank's payment system facility is the Frankfurt Electronic Clearing System (EAF 2). This system is exceptional in that it combines the liquidity-conserving elements of a net settlement procedure with the risk-reducing features of gross settlement systems. The second linchpin is the express electronic intercity credit transfer system known as EIL-ZV. This gross settlement system will constitute the interface to the ESCB's TARGET system in stage 3 of EMU which links the national RTGS systems. Money market transactions within the euro area will then take just a few seconds. 4. Concluding remark Ladies and Gentlemen, as you can see, Finanzplatz Deutschland -- the German financial centre -- is entering the European competition from a good starting position. We are in favour of an open exchange with other financial centres in Europe and are looking forward to this competition. No one should have any doubt that our ambition is to remain the best in those fields which we already lead and to become the best in those fields in which we are still trailing at the moment. Colour charts for this text can be found on the BIS Website (for address see last page)	['mr. gaddum discusses germany as a financial centre and the strengths of the german capital market of today speech by the vice-president of the deutsche bundesbank, mr. johann wilhelm gaddum, at the financial centre roadshow in new york on 14/10/97.', '1. strengths of the german capital market of today finanzplatz deutschland -- the financial centre germany, which is the "home port" of the d-mark -- is characterised by the long-standing stability culture of the deutsche bundesbank.', "and the financial centre germany has benefited considerably from the currency's stability.", 'with the introduction of the euro everything will change.', 'the financial centre germany will lose its d-mark bonus.', 'however, it will gain the opportunity to display its competitiveness with the euro in a larger market.', 'the banks, the german parliament and the bundesbank have been working for years to increase the attractiveness of germany as a financial centre.', 'with a view to the introduction of the euro, it is important to further strengthen the competitiveness reached so far through additional innovations.', 'it is essential to prepare for competition in the large european market.', 'but we can say with some satisfaction that even today the financial centre germany, which is the biggest and most dynamic financial market in continental europe, is in a good position.', 'germany is currently the third-largest industrial nation in the world and, since german reunification, it has had the highest population of any country in the european union; in the wake of reunification, however, it has also changed from a capital-exporting country into a capital-importing one.', 'the large current account surpluses which had prevailed until 1990 have turned into sizeable deficits.', "but the era of germany's current account deficits could soon be a thing of the past.", 'after a seasonally adjusted positive balance was recorded in the second quarter of this year, i expect the german current account will show an annual surplus again in 1998 at the latest.', '- 2 - the deficit on current account was covered in part by sales of fixed-rate bonds -- especially federal securities -- abroad.', "in view of the d-mark's role as a reserve currency and the high creditworthiness of the federal republic of germany as a borrower (triple a rating), it is not -- and never has been -- a problem for germany to raise funds abroad.", 'german banks are among the premier credit institutions worldwide in all sectors of traditional banking business.', 'in only a short period of time they have diversified into new areas of business (investment banking, derivatives, etc.', '); here, too, they have meanwhile established professional and efficient lines of business.', 'this trend has been and is being accompanied by modernisations undertaken at the german stock exchanges, which are acquiring new structures, opening up new markets and, in doing so, consistently put their faith in the use of electronic systems.', 'concerning the speed, security and cost-effectiveness of securities trading, the german stock exchange deutsche börse leads the field.', 'it has made rapid progress towards full computerisation and soon will offer a trading platform which will be trend-setting in the european context.', 'the tool needed for this -- xetra (exchange electronic trading) is currently being implemented.', 'the aim of xetra is to facilitate full electronic handling of stock exchange trading with up to 40,000 securities -- with a worldwide remote membership facility.', 'this will mean lower costs, more efficiency and a high degree of liquidity.', 'in this context the centralised securities settlement system of deutsche börse clearing ag, the leading german stock exchange clearing house, deserves a mention.', 'its functionality and speed, together with its cost-effective settlement procedures, are unmatched internationally.', 'in germany, settlement is generally completed within just two days (t+2) -- if necessary, even on the same day; that is faster than anywhere else.', 'and, for the sake of security, they are working on cutting the time even further.', 'the question of deregulation proved to be a less pressing problem in the traditionally liberal german financial market than in other countries; however, in germany, too, further steps in this direction were necessary.', 'thus -- to cite just a few examples -- the securities transfer tax was abolished in 1990. since 1992, foreign non-banks have been able to issue commercial paper denominated in d-mark.', "- 3 - in 1994 investors' protection was reinforced by the establishment of the federal supervisory office for securities trading and the legal ban on insider dealing.", 'in 1994, too, genuine money market funds were admitted.', 'in january 1997 minimum reserve requirements on repo transactions were abolished.', 'in march 1997 the new stock exchange segment "new market" was introduced for small and medium-sized fast-growing enterprises.', 'since may 1997, banks have been allowed to collateralise and sell loans in the form of asset-backed securities.', 'measured by the volume of securities outstanding, the german bond market is currently the third-largest debt securities market in the world.', 'within europe it leads the field.', 'approximately 40 per cent of the german government bonds outstanding are held by foreign investors.', 'this shows that the long-standing benchmark position of german federal bonds rests on a sound real base.', 'and it is surely not surprising either that, with a 42% market share, the trade in d-mark-denominated interest-related products is the leading business in the european financial futures exchanges.', 'annual net sales of fixed-rate bonds issued by german borrowers amounted to the equivalent of more than us$ 100 billion in each of the past few years.', 'the primary and the secondary markets exhibit a very high degree of liquidity, especially in respect of federal securities.', 'in order to maintain its leading position in the market, the federal government has gradually streamlined its array of issue instruments.', 'thus, the maturity range was complemented both at the short end ("bubills") and at the long end of the market (30-year bonds).', 'the further fixing of issue dates has meanwhile led in effect to a regular issuance calendar over the entire year.', 'the concentration on standardised instruments and regular issue dates, in combination with re-openings of issues, ensures large and liquid issue amounts.', "the introduction of stripping for federal bonds is likewise part of the strategy to protect the federal government's benchmark position.", 'whereas in the primary market the government focuses on certain maturity segments, by allowing the stripping of government bonds it offers international institutional investors facilities for investment along the entire yield curve.', '- 4 - some regional land governments in germany have meanwhile started to combine their issues into joint bonds, which has proved to be rather successful.', 'another important segment of the german debt securities market is constituted by mortgage bonds (pfandbriefe) which, as "jumbo" issues, have met with a positive response in the international capital market for some time now.', 'the picture is complemented by the german financial futures exchange (dtb).', 'although it was established relatively late, it has already conquered a major market position.', 'in conjunction with matif in paris and soffex in zurich, the dtb is seeking to build a joint continental european trading and clearing platform.', 'not least because of its efficient settlement and its electronic access facilities installed in foreign financial centres, the dtb offers global capital market players access to all derivative business.', 'in its efforts to catch up with the longer-established futures exchanges, it has already made ground especially with the introduction of the bobl future; in this respect, it has even surpassed liffe.', "the dtb's range of products meanwhile cover maturities from one month to ten years.", "contracts such as the 1-month and the 3-month euro-mark future and the future on 2-year federal treasury notes are the most recent examples of the dtb's market orientation.", '2. further capital market improvements in the pipeline the launch of european monetary union will change the operating framework in europe.', 'thus, the d-mark will cease to exist as an internationally renowned reserve currency.', 'for the emerging single currency area and the larger single financial market, a number of european union directives will have to be incorporated into national law.', 'you may rest assured that in doing so we will endeavour to further strengthen germany as a financial centre.', 'these measures are being supported by practical considerations aimed at smoothing the transition from the d-mark to the euro for capital market players.', 'the federal government will do justice to its leading position as an issuer also by converting its marketable old issues to euros right at the - 5 - start of monetary union on january 1, 1999. that will prevent any split in the market between d-mark and euro-denominated federal government bonds.', 'in other words, large and liquid euro issues covering the entire maturity range will be available from the outset.', 'with regard to the conversion procedures, due consideration has to be given, among other things, to avoiding costs and to agreeing general practical rules in the interest of ensuring a smoothly functioning capital market.', 'this includes a simple and relatively cost-effective concept for bonds in respect of the conversion of (even) d-mark nominal amounts into (odd) euro amounts, i.e.', 'the so-called 1-cent method.', 'as far as equities are concerned, conversion is likely to be facilitated by the introduction of stock based not on par values, but on divisible units.', 'thus an instrument which has long been common in the united states will be established in germany, too.', 'to put it in a nutshell: the german capital market is itself in excellent shape and is or will be very well prepared for the future challenges.', '3. trends in other market sectors 3.1. foreign exchange market the launch of monetary union in europe will definitely have far-reaching consequences for the foreign exchange market, too.', 'monetary union will lead to the elimination of dealings in currencies belonging to the european monetary system.', 'on the other hand, the odds are that the remaining foreign exchange dealings will concentrate further within continental europe in favour of frankfurt.', '- 6 - at a roughly constant level of trade in us dollars, german banks have been able to increase their operations in sterling, swiss francs and yen distinctly already during the past few years.', 'and further growth prospects look likely.', 'another cause of optimism is undoubtedly that frankfurt will continue to be the location of one of the three central banks which issue the major international currencies, i.e.', 'the us dollar, yen and euro.', '3.2. money market in the german money market, too, progress has been recorded in the past few years.', 'and the bundesbank has made a major contribution to that.', "the list is headed by the drastic lowering of the minimum reserve ratios to a level of 1.5% to 2.0% in several stages up to 1995. that has lessened the incentives to circumvent the regulations while preserving the instrument's functional effectiveness.", 'since then the growth of short-term d-mark-denominated deposits in the euro-market has come to a halt.', 'this effect has been reinforced by the exemption from minimum reserve requirements of liabilities under repo transactions with maturities of up to one year, which came into force at the beginning of this year.', 'within a short period of time this measure fostered the growth of a repo market in germany and led to a shift of d-mark-denominated repo business from the euro-market, particularly london, back to germany.', "the set of monetary policy instruments of the future european central bank are expected to incorporate key elements of the bundesbank's tried and tested toolkit.", 'and i am convinced that even if the minimum reserve instrument is likewise employed, solutions will be found which exclude any negative effects on financial markets in the euro area, especially shifts to offshore financial centres.', 'in comparison to the existing national markets, the money market in the euro area is likely to become considerably wider and deeper.', 'the harmonisation of market practices which is currently being vigorously pursued will create a level playing field conducive to boosting competition.', 'a european interbank offered rate (euribor) is to be determined by a representative selection of banks from the euro area as the benchmark interest rate for the financial markets.', "it will enhance the profile of the european continent and of frankfurt against london's euro-libor.", 'the euribor will establish itself as a major benchmark for derivative financial instruments such as options, futures, floating-rate notes, etc.', 'the fast, smooth and secure settlement of money market transactions is ensured by efficient payment systems.', "one of the linchpins of the bundesbank's payment system facility is the frankfurt electronic clearing system (eaf 2).", 'this system is exceptional in that it combines the liquidity-conserving elements of a net settlement procedure with the risk-reducing features of gross settlement systems.', 'the second linchpin is the express electronic intercity credit transfer system known as eil-zv.', "this gross settlement system will constitute the interface to the escb's target system in stage 3 of emu which links the national rtgs systems.", 'money market transactions within the euro area will then take just a few seconds.', '4. concluding remark ladies and gentlemen, as you can see, finanzplatz deutschland -- the german financial centre -- is entering the european competition from a good starting position.', 'we are in favour of an open exchange with other financial centres in europe and are looking forward to this competition.', 'no one should have any doubt that our ambition is to remain the best in those fields which we already lead and to become the best in those fields in which we are still trailing at the moment.', 'colour charts for this text can be found on the bis website (for address see last page)']	Johann Wilhelm Gaddum	Deutsche Bundesbank	Vice-President	Germany
https://www.bis.org/review/r971105d.pdf	Mr. Reddy considers the future of India's debt market 1997 (Central Bank Articles and Speeches, 9 Oct 97)	Inaugural address given by the Deputy Governor of the Reserve Bank of India, Dr. Y.V. Reddy, at the Invest India Conferences in Mumbai, on 9/10/97.	1997-10-09 00:00:00	Mr. Reddy considers the future of India's debt market 1997 Inaugural address given by the Deputy Governor of the Reserve Bank of India, Dr. Y.V. Reddy, at the Invest India Conferences in Mumbai, on 9/10/97. The Future of India's Debt Market 1997 I am happy to be amongst you this morning. This conference gives me an opportunity to sharpen my thoughts, and gain insights from the deliberations. The subject has gained importance over the years, and in particular, more recently after the Monetary and Credit Policy of April 1997. In fact, there is a sudden spurt in conferences on this subject, as for example, the SBICAP Debt Market Seminar held last month. Also, there was pretty elaborate coverage of this subject during the last two days in the discussions of Bank Economists' Conference on the Second Phase of Reforms in the Financial Sector. The objective of this national conference, as I understand, is to assess recent changes and examine issues which merit urgent consideration in order to achieve an efficient and vibrant debt market. In the seminar organised by the SBICAP, Governor, Dr. C. Rangarajan had flagged some specific issues which would help in formulating an agenda for further reforms in the debt markets. I would urge this audience to give serious consideration to these issues. 2. Let me, therefore, begin by highlighting the reforms initiated by the Reserve Bank of India and the Government of India in the debt market in the recent period. These include: • setting up of a comprehensive system of primary dealers, • adoption of DVP system for settlement of government securities transactions, • abolition of tax deduction at source on government securities, • permitting FIIs to invest in debt instruments including government stock and allowing them to hedge their foreign currency risk in the forward market, • introduction of Treasury bills of varying maturities, and • placing investments of banks in preference shares/debentures/bonds of corporates outside the five per cent limit. In a bid to increase transparency in operations, the Reserve Bank of India (RBI) has been disseminating information on its transactions in gilts and publishing the calendar of auctions in respect of Treasury bills and repos. Soon, the RBI proposes to publish data on banks' investments in corporate and PSU debt in the Weekly Statistical Supplement to the RBI Bulletin. To foster inter-institutional coordination, a Technical Advisory Committee for government securities and a Standing Committee on Money Market have been set up. Major issues confronting the debt and money markets are discussed in these committees. These committees have been found to be useful to all participants. 3. As I observe, the discussions in this conference are structured around five sessions, viz., primary market, secondary market, legal issues, risk management and future directions. For the sake of convenience, I will follow broadly the same structure and pose issues for further deliberations. Primary Market 4. Lack of market clearing yields at primary auctions of government debt is often being cited as a significant factor slowing the development of the secondary market. The arguments run as follows: First, it hampers efforts to broaden the investor base. - 2 - Second, at times when cut-off yields in the primary market are lower than prevailing secondary market yields, it curbs secondary trading. Third, to the extent the cut-off yields are lower than secondary market yields, it constrains inventory build-up by primary dealers. Finally, to the extent volumes of pick-up in primary auctions are reduced due to interest rate considerations, it reduces the availability of floating stock in the secondary market. 5. What are the factors that inhibit market clearing mechanisms? There are four important issues, viz., notifying auction size, type of auction, element of non-competitive bids and frequency of auctions of Treasury bills. Another issue of concern relates to large private placements of corporate debt. 6. At present, there is no pre-announced notified amount in 364-day and 14-day auctions. This procedure enables the RBI to determine either the cut-off price or the amounts to be accepted in a flexible manner. Notifying amounts in auctions will bring more transparency in the auction procedure by removing the uncertainty about volumes in auctions. In this context, it needs to be emphasised that the capacity of primary dealers to absorb auction supply as an underwriter is limited. Currently, primary dealers underwrite to the extent of 50 per cent of the amounts in auctions with notified amounts. In this scenario, there is a danger of devolvement on the RBI, if there is a pre-announced notified amount. The extent of the devolvement on the RBI can be minimised by increasing the underwriting amounts to primary dealers. The RBI could also change the notified amounts between each auction, depending on prevailing market conditions, in order to minimise the devolvement risk on itself. 7. Presently, there are six primary dealers. The institution of primary dealers has partly contributed to a significant increase in secondary market transactions in government securities. Authorising primary dealers is an on-going process. All eligible applicants will be considered by the RBI for primary dealership. While on this subject, an issue that needs to be considered relates to the when-issued market. At present, the Securities Contracts (Regulation) Act, 1956 prohibits short-selling of securities. Two options could be considered. First, whether to give exclusive access of primary auctions to primary dealers and simultaneously permit them to engage in short sales of government securities. Second, whether to continue with the existing system of access to primary auctions and allow all participants to engage in short sales of government securities. The timing and sequencing of this reform -- whether to introduce it now or wait until the number of primary dealers has enlarged -- are aspects that need to be carefully considered. I would urge upon the participants to discuss the pros and cons of these options and the international practices in this regard. 8. There is some debate over the type of auction that is most suitable for selling Treasury bills and dated government securities in India. There are advocates for both the discriminatory and uniform price auctions. But, international practices seem to be in favour of discriminatory price auctions. In a switch-over from one auction system to another, a number of considerations arise such as easy entry, cost to issuer, return to investor, role of primary dealers, incentive to gather information, etc. This is another area fit for a careful assessment. 9. As you are aware, non-competitive bids are allowed in 91- and 14-day Treasury bills auctions. A major issue relates to the treatment of non-competitive bids. Country practices show that non-competitive bidders are made allocations within the notified amount. However, the non-competitive bidders in other countries consist essentially of small, retail and inexperienced investors. Since the maximum bid is restricted to a small value, the competitive bid prices do not get distorted. There is a view in the Indian market that non-competitive bidders should also be allowed as competitive bidders. However, in our country, since State Governments are major non-competitive bidders, their volatile surplus funds position could make their participation in Treasury bills auctions very uncertain. Thus, there could be large swings in terms of volumes in auctions. Another view is to make allocation for non-competitive bidders outside the notified amount. - 3 - 10. There is a view in the market that the high frequency of auctions recently brought about by introducing 14-day Treasury bills auctions (along with frequent repos) tends to hinder secondary market activities by reducing investor participation in the secondary market in favour of waiting for a few days for primary issues. Also, the staggered settlement dates for Treasury bills falling on different days in the week make secondary market trading across different maturities of Treasury bills less efficient. Perhaps, it would be useful for this conference to discuss the need, if any, to reduce auction frequency and adjust settlement dates of different maturity Treasury bills to fall on the same day in the week so as to improve fungibility and thereby price discovery and market efficiency. 11. Finally, an increasingly important concern relates to the issuance of PSU bonds and corporate debentures through private placements. Although, the private placement market plays a crucial role in enabling corporates to raise resources, certain vital issues need to be considered for a well-directed and efficient functioning of the market. At present, there is no transparency in this market and virtually little information. In developed markets, the regulatory authorities indicate the framework within which the private placement has to function, like number of persons per placement, arrangements with only qualified investors and strict regulations to access certain qualified investors. We have to assess the adequacy of the regulatory framework to protect the interest of investors from risks associated with subscriptions in the private placement market. With a proper regulatory framework and more transparency, the private placement market can develop further as an integral and important constituent of the primary market for the raising of resources by corporates; hence, the need to deliberate on the status of regulatory framework. Secondary Market 12. As part of the reform process, a number of technical impediments that prevented more active secondary market trading in government securities and Treasury bills have been progressively removed. Let me briefly recall these: • abolition of the system of TDS, • issuance of benchmark securities, and • operationalising the DVP system at all centres. The RBI is encouraging banks to open SGL II accounts for constituents, thereby enlarging the coverage of book-entry holding of government securities. Recently, the National Stock Exchange has been authorised to open a SGL II account and a current account with the RBI. A decision has been taken to extend a similar facility to the Stock Holding Corporation of India. These steps would further streamline transfer and settlement procedures in the government securities market. 13. In respect of PSU bonds and corporate debentures, which are held mostly in scrip form, a proper settlement system is yet to be put in place. The National Securities Depository Limited (NSDL) was expected to dematerialise a sizeable stock of non-government debt. But, at present, NSDL has been able to dematerialise only those securities which are exempt from stamp duty. Suitable amendments to the stamp duty regime appear, therefore, necessary to avoid transaction costs and enable active use of the facility. An appropriate solution is needed, since an efficient transfer and settlement system in the PSU bonds and corporate debt segments could usher in the resumption of repos in these instruments. Once it is assured that risk-free and transparent payment and settlement systems are put in place through a depository like NSDL in dematerialised form, it should be possible to permit such repos. 14. Another issue that has been raised frequently relates to giving permission to financial institutions to borrow through repos in eligible securities. While there is a risk of generating asset-liability mismatches among non-bank participants, the conference could discuss the operational feasibility of allowing such participants into the repo market under suitable safeguards. 15. The Reserve Bank of India is considering a range of options to increase the interest of individual investors in government securities. There is an inherent potential for households to diversify - 4 - their investment portfolio encompassing government securities. It would be useful to quickly review marketing and distribution strategies adopted in other countries for reaching government securities to households. Australia, Ireland, the Netherlands and Sweden adopt direct sales of government securities to the retail sector through special registration facilities. Hungary, Switzerland, the UK and the USA retail through non-competitive bidding arrangements. France and Norway use the primary dealers network. Germany, Spain and Turkey have retailing arrangements through the banking system, while Denmark, Ireland, and Poland retail government securities through the stock exchanges. Italy uses both the banking and stock exchange network. The conference could do well to consider strategic options for this important phase of market development. Legal Issues 16. The most important segment of the debt market being government securities, let me start with the relevant law on this. The law relating to government securities and their management by the Reserve Bank of India is the Public Debt Act, 1944. The present act dates to pre-independence days, when marketable debt comprised almost the entire borrowing by the Government. This is no longer valid, with almost over Rs.300,000 crore worth of other liabilities of the Government comprising, inter alia, instruments like NSS, Indira Vikas Patra, etc., falling outside the purview of this Act. Further, provisions of the Public Debt Act relate to issue, servicing and repayment of government securities and do not provide regulation of trading/marketing of government securities. For instance, under the present Act, the Reserve Bank has no substantive powers to design and introduce an instrument of transfer suited to the computer environment. There are other constraints, such as those which preclude the RBI from issuing government securities in the form of promissory notes in the name of trusts, non-availability of nomination facility in respect of government securities, barring a minor from holding government securities, etc. A new Act on government securities is proposed to take care of these issues. Any suggestions on this reform are welcome. 17. It seems appropriate to consider extending the use of depositories established under the Depositories Act to government securities. The Depositories Act came into force in 1996 providing for a legal framework for holding of equities, bonds, debentures, units and other market instruments in dematerialised form in a depository. Such deposits come under the regulatory framework of SEBI. Since the RBI manages the public debt of central and state governments, Public Debt Offices (PDOs) of the RBI are in effect depositories under the Public Debt Act. Thus, giving permission to depositories to hold government securities in dematerialised form would make the provisions of the Depositories Act applicable to the Reserve Bank as an issuer, bringing into focus the respective regulatory roles of the Reserve Bank and SEBI in government securities. One of the suggestions to resolve this is by way of incorporating a provision in the proposed Government Securities Act, excluding the provisions of Depositories Act being applicable to government securities. 18. It would certainly be useful to survey the international experience in this regard. In Canada, Germany and Switzerland, there is central government prudential regulation of depository institutions and provincial or state supervision of securities trading. The Bank of England used to provide regulation of depository institutions, although after the passage of the Bank of England Bill, responsibility for banking supervision will be transferred to the new and strengthened Securities and Investments Board (SIB). The SIB will also take direct responsibility for the regulatory regime covered by the Financial Services Act. In Australia and New Zealand, the central banks provide prudential regulation of depository institutions, but there is no specific regulation of the government securities market. The Japanese Ministry of Finance and the Danish Supervisory Authority for Financial Affairs provide centralised regulation of government securities. As you will have observed, international experience is varied. 19. Another legal issue which is often alluded to relates to forward contracts. This forum would do well to discuss the advantages and disadvantages of the repeal of the government notification issued in l969 prohibiting forward contracts in securities. - 5 - Risk Management 20. Investors in debt instruments face three major components of risk, viz., credit risk, interest rate risk and foreign currency risk. In case of government bonds, credit risk is zero. The foreign currency risk is relevant only to non-resident investors like FIIs who are investing in debt instruments. Recently, the 100 per cent debt funds dedicated to the debt market were allowed to take forward cover to enable them to hedge their exchange rate risk. Investments in all debt instruments are exposed to interest rate risk. This risk can be better hedged if a futures market in interest rate exists, or if short-selling in securities is allowed. However, the futures market will be meaningful only in an environment of totally deregulated interest rates and the existence of a term money market which itself is dependent on a credible yield curve. Thus, while the eventual introduction of interest rate futures and permission for short-selling is inevitable, the real issue is one of the timing of these reforms, so that it does not entail any systemic risks. Future Direction 21. Consistent with the spirit of financial sector reforms, the RBI is in the process of the divestment of part of its shareholding of DFHI and STCI, so that the RBI does not have the majority of shareholding. As you are aware, the RBI has taken the initiative to promote STCI and DFHI. The RBI is now a minority shareholder in DFHI and, after the second round of disinvestment in l995, its share is only l0.5 per cent. It has also been decided to disinvest shares of STCI so that after the first phase of disinvestment, the RBI's shareholding will be less than fifty per cent. 22. Second, non-banking financial companies are now required to maintain a higher level of liquid assets in the form of government securities and government-guaranteed bonds. This will increase the demand for government paper in the market. This will be in addition to the demand generated due to the opening up of provident funds to debt market instruments, emergence of MMMFs and investments by l00 per cent FII debt funds. 23. Third, I would like to flag the vital issue of the role of market participants. Standard practices have to be evolved by the market with regard to the manner of quotes, the conclusion of deals, the manner of pricing and accounting standards. A code of best practices also has to be evolved for repo transactions in eligible securities. In the context of moving towards a liberalised and market-oriented environment in the financial sector, it would be desirable if such standard practices were evolved and accepted in a common forum of a self-regulatory body. At present, I understand that there are moves to create such self-regulatory body/bodies among the PDs and among banks and financial institutions covering transactions in money and fixed-income securities markets. This is a welcome trend and the RBI would be willing to nurture such developments in the market. 24. Finally, the time has come to accord priority for establishing electronic links between the Deposit Accounts Department and Public Accounts Department/Public Debt Office of the RBI for achieving synchronisation of funds and securities transfers. We should also begin planning electronic links between banks, primary dealers and others who have access to the system, so as to pave the way for a more information-efficient and transparent securities market. These plans can succeed only with the concerted efforts of all -- the Government, the Reserve Bank of India and the market participants. I would appreciate your detailed suggestions.	["mr. reddy considers the future of india's debt market 1997 inaugural address given by the deputy governor of the reserve bank of india, dr. y.v.", 'reddy, at the invest india conferences in mumbai, on 9/10/97.', "the future of india's debt market 1997 i am happy to be amongst you this morning.", 'this conference gives me an opportunity to sharpen my thoughts, and gain insights from the deliberations.', 'the subject has gained importance over the years, and in particular, more recently after the monetary and credit policy of april 1997. in fact, there is a sudden spurt in conferences on this subject, as for example, the sbicap debt market seminar held last month.', "also, there was pretty elaborate coverage of this subject during the last two days in the discussions of bank economists' conference on the second phase of reforms in the financial sector.", 'the objective of this national conference, as i understand, is to assess recent changes and examine issues which merit urgent consideration in order to achieve an efficient and vibrant debt market.', 'in the seminar organised by the sbicap, governor, dr. c. rangarajan had flagged some specific issues which would help in formulating an agenda for further reforms in the debt markets.', 'i would urge this audience to give serious consideration to these issues.', '2. let me, therefore, begin by highlighting the reforms initiated by the reserve bank of india and the government of india in the debt market in the recent period.', 'these include: • setting up of a comprehensive system of primary dealers, • adoption of dvp system for settlement of government securities transactions, • abolition of tax deduction at source on government securities, • permitting fiis to invest in debt instruments including government stock and allowing them to hedge their foreign currency risk in the forward market, • introduction of treasury bills of varying maturities, and • placing investments of banks in preference shares/debentures/bonds of corporates outside the five per cent limit.', 'in a bid to increase transparency in operations, the reserve bank of india (rbi) has been disseminating information on its transactions in gilts and publishing the calendar of auctions in respect of treasury bills and repos.', "soon, the rbi proposes to publish data on banks' investments in corporate and psu debt in the weekly statistical supplement to the rbi bulletin.", 'to foster inter-institutional coordination, a technical advisory committee for government securities and a standing committee on money market have been set up.', 'major issues confronting the debt and money markets are discussed in these committees.', 'these committees have been found to be useful to all participants.', '3. as i observe, the discussions in this conference are structured around five sessions, viz., primary market, secondary market, legal issues, risk management and future directions.', 'for the sake of convenience, i will follow broadly the same structure and pose issues for further deliberations.', 'primary market 4. lack of market clearing yields at primary auctions of government debt is often being cited as a significant factor slowing the development of the secondary market.', 'the arguments run as follows: first, it hampers efforts to broaden the investor base.', '- 2 - second, at times when cut-off yields in the primary market are lower than prevailing secondary market yields, it curbs secondary trading.', 'third, to the extent the cut-off yields are lower than secondary market yields, it constrains inventory build-up by primary dealers.', 'finally, to the extent volumes of pick-up in primary auctions are reduced due to interest rate considerations, it reduces the availability of floating stock in the secondary market.', '5. what are the factors that inhibit market clearing mechanisms?', 'there are four important issues, viz., notifying auction size, type of auction, element of non-competitive bids and frequency of auctions of treasury bills.', 'another issue of concern relates to large private placements of corporate debt.', '6. at present, there is no pre-announced notified amount in 364-day and 14-day auctions.', 'this procedure enables the rbi to determine either the cut-off price or the amounts to be accepted in a flexible manner.', 'notifying amounts in auctions will bring more transparency in the auction procedure by removing the uncertainty about volumes in auctions.', 'in this context, it needs to be emphasised that the capacity of primary dealers to absorb auction supply as an underwriter is limited.', 'currently, primary dealers underwrite to the extent of 50 per cent of the amounts in auctions with notified amounts.', 'in this scenario, there is a danger of devolvement on the rbi, if there is a pre-announced notified amount.', 'the extent of the devolvement on the rbi can be minimised by increasing the underwriting amounts to primary dealers.', 'the rbi could also change the notified amounts between each auction, depending on prevailing market conditions, in order to minimise the devolvement risk on itself.', '7. presently, there are six primary dealers.', 'the institution of primary dealers has partly contributed to a significant increase in secondary market transactions in government securities.', 'authorising primary dealers is an on-going process.', 'all eligible applicants will be considered by the rbi for primary dealership.', 'while on this subject, an issue that needs to be considered relates to the when-issued market.', 'at present, the securities contracts (regulation) act, 1956 prohibits short-selling of securities.', 'two options could be considered.', 'first, whether to give exclusive access of primary auctions to primary dealers and simultaneously permit them to engage in short sales of government securities.', 'second, whether to continue with the existing system of access to primary auctions and allow all participants to engage in short sales of government securities.', 'the timing and sequencing of this reform -- whether to introduce it now or wait until the number of primary dealers has enlarged -- are aspects that need to be carefully considered.', 'i would urge upon the participants to discuss the pros and cons of these options and the international practices in this regard.', '8. there is some debate over the type of auction that is most suitable for selling treasury bills and dated government securities in india.', 'there are advocates for both the discriminatory and uniform price auctions.', 'but, international practices seem to be in favour of discriminatory price auctions.', 'in a switch-over from one auction system to another, a number of considerations arise such as easy entry, cost to issuer, return to investor, role of primary dealers, incentive to gather information, etc.', 'this is another area fit for a careful assessment.', '9. as you are aware, non-competitive bids are allowed in 91- and 14-day treasury bills auctions.', 'a major issue relates to the treatment of non-competitive bids.', 'country practices show that non-competitive bidders are made allocations within the notified amount.', 'however, the non-competitive bidders in other countries consist essentially of small, retail and inexperienced investors.', 'since the maximum bid is restricted to a small value, the competitive bid prices do not get distorted.', 'there is a view in the indian market that non-competitive bidders should also be allowed as competitive bidders.', 'however, in our country, since state governments are major non-competitive bidders, their volatile surplus funds position could make their participation in treasury bills auctions very uncertain.', 'thus, there could be large swings in terms of volumes in auctions.', 'another view is to make allocation for non-competitive bidders outside the notified amount.', '- 3 - 10. there is a view in the market that the high frequency of auctions recently brought about by introducing 14-day treasury bills auctions (along with frequent repos) tends to hinder secondary market activities by reducing investor participation in the secondary market in favour of waiting for a few days for primary issues.', 'also, the staggered settlement dates for treasury bills falling on different days in the week make secondary market trading across different maturities of treasury bills less efficient.', 'perhaps, it would be useful for this conference to discuss the need, if any, to reduce auction frequency and adjust settlement dates of different maturity treasury bills to fall on the same day in the week so as to improve fungibility and thereby price discovery and market efficiency.', '11. finally, an increasingly important concern relates to the issuance of psu bonds and corporate debentures through private placements.', 'although, the private placement market plays a crucial role in enabling corporates to raise resources, certain vital issues need to be considered for a well-directed and efficient functioning of the market.', 'at present, there is no transparency in this market and virtually little information.', 'in developed markets, the regulatory authorities indicate the framework within which the private placement has to function, like number of persons per placement, arrangements with only qualified investors and strict regulations to access certain qualified investors.', 'we have to assess the adequacy of the regulatory framework to protect the interest of investors from risks associated with subscriptions in the private placement market.', 'with a proper regulatory framework and more transparency, the private placement market can develop further as an integral and important constituent of the primary market for the raising of resources by corporates; hence, the need to deliberate on the status of regulatory framework.', 'secondary market 12. as part of the reform process, a number of technical impediments that prevented more active secondary market trading in government securities and treasury bills have been progressively removed.', 'let me briefly recall these: • abolition of the system of tds, • issuance of benchmark securities, and • operationalising the dvp system at all centres.', 'the rbi is encouraging banks to open sgl ii accounts for constituents, thereby enlarging the coverage of book-entry holding of government securities.', 'recently, the national stock exchange has been authorised to open a sgl ii account and a current account with the rbi.', 'a decision has been taken to extend a similar facility to the stock holding corporation of india.', 'these steps would further streamline transfer and settlement procedures in the government securities market.', '13. in respect of psu bonds and corporate debentures, which are held mostly in scrip form, a proper settlement system is yet to be put in place.', 'the national securities depository limited (nsdl) was expected to dematerialise a sizeable stock of non-government debt.', 'but, at present, nsdl has been able to dematerialise only those securities which are exempt from stamp duty.', 'suitable amendments to the stamp duty regime appear, therefore, necessary to avoid transaction costs and enable active use of the facility.', 'an appropriate solution is needed, since an efficient transfer and settlement system in the psu bonds and corporate debt segments could usher in the resumption of repos in these instruments.', 'once it is assured that risk-free and transparent payment and settlement systems are put in place through a depository like nsdl in dematerialised form, it should be possible to permit such repos.', '14. another issue that has been raised frequently relates to giving permission to financial institutions to borrow through repos in eligible securities.', 'while there is a risk of generating asset-liability mismatches among non-bank participants, the conference could discuss the operational feasibility of allowing such participants into the repo market under suitable safeguards.', '15. the reserve bank of india is considering a range of options to increase the interest of individual investors in government securities.', 'there is an inherent potential for households to diversify - 4 - their investment portfolio encompassing government securities.', 'it would be useful to quickly review marketing and distribution strategies adopted in other countries for reaching government securities to households.', 'australia, ireland, the netherlands and sweden adopt direct sales of government securities to the retail sector through special registration facilities.', 'hungary, switzerland, the uk and the usa retail through non-competitive bidding arrangements.', 'france and norway use the primary dealers network.', 'germany, spain and turkey have retailing arrangements through the banking system, while denmark, ireland, and poland retail government securities through the stock exchanges.', 'italy uses both the banking and stock exchange network.', 'the conference could do well to consider strategic options for this important phase of market development.', 'legal issues 16. the most important segment of the debt market being government securities, let me start with the relevant law on this.', 'the law relating to government securities and their management by the reserve bank of india is the public debt act, 1944. the present act dates to pre-independence days, when marketable debt comprised almost the entire borrowing by the government.', 'this is no longer valid, with almost over rs.300,000 crore worth of other liabilities of the government comprising, inter alia, instruments like nss, indira vikas patra, etc., falling outside the purview of this act.', 'further, provisions of the public debt act relate to issue, servicing and repayment of government securities and do not provide regulation of trading/marketing of government securities.', 'for instance, under the present act, the reserve bank has no substantive powers to design and introduce an instrument of transfer suited to the computer environment.', 'there are other constraints, such as those which preclude the rbi from issuing government securities in the form of promissory notes in the name of trusts, non-availability of nomination facility in respect of government securities, barring a minor from holding government securities, etc.', 'a new act on government securities is proposed to take care of these issues.', 'any suggestions on this reform are welcome.', '17. it seems appropriate to consider extending the use of depositories established under the depositories act to government securities.', 'the depositories act came into force in 1996 providing for a legal framework for holding of equities, bonds, debentures, units and other market instruments in dematerialised form in a depository.', 'such deposits come under the regulatory framework of sebi.', 'since the rbi manages the public debt of central and state governments, public debt offices (pdos) of the rbi are in effect depositories under the public debt act.', 'thus, giving permission to depositories to hold government securities in dematerialised form would make the provisions of the depositories act applicable to the reserve bank as an issuer, bringing into focus the respective regulatory roles of the reserve bank and sebi in government securities.', 'one of the suggestions to resolve this is by way of incorporating a provision in the proposed government securities act, excluding the provisions of depositories act being applicable to government securities.', '18. it would certainly be useful to survey the international experience in this regard.', 'in canada, germany and switzerland, there is central government prudential regulation of depository institutions and provincial or state supervision of securities trading.', 'the bank of england used to provide regulation of depository institutions, although after the passage of the bank of england bill, responsibility for banking supervision will be transferred to the new and strengthened securities and investments board (sib).', 'the sib will also take direct responsibility for the regulatory regime covered by the financial services act.', 'in australia and new zealand, the central banks provide prudential regulation of depository institutions, but there is no specific regulation of the government securities market.', 'the japanese ministry of finance and the danish supervisory authority for financial affairs provide centralised regulation of government securities.', 'as you will have observed, international experience is varied.', '19. another legal issue which is often alluded to relates to forward contracts.', 'this forum would do well to discuss the advantages and disadvantages of the repeal of the government notification issued in l969 prohibiting forward contracts in securities.', '- 5 - risk management 20. investors in debt instruments face three major components of risk, viz., credit risk, interest rate risk and foreign currency risk.', 'in case of government bonds, credit risk is zero.', 'the foreign currency risk is relevant only to non-resident investors like fiis who are investing in debt instruments.', 'recently, the 100 per cent debt funds dedicated to the debt market were allowed to take forward cover to enable them to hedge their exchange rate risk.', 'investments in all debt instruments are exposed to interest rate risk.', 'this risk can be better hedged if a futures market in interest rate exists, or if short-selling in securities is allowed.', 'however, the futures market will be meaningful only in an environment of totally deregulated interest rates and the existence of a term money market which itself is dependent on a credible yield curve.', 'thus, while the eventual introduction of interest rate futures and permission for short-selling is inevitable, the real issue is one of the timing of these reforms, so that it does not entail any systemic risks.', 'future direction 21. consistent with the spirit of financial sector reforms, the rbi is in the process of the divestment of part of its shareholding of dfhi and stci, so that the rbi does not have the majority of shareholding.', 'as you are aware, the rbi has taken the initiative to promote stci and dfhi.', 'the rbi is now a minority shareholder in dfhi and, after the second round of disinvestment in l995, its share is only l0.5 per cent.', "it has also been decided to disinvest shares of stci so that after the first phase of disinvestment, the rbi's shareholding will be less than fifty per cent.", '22. second, non-banking financial companies are now required to maintain a higher level of liquid assets in the form of government securities and government-guaranteed bonds.', 'this will increase the demand for government paper in the market.', 'this will be in addition to the demand generated due to the opening up of provident funds to debt market instruments, emergence of mmmfs and investments by l00 per cent fii debt funds.', '23. third, i would like to flag the vital issue of the role of market participants.', 'standard practices have to be evolved by the market with regard to the manner of quotes, the conclusion of deals, the manner of pricing and accounting standards.', 'a code of best practices also has to be evolved for repo transactions in eligible securities.', 'in the context of moving towards a liberalised and market-oriented environment in the financial sector, it would be desirable if such standard practices were evolved and accepted in a common forum of a self-regulatory body.', 'at present, i understand that there are moves to create such self-regulatory body/bodies among the pds and among banks and financial institutions covering transactions in money and fixed-income securities markets.', 'this is a welcome trend and the rbi would be willing to nurture such developments in the market.', '24. finally, the time has come to accord priority for establishing electronic links between the deposit accounts department and public accounts department/public debt office of the rbi for achieving synchronisation of funds and securities transfers.', 'we should also begin planning electronic links between banks, primary dealers and others who have access to the system, so as to pave the way for a more information-efficient and transparent securities market.', 'these plans can succeed only with the concerted efforts of all -- the government, the reserve bank of india and the market participants.', 'i would appreciate your detailed suggestions.']	Y V Reddy	Reserve Bank of India	Deputy Governor	India
https://www.bis.org/review/r971105c.pdf	Bank of Japan presents its quarterly economic outlook for autumn 1997	BANK OF JAPAN, QUARTERLY BULLETIN, November 1997 (advance issue).	1997-11-04 23:00:00	Bank of Japan presents its quarterly economic outlook for autumn 1997 BANK OF JAPAN, QUARTERLY BULLETIN, November 1997 (advance issue). Summary 1. Japan's economic growth has been decelerating since April, partly reflecting the impact of the consumption tax hike. Corporate sentiment has also weakened somewhat. However, the recovery trend in corporate profits, employment and income conditions has not been undermined, supported by the rise in exports and business fixed investment. Among final demand items, public-sector investment has been declining, and housing investment has also dropped significantly, mainly reflecting the decline after the surge in demand prior to the consumption tax hike. Personal consumption has continued to be sluggish on the whole, although the impact of the consumption tax hike has gradually subsided. However, net exports and business fixed investment have been increasing. In these circumstances, excessive inventories are seen in some industries such as in consumer durables, and industrial production has stayed virtually unchanged. Employment and income conditions have continued to improve, although the pace of recovery has moderated somewhat. Prices remained stable on the whole, excluding the effect of the consumption tax hike. Domestic wholesale prices (adjusted for seasonal electricity rates) have been relatively weak, reflecting easy supply and demand conditions for construction-related goods. The year-to-year decline in corporate service prices has slowed steadily, and the year-to-year growth in consumer prices (nationwide, excluding perishables) has been stable at around 0.5-0.6 per cent. Meanwhile, changes in land prices varied by type, and have not stopped declining on the whole. 2. In the financial markets, the overnight call rate (uncollateralized) stayed at the level slightly below the official discount rate of 0.5 per cent. The long-term government bond yield temporarily rose to near 2.7 per cent at the end of May, but it followed a declining trend since then, reflecting the uncertainty about future economic growth. It has been moving at around the record low level of around 1.7 per cent since early October. Stock prices also moved at a low level of around 17,000 - 18,000. Meanwhile, the yen depreciated somewhat against the U.S. dollar as the contrast between Japan's and U.S. economic growth gained more attention. The yen has recently moved at around 120 - 122 to the U.S. dollar. Growth in bank lending continues to be lackluster. Fund-raising activities through capital markets fell below the previous year's level. Growth in monetary aggregates in terms of M2 + CDs year-to-year average outstanding has continued at around 3 per cent. 3. With respect to the outlook, public-sector investment is expected to continue declining, judging from the government's budget. On the other hand, net exports are expected to follow an increasing trend, reflecting firm overseas demand and the depreciation of the yen to date, although the pace of increase will be slower than that recorded up to the second quarter. According to the Bank of Japan's Tankan -- Short-Term Economic Survey of Enterprises of September 1997, the increase in corporate profits overall is expected to be maintained, albeit at a slower pace. While profits of small non-manufacturing firms are expected to decline owing to the decline in demand in addition to structural factors, those of large manufacturing firms are projected to continue on an increasing trend, largely supported by exports. In these circumstances, the pace of increase in business fixed investment may slow down somewhat as investment in telecommunications is expected to remain unchanged after surging in the previous fiscal year. However, given that stock accumulation is not excessive and demand for information-related investment is strong, business fixed investment will continue a steady increase. - 2 - As for the household sector, the growth in bonus payments and overtime payments has been slowing. This may suggest that the economic deceleration since spring 1997 has started to affect household income. However, the significant deterioration of household confidence is unlikely to be triggered by these developments, as the current employment conditions are very different from those of around 1993 when the risk of severe employment adjustment was large. Also, the recent weaknesses in personal consumption and housing investment partly reflect the temporary factors, such as the reaction to the front-loading of demand before the consumption tax hike. The downward pressure from fiscal policies is likely to weaken gradually in the near future. Therefore, once the impact of the consumption tax hike subsides, an early recovery of household expenditure may translate into the positive cycle of production, income and expenditure. Still, there are uncertainties about the recovery in personal consumption, as consumer confidence is susceptible to psychological elements. 4. With respect to price developments, domestic wholesale prices are likely to continue to be weak for the time being. This is because inventory adjustment pressures are being exerted, and the downward pressure from electrical goods prices caused by technological innovation remains strong, although the downward pressure coming from import prices has been subsiding. Meanwhile, corporate service prices will stay virtually unchanged, and consumer prices are likely to continue a similar moderate rise. 5. In sum, fiscal policies, including the consumption tax hike, continue to affect Japan's economy, and the slowdown in domestic demand seems to have influenced corporate profits, employment and income conditions gradually through a deceleration in production activity. However, corporate profits and employees' income have maintained their growth, although at a somewhat slower pace. Also, labor adjustment and capital stock adjustment pressures are not so large, and the risk of deflation is negligible. In light of this, the basis for economic recovery has not been undermined. If household expenditure picks up and inventory adjustment pressures subside steadily, the economic recovery is likely to gather momentum again, albeit gradually. Given the cautious corporate sentiments and the uncertainty about future developments in demand, it is essential to monitor closely future economic developments, particularly the pace of recovery in household expenditure, and the progress in inventory adjustment.	['bank of japan presents its quarterly economic outlook for autumn 1997 bank of japan, quarterly bulletin, november 1997 (advance issue).', "summary 1. japan's economic growth has been decelerating since april, partly reflecting the impact of the consumption tax hike.", 'corporate sentiment has also weakened somewhat.', 'however, the recovery trend in corporate profits, employment and income conditions has not been undermined, supported by the rise in exports and business fixed investment.', 'among final demand items, public-sector investment has been declining, and housing investment has also dropped significantly, mainly reflecting the decline after the surge in demand prior to the consumption tax hike.', 'personal consumption has continued to be sluggish on the whole, although the impact of the consumption tax hike has gradually subsided.', 'however, net exports and business fixed investment have been increasing.', 'in these circumstances, excessive inventories are seen in some industries such as in consumer durables, and industrial production has stayed virtually unchanged.', 'employment and income conditions have continued to improve, although the pace of recovery has moderated somewhat.', 'prices remained stable on the whole, excluding the effect of the consumption tax hike.', 'domestic wholesale prices (adjusted for seasonal electricity rates) have been relatively weak, reflecting easy supply and demand conditions for construction-related goods.', 'the year-to-year decline in corporate service prices has slowed steadily, and the year-to-year growth in consumer prices (nationwide, excluding perishables) has been stable at around 0.5-0.6 per cent.', 'meanwhile, changes in land prices varied by type, and have not stopped declining on the whole.', '2. in the financial markets, the overnight call rate (uncollateralized) stayed at the level slightly below the official discount rate of 0.5 per cent.', 'the long-term government bond yield temporarily rose to near 2.7 per cent at the end of may, but it followed a declining trend since then, reflecting the uncertainty about future economic growth.', 'it has been moving at around the record low level of around 1.7 per cent since early october.', "stock prices also moved at a low level of around 17,000 - 18,000. meanwhile, the yen depreciated somewhat against the u.s. dollar as the contrast between japan's and u.s. economic growth gained more attention.", 'the yen has recently moved at around 120 - 122 to the u.s. dollar.', 'growth in bank lending continues to be lackluster.', "fund-raising activities through capital markets fell below the previous year's level.", 'growth in monetary aggregates in terms of m2 + cds year-to-year average outstanding has continued at around 3 per cent.', "3. with respect to the outlook, public-sector investment is expected to continue declining, judging from the government's budget.", 'on the other hand, net exports are expected to follow an increasing trend, reflecting firm overseas demand and the depreciation of the yen to date, although the pace of increase will be slower than that recorded up to the second quarter.', "according to the bank of japan's tankan -- short-term economic survey of enterprises of september 1997, the increase in corporate profits overall is expected to be maintained, albeit at a slower pace.", 'while profits of small non-manufacturing firms are expected to decline owing to the decline in demand in addition to structural factors, those of large manufacturing firms are projected to continue on an increasing trend, largely supported by exports.', 'in these circumstances, the pace of increase in business fixed investment may slow down somewhat as investment in telecommunications is expected to remain unchanged after surging in the previous fiscal year.', 'however, given that stock accumulation is not excessive and demand for information-related investment is strong, business fixed investment will continue a steady increase.', '- 2 - as for the household sector, the growth in bonus payments and overtime payments has been slowing.', 'this may suggest that the economic deceleration since spring 1997 has started to affect household income.', 'however, the significant deterioration of household confidence is unlikely to be triggered by these developments, as the current employment conditions are very different from those of around 1993 when the risk of severe employment adjustment was large.', 'also, the recent weaknesses in personal consumption and housing investment partly reflect the temporary factors, such as the reaction to the front-loading of demand before the consumption tax hike.', 'the downward pressure from fiscal policies is likely to weaken gradually in the near future.', 'therefore, once the impact of the consumption tax hike subsides, an early recovery of household expenditure may translate into the positive cycle of production, income and expenditure.', 'still, there are uncertainties about the recovery in personal consumption, as consumer confidence is susceptible to psychological elements.', '4. with respect to price developments, domestic wholesale prices are likely to continue to be weak for the time being.', 'this is because inventory adjustment pressures are being exerted, and the downward pressure from electrical goods prices caused by technological innovation remains strong, although the downward pressure coming from import prices has been subsiding.', 'meanwhile, corporate service prices will stay virtually unchanged, and consumer prices are likely to continue a similar moderate rise.', "5. in sum, fiscal policies, including the consumption tax hike, continue to affect japan's economy, and the slowdown in domestic demand seems to have influenced corporate profits, employment and income conditions gradually through a deceleration in production activity.", "however, corporate profits and employees' income have maintained their growth, although at a somewhat slower pace.", 'also, labor adjustment and capital stock adjustment pressures are not so large, and the risk of deflation is negligible.', 'in light of this, the basis for economic recovery has not been undermined.', 'if household expenditure picks up and inventory adjustment pressures subside steadily, the economic recovery is likely to gather momentum again, albeit gradually.', 'given the cautious corporate sentiments and the uncertainty about future developments in demand, it is essential to monitor closely future economic developments, particularly the pace of recovery in household expenditure, and the progress in inventory adjustment.']	Bank of Japan	Bank of Japan	not specified	Japan
https://www.bis.org/review/r971104b.pdf	Mr. Greenspan's testimony before the Joint Economic Committee of the US Congress (Central Bank Articles and Speeches, 29 Oct 97)	Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress in Washington DC on 29/10/97.	1997-10-29 00:00:00	Mr. Greenspan's testimony before the Joint Economic Committee of the US Congress Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress in Washington DC on 29/10/97. We meet against the background of considerable turbulence in world financial markets, and I shall address the bulk of my remarks to those circumstances. We need to assess these developments against the backdrop of a continuing impressive performance of the American economy in recent months. Growth appears to have remained robust and inflation low, and even falling, despite an ever tightening labor market. Our economy has enjoyed a lengthy period of good economic growth, linked, not coincidentally, to damped inflation. The Federal Reserve is dedicated to contributing as best it can to prolonging this performance, and we will be watching economic and financial market developments closely and evaluating their implications. Even after the sharp rebound around the world in the past twenty-four hours, declines in stock markets in the United States and elsewhere have left investors less wealthy than they were a week ago and businesses facing higher equity cost of capital. Yet, provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy. The 1987 crash occurred at a time when the American economy was operating with a significant degree of inflationary excess that the fall in market values arguably neutralized. Today's economy, as I have been suggesting of late, has been drawing down unused labor resources at an unsustainable pace, spurred, in part, by a substantial wealth effect on demand. The market's net retrenchment of recent days will tend to damp that impetus, a development that should help to prolong our six-and-a-half-year business expansion. As I have testified previously, much of the stock price gain since early 1995 seems to have reflected upward revisions of long-term earnings expectations, which were implying a continuing indefinite rise in profit margins from already high levels. I suspect we are experiencing some scaling back of the projected gains in foreign affiliate earnings, and investors probably also are revisiting expectations of domestic earnings growth. Still, the foundation for good business performance remains solid. Indeed, data on our national economy in recent months are beginning to support the notion that productivity growth, the basis for increases in earnings, is beginning to pick up. I also suspect earnings expectations and equity prices in the United States were primed to adjust. The currency crises in Southeast Asia and the declines in equity prices there and elsewhere do have some direct effects on U.S. corporate earnings, but not enough to explain the recent behavior of our financial markets. If it was not developments in Southeast Asia, something else would have been the proximate cause for a re-evaluation. While productivity growth does appear to have picked up in the last six months, as I have pointed out in the past, it likely is overly optimistic to assume that the dimension of any acceleration in productivity will be great enough and persistent enough to close, by itself, the gap between an excess of long-term demand for labor and its supply. It will take some time to judge the extent of a lasting improvement. Regrettably, over the last year the argument for the so-called new paradigm has slowly shifted from the not unreasonable notion that productivity is in the process of accelerating, to a less than credible view, often implied rather than stated, that we need no longer be concerned about the risk that inflation can rise again. The Federal Reserve cannot afford to take such a complacent view of our price prospects. There is much that is encouraging in the recent performance of the American economy, but, as I have often mentioned before, fundamental change comes slowly and we need to evaluate the prospective balance of supply and demand for various productive resources in deciding policy. - 2 - Recent developments in equity markets have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. The recent turmoil is a case in point. I believe there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have recently emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows, into these economies, in particular short-term flows, was denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. - 3 - The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about four percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there may be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts and relatively robust financial systems, have experienced severe pressures in recent days. One can debate whether the recent turbulence in Latin American asset values reflect contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the liabilities of failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, and the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the - 4 - interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.	["mr. greenspan's testimony before the joint economic committee of the us congress testimony by the chairman of the board of the us federal reserve system, mr. alan greenspan, before the joint economic committee of the us congress in washington dc on 29/10/97.", 'we meet against the background of considerable turbulence in world financial markets, and i shall address the bulk of my remarks to those circumstances.', 'we need to assess these developments against the backdrop of a continuing impressive performance of the american economy in recent months.', 'growth appears to have remained robust and inflation low, and even falling, despite an ever tightening labor market.', 'our economy has enjoyed a lengthy period of good economic growth, linked, not coincidentally, to damped inflation.', 'the federal reserve is dedicated to contributing as best it can to prolonging this performance, and we will be watching economic and financial market developments closely and evaluating their implications.', 'even after the sharp rebound around the world in the past twenty-four hours, declines in stock markets in the united states and elsewhere have left investors less wealthy than they were a week ago and businesses facing higher equity cost of capital.', 'yet, provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy.', 'the 1987 crash occurred at a time when the american economy was operating with a significant degree of inflationary excess that the fall in market values arguably neutralized.', "today's economy, as i have been suggesting of late, has been drawing down unused labor resources at an unsustainable pace, spurred, in part, by a substantial wealth effect on demand.", "the market's net retrenchment of recent days will tend to damp that impetus, a development that should help to prolong our six-and-a-half-year business expansion.", 'as i have testified previously, much of the stock price gain since early 1995 seems to have reflected upward revisions of long-term earnings expectations, which were implying a continuing indefinite rise in profit margins from already high levels.', 'i suspect we are experiencing some scaling back of the projected gains in foreign affiliate earnings, and investors probably also are revisiting expectations of domestic earnings growth.', 'still, the foundation for good business performance remains solid.', 'indeed, data on our national economy in recent months are beginning to support the notion that productivity growth, the basis for increases in earnings, is beginning to pick up.', 'i also suspect earnings expectations and equity prices in the united states were primed to adjust.', 'the currency crises in southeast asia and the declines in equity prices there and elsewhere do have some direct effects on u.s. corporate earnings, but not enough to explain the recent behavior of our financial markets.', 'if it was not developments in southeast asia, something else would have been the proximate cause for a re-evaluation.', 'while productivity growth does appear to have picked up in the last six months, as i have pointed out in the past, it likely is overly optimistic to assume that the dimension of any acceleration in productivity will be great enough and persistent enough to close, by itself, the gap between an excess of long-term demand for labor and its supply.', 'it will take some time to judge the extent of a lasting improvement.', 'regrettably, over the last year the argument for the so-called new paradigm has slowly shifted from the not unreasonable notion that productivity is in the process of accelerating, to a less than credible view, often implied rather than stated, that we need no longer be concerned about the risk that inflation can rise again.', 'the federal reserve cannot afford to take such a complacent view of our price prospects.', 'there is much that is encouraging in the recent performance of the american economy, but, as i have often mentioned before, fundamental change comes slowly and we need to evaluate the prospective balance of supply and demand for various productive resources in deciding policy.', '- 2 - recent developments in equity markets have highlighted growing interactions among national financial markets.', 'the underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems.', 'that improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly.', 'the recent turmoil is a case in point.', 'i believe there is much to be learned from the recent experience in asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide.', 'while each of the asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have recently emerged are relevant to a greater or lesser extent to nearly all of them.', 'following the early post-world war ii period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s.', 'by the 1980s most economies in the region were expanding vigorously.', 'foreign net capital inflows grew, but until recent years were relatively modest.', 'the world bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the asia pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996. a major impetus behind this rapid expansion was the global stock market boom of the 1990s.', 'as that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in asia.', 'the resultant diversification induced a sharp increase in capital flows into those economies.', 'to a large extent, they came from investors in the united states and western europe.', 'a substantial amount came from japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country.', 'the rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from japan.', 'in retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk.', 'i suspect that it was inevitable in those conditions of low inflation, rapid growth and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects.', 'this is an experience, of course, not unknown in the united states on occasion.', 'these real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems.', 'in many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital.', "moreover, in most cases, the currencies of these economies were closely tied to the u.s. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive.", 'in addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses.', 'however, overall gdp growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies.', 'moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows, into these economies, in particular short-term flows, was denominated by the ultimate borrowers in foreign currencies.', 'this put additional pressure on companies to earn foreign exchange through exports.', '- 3 - the pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies.', 'the shifts in perceived future investment risks led to sharp declines in stock markets across asia, often on top of earlier declines or lackluster performances.', 'to date, the direct impact of these developments on the american economy has been modest, but it can be expected not to be negligible.', 'u.s. exports to thailand, the philippines, indonesia, and malaysia (the four countries initially affected) were about four percent of total u.s. exports in 1996. however, an additional 12 percent went to hong kong, korea, singapore and taiwan (economies that have been affected more recently).', 'thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted.', 'our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports.', 'the share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead.', 'in addition, there may be indirect effects on the u.s. real economy from countries such as japan that compete even more extensively with the economies in the asian region.', 'particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities.', 'even economies, such as hong kong, with formidable stocks of international reserves, balanced external accounts and relatively robust financial systems, have experienced severe pressures in recent days.', 'one can debate whether the recent turbulence in latin american asset values reflect contagion effects from asia, the influence of developments in u.s. financial markets, or home-grown causes.', "whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system.", 'perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the asian region would run into a temporary slowdown or pause.', 'but there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time.', 'nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy.', 'private capital flows may temporarily turn adverse.', 'in these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge.', 'similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the liabilities of failed domestic businesses.', 'to do otherwise could lead to distorted investments and could ultimately unbalance the world financial system.', 'the recent experience in asia underscores the importance of financially sound domestic banking and other associated financial institutions.', 'while the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with.', 'our unlamented savings and loan crises come to mind.', 'these are trying days for economic policymakers in asia.', 'they must fend off domestic pressures that seek disengagement from the world trading and financial system.', 'the authorities in these countries are working hard, in some cases with substantial assistance from the imf, and the world bank, and the asian development bank, to stabilize their financial systems and economies.', 'the financial disturbances that have afflicted a number of currencies in asia do not at this point, as i indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize.', 'it is in the - 4 - interest of the united states and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman	US
https://www.bis.org/review/r971030d.pdf	Mr. Tietmeyer considers European monetary integration and its implications for the international monetary system (Central Bank Articles and Speeches, 17 Oct 97)	Lecture delivered in honour of Professor Xenophon Zolotas, Honorary Governor of the Bank of Greece, by the President of the Deutsche Bundesbank, Prof. Hans Tietmeyer, in Athens on 17/10/97.	1997-10-17 00:00:00	Mr. Tietmeyer considers European monetary integration and its implications for the international monetary system Lecture delivered in honour of Professor Xenophon Zolotas, Honorary Governor of the Bank of Greece, by the President of the Deutsche Bundesbank, Prof. Hans Tietmeyer, in Athens on 17/10/97. I. The twentieth century does not lack for experience or lessons derived from different international monetary arrangements. Now -- just before this century comes to a close -- Europe is about to embark on a new experiment with far-reaching implications: a monetary union of nation states with a supranational central bank. Some economists see this as things coming full circle. The century began with the gold standard. It will end with a monetary union. As at the beginning of this century, at its end there will be a "denationalised" currency. Countries cannot produce this money more as they see fit. Whereas earlier this century they tied themselves to the availability of gold, in the future European monetary union the guardian of the currency will be a European Central Bank which is independent of national decision-making and which is committed solely to the objective of internal monetary stability. Those economists who stress this historical connection generally take an optimistic view of it. They expect the single currency to bring about an economic and political commitment which is in itself strong enough permanently to compel the participating countries to abide by the rules of the game. Without the option of altering the exchange rate and without the option of an autonomous interest-rate policy, national monetary policy will not be available as an instrument for correcting a current account deficit within the Union. The only possibility will be an adjustment in the real economy. According to this view, monetary union will have a strong disciplining effect. It will exert sufficient pressure on countries to tackle their real problems and to solve them internally, too. To that extent, it will carry on those effects of the gold standard which are regarded as having been successful. This optimistic reference to experience of the gold standard is not entirely convincing, however. First of all, one might ask how far that view idealises the way in which the gold standard worked. That is something which historians may argue over. At all events, that era was by no means a golden age. Be that as it may -- above all, the conditions for the functioning of the gold standard were different then. Countries' government ratios were in the order of scarcely more than ten per cent at that time. The adjustments that were necessary given a change in competitive conditions -- which, naturally enough, primarily concern the private sector -- were spread comparatively widely over the major part of the economy. By contrast, the government ratio in many European countries nowadays is around fifty per cent or more. Adjustment in line with market conditions is thus now concentrated -- more or less -- on half of the economy. Prices and wages were also more flexible a hundred years ago; at any rate, more flexible than they are now in the majority of countries on the European continent. And, above all, the government had a different perception of its own role. Its core tasks at that time were to frame and protect the domestic legal system and to pursue national interests abroad. Nowadays, in the eyes of citizens and the electorate, the nation state and the government have a much deeper and more general economic and social responsibility for growth, incomes and employment. It is, at any rate, very optimistic under present-day conditions to assume that monetary commitment by the monetary union and the supranational central bank would only have to be strong enough and that it would then be able to enforce any desired adjustment needs automatically. What should not be overlooked is that abiding by the rules of the game depends on countries having an adequate capacity to be correspondingly flexible, just as it presupposes the common political will to submit to those rules of monetary stability on a lasting basis. That far-reaching economic and political dimension of monetary union should not be underestimated -- precisely in the world of today and tomorrow. The abolition of the exchange rate is, at all events, an occurrence of far-reaching importance. II. The exchange rate is a price; one of the most important in an economy. Like all prices, its prime task is to manage allocation. Put in simple terms, this means that if the exchange rate is at a level which is appropriate to competitive conditions and if the fundamental determinants -- such as differences in the inflation rate and productivity or the conditions of demand -- remain largely constant, then the exchange rate can and should be as stable as possible, too. It is then that its information content is at its highest. And this also brings about a high degree of certainty in planning for economic arrangements. If, on the other hand, there is a change in the fundamental determinants, the exchange rate should realign as rapidly as possible -- unless an economy is in a position to correct disequilibria quickly and efficiently by virtue of its own adjustment measures. These two requirements which exchange rates are expected to meet appear at first glance to pose a dilemma for monetary policy. On the one hand, the exchange rate should be stable; on the other, it should react as quickly as possible to fundamental imbalances. But, given appropriate policies, this is a pseudo-problem. It is largely solved for a monetary policy which is guided by the internal objective of stability; a steady policy geared to monetary stability helps in both respects. It reduces volatility because it introduces calm into the markets. At the same time, it is the best contribution that monetary policy can make to keeping fundamentally forced exchange rate changes at a low level and to strengthening flexibility and market mechanisms domestically. This pseudo-dilemma is then essentially solved for exchange-rate policy, too. That is because a country cannot in any case freely decide between exchange-rate systems -- say, more fixed or more flexible rates -- in line with its preferences like a visitor to a restaurant between different dishes on the menu. Fixed exchange rates presuppose the ability to cope with that arrangement. It is therefore not a matter of whether one finds less flexible exchange rates, or even their final elimination in a monetary union, "appealing" or "attractive". The crucial point is: fixed exchange rates must be feasible and, above all, sustainable under prevailing political and economic conditions. III. Post-war global and European monetary history was inseparably linked for a quarter of a century with the Bretton Woods system. In origin, it was a gold exchange standard with fixed but adjustable exchange rates against the US dollar, for which there was an obligation to exchange currency for gold. At its inception there was, above all, the desire to overcome the monetary conditions of the 1930s. Competitive devaluations, far-reaching import restrictions and exchange controls seriously hindered world trade and economic cooperation between countries at that time. Against that historical backdrop, many economists rightly celebrated the Bretton Woods system as a great success. Without doubt, it put in place important groundwork for today's high degree of openness in the goods and financial markets. Admittedly, a comprehensive assessment must not overlook at least three problem areas. Firstly, even the Bretton Woods system displayed the "vulnerability" of almost all systems of fixed exchange rates. Current account imbalances were combated too hesitantly. Corrections of exchange rates were made too late and often brought about new misalignments. Secondly, the years in which the system flourished have to be seen against the backdrop of restricted convertibility. It was not until 1961 that most west European countries introduced full convertibility. And precisely in the United States, too, capital controls were a frequently deployed instrument into the 1960s. Incidentally, even the financial markets which -- from the present perspective -- were still not very developed at that time showed their strength in that situation. There was, on the one hand, the ability to bypass administrative regulations. The Euro-dollar market came into being as early as the late 1950s, for example. On the other, there was the ability to exert speculative pressure on a currency with an exchange rate that appeared no longer to deserve confidence. Thirdly, countries with a better domestic stability record than the anchor country at that time, the United States -- such as Germany in the 1096s and early 1970s -- imported inflation through the fixed rate system. The expression "dollar inflation machine" was in use for a time. A firm anchor and a timely realignment of parities -- those are the basic requirements of any stability-oriented system of fixed exchange rates. The European Monetary System established at the end of the 1970s has performed better than the Bretton Woods system in a number of respects. It has provided a better solution for the question of the nominal anchor -- without officially designating the D-Mark for that role. Rather, it is a role which the D-Mark has acquired on account of its long-standing stability and its early convertibility. The parity-grid system permits the currency which is most stable on a long-term basis to set the standard. The anchor in the ERM is a position which can be recalled, however. Admittedly, even in the ERM there have been times when exchange rates that had become doubtful have not been corrected in time -- as the events of 1992 and 1993, in particular, showed. At all events, it was possible to guide the ERM out of the crisis by a formal widening of the fluctuation margins and largely stabilise it in the ensuing period. IV. Despite a number of earlier reform efforts, the Bretton Woods system eventually collapsed in 1973. Since then, the exchange rates of most European countries and of Japan have floated against the US dollar. By abandoning the fixed rates against the US dollar, monetary policy gained new freedom. From that time onwards, it has, above all, been able to pursue a domestic goal. The initial phase in the era of flexible exchange rates was clearly marked by differences in the domestic stance of monetary policy in a large number of countries. That was apparent particularly in the 1970s when most countries were hit hard -- although to differing degrees -- by oil price movements. A number of countries -- including Germany -- were principally concerned with restoring domestic monetary stability or with ensuring that it was jeopardised as little as possible in the long term. Others attempted to use a relaxed monetary policy to cushion the adjustment needs of their economies caused by the oil price shocks. In line with that, there came to be wide differences between inflation rates. Those differences had the following results. Firstly, the countries which gave priority to safeguarding monetary stability adapted more quickly to the new conditions and also achieved better results in the medium term with regard to the goal of employment. Secondly, a disparity arose between individual countries in terms of the reputation and credibility of their anti-inflationary stance -- some of the effects of which are still felt today. Thirdly, the plan to realise a European monetary union which was initiated at the end of the 1960s at the Hague Summit foundered before a real political decision had been taken. The initial phase of world-wide flexible exchange rates thus up to now has two crucial messages. Firstly, the best contribution that monetary policy can make to lasting growth and employment is a clear anti-inflationary stance. In the long term, jobs cannot be "bought" by higher inflation. That was already true even in the 1970s when unemployment -- at least in many industrial countries -- was still predominantly cyclical in nature. That is all the more the case today when unemployment in Europe has largely structural causes. The permanent anti-inflationary stance of the monetary union is therefore an essential condition for Europe's future success in creating and safeguarding jobs. Secondly, it would be disastrous for the monetary union if political differences concerning the role of monetary policy were to emerge as they did in the 1970s. That is because countries cannot pursue different monetary policies in the monetary union. That would lead to political conflicts -- with the European Central Bank, which operates supranationally, and probably also between the political opinions that prevail at the national level. V. That first phase with -- in some cases -- high rates of inflation initially brought the system of flexible exchange rates into disrepute. The 1980s taught new lessons, however -- at least following the change of course in domestic policy starting in France after 1983. Inflation rates gradually receded in many countries. This was a broad process. It took place in the European countries which belonged to the European Monetary System. It also took place in countries without fixed exchange rates, however. Obviously, many countries changed their orientation. External exchange rate pegging, such as to the D-Mark in the European Monetary System, certainly made that easier for some countries. But it also became apparent that what mattered crucially in the final analysis was the political will for monetary stability. This reorientation was undoubtedly in part a reaction to the negative experience of an inflation-accommodating monetary policy in the 1970s and early 1980s. At the same time, it was made easier by the fact that over the years, together with a clear-cut target, a number of central banks had also gained greater independence. For that reason, the system of flexible (or, at least, sufficiently, flexible) exchange rates is now regarded in a certain way as having been rehabilitated. It is precisely on the condition of free movement of capital and financial markets which nowadays largely operate internationally that it can indeed exert pressure for a monetary policy geared to stability. Another hope of the supporters of flexible exchange rates is likely to remain unfulfilled, however: the hope that speculation will always have only a stabilising impact and that, following a change in the fundamentals, the exchange rate will glide smoothly and gently to a new equilibrium level. In actual fact, the path taken by exchange rates is often quite bumpy and cannot always be explained convincingly even ex post. Overreactions are not infrequent. Obviously, expectations of future economic and political trends play a major role in the formation of exchange rates. Not only do they contribute to higher volatility because swings in mood often set in abruptly. They can apparently also superimpose themselves on current data so strongly that misalignments may occur, at least for a while. The sharp appreciation of the D-Mark against the US dollar in spring 1995 was a development of that kind. Admittedly, a fair critic has to concede two mitigating arguments to the system of flexible exchange rates. First of all, it is undoubtedly too simplistic to blame the system for every obviously excessive exchange rate movement of currencies whose rates are formed flexibly. There are some, for example, who regard the excessive trend of the US dollar in the 1980s as the nightmare of the present global monetary system. But one has to recognise, of course, what lay behind this. It was during that period that the resolute reversal in the Fed's monetary policy under Paul Volcker coincided with the expansionary fiscal policy of the Reagan administration. In particular, US fiscal policy stood in marked contrast at that time with German fiscal policy, which was on a course of moderate consolidation. It is quite possible to ask the question: "What other exchange rate arrangement would have actually withstood those tensions?" If anything, fixed exchange rates would probably have increased those tensions or would at least have politicised them more strongly. The Plaza and Louvre cooperation initiatives were probably the most that could be achieved at that time, although it has to be said in passing that the results were by no means only positive ones -- as is shown by the example of the development of asset price inflation in Japan, which was encouraged at that time by an expansionary monetary policy, and its consequences -- from which that country is still suffering. As a second line of defence it can be pointed out that world trade is developing at a furious pace despite flexible exchange rates between the major international currencies. That may be due to the fact that incorrectly valuated exchange rates tend to correct themselves in the medium term. It may also be due to the fact that good possibilities are now available for guarding against sharp exchange rate fluctuations. This can take the form of hedging operations in the financial markets. It can also take the form of a diversification of production centres. To that extent, highly volatile exchange rates can influence not only trade but also direct investment. And that undoubtedly has longer-term effects which should not be underrated. For that reason, exchange rates which are as stable as possible are, of course, important -- but more in terms of real rather than nominal stability. However, the question remains of how the objective of real exchange rate stability can be achieved as comprehensively as possible. There is unlikely to be an answer which is valid for all countries and their relations with each other. VI. In the current debate in Europe the question is also asked repeatedly whether the future euro/dollar exchange rate will be more stable than, say, the present relationship between the D-Mark and the dollar. Ultimately, this is an empirical question, of course. It can really be answered only in the light of the monetary union. There are a number of considerations which point in differing directions. The euro will probably have a larger and deeper financial market than the D-Mark. That means, first of all, that the price effects will tend to be slighter when assets are switched by the individual investors and that the exchange rate will also be moved less as a result. The larger euro financial market might, however, also lead to investors generally regarding the euro -- more than the D-Mark now -- as a substitute for the US dollar. That might increase the desire to switch funds in certain situations. In that case, the exchange rate would tend to fluctuate more. At times, one also encounters the argument that the euro area -- as a large economic and currency area -- will be relatively less dependent on foreign trade, particularly as the structure of exports is heavily diversified. The outcome would be -- at least, according to the standard textbooks -- that the euro/dollar exchange rate is not as important for Europe. This argument is undoubtedly fundamentally correct and also of significance. The comparison with other major currency areas -- such as the dollar area -- has only limited validity, however. The high share of domestic transactions is not the only reason why the United States can, if anything, neglect the dollar's exchange rate. It can also do that because its own currency area corresponds to its national boundaries. In the United States, not only is there a comparatively high degree of labour mobility and flexibility in labour costs, there are also compensatory and cooperative mechanisms in the area of public finance at the level of national government. These are able to cushion remaining regional and sectoral tensions which cause major exchange rate fluctuations. The supranational monetary union in Europe has neither comparable mobility and flexibility nor compensatory mechanisms in the area of public finance. This, too, reveals, the particular conditions of monetary union in Europe. In the European monetary union asymmetrical effects will probably tend to lead more quickly to a need for real adjustment in the countries or regions concerned. VII. The present world monetary system is, of course, not just characterised by the major international currencies floating against each other. At the same time, many countries have entered into arrangements to peg exchange rates of varying intensity. There are essentially two motives for this: Firstly -- particularly in the case of smaller economies -- the foreign trade motive. Countries want to strengthen their international economic integration with a fixed exchange rate. Secondly, the stability motive. By pegging the exchange rate, countries want to import credibility for an anti-inflationary stance -- particularly one which is to be newly established. The record of these arrangements is as varied as the forms of pegging themselves. A number of emerging countries and countries in transition have had mixed experiences of pegging their exchange rates to other currencies. However useful it was for them in an initial phase to gain confidence in the international markets by pegging their exchange rate, it has almost always been the case that tensions have arisen and, unfortunately, often erupted after a few years if the trend in domestic competitiveness was not able to keep up with the anchor country on a long-term basis. That has become apparent not only for some countries in Latin America and in eastern Europe but only just recently in South-East Asia, too -- especially if exchange rates have not been adjusted quickly enough to changed competitive conditions. The prospects of a pegging of exchange rates being successful have to be seen in the context of the present-day international financial markets. Their impact on the permanence of exchange rate pegging is an ambivalent one. On the one hand, the international financial markets can make arrangements of this kind obsolete more or less overnight if the conviction disappears that the pegging will hold. On the other hand, they encourage strategies of this kind since they offer the countries the option of financing quite sizeable current account deficits. Mainly two problems arise when pegging the exchange rate. Firstly, it may be that a country is currently achieving a comparatively high level of monetary stability but the markets still doubt the country's determination to persist with that strategy. In that case, real interest rates -- at least in a transitional phase -- are relatively high. Doubts about sustainability threaten to become a kind of self-fulfilling prophecy. That was at certain periods the French problem with its franc fort policy. Secondly, it may be that a country achieves a significant fall in inflation by pegging the exchange rate. But a certain -- if only slight -- inflation differential vis-à-vis the reference currency often stubbornly remains nonetheless. That may be due to inflation expectations from the past which are not entirely eliminated. That may also be due in part to a political deficit; a fiscal policy that fails to give adequate support to the pegging of the exchange rate or an overgenerous domestic monetary policy in the light of capital inflows. Be that as it may, the outcome is that the currency gradually appreciates in real terms. The current account shows a chronic deficit. In a situation of that kind, a country must consider a strategy to find its way out. The fixed parity is not sustainable on a lasting basis, even if the financial markets go along with it for a time. This implies an important message for the envisaged monetary union in Europe since monetary union does not offer the possibility of a way out. The requisite ability to achieve lasting domestic and external stability must be established and proven before entry in all the member states. That is what the entry criteria aim for. It would be a risk to hope that a country's necessary ability to achieve stability will gradually come about after entry into monetary union. Even if this were achieved over time, price competitiveness might already have been seriously impaired by then. And the catching-up process would be even more ambitious. There will, in fact, be certain regional differences in inflation rates within the monetary union. That is a normal process, to the extent that it will reflect differing trends in productivity or shifts in patterns of demand. Enormous economic tensions would occur, however, if it were also a reflection of varying ability to achieve stability and hence to accept the supranational monetary policy. Sufficient anti-inflationary convergence must therefore precede entry into monetary union, not the other way round. At all events, the reverse order would not be without considerable risks. VIII. It is desirable and beneficial to have as high a degree of exchange rate stability as possible against the currencies of other EU and non-EU countries, too. Stable exchange rates need convergence -- either in the sense that fundamental deviations do not occur or in the sense that existing imbalances are rapidly eliminated owing to a high level of flexibility in domestic prices and in the structure of the economy. In principle, that is a valid statement irrespective of the exchange rate system, in fact. It just happens to be the case that in the reverse situation -- if there is a lack of convergence -- the exchange rate system plays a major role. If exchange rates are flexible, divergence in anti-inflationary policy can increase volatility but it is less dramatic overall. In turn, the degree of convergence is also lower, of course. The degree of convergence tends to be higher with fixed but adjustable exchange rates. If there is, nevertheless, no adequate convergence, costs will depend on whether there is a timely realignment. If prompt action is taken, the consequences will be contained. By contrast, if the realignments take place only under pressure from the markets, high costs can easily arise -- not just for the country itself, by the way. A "case" like this can easily negate the credibility of a whole system or make the unilateral pegging of other countries -- even those in other continents -- more difficult. For that reason the fact that the alignment of the exchange rates in ERM II is to be made easier than in the present system is a positive development. It is to be hoped that this will prove its value in practice, too, in future. The choice of the exchange rate system must, at any rate, be consistent with the economic and political conditions which obtain in the participating countries. A mixed world monetary system -- with floating key currencies, on the one hand, and regional integration through monetary union and fixed exchange rates, on the other -- might not be the best of all hypothetical worlds. But that system is probably the one that corresponds most closely to conditions in the real world. It is not inherently a badly designed structure or a non-system. There can indeed be appropriate graduations of flexibility that are in line with the realities. IX. Understandably, the question is now frequently being asked: "What place will the euro take in the future world monetary system?" The answer which is often given is the notion of a future tripolar system consisting of the dollar, the yen and the euro. That vision is, at least, not very accurate. If one wants to speak of a tripolar system at all, the weights in it will differ quite considerably. Even now, it is becoming apparent that the yen's potential relative to the other two currencies will, if anything, remain limited. At all events, in the foreseeable future it will probably lack the regional base in Asia itself which the euro is likely to have in Europe. But the euro will first have to earn its position. That is because an international currency essentially needs three properties: • a high level of lasting stability • a strong base in the real economy • and efficient financial markets. The euro has the potential to fulfil those three conditions. But that will not occur automatically. For that to happen, the preconditions have to be right. Replacing the dollar as the leading currency is, however, probably not on the agenda. Monetary history has shown that a key currency being superseded is ultimately due to an internal crisis in the country in question. The former leading country loses the confidence of the markets. The capacity for domestic stability diminishes. The economy becomes less competitive. That was also the history of the decline of the pound sterling as a global key currency following the Second World War. There are no indications whatsoever of a comparable development in the case of the US dollar. On the contrary, the dollar is a strong currency and -- despite a current account deficit and growing external debt -- the US fundamentals do not point to a change in that situation. X. The euro and the dollar can enter into fruitful competition, however. The world monetary system as a whole will be able to benefit from healthy competition between two currencies which are geared to stability. There are three particular factors which would promote productive competition of this kind: Firstly, that the current high degree of correspondence in the anti-inflationary stance of the United States and Europe continues; secondly that fiscal policy in both the Unites States and Europe remains on a similar course of consolidation and -- particularly in Europe -achieves further progress; and thirdly, that both the United States and Europe fulfil the expectations of meeting the economic challenges which they face. The United States must demonstrate that its high debtor position and hence its future financial obligations are covered by the dynamism, efficiency and innovative potential of its economy. The Europeans must show that they are making structural changes to tackle the problem of unemployment and that they are improving their competitiveness in global markets. Productive competition of this kind does not imply a rejection of greater world-wide cooperation in economic and monetary policies with the aim of contributing to higher exchange rate stability. On the contrary, it is precisely in the future, too, that cooperation of this kind will be meaningful and desirable. In saying this, what should not be overlooked is that exchange rates are not the actual operational parameters. Rather, they are the result of economic developments and economic policy in the participating countries. For that reason, there is one lesson which should conclude this lecture. It is perhaps as old as monetary history itself. A suitable monetary framework can help a country to carry out the structural reforms which are needed. Being a substitute for the adjustments which an economy has to make to changed conditions, however, is something which monetary policy -- however good it is -- cannot do.	['mr. tietmeyer considers european monetary integration and its implications for the international monetary system lecture delivered in honour of professor xenophon zolotas, honorary governor of the bank of greece, by the president of the deutsche bundesbank, prof. hans tietmeyer, in athens on 17/10/97.', 'i. the twentieth century does not lack for experience or lessons derived from different international monetary arrangements.', 'now -- just before this century comes to a close -- europe is about to embark on a new experiment with far-reaching implications: a monetary union of nation states with a supranational central bank.', 'some economists see this as things coming full circle.', 'the century began with the gold standard.', 'it will end with a monetary union.', 'as at the beginning of this century, at its end there will be a "denationalised" currency.', 'countries cannot produce this money more as they see fit.', 'whereas earlier this century they tied themselves to the availability of gold, in the future european monetary union the guardian of the currency will be a european central bank which is independent of national decision-making and which is committed solely to the objective of internal monetary stability.', 'those economists who stress this historical connection generally take an optimistic view of it.', 'they expect the single currency to bring about an economic and political commitment which is in itself strong enough permanently to compel the participating countries to abide by the rules of the game.', 'without the option of altering the exchange rate and without the option of an autonomous interest-rate policy, national monetary policy will not be available as an instrument for correcting a current account deficit within the union.', 'the only possibility will be an adjustment in the real economy.', 'according to this view, monetary union will have a strong disciplining effect.', 'it will exert sufficient pressure on countries to tackle their real problems and to solve them internally, too.', 'to that extent, it will carry on those effects of the gold standard which are regarded as having been successful.', 'this optimistic reference to experience of the gold standard is not entirely convincing, however.', 'first of all, one might ask how far that view idealises the way in which the gold standard worked.', 'that is something which historians may argue over.', 'at all events, that era was by no means a golden age.', 'be that as it may -- above all, the conditions for the functioning of the gold standard were different then.', "countries' government ratios were in the order of scarcely more than ten per cent at that time.", 'the adjustments that were necessary given a change in competitive conditions -- which, naturally enough, primarily concern the private sector -- were spread comparatively widely over the major part of the economy.', 'by contrast, the government ratio in many european countries nowadays is around fifty per cent or more.', 'adjustment in line with market conditions is thus now concentrated -- more or less -- on half of the economy.', 'prices and wages were also more flexible a hundred years ago; at any rate, more flexible than they are now in the majority of countries on the european continent.', 'and, above all, the government had a different perception of its own role.', 'its core tasks at that time were to frame and protect the domestic legal system and to pursue national interests abroad.', 'nowadays, in the eyes of citizens and the electorate, the nation state and the government have a much deeper and more general economic and social responsibility for growth, incomes and employment.', 'it is, at any rate, very optimistic under present-day conditions to assume that monetary commitment by the monetary union and the supranational central bank would only have to be strong enough and that it would then be able to enforce any desired adjustment needs automatically.', 'what should not be overlooked is that abiding by the rules of the game depends on countries having an adequate capacity to be correspondingly flexible, just as it presupposes the common political will to submit to those rules of monetary stability on a lasting basis.', 'that far-reaching economic and political dimension of monetary union should not be underestimated -- precisely in the world of today and tomorrow.', 'the abolition of the exchange rate is, at all events, an occurrence of far-reaching importance.', 'the exchange rate is a price; one of the most important in an economy.', 'like all prices, its prime task is to manage allocation.', 'put in simple terms, this means that if the exchange rate is at a level which is appropriate to competitive conditions and if the fundamental determinants -- such as differences in the inflation rate and productivity or the conditions of demand -- remain largely constant, then the exchange rate can and should be as stable as possible, too.', 'it is then that its information content is at its highest.', 'and this also brings about a high degree of certainty in planning for economic arrangements.', 'if, on the other hand, there is a change in the fundamental determinants, the exchange rate should realign as rapidly as possible -- unless an economy is in a position to correct disequilibria quickly and efficiently by virtue of its own adjustment measures.', 'these two requirements which exchange rates are expected to meet appear at first glance to pose a dilemma for monetary policy.', 'on the one hand, the exchange rate should be stable; on the other, it should react as quickly as possible to fundamental imbalances.', 'but, given appropriate policies, this is a pseudo-problem.', 'it is largely solved for a monetary policy which is guided by the internal objective of stability; a steady policy geared to monetary stability helps in both respects.', 'it reduces volatility because it introduces calm into the markets.', 'at the same time, it is the best contribution that monetary policy can make to keeping fundamentally forced exchange rate changes at a low level and to strengthening flexibility and market mechanisms domestically.', 'this pseudo-dilemma is then essentially solved for exchange-rate policy, too.', 'that is because a country cannot in any case freely decide between exchange-rate systems -- say, more fixed or more flexible rates -- in line with its preferences like a visitor to a restaurant between different dishes on the menu.', 'fixed exchange rates presuppose the ability to cope with that arrangement.', 'it is therefore not a matter of whether one finds less flexible exchange rates, or even their final elimination in a monetary union, "appealing" or "attractive".', 'the crucial point is: fixed exchange rates must be feasible and, above all, sustainable under prevailing political and economic conditions.', 'post-war global and european monetary history was inseparably linked for a quarter of a century with the bretton woods system.', 'in origin, it was a gold exchange standard with fixed but adjustable exchange rates against the us dollar, for which there was an obligation to exchange currency for gold.', 'at its inception there was, above all, the desire to overcome the monetary conditions of the 1930s.', 'competitive devaluations, far-reaching import restrictions and exchange controls seriously hindered world trade and economic cooperation between countries at that time.', 'against that historical backdrop, many economists rightly celebrated the bretton woods system as a great success.', "without doubt, it put in place important groundwork for today's high degree of openness in the goods and financial markets.", 'admittedly, a comprehensive assessment must not overlook at least three problem areas.', 'firstly, even the bretton woods system displayed the "vulnerability" of almost all systems of fixed exchange rates.', 'current account imbalances were combated too hesitantly.', 'corrections of exchange rates were made too late and often brought about new misalignments.', 'secondly, the years in which the system flourished have to be seen against the backdrop of restricted convertibility.', 'it was not until 1961 that most west european countries introduced full convertibility.', 'and precisely in the united states, too, capital controls were a frequently deployed instrument into the 1960s.', 'incidentally, even the financial markets which -- from the present perspective -- were still not very developed at that time showed their strength in that situation.', 'there was, on the one hand, the ability to bypass administrative regulations.', 'the euro-dollar market came into being as early as the late 1950s, for example.', 'on the other, there was the ability to exert speculative pressure on a currency with an exchange rate that appeared no longer to deserve confidence.', 'thirdly, countries with a better domestic stability record than the anchor country at that time, the united states -- such as germany in the 1096s and early 1970s -- imported inflation through the fixed rate system.', 'the expression "dollar inflation machine" was in use for a time.', 'a firm anchor and a timely realignment of parities -- those are the basic requirements of any stability-oriented system of fixed exchange rates.', 'the european monetary system established at the end of the 1970s has performed better than the bretton woods system in a number of respects.', 'it has provided a better solution for the question of the nominal anchor -- without officially designating the d-mark for that role.', 'rather, it is a role which the d-mark has acquired on account of its long-standing stability and its early convertibility.', 'the parity-grid system permits the currency which is most stable on a long-term basis to set the standard.', 'the anchor in the erm is a position which can be recalled, however.', 'admittedly, even in the erm there have been times when exchange rates that had become doubtful have not been corrected in time -- as the events of 1992 and 1993, in particular, showed.', 'at all events, it was possible to guide the erm out of the crisis by a formal widening of the fluctuation margins and largely stabilise it in the ensuing period.', 'despite a number of earlier reform efforts, the bretton woods system eventually collapsed in 1973. since then, the exchange rates of most european countries and of japan have floated against the us dollar.', 'by abandoning the fixed rates against the us dollar, monetary policy gained new freedom.', 'from that time onwards, it has, above all, been able to pursue a domestic goal.', 'the initial phase in the era of flexible exchange rates was clearly marked by differences in the domestic stance of monetary policy in a large number of countries.', 'that was apparent particularly in the 1970s when most countries were hit hard -- although to differing degrees -- by oil price movements.', 'a number of countries -- including germany -- were principally concerned with restoring domestic monetary stability or with ensuring that it was jeopardised as little as possible in the long term.', 'others attempted to use a relaxed monetary policy to cushion the adjustment needs of their economies caused by the oil price shocks.', 'in line with that, there came to be wide differences between inflation rates.', 'those differences had the following results.', 'firstly, the countries which gave priority to safeguarding monetary stability adapted more quickly to the new conditions and also achieved better results in the medium term with regard to the goal of employment.', 'secondly, a disparity arose between individual countries in terms of the reputation and credibility of their anti-inflationary stance -- some of the effects of which are still felt today.', 'thirdly, the plan to realise a european monetary union which was initiated at the end of the 1960s at the hague summit foundered before a real political decision had been taken.', 'the initial phase of world-wide flexible exchange rates thus up to now has two crucial messages.', 'firstly, the best contribution that monetary policy can make to lasting growth and employment is a clear anti-inflationary stance.', 'in the long term, jobs cannot be "bought" by higher inflation.', 'that was already true even in the 1970s when unemployment -- at least in many industrial countries -- was still predominantly cyclical in nature.', 'that is all the more the case today when unemployment in europe has largely structural causes.', "the permanent anti-inflationary stance of the monetary union is therefore an essential condition for europe's future success in creating and safeguarding jobs.", 'secondly, it would be disastrous for the monetary union if political differences concerning the role of monetary policy were to emerge as they did in the 1970s.', 'that is because countries cannot pursue different monetary policies in the monetary union.', 'that would lead to political conflicts -- with the european central bank, which operates supranationally, and probably also between the political opinions that prevail at the national level.', 'v. that first phase with -- in some cases -- high rates of inflation initially brought the system of flexible exchange rates into disrepute.', 'the 1980s taught new lessons, however -- at least following the change of course in domestic policy starting in france after 1983. inflation rates gradually receded in many countries.', 'this was a broad process.', 'it took place in the european countries which belonged to the european monetary system.', 'it also took place in countries without fixed exchange rates, however.', 'obviously, many countries changed their orientation.', 'external exchange rate pegging, such as to the d-mark in the european monetary system, certainly made that easier for some countries.', 'but it also became apparent that what mattered crucially in the final analysis was the political will for monetary stability.', 'this reorientation was undoubtedly in part a reaction to the negative experience of an inflation-accommodating monetary policy in the 1970s and early 1980s.', 'at the same time, it was made easier by the fact that over the years, together with a clear-cut target, a number of central banks had also gained greater independence.', 'for that reason, the system of flexible (or, at least, sufficiently, flexible) exchange rates is now regarded in a certain way as having been rehabilitated.', 'it is precisely on the condition of free movement of capital and financial markets which nowadays largely operate internationally that it can indeed exert pressure for a monetary policy geared to stability.', 'another hope of the supporters of flexible exchange rates is likely to remain unfulfilled, however: the hope that speculation will always have only a stabilising impact and that, following a change in the fundamentals, the exchange rate will glide smoothly and gently to a new equilibrium level.', 'in actual fact, the path taken by exchange rates is often quite bumpy and cannot always be explained convincingly even ex post.', 'overreactions are not infrequent.', 'obviously, expectations of future economic and political trends play a major role in the formation of exchange rates.', 'not only do they contribute to higher volatility because swings in mood often set in abruptly.', 'they can apparently also superimpose themselves on current data so strongly that misalignments may occur, at least for a while.', 'the sharp appreciation of the d-mark against the us dollar in spring 1995 was a development of that kind.', 'admittedly, a fair critic has to concede two mitigating arguments to the system of flexible exchange rates.', 'first of all, it is undoubtedly too simplistic to blame the system for every obviously excessive exchange rate movement of currencies whose rates are formed flexibly.', 'there are some, for example, who regard the excessive trend of the us dollar in the 1980s as the nightmare of the present global monetary system.', 'but one has to recognise, of course, what lay behind this.', "it was during that period that the resolute reversal in the fed's monetary policy under paul volcker coincided with the expansionary fiscal policy of the reagan administration.", 'in particular, us fiscal policy stood in marked contrast at that time with german fiscal policy, which was on a course of moderate consolidation.', 'it is quite possible to ask the question: "what other exchange rate arrangement would have actually withstood those tensions?"', 'if anything, fixed exchange rates would probably have increased those tensions or would at least have politicised them more strongly.', 'the plaza and louvre cooperation initiatives were probably the most that could be achieved at that time, although it has to be said in passing that the results were by no means only positive ones -- as is shown by the example of the development of asset price inflation in japan, which was encouraged at that time by an expansionary monetary policy, and its consequences -- from which that country is still suffering.', 'as a second line of defence it can be pointed out that world trade is developing at a furious pace despite flexible exchange rates between the major international currencies.', 'that may be due to the fact that incorrectly valuated exchange rates tend to correct themselves in the medium term.', 'it may also be due to the fact that good possibilities are now available for guarding against sharp exchange rate fluctuations.', 'this can take the form of hedging operations in the financial markets.', 'it can also take the form of a diversification of production centres.', 'to that extent, highly volatile exchange rates can influence not only trade but also direct investment.', 'and that undoubtedly has longer-term effects which should not be underrated.', 'for that reason, exchange rates which are as stable as possible are, of course, important -- but more in terms of real rather than nominal stability.', 'however, the question remains of how the objective of real exchange rate stability can be achieved as comprehensively as possible.', 'there is unlikely to be an answer which is valid for all countries and their relations with each other.', 'in the current debate in europe the question is also asked repeatedly whether the future euro/dollar exchange rate will be more stable than, say, the present relationship between the d-mark and the dollar.', 'ultimately, this is an empirical question, of course.', 'it can really be answered only in the light of the monetary union.', 'there are a number of considerations which point in differing directions.', 'the euro will probably have a larger and deeper financial market than the d-mark.', 'that means, first of all, that the price effects will tend to be slighter when assets are switched by the individual investors and that the exchange rate will also be moved less as a result.', 'the larger euro financial market might, however, also lead to investors generally regarding the euro -- more than the d-mark now -- as a substitute for the us dollar.', 'that might increase the desire to switch funds in certain situations.', 'in that case, the exchange rate would tend to fluctuate more.', 'at times, one also encounters the argument that the euro area -- as a large economic and currency area -- will be relatively less dependent on foreign trade, particularly as the structure of exports is heavily diversified.', 'the outcome would be -- at least, according to the standard textbooks -- that the euro/dollar exchange rate is not as important for europe.', 'this argument is undoubtedly fundamentally correct and also of significance.', 'the comparison with other major currency areas -- such as the dollar area -- has only limited validity, however.', "the high share of domestic transactions is not the only reason why the united states can, if anything, neglect the dollar's exchange rate.", 'it can also do that because its own currency area corresponds to its national boundaries.', 'in the united states, not only is there a comparatively high degree of labour mobility and flexibility in labour costs, there are also compensatory and cooperative mechanisms in the area of public finance at the level of national government.', 'these are able to cushion remaining regional and sectoral tensions which cause major exchange rate fluctuations.', 'the supranational monetary union in europe has neither comparable mobility and flexibility nor compensatory mechanisms in the area of public finance.', 'this, too, reveals, the particular conditions of monetary union in europe.', 'in the european monetary union asymmetrical effects will probably tend to lead more quickly to a need for real adjustment in the countries or regions concerned.', 'the present world monetary system is, of course, not just characterised by the major international currencies floating against each other.', 'at the same time, many countries have entered into arrangements to peg exchange rates of varying intensity.', 'there are essentially two motives for this: firstly -- particularly in the case of smaller economies -- the foreign trade motive.', 'countries want to strengthen their international economic integration with a fixed exchange rate.', 'secondly, the stability motive.', 'by pegging the exchange rate, countries want to import credibility for an anti-inflationary stance -- particularly one which is to be newly established.', 'the record of these arrangements is as varied as the forms of pegging themselves.', 'a number of emerging countries and countries in transition have had mixed experiences of pegging their exchange rates to other currencies.', 'however useful it was for them in an initial phase to gain confidence in the international markets by pegging their exchange rate, it has almost always been the case that tensions have arisen and, unfortunately, often erupted after a few years if the trend in domestic competitiveness was not able to keep up with the anchor country on a long-term basis.', 'that has become apparent not only for some countries in latin america and in eastern europe but only just recently in south-east asia, too -- especially if exchange rates have not been adjusted quickly enough to changed competitive conditions.', 'the prospects of a pegging of exchange rates being successful have to be seen in the context of the present-day international financial markets.', 'their impact on the permanence of exchange rate pegging is an ambivalent one.', 'on the one hand, the international financial markets can make arrangements of this kind obsolete more or less overnight if the conviction disappears that the pegging will hold.', 'on the other hand, they encourage strategies of this kind since they offer the countries the option of financing quite sizeable current account deficits.', 'mainly two problems arise when pegging the exchange rate.', "firstly, it may be that a country is currently achieving a comparatively high level of monetary stability but the markets still doubt the country's determination to persist with that strategy.", 'in that case, real interest rates -- at least in a transitional phase -- are relatively high.', 'doubts about sustainability threaten to become a kind of self-fulfilling prophecy.', 'that was at certain periods the french problem with its franc fort policy.', 'secondly, it may be that a country achieves a significant fall in inflation by pegging the exchange rate.', 'but a certain -- if only slight -- inflation differential vis-à-vis the reference currency often stubbornly remains nonetheless.', 'that may be due to inflation expectations from the past which are not entirely eliminated.', 'that may also be due in part to a political deficit; a fiscal policy that fails to give adequate support to the pegging of the exchange rate or an overgenerous domestic monetary policy in the light of capital inflows.', 'be that as it may, the outcome is that the currency gradually appreciates in real terms.', 'the current account shows a chronic deficit.', 'in a situation of that kind, a country must consider a strategy to find its way out.', 'the fixed parity is not sustainable on a lasting basis, even if the financial markets go along with it for a time.', 'this implies an important message for the envisaged monetary union in europe since monetary union does not offer the possibility of a way out.', 'the requisite ability to achieve lasting domestic and external stability must be established and proven before entry in all the member states.', 'that is what the entry criteria aim for.', "it would be a risk to hope that a country's necessary ability to achieve stability will gradually come about after entry into monetary union.", 'even if this were achieved over time, price competitiveness might already have been seriously impaired by then.', 'and the catching-up process would be even more ambitious.', 'there will, in fact, be certain regional differences in inflation rates within the monetary union.', 'that is a normal process, to the extent that it will reflect differing trends in productivity or shifts in patterns of demand.', 'enormous economic tensions would occur, however, if it were also a reflection of varying ability to achieve stability and hence to accept the supranational monetary policy.', 'sufficient anti-inflationary convergence must therefore precede entry into monetary union, not the other way round.', 'at all events, the reverse order would not be without considerable risks.', 'it is desirable and beneficial to have as high a degree of exchange rate stability as possible against the currencies of other eu and non-eu countries, too.', 'stable exchange rates need convergence -- either in the sense that fundamental deviations do not occur or in the sense that existing imbalances are rapidly eliminated owing to a high level of flexibility in domestic prices and in the structure of the economy.', 'in principle, that is a valid statement irrespective of the exchange rate system, in fact.', 'it just happens to be the case that in the reverse situation -- if there is a lack of convergence -- the exchange rate system plays a major role.', 'if exchange rates are flexible, divergence in anti-inflationary policy can increase volatility but it is less dramatic overall.', 'in turn, the degree of convergence is also lower, of course.', 'the degree of convergence tends to be higher with fixed but adjustable exchange rates.', 'if there is, nevertheless, no adequate convergence, costs will depend on whether there is a timely realignment.', 'if prompt action is taken, the consequences will be contained.', 'by contrast, if the realignments take place only under pressure from the markets, high costs can easily arise -- not just for the country itself, by the way.', 'a "case" like this can easily negate the credibility of a whole system or make the unilateral pegging of other countries -- even those in other continents -- more difficult.', 'for that reason the fact that the alignment of the exchange rates in erm ii is to be made easier than in the present system is a positive development.', 'it is to be hoped that this will prove its value in practice, too, in future.', 'the choice of the exchange rate system must, at any rate, be consistent with the economic and political conditions which obtain in the participating countries.', 'a mixed world monetary system -- with floating key currencies, on the one hand, and regional integration through monetary union and fixed exchange rates, on the other -- might not be the best of all hypothetical worlds.', 'but that system is probably the one that corresponds most closely to conditions in the real world.', 'it is not inherently a badly designed structure or a non-system.', 'there can indeed be appropriate graduations of flexibility that are in line with the realities.', 'understandably, the question is now frequently being asked: "what place will the euro take in the future world monetary system?"', 'the answer which is often given is the notion of a future tripolar system consisting of the dollar, the yen and the euro.', 'that vision is, at least, not very accurate.', 'if one wants to speak of a tripolar system at all, the weights in it will differ quite considerably.', "even now, it is becoming apparent that the yen's potential relative to the other two currencies will, if anything, remain limited.", 'at all events, in the foreseeable future it will probably lack the regional base in asia itself which the euro is likely to have in europe.', 'but the euro will first have to earn its position.', 'that is because an international currency essentially needs three properties: • a high level of lasting stability • a strong base in the real economy • and efficient financial markets.', 'the euro has the potential to fulfil those three conditions.', 'but that will not occur automatically.', 'for that to happen, the preconditions have to be right.', 'replacing the dollar as the leading currency is, however, probably not on the agenda.', 'monetary history has shown that a key currency being superseded is ultimately due to an internal crisis in the country in question.', 'the former leading country loses the confidence of the markets.', 'the capacity for domestic stability diminishes.', 'the economy becomes less competitive.', 'that was also the history of the decline of the pound sterling as a global key currency following the second world war.', 'there are no indications whatsoever of a comparable development in the case of the us dollar.', 'on the contrary, the dollar is a strong currency and -- despite a current account deficit and growing external debt -- the us fundamentals do not point to a change in that situation.', 'x. the euro and the dollar can enter into fruitful competition, however.', 'the world monetary system as a whole will be able to benefit from healthy competition between two currencies which are geared to stability.', 'there are three particular factors which would promote productive competition of this kind: firstly, that the current high degree of correspondence in the anti-inflationary stance of the united states and europe continues; secondly that fiscal policy in both the unites states and europe remains on a similar course of consolidation and -- particularly in europe -achieves further progress; and thirdly, that both the united states and europe fulfil the expectations of meeting the economic challenges which they face.', 'the united states must demonstrate that its high debtor position and hence its future financial obligations are covered by the dynamism, efficiency and innovative potential of its economy.', 'the europeans must show that they are making structural changes to tackle the problem of unemployment and that they are improving their competitiveness in global markets.', 'productive competition of this kind does not imply a rejection of greater world-wide cooperation in economic and monetary policies with the aim of contributing to higher exchange rate stability.', 'on the contrary, it is precisely in the future, too, that cooperation of this kind will be meaningful and desirable.', 'in saying this, what should not be overlooked is that exchange rates are not the actual operational parameters.', 'rather, they are the result of economic developments and economic policy in the participating countries.', 'for that reason, there is one lesson which should conclude this lecture.', 'it is perhaps as old as monetary history itself.', 'a suitable monetary framework can help a country to carry out the structural reforms which are needed.', 'being a substitute for the adjustments which an economy has to make to changed conditions, however, is something which monetary policy -- however good it is -- cannot do.']	Hans Tietmeyer	Deutsche Bundesbank	President	Germany
https://www.bis.org/review/r971030c.pdf	Ms. Phillips reassesses the stock market crash of 1987 in the context of subsequent market and regulatory changes (Central Bank Articles and Speeches, 15 Oct 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Bentley College, Waltham, Massachusetts on 15/10/97.	1997-10-15 00:00:00	Ms. Phillips reassesses the stock market crash of 1987 in the context of subsequent market and regulatory changes Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Bentley College, Waltham, Massachusetts on 15/10/97. Black Monday: 10 Years Later Thank you for inviting me to participate in this program sponsored by the Financial Women's Association. We are drawing very close to the tenth anniversary of the stock market crash. It is useful to reassess that event in the context of subsequent market and regulatory changes. The crash was one of those (fortunately rare) events that serve as a watershed for our discussion of markets and public policies. Considerations of regulatory approaches now almost always use the crash as a reference point. Panels such as this one provide a vehicle for evaluating not only what we have learned from the event but also the various actions taken following the crash. But it is also appropriate to look forward. Changes in financial markets and the risk management capability of firms have been significant in the intervening years. The crash may no longer be as useful a reference point for judging events and evaluating public policy responses. I suppose everyone can remember what they were doing on the day of the crash. I had the good fortune to have left the CFTC prior to the crash. Thus, I got to watch events unfold from the cornfields of Iowa. Later, however, I participated in several post-crash evaluations. Even now, at the Federal Reserve Board, the crash periodically comes up in supervisory discussions about bank risk. (Regrettably, the crash is now part of a pantheon of financial market "problems" that include Barings, Daiwa, Metallgesellschaft, Orange County, and Sumitomo.) The Legacy of the Crash The legacy of the crash is both tangible and intangible. An impressive number of studies of the crash were done. The more noteworthy ones take up about three linear feet on my bookshelf, a very tangible reminder. More seriously, the studies done after the crash were wide-ranging and examined events through the eyes of many different market participants, many different regulators, and a host of academicians. They identified weaknesses in trading and clearing systems that have resulted in tangible changes to those systems. These changes have been very positive. Exchanges have greatly expanded their ability to handle surges in volume, for example. The capitalization of market makers has been bolstered as well. Numerous changes also have been implemented in clearing systems. Doubts that emerged about the soundness of clearing systems were some of the most frightening aspects of the crash. The changes to clearing systems have received far less attention than those to trading systems, but their long-term consequences likely are more profound. Such critical parts of the "plumbing" as the agreements between the futures clearing houses and the settlement banks have been clarified and put on a much sounder footing. In addition, many clearing organizations have established back-up liquidity facilities that will enable them to make payments to clearing members in a timely fashion even if a clearing member has defaulted. In both our evaluation of trading mechanisms and our evaluation of clearing systems, an important intangible outcome of the crash is that we now have a better understanding of the way these systems work. During ordinary trading days, market participants rarely if ever question counterparties' ability and willingness to perform on obligations. In the months following the crash, policy makers and market participants began to examine those payment conventions more closely. The bulk of the changes to risk management systems that flowed from the crash related to efforts to clarify or make more rigorous the responsibilities and obligations of market participants that previously had been left ambiguous or were part of the lore of "normal" market practice. - 2 - Another very important intangible legacy of the crash is our better understanding of the need for cooperation and coordination among commodity, securities, and banking market authorities. The crash vividly illustrated the extent to which markets are intertwined and the extent to which large financial firms have lines of business that cut across many markets. The forums for coordination are almost too numerous to mention, not least of which is the President's Working Group on Financial Markets. The Working Group comprises the heads of the Treasury, SEC, CFTC, and Federal Reserve, and in addition, other banking supervisory agencies, the National Economic Council, and the Council of Economic Advisers participate. Prospect Looking forward, we are better positioned today to absorb market shocks than we were prior to the 1987 crash. We undoubtedly, however, will have many different problems in future periods of volatility. Responses to events such as the 1987 crash tend to be crisis-specific. One of our challenges is to make public policy responsive to changing market conditions rather than let it be driven solely by the most recent crisis. The circuit breakers put in place after the crash offer an interesting example of this phenomenon. Circuit breakers are trading halts coordinated across the equity and equity derivatives markets. They were first suggested by the Brady Task Force, and they are one of the more notable recommendations of that report. As stated in the report, the purpose of this (and the other recommendations) was "[t]o help prevent a repetition of the events of mid-October and to provide an effective and coordinated response in the face of market disorder." Circuit breakers are widely cited today as one of the successes of the crash post-mortems. But I, for one, question this evaluation. Circuit breakers have never actually been triggered, in contrast to some of the so-called "speed bumps" which affect particular trading strategies and are now tripped routinely. (In contrast to circuit breakers, which are coordinated across the equity and derivative markets, speed bumps are trading restrictions that have been put in place by individual market places.) If circuit breakers have never been used to halt trading, it follows that we have never had the experience of trying to re-start trading either. To an economist such as myself, some of the scariest times during the market crash were those in which trading was not occurring. Our tendency to worry more about stopping trading than re-starting it is mystifying. (I realize that there has been some discussion about the rules for the resumption of trading but the overwhelming attention has been on the halt.) Recent re-assessments of circuit breakers have focused on increasing the magnitude of price declines necessary to trigger coordinated trading halts. If we are going to continue having circuit breakers, I am supportive of this action and feel that a periodic evaluation of circuit breakers is valuable to ensure that trading halts only occur during very unusual market conditions. Nonetheless, I think that we also should broadly re-evaluate circuit breakers in light of current market conditions. Are circuit breakers fulfilling the goal articulated by the Brady Task Force of providing an effective and coordinated response in the face of market disorder? Do circuit breakers continue to be the best public policy response to market volatility? Many features of financial markets have changed over the last ten years, not least of which is the continuing growth in international activity. Circuit breakers are much more difficult to impose when trading activity can move to markets that do not participate in the trading halt. As I noted earlier, one of my main concerns is the restarting of trading following a halt. If liquidity has moved to over-the-counter markets or foreign venues, how does one get that liquidity back in the domestic, exchange-traded market when the trading halt ends? What kinds of problems might domestic specialists and market makers have in restarting if the market has moved away from them during the halt? Recent changes to shorten the duration of the circuit breakers likely would ameliorate these concerns somewhat, but the worry remains. - 3 - Another important change in the financial landscape in the years since the crash has been a greater focus on risk management by both market participants and supervisors. Developments of new instruments, both on and off exchanges, and of new methods for evaluating risk, have given market participants powerful new tools to allow them to absorb market shocks. Similarly, risk management tools have been enhanced at clearing organizations. Regulators must respond to these new tools. To fully utilize their benefits, regulators will need to approach regulation and supervision in different ways. A good example is to be found in the approach by banking supervisors to developing a capital requirement for market risk. After initial fits and starts, the Basle Supervisors' Committee embraced the concept of using banks' internal models as a basis for a capital requirement for market risk. The Federal Reserve has taken this process of employing new approaches to regulation a step further with its pre-commitment proposal. Pre-commitment allows banks to commit to the maximum loss they will experience over the next quarter in their trading portfolio; this commitment becomes their capital requirement. The proposal gives banks incentives to establish the commitment in a prudent fashion through fines and disclosures if it is violated. Economists in the audience will recognize this proposal as an application of an incentive-compatible approach to regulation. I suspect that there are far more areas in our regulatory structure in which incentive-compatible approaches could be implemented. Self-regulatory organizations also may find such an approach beneficial, particularly in this era in which SROs are being asked to assume more and more regulatory responsibilities. Incentive-compatible regulation essentially tries to harness the self-interest of market participants to achieve broader public policy goals. By using such an approach, our overall goal is to make individual market participants more resilient and better able to withstand shocks. This, after all, is the most basic (and probably the most effective) protection for firms faced with events such as the 1987 crash. At a macroeconomic level, public policies also should ensure that markets and the economy itself can withstand shocks. While the 1987 crash did not have significant, real economic effects, this is not always the case with stock market crashes. Such episodes are generally accompanied by dramatic increases in uncertainty and increased demands for liquidity and safety. Some of these demands for liquidity may, in turn, reflect the fear that the crisis will spread more broadly to the economy. In 1987, a key role played by the Federal Reserve was to demonstrate a determination to meet liquidity demands, and thereby to reassure market participants that problems would not spread beyond the financial system. Problems were contained in this instance, but policy makers cannot be complacent. In the lessons to be learned from the crash, we should not lose sight of the potential for financial crises to have real effects and of the on-going need for public policies to be directed toward mitigating these effects.	['ms. phillips reassesses the stock market crash of 1987 in the context of subsequent market and regulatory changes remarks by ms. susan m. phillips, a member of the board of governors of the us federal reserve system, at bentley college, waltham, massachusetts on 15/10/97.', "black monday: 10 years later thank you for inviting me to participate in this program sponsored by the financial women's association.", 'we are drawing very close to the tenth anniversary of the stock market crash.', 'it is useful to reassess that event in the context of subsequent market and regulatory changes.', 'the crash was one of those (fortunately rare) events that serve as a watershed for our discussion of markets and public policies.', 'considerations of regulatory approaches now almost always use the crash as a reference point.', 'panels such as this one provide a vehicle for evaluating not only what we have learned from the event but also the various actions taken following the crash.', 'but it is also appropriate to look forward.', 'changes in financial markets and the risk management capability of firms have been significant in the intervening years.', 'the crash may no longer be as useful a reference point for judging events and evaluating public policy responses.', 'i suppose everyone can remember what they were doing on the day of the crash.', 'i had the good fortune to have left the cftc prior to the crash.', 'thus, i got to watch events unfold from the cornfields of iowa.', 'later, however, i participated in several post-crash evaluations.', 'even now, at the federal reserve board, the crash periodically comes up in supervisory discussions about bank risk.', '(regrettably, the crash is now part of a pantheon of financial market "problems" that include barings, daiwa, metallgesellschaft, orange county, and sumitomo.)', 'the legacy of the crash the legacy of the crash is both tangible and intangible.', 'an impressive number of studies of the crash were done.', 'the more noteworthy ones take up about three linear feet on my bookshelf, a very tangible reminder.', 'more seriously, the studies done after the crash were wide-ranging and examined events through the eyes of many different market participants, many different regulators, and a host of academicians.', 'they identified weaknesses in trading and clearing systems that have resulted in tangible changes to those systems.', 'these changes have been very positive.', 'exchanges have greatly expanded their ability to handle surges in volume, for example.', 'the capitalization of market makers has been bolstered as well.', 'numerous changes also have been implemented in clearing systems.', 'doubts that emerged about the soundness of clearing systems were some of the most frightening aspects of the crash.', 'the changes to clearing systems have received far less attention than those to trading systems, but their long-term consequences likely are more profound.', 'such critical parts of the "plumbing" as the agreements between the futures clearing houses and the settlement banks have been clarified and put on a much sounder footing.', 'in addition, many clearing organizations have established back-up liquidity facilities that will enable them to make payments to clearing members in a timely fashion even if a clearing member has defaulted.', 'in both our evaluation of trading mechanisms and our evaluation of clearing systems, an important intangible outcome of the crash is that we now have a better understanding of the way these systems work.', "during ordinary trading days, market participants rarely if ever question counterparties' ability and willingness to perform on obligations.", 'in the months following the crash, policy makers and market participants began to examine those payment conventions more closely.', 'the bulk of the changes to risk management systems that flowed from the crash related to efforts to clarify or make more rigorous the responsibilities and obligations of market participants that previously had been left ambiguous or were part of the lore of "normal" market practice.', '- 2 - another very important intangible legacy of the crash is our better understanding of the need for cooperation and coordination among commodity, securities, and banking market authorities.', 'the crash vividly illustrated the extent to which markets are intertwined and the extent to which large financial firms have lines of business that cut across many markets.', "the forums for coordination are almost too numerous to mention, not least of which is the president's working group on financial markets.", 'the working group comprises the heads of the treasury, sec, cftc, and federal reserve, and in addition, other banking supervisory agencies, the national economic council, and the council of economic advisers participate.', 'prospect looking forward, we are better positioned today to absorb market shocks than we were prior to the 1987 crash.', 'we undoubtedly, however, will have many different problems in future periods of volatility.', 'responses to events such as the 1987 crash tend to be crisis-specific.', 'one of our challenges is to make public policy responsive to changing market conditions rather than let it be driven solely by the most recent crisis.', 'the circuit breakers put in place after the crash offer an interesting example of this phenomenon.', 'circuit breakers are trading halts coordinated across the equity and equity derivatives markets.', 'they were first suggested by the brady task force, and they are one of the more notable recommendations of that report.', 'as stated in the report, the purpose of this (and the other recommendations) was "[t]o help prevent a repetition of the events of mid-october and to provide an effective and coordinated response in the face of market disorder."', 'circuit breakers are widely cited today as one of the successes of the crash post-mortems.', 'but i, for one, question this evaluation.', 'circuit breakers have never actually been triggered, in contrast to some of the so-called "speed bumps" which affect particular trading strategies and are now tripped routinely.', '(in contrast to circuit breakers, which are coordinated across the equity and derivative markets, speed bumps are trading restrictions that have been put in place by individual market places.)', 'if circuit breakers have never been used to halt trading, it follows that we have never had the experience of trying to re-start trading either.', 'to an economist such as myself, some of the scariest times during the market crash were those in which trading was not occurring.', 'our tendency to worry more about stopping trading than re-starting it is mystifying.', '(i realize that there has been some discussion about the rules for the resumption of trading but the overwhelming attention has been on the halt.)', 'recent re-assessments of circuit breakers have focused on increasing the magnitude of price declines necessary to trigger coordinated trading halts.', 'if we are going to continue having circuit breakers, i am supportive of this action and feel that a periodic evaluation of circuit breakers is valuable to ensure that trading halts only occur during very unusual market conditions.', 'nonetheless, i think that we also should broadly re-evaluate circuit breakers in light of current market conditions.', 'are circuit breakers fulfilling the goal articulated by the brady task force of providing an effective and coordinated response in the face of market disorder?', 'do circuit breakers continue to be the best public policy response to market volatility?', 'many features of financial markets have changed over the last ten years, not least of which is the continuing growth in international activity.', 'circuit breakers are much more difficult to impose when trading activity can move to markets that do not participate in the trading halt.', 'as i noted earlier, one of my main concerns is the restarting of trading following a halt.', 'if liquidity has moved to over-the-counter markets or foreign venues, how does one get that liquidity back in the domestic, exchange-traded market when the trading halt ends?', 'what kinds of problems might domestic specialists and market makers have in restarting if the market has moved away from them during the halt?', 'recent changes to shorten the duration of the circuit breakers likely would ameliorate these concerns somewhat, but the worry remains.', '- 3 - another important change in the financial landscape in the years since the crash has been a greater focus on risk management by both market participants and supervisors.', 'developments of new instruments, both on and off exchanges, and of new methods for evaluating risk, have given market participants powerful new tools to allow them to absorb market shocks.', 'similarly, risk management tools have been enhanced at clearing organizations.', 'regulators must respond to these new tools.', 'to fully utilize their benefits, regulators will need to approach regulation and supervision in different ways.', 'a good example is to be found in the approach by banking supervisors to developing a capital requirement for market risk.', "after initial fits and starts, the basle supervisors' committee embraced the concept of using banks' internal models as a basis for a capital requirement for market risk.", 'the federal reserve has taken this process of employing new approaches to regulation a step further with its pre-commitment proposal.', 'pre-commitment allows banks to commit to the maximum loss they will experience over the next quarter in their trading portfolio; this commitment becomes their capital requirement.', 'the proposal gives banks incentives to establish the commitment in a prudent fashion through fines and disclosures if it is violated.', 'economists in the audience will recognize this proposal as an application of an incentive-compatible approach to regulation.', 'i suspect that there are far more areas in our regulatory structure in which incentive-compatible approaches could be implemented.', 'self-regulatory organizations also may find such an approach beneficial, particularly in this era in which sros are being asked to assume more and more regulatory responsibilities.', 'incentive-compatible regulation essentially tries to harness the self-interest of market participants to achieve broader public policy goals.', 'by using such an approach, our overall goal is to make individual market participants more resilient and better able to withstand shocks.', 'this, after all, is the most basic (and probably the most effective) protection for firms faced with events such as the 1987 crash.', 'at a macroeconomic level, public policies also should ensure that markets and the economy itself can withstand shocks.', 'while the 1987 crash did not have significant, real economic effects, this is not always the case with stock market crashes.', 'such episodes are generally accompanied by dramatic increases in uncertainty and increased demands for liquidity and safety.', 'some of these demands for liquidity may, in turn, reflect the fear that the crisis will spread more broadly to the economy.', 'in 1987, a key role played by the federal reserve was to demonstrate a determination to meet liquidity demands, and thereby to reassure market participants that problems would not spread beyond the financial system.', 'problems were contained in this instance, but policy makers cannot be complacent.', 'in the lessons to be learned from the crash, we should not lose sight of the potential for financial crises to have real effects and of the on-going need for public policies to be directed toward mitigating these effects.']	Susan M Phillips	Board of Governors of the US Federal Reserve System	Member of the Board of Governors	US
https://www.bis.org/review/r971030b.pdf	Mr. Heikensten considers inflation and the interest rate in Sweden (Central Bank Articles and Speeches, 15 Oct 97)	Speech given by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at the Sweden Financial Forum, Örebro, on 15/10/97.	1997-10-15 00:00:00	Mr. Heikensten considers inflation and the interest rate in Sweden Speech given by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at the Sweden Financial Forum, Örebro, on 15/10/97. What I have to say is based in the main on the Riksbank's latest inflation report, which was published less than a month ago. In some respects, I shall be developing what we said there about the outlook for inflation, though our assessment of the situation is essentially unchanged. I shall begin, however, with some remarks about why monetary policy is constructed as it is, with the objective of safeguarding the value of money. 1. Monetary policy's foundations Experience advocates a stable environment The reason why the Riksbank's objective is to safeguard the value of money is basically simple: low, stable inflation contributes to a good environment for the growth of production and employment. Support for this view is readily found in the pattern of economic developments in different industrialised countries. In those countries where inflation has been allowed to accelerate, growth has normally been weaker and more erratic. We have seen this in Sweden. In the first two-to-three post-war decades Swedish economic policy was characterised by stable rules and inflation was low. Economic growth in those years was good and new jobs were created to a greater extent than in the past two decades, when inflation shot up and there was a series of devaluation cycles. There is really nothing odd about this. We all know that stable conditions make it easier to arrive at wise economic decisions. When wages and prices chase each other in an unpredictable way, and both interest rates and the exchange rate fluctuate widely as a result of this, with a certain amount of luck or smartness it is sometimes possible to do good business. But most people surely realise that this is not the best setting for either long-term investment or for those who have to live on an earned income or a pension. The head of the US Federal Reserve, Alan Greenspan, has formulated his view of what monetary policy's objective should be in roughly these words: inflation should be so low that economic agents do not have to worry about it. Limited room for employment policy Why, then, are there those who still argue that higher inflation would be a good thing? I believe this is mainly because they perceive a conflict between price stability and low unemployment. This perception in turn has its roots in a short-run, cyclical perspective. When economic activity is rising or falling on account of transitory demand fluctuations around a long-term trend, this negative relationship does exist. Rising demand for goods and services generates increased demand for labour and lower unemployment; this tends to be accompanied by rising wages and higher inflation. The opposite also applies. But this does not mean that higher inflation results in permanently higher employment and lastingly lower unemployment. On the contrary, as a result of the economic setback that normally follows a return to an inflation economy, unemployment is liable to rise even higher. Against this it might be argued that it is not a matter of giving inflation its head, but of allowing just a little more inflation. Nor is it a matter of doing this as a systematic policy, but just for once. Once again, the Swedish experience in the 1970s and 1980s is both instructive and representative of what has happened in many other countries. A little more inflation over a short period can very easily become inflation that is high and persistent. - 2 - In any event, in the longer run the level of unemployment is determined by factors other than the demand situation, factors such as institutions, rules and conventions in the economy and above all in the labour market and wage formation. If the causes of unemployment were in fact solely or even mainly cyclical, then unemployment would not differ so greatly as it does between countries that are in the same cyclical phase and have had much the same growth rate for a long time. Targeting inflation The Riksbank has the objective of safeguarding the value of money. In practice, the Riksbank targets inflation. The target rate is 2 per cent (with a tolerance interval of ±1 percentage point), assessed in annual terms. As there is a time lag of 1 to 2 years before an interest rate adjustment has its full effect on the rate of price increases, the Riksbank has to work with forecast inflation. When we have reason to fear that inflation is rising above the targeted rate, it will soon be time to raise the instrumental rate and vice versa. Assessments of future inflation are presented by the Riksbank four times a year in the series of inflation reports. The assessments are published as a guide to economic agents in their own deliberations about what the future level of interest rates is likely to be. The reports also provide a basis for the discussion of monetary policy's construction that the Riksbank is interested in encouraging. Simplifying somewhat, inflation is determined by two factors: the situation concerning demand and supply and economic agents' expectations of future inflation. The first factor is fairly straightforward; when demand tends to exceed what the economy is capable of producing, the resultant shortages and bottlenecks will normally push prices and wages up. The part played by expectations may be less evident. If firms and employees expect increased inflation, they will tend to raise prices and demand higher wages, respectively. This may be sufficient to start and continue an inflationary process. Another factor of importance for inflation is the value of the krona, both because it directly affects pricing and demand and because it can serve as an indication of expected inflation. 2. Economic activity and inflation expectations Now for the assessment in our latest inflation report. First let me say something about the Riksbank's appraisal of the economic situation. Demand and supply The statistics from recent months clearly point to an upswing in the greater part of the economy. This largely confirms the Riksbank's assessments last spring. Developments to date in 1997 have been more balanced than before. Demand growth is now coming not only from exports and investment, but to an increasing extent from private consumption as well. The growth of household income has been held back for some years by the programme for fiscal consolidation. Activity has been further depressed by the need to cut spending on public activities. The fiscal withdrawal of household purchasing power is continuing both this year and next, so disposable income is largely unchanged in 1997, but will rise in 1998. After that, when the consolidation programme has been completed, fiscal policy is not expected to be as restrictive on households. Some increase in public activities can also be expected in the coming two years. After rising for some years at a rather modest rate, private consumption has picked up in the past year. Households' expectations concerning their own as well as the national economy improved in September after a minor setback in August. Households are also more optimistic about the outlook in the labour market. Moreover, the August survey by the National Institute of Economic Research shows that firms in both everyday and infrequent trade are optimistic about sales trends in the near future. - 3 - It is not just disposable income that determines private consumption. The appreciation of wealth in the past year is probably important, too. Since the turn of 1996, house prices have risen 9 per cent and share prices 28 per cent. This suggests that in 1997 households could realise capital gains that may reach the equivalent of about 25 per cent of disposable income. It would be surprising if such an increase in wealth did not contribute to stronger consumer demand. To sum up, most signs point to a good development of demand in the years ahead. In an expanding world market, export growth should continue to be relatively high. The Riksbank also counts on an accelerating increase in private consumption and at least an end to the fall in public consumption. The broad increase in all the major demand components naturally exerts some pressure on the available resources. This implies rising capacity utilisation and a decreased availability of unutilised resources. The business tendency surveys for manufacturing, which provide information about capacity there, consistently indicate that unutilised resources fell from the first to the second quarter. An increased proportion of firms reported that output was being restricted by production factors rather than demand. This was accompanied by rising shortages of skilled workers and salaried technicians. An important, though elusive, indicator of inflationary pressure is the gap between total demand and total output. Most indicators suggest that this gap has become somewhat smaller. In the inflation report, however, the Riksbank judges that the supply of unutilised resources is still relatively good. It is not least the high level of total unemployment that indicates this. A high rate of investment and rapid increases in productivity have contributed, at least to date, to an expansion of potential output to meet the growing demand. This has eased inflationary pressure during the upswing. Inflation expectations Another important indicator of inflationary pressure is the expectations of economic agents about future inflation. Along with actual inflation, these expectations have declined in recent years. They also show a tendency to converge around the 2 per cent inflation target. If this is the case, it is a good sign because it can be seen as increased confidence in the inflation target. This means that to a greater extent, economic agents are basing their own plans on expectations of low inflation, which provides better conditions for monetary policy to fulfil the inflation target. In recent months the expectations of future inflation have tended to move up, but this seems to be mainly an adjustment to the increase in registered inflation. The tendency, however, must be closely watched; a clear increase in inflation expectations above the inflation target would give cause for concern. 3. Inflation in the coming years In the course of 1996 CPI inflation decreased markedly and the annual level was somewhat below the lower limit of the tolerance interval. Transitory factors partly explain the drop. Falling house mortgage interest costs, occasioned in part by the Riksbank's own interest rate cuts, played a large part in the low inflation figures. The trend has now turned and the rate of inflation is beginning to move up. But the main reason for this is that the transient downward factors are no longer at work to the same degree; the increase in underlying inflation is therefore more subdued. In the light of the assessments of economic activity and other factors that affect inflation (e.g. inflation expectations), in the inflation report the Riksbank forecast that annual CPI inflation would be around 1 per cent in 1997 and around 2 per cent in both 1998 and 1999. Some acceleration was envisaged in the latter two years. The assessment carried some reservations. Matters discussed in the report included the risks associated with rising activity, the difficulties in knowing how the supply side would react and the - 4 - coming round of wage negotiations. There may be reasons for elaborating on that discussion in some respects. Output gap closing by degrees In the inflation report the Riksbank considers that Sweden's gross domestic product will grow by around 2 per cent in 1997 and around 3 per cent in 1998. In 1999 the GDP growth rate is expected to be rather more than 3 per cent. This implies that in 1998 and 1999 growth will be stronger than the increase in potential output, for which the annual trend is estimated to be just over 2 per cent. That means that today's surplus capacity will be activated by degrees. It is difficult to tell how quickly this will happen. The Riksbank considers that the output gap -- a way of attempting to gauge unutilised capacity in the economy as a whole -- is currently about 2 per cent of GDP. With the growth rates envisaged above, the gap would then close some time in 1999. Other information with a bearing on when inflation might be likely to accelerate was also included in the inflation report. Estimates of structural unemployment and thereby, indirectly, of the level of unemployment that can be combined with stable, low inflation, suggest that risks of inflation also exist less than two years ahead. The rate at which capacity utilisation rises may likewise play a part. A rapid reduction of unutilised resources might generate inflationary impulses even though there is still a capacity surplus at total level. Risks in the wage negotiations Wage formation is particularly relevant at present because the settlements that are due in the coming six months will cover a large part of the labour market. Labour shortages are not yet being reported from more than a few sectors, but experience shows that the domino effects can be substantial. The Riksbank's assessment of inflation in the latest report is based on an assumption that the rate of wage increases will be lower than in recent years. Support for this assumption can be found, for example, in recent wage statistics. The report, however, does not envisage a downward shift to, or even below, the level that has prevailed in the European Union in recent years, a shift that would make it easier for Sweden to tackle unemployment. Wage formation is primarily a matter for the labour market organisations to arrange. The level of wage increases that different segments of the economy can cope with depends, for example, on the initial profit level, together with the development of that segment's productivity, costs and prices. For the economy as a whole it is difficult to avoid the conclusion that, if an effective reduction of unemployment is to be feasible, a rate of wage increases which equals the inflation target plus expected long-term productivity growth represents a ceiling. Lower wage increases would make labour cheaper relative to capital investment and would thereby stimulate employment. It is important to understand today's rules for economic policy. In keeping with the situation a quarter of a century ago, when Sweden was participating in the Bretton Woods system, which was a functional and efficient arrangement with fixed exchange rates, for some years now the rules of the game have been clear. If the Riksbank judges that inflation will rise above the 2 per cent target, it is up to us to raise interest rates. Consequently, excessively high wage increases will not lead, except possibly in the very short run, to higher inflation. Instead they will result in weaker economic activity and lower employment in the years ahead. In the earlier situation with a fixed exchange rate, excessively high wage increases primarily affected manufacturing and other parts of the economy that are exposed to international competition. Today the effects will be felt in particular by sectors that are sensitive to interest rates, such as distributive trades and a debt-burdened public sector. - 5 - 4. Conclusions for monetary policy The overall assessment in the inflation report is that the monetary stance is well balanced. Today there is no reason to modify that conclusion. In the past month there has been no appreciable change in the outlook for inflation. After the interest rate increases in Germany and other countries almost a week ago, many people have asked how this affects the Riksbank's actions. As stated already on several occasions, the answer is: not much as long as the conditions for inflation have not changed. The Riksbank targets inflation and it is this target that guides policy. In view of what has happened in the past month, there is reason, finally, to highlight a couple of points in the report. The first is that monetary policy is being conducted against the background of an economic upswing. A gradual increase in capacity utilisation is therefore probable. Sweden does not differ from Germany in that particular respect. The other point is the diminished risk of a development that is appreciably weaker than in the main scenario; this assessment is supported by the latest statistics. In the light of the rising activity, the main difficulty in assessing future inflation currently lies in an uncertainty about developments on the supply side, wage formation in particular. It is difficult to foresee how the Swedish economy will react to a broad economic upswing. It is therefore important, not least on that account, to analyse incoming information.	['mr. heikensten considers inflation and the interest rate in sweden speech given by the deputy governor of the bank of sweden, mr. lars heikensten, at the sweden financial forum, örebro, on 15/10/97.', "what i have to say is based in the main on the riksbank's latest inflation report, which was published less than a month ago.", 'in some respects, i shall be developing what we said there about the outlook for inflation, though our assessment of the situation is essentially unchanged.', 'i shall begin, however, with some remarks about why monetary policy is constructed as it is, with the objective of safeguarding the value of money.', "1. monetary policy's foundations experience advocates a stable environment the reason why the riksbank's objective is to safeguard the value of money is basically simple: low, stable inflation contributes to a good environment for the growth of production and employment.", 'support for this view is readily found in the pattern of economic developments in different industrialised countries.', 'in those countries where inflation has been allowed to accelerate, growth has normally been weaker and more erratic.', 'we have seen this in sweden.', 'in the first two-to-three post-war decades swedish economic policy was characterised by stable rules and inflation was low.', 'economic growth in those years was good and new jobs were created to a greater extent than in the past two decades, when inflation shot up and there was a series of devaluation cycles.', 'there is really nothing odd about this.', 'we all know that stable conditions make it easier to arrive at wise economic decisions.', 'when wages and prices chase each other in an unpredictable way, and both interest rates and the exchange rate fluctuate widely as a result of this, with a certain amount of luck or smartness it is sometimes possible to do good business.', 'but most people surely realise that this is not the best setting for either long-term investment or for those who have to live on an earned income or a pension.', "the head of the us federal reserve, alan greenspan, has formulated his view of what monetary policy's objective should be in roughly these words: inflation should be so low that economic agents do not have to worry about it.", 'limited room for employment policy why, then, are there those who still argue that higher inflation would be a good thing?', 'i believe this is mainly because they perceive a conflict between price stability and low unemployment.', 'this perception in turn has its roots in a short-run, cyclical perspective.', 'when economic activity is rising or falling on account of transitory demand fluctuations around a long-term trend, this negative relationship does exist.', 'rising demand for goods and services generates increased demand for labour and lower unemployment; this tends to be accompanied by rising wages and higher inflation.', 'the opposite also applies.', 'but this does not mean that higher inflation results in permanently higher employment and lastingly lower unemployment.', 'on the contrary, as a result of the economic setback that normally follows a return to an inflation economy, unemployment is liable to rise even higher.', 'against this it might be argued that it is not a matter of giving inflation its head, but of allowing just a little more inflation.', 'nor is it a matter of doing this as a systematic policy, but just for once.', 'once again, the swedish experience in the 1970s and 1980s is both instructive and representative of what has happened in many other countries.', 'a little more inflation over a short period can very easily become inflation that is high and persistent.', '- 2 - in any event, in the longer run the level of unemployment is determined by factors other than the demand situation, factors such as institutions, rules and conventions in the economy and above all in the labour market and wage formation.', 'if the causes of unemployment were in fact solely or even mainly cyclical, then unemployment would not differ so greatly as it does between countries that are in the same cyclical phase and have had much the same growth rate for a long time.', 'targeting inflation the riksbank has the objective of safeguarding the value of money.', 'in practice, the riksbank targets inflation.', 'the target rate is 2 per cent (with a tolerance interval of ±1 percentage point), assessed in annual terms.', 'as there is a time lag of 1 to 2 years before an interest rate adjustment has its full effect on the rate of price increases, the riksbank has to work with forecast inflation.', 'when we have reason to fear that inflation is rising above the targeted rate, it will soon be time to raise the instrumental rate and vice versa.', 'assessments of future inflation are presented by the riksbank four times a year in the series of inflation reports.', 'the assessments are published as a guide to economic agents in their own deliberations about what the future level of interest rates is likely to be.', "the reports also provide a basis for the discussion of monetary policy's construction that the riksbank is interested in encouraging.", "simplifying somewhat, inflation is determined by two factors: the situation concerning demand and supply and economic agents' expectations of future inflation.", 'the first factor is fairly straightforward; when demand tends to exceed what the economy is capable of producing, the resultant shortages and bottlenecks will normally push prices and wages up.', 'the part played by expectations may be less evident.', 'if firms and employees expect increased inflation, they will tend to raise prices and demand higher wages, respectively.', 'this may be sufficient to start and continue an inflationary process.', 'another factor of importance for inflation is the value of the krona, both because it directly affects pricing and demand and because it can serve as an indication of expected inflation.', '2. economic activity and inflation expectations now for the assessment in our latest inflation report.', "first let me say something about the riksbank's appraisal of the economic situation.", 'demand and supply the statistics from recent months clearly point to an upswing in the greater part of the economy.', "this largely confirms the riksbank's assessments last spring.", 'developments to date in 1997 have been more balanced than before.', 'demand growth is now coming not only from exports and investment, but to an increasing extent from private consumption as well.', 'the growth of household income has been held back for some years by the programme for fiscal consolidation.', 'activity has been further depressed by the need to cut spending on public activities.', 'the fiscal withdrawal of household purchasing power is continuing both this year and next, so disposable income is largely unchanged in 1997, but will rise in 1998. after that, when the consolidation programme has been completed, fiscal policy is not expected to be as restrictive on households.', 'some increase in public activities can also be expected in the coming two years.', 'after rising for some years at a rather modest rate, private consumption has picked up in the past year.', "households' expectations concerning their own as well as the national economy improved in september after a minor setback in august.", 'households are also more optimistic about the outlook in the labour market.', 'moreover, the august survey by the national institute of economic research shows that firms in both everyday and infrequent trade are optimistic about sales trends in the near future.', '- 3 - it is not just disposable income that determines private consumption.', 'the appreciation of wealth in the past year is probably important, too.', 'since the turn of 1996, house prices have risen 9 per cent and share prices 28 per cent.', 'this suggests that in 1997 households could realise capital gains that may reach the equivalent of about 25 per cent of disposable income.', 'it would be surprising if such an increase in wealth did not contribute to stronger consumer demand.', 'to sum up, most signs point to a good development of demand in the years ahead.', 'in an expanding world market, export growth should continue to be relatively high.', 'the riksbank also counts on an accelerating increase in private consumption and at least an end to the fall in public consumption.', 'the broad increase in all the major demand components naturally exerts some pressure on the available resources.', 'this implies rising capacity utilisation and a decreased availability of unutilised resources.', 'the business tendency surveys for manufacturing, which provide information about capacity there, consistently indicate that unutilised resources fell from the first to the second quarter.', 'an increased proportion of firms reported that output was being restricted by production factors rather than demand.', 'this was accompanied by rising shortages of skilled workers and salaried technicians.', 'an important, though elusive, indicator of inflationary pressure is the gap between total demand and total output.', 'most indicators suggest that this gap has become somewhat smaller.', 'in the inflation report, however, the riksbank judges that the supply of unutilised resources is still relatively good.', 'it is not least the high level of total unemployment that indicates this.', 'a high rate of investment and rapid increases in productivity have contributed, at least to date, to an expansion of potential output to meet the growing demand.', 'this has eased inflationary pressure during the upswing.', 'inflation expectations another important indicator of inflationary pressure is the expectations of economic agents about future inflation.', 'along with actual inflation, these expectations have declined in recent years.', 'they also show a tendency to converge around the 2 per cent inflation target.', 'if this is the case, it is a good sign because it can be seen as increased confidence in the inflation target.', 'this means that to a greater extent, economic agents are basing their own plans on expectations of low inflation, which provides better conditions for monetary policy to fulfil the inflation target.', 'in recent months the expectations of future inflation have tended to move up, but this seems to be mainly an adjustment to the increase in registered inflation.', 'the tendency, however, must be closely watched; a clear increase in inflation expectations above the inflation target would give cause for concern.', '3. inflation in the coming years in the course of 1996 cpi inflation decreased markedly and the annual level was somewhat below the lower limit of the tolerance interval.', 'transitory factors partly explain the drop.', "falling house mortgage interest costs, occasioned in part by the riksbank's own interest rate cuts, played a large part in the low inflation figures.", 'the trend has now turned and the rate of inflation is beginning to move up.', 'but the main reason for this is that the transient downward factors are no longer at work to the same degree; the increase in underlying inflation is therefore more subdued.', 'in the light of the assessments of economic activity and other factors that affect inflation (e.g.', 'inflation expectations), in the inflation report the riksbank forecast that annual cpi inflation would be around 1 per cent in 1997 and around 2 per cent in both 1998 and 1999. some acceleration was envisaged in the latter two years.', 'the assessment carried some reservations.', 'matters discussed in the report included the risks associated with rising activity, the difficulties in knowing how the supply side would react and the - 4 - coming round of wage negotiations.', 'there may be reasons for elaborating on that discussion in some respects.', "output gap closing by degrees in the inflation report the riksbank considers that sweden's gross domestic product will grow by around 2 per cent in 1997 and around 3 per cent in 1998. in 1999 the gdp growth rate is expected to be rather more than 3 per cent.", 'this implies that in 1998 and 1999 growth will be stronger than the increase in potential output, for which the annual trend is estimated to be just over 2 per cent.', "that means that today's surplus capacity will be activated by degrees.", 'it is difficult to tell how quickly this will happen.', 'the riksbank considers that the output gap -- a way of attempting to gauge unutilised capacity in the economy as a whole -- is currently about 2 per cent of gdp.', 'with the growth rates envisaged above, the gap would then close some time in 1999. other information with a bearing on when inflation might be likely to accelerate was also included in the inflation report.', 'estimates of structural unemployment and thereby, indirectly, of the level of unemployment that can be combined with stable, low inflation, suggest that risks of inflation also exist less than two years ahead.', 'the rate at which capacity utilisation rises may likewise play a part.', 'a rapid reduction of unutilised resources might generate inflationary impulses even though there is still a capacity surplus at total level.', 'risks in the wage negotiations wage formation is particularly relevant at present because the settlements that are due in the coming six months will cover a large part of the labour market.', 'labour shortages are not yet being reported from more than a few sectors, but experience shows that the domino effects can be substantial.', "the riksbank's assessment of inflation in the latest report is based on an assumption that the rate of wage increases will be lower than in recent years.", 'support for this assumption can be found, for example, in recent wage statistics.', 'the report, however, does not envisage a downward shift to, or even below, the level that has prevailed in the european union in recent years, a shift that would make it easier for sweden to tackle unemployment.', 'wage formation is primarily a matter for the labour market organisations to arrange.', "the level of wage increases that different segments of the economy can cope with depends, for example, on the initial profit level, together with the development of that segment's productivity, costs and prices.", 'for the economy as a whole it is difficult to avoid the conclusion that, if an effective reduction of unemployment is to be feasible, a rate of wage increases which equals the inflation target plus expected long-term productivity growth represents a ceiling.', 'lower wage increases would make labour cheaper relative to capital investment and would thereby stimulate employment.', "it is important to understand today's rules for economic policy.", 'in keeping with the situation a quarter of a century ago, when sweden was participating in the bretton woods system, which was a functional and efficient arrangement with fixed exchange rates, for some years now the rules of the game have been clear.', 'if the riksbank judges that inflation will rise above the 2 per cent target, it is up to us to raise interest rates.', 'consequently, excessively high wage increases will not lead, except possibly in the very short run, to higher inflation.', 'instead they will result in weaker economic activity and lower employment in the years ahead.', 'in the earlier situation with a fixed exchange rate, excessively high wage increases primarily affected manufacturing and other parts of the economy that are exposed to international competition.', 'today the effects will be felt in particular by sectors that are sensitive to interest rates, such as distributive trades and a debt-burdened public sector.', '- 5 - 4. conclusions for monetary policy the overall assessment in the inflation report is that the monetary stance is well balanced.', 'today there is no reason to modify that conclusion.', 'in the past month there has been no appreciable change in the outlook for inflation.', "after the interest rate increases in germany and other countries almost a week ago, many people have asked how this affects the riksbank's actions.", 'as stated already on several occasions, the answer is: not much as long as the conditions for inflation have not changed.', 'the riksbank targets inflation and it is this target that guides policy.', 'in view of what has happened in the past month, there is reason, finally, to highlight a couple of points in the report.', 'the first is that monetary policy is being conducted against the background of an economic upswing.', 'a gradual increase in capacity utilisation is therefore probable.', 'sweden does not differ from germany in that particular respect.', 'the other point is the diminished risk of a development that is appreciably weaker than in the main scenario; this assessment is supported by the latest statistics.', 'in the light of the rising activity, the main difficulty in assessing future inflation currently lies in an uncertainty about developments on the supply side, wage formation in particular.', 'it is difficult to foresee how the swedish economy will react to a broad economic upswing.', 'it is therefore important, not least on that account, to analyse incoming information.']	Lars Heikensten	Sveriges Riksbank	Deputy Governor	Sweden
https://www.bis.org/review/r971030a.pdf	Mr. Rangarajan addresses a special convocation of the Indian Institute of Management (Central Bank Articles and Speeches, 3 Oct 97)	Address by the Governor of the Reserve Bank of India, Dr. C. Rangarajan, at a special convocation held to confer upon him the honorary title of Fellow of the Indian Institute of Management at Ahmedabad on 3/10/97.	1997-10-03 00:00:00	Mr. Rangarajan addresses a special convocation of the Indian Institute of Management Address by the Governor of the Reserve Bank of India, Dr. C. Rangarajan, at a special convocation held to confer upon him the honorary title of Fellow of the Indian Institute of Management at Ahmedabad on 3/10/97. It gives me immense pleasure to be on the campus of the Indian Institute of Management. I accept in all humility the award of the title "Fellow of the Indian Institute of Management", Ahmedabad. What can be a greater honour than the recognition by one's own peers and family? I look back with immense satisfaction on the years that I spent on the campus here. Those fourteen years marked the most productive period of my academic life. It is no mean task to have created here an institution of world-class excellence. All those who have been associated with IIMA can take legitimate pride in this achievement. This, however, makes the task of the current faculty members and students even harder. The race of excellence is a perpetual one and is, therefore, very demanding. I am sure that IIMA will always remain ahead. We are celebrating this year the Golden Jubilee of India's Independence. As a nation, we have accomplished much during this period. We have moved from the status of dependent country stricken at periodic intervals by famine and shortages to that of an independent nation with a high degree of stability. But the unfinished agenda is still long. Our rate of growth, though high in relation to our own performance in the previous fifty years, has fallen short of our expectations and that of what certain other countries have been able to achieve. The miracle of East Asian countries may to some extent have been dimmed by the recent crises in these countries. Nevertheless, they have shown that it is possible for countries to grow at a sustained rate of 7 per cent or more for several decades. We need to set our goals high. We have over time created the wherewithal for progress. The real task today is to use these advantages for further growth. All of us are conditioned by history. History is a great teacher if we can draw appropriate lessons. The present is an extension of the past. We should not, however, become prisoners of the past. Where changes are called for, we must be willing to make them. It is only by making such changes that a nation can progress. In the recent period we have made some basic changes in our approach to economic development and the means to achieve the desired results. The fundamental objectives of economic development in our country remain the same: growth and social justice. Instrumentalities to achieve these will have to change in tune with our experience and according to the demands of the time and the responses of the society. In bringing about faster growth we need to address many issues. Perhaps one that is most relevant in the context of work that is going on at IIMA is the issue of productivity. In ensuring a higher growth rate, there is no doubt that we must bring about an increase in the saving rate and, consequently, the investment rate. But at the same time one cannot over-emphasise the need for improving the productivity and efficiency of input use. Economists in fact talk about total factor productivity, which identifies the contribution to the increase in output of influences other than increase in factor inputs. The total factor productivity growth thus encompasses the effect not only of technological progress but also of better utilisation of capacities, improved skills of labour, etc. In fact during the period 1960-87 the total factor productivity growth of East Asia was 1.9 per cent per productivity and efficiency. Contrary to the general impression, the natural resources of our country are not large. From the point of view of long-range sustainability, the need for greater efficiency in the management of natural resources of land, water, minerals, etc. has become urgent. In a capital-scarce economy like ours, there can be no excuse for under-utilisation of capacity. Macro-policy framework and micro-management practices must be such as to bring about the desired increase in productivity. While the policy framework must be supportive, industrial structure must be such as to compel firms to continually innovate and to cut costs. The policy environment, the organisational structure and the attitude to work and technology: all these have to be right. Needless to say, institutes of management have an important role to play in bringing about this improvement in productivity by sharpening the skills and the vision of managers. - 2 - The recent development experience has clearly shown that countries which have grown fast are those which have made very heavy investment in education. Even as we aim at creating a broad-based educational system, including compulsory education at the primary and secondary levels, we also need institutions of excellence. Living as we are in a complex and globally competitive world, institutions of excellence in all disciplines are required to meet the challenges of competition, which in effect is the competition in skills and techniques. We are living in a fast-changing world. One analyst has compared these changes to the movement of the continental plates under the surface of the earth -- "plate tectonics" as geologists call it. The same analyst has also compared the dramatic changes using an analogy from evolutionary biology: "punctuated equilibrium". In these periods, the environment undergoes such significant changes that the dominant species is replaced by another one and evolution takes a quantum leap. Whether such a description fits the changes that are occurring today, history alone can tell. There is, however little doubt that we are living in exciting times. India missed the first Industrial Revolution. We cannot afford to miss the second one. All of our institutions of higher learning have an important responsibility in this regard. IIM, Ahmedabad has played a major role in improving the managerial practices in this country in the last three decades. In the current phases of industrial development, when Indian firms are subject to competitive forces, both domestic and global, the role of IIM is even greater. If the past is any guide, I am sure it will fulfil this historic role.	['mr. rangarajan addresses a special convocation of the indian institute of management address by the governor of the reserve bank of india, dr. c. rangarajan, at a special convocation held to confer upon him the honorary title of fellow of the indian institute of management at ahmedabad on 3/10/97.', 'it gives me immense pleasure to be on the campus of the indian institute of management.', 'i accept in all humility the award of the title "fellow of the indian institute of management", ahmedabad.', "what can be a greater honour than the recognition by one's own peers and family?", 'i look back with immense satisfaction on the years that i spent on the campus here.', 'those fourteen years marked the most productive period of my academic life.', 'it is no mean task to have created here an institution of world-class excellence.', 'all those who have been associated with iima can take legitimate pride in this achievement.', 'this, however, makes the task of the current faculty members and students even harder.', 'the race of excellence is a perpetual one and is, therefore, very demanding.', 'i am sure that iima will always remain ahead.', "we are celebrating this year the golden jubilee of india's independence.", 'as a nation, we have accomplished much during this period.', 'we have moved from the status of dependent country stricken at periodic intervals by famine and shortages to that of an independent nation with a high degree of stability.', 'but the unfinished agenda is still long.', 'our rate of growth, though high in relation to our own performance in the previous fifty years, has fallen short of our expectations and that of what certain other countries have been able to achieve.', 'the miracle of east asian countries may to some extent have been dimmed by the recent crises in these countries.', 'nevertheless, they have shown that it is possible for countries to grow at a sustained rate of 7 per cent or more for several decades.', 'we need to set our goals high.', 'we have over time created the wherewithal for progress.', 'the real task today is to use these advantages for further growth.', 'all of us are conditioned by history.', 'history is a great teacher if we can draw appropriate lessons.', 'the present is an extension of the past.', 'we should not, however, become prisoners of the past.', 'where changes are called for, we must be willing to make them.', 'it is only by making such changes that a nation can progress.', 'in the recent period we have made some basic changes in our approach to economic development and the means to achieve the desired results.', 'the fundamental objectives of economic development in our country remain the same: growth and social justice.', 'instrumentalities to achieve these will have to change in tune with our experience and according to the demands of the time and the responses of the society.', 'in bringing about faster growth we need to address many issues.', 'perhaps one that is most relevant in the context of work that is going on at iima is the issue of productivity.', 'in ensuring a higher growth rate, there is no doubt that we must bring about an increase in the saving rate and, consequently, the investment rate.', 'but at the same time one cannot over-emphasise the need for improving the productivity and efficiency of input use.', 'economists in fact talk about total factor productivity, which identifies the contribution to the increase in output of influences other than increase in factor inputs.', 'the total factor productivity growth thus encompasses the effect not only of technological progress but also of better utilisation of capacities, improved skills of labour, etc.', 'in fact during the period 1960-87 the total factor productivity growth of east asia was 1.9 per cent per productivity and efficiency.', 'contrary to the general impression, the natural resources of our country are not large.', 'from the point of view of long-range sustainability, the need for greater efficiency in the management of natural resources of land, water, minerals, etc.', 'in a capital-scarce economy like ours, there can be no excuse for under-utilisation of capacity.', 'macro-policy framework and micro-management practices must be such as to bring about the desired increase in productivity.', 'while the policy framework must be supportive, industrial structure must be such as to compel firms to continually innovate and to cut costs.', 'the policy environment, the organisational structure and the attitude to work and technology: all these have to be right.', 'needless to say, institutes of management have an important role to play in bringing about this improvement in productivity by sharpening the skills and the vision of managers.', '- 2 - the recent development experience has clearly shown that countries which have grown fast are those which have made very heavy investment in education.', 'even as we aim at creating a broad-based educational system, including compulsory education at the primary and secondary levels, we also need institutions of excellence.', 'living as we are in a complex and globally competitive world, institutions of excellence in all disciplines are required to meet the challenges of competition, which in effect is the competition in skills and techniques.', 'we are living in a fast-changing world.', 'one analyst has compared these changes to the movement of the continental plates under the surface of the earth -- "plate tectonics" as geologists call it.', 'the same analyst has also compared the dramatic changes using an analogy from evolutionary biology: "punctuated equilibrium".', 'in these periods, the environment undergoes such significant changes that the dominant species is replaced by another one and evolution takes a quantum leap.', 'whether such a description fits the changes that are occurring today, history alone can tell.', 'there is, however little doubt that we are living in exciting times.', 'india missed the first industrial revolution.', 'we cannot afford to miss the second one.', 'all of our institutions of higher learning have an important responsibility in this regard.', 'iim, ahmedabad has played a major role in improving the managerial practices in this country in the last three decades.', 'in the current phases of industrial development, when indian firms are subject to competitive forces, both domestic and global, the role of iim is even greater.', 'if the past is any guide, i am sure it will fulfil this historic role.']	Bimal Jalan	Reserve Bank of India	Governor	India
https://www.bis.org/review/r971021d.pdf	Mr. Greenspan inaugurates a series of economic seminars (Central Bank Articles and Speeches, 14 Oct 97)	Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the University of Connecticut, Storrs, Connecticut on 14/10/97.	1997-10-14 00:00:00	Mr. Greenspan inaugurates a series of economic seminars Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the University of Connecticut, Storrs, Connecticut on 14/10/97. I welcome the opportunity to inaugurate your economic seminar series because I believe that the education community has a crucial role to play in the current era of rapid economic change. Our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. Our success in preparing workers and managers to harness those forces will be an important element in the outcome. One of the most central dynamic forces is the accelerated expansion of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, fast-paced technological change creates an environment in which the stock of plant and equipment with which most managers and workers interact is turning over more rapidly, creating a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, I hope, to explain why education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value. More specifically, they seek the added value that customers place on products and services tailored to their particular needs, delivered in shorter time frames, or improved in quality. A century ago, much, if not most, of our effort was expended in producing food, clothing, and shelter. Only when crop yields increased, steam power was developed, and textile fabrication became more efficient were available work hours freed for the production and consumption of more discretionary goods and services. We manufactured cars and refrigerators and learned how to produce them with ever less human effort. As those products found their way into most homes, human effort moved on to the creation of values that were less constrained by limits of physical bulk, such as smaller, transistor-based electronics, and beyond to a wide variety of impalpable services -- medical care, education, entertainment, and travel, to name just a few. The demand for a virtually infinite array of impalpable values is, to a first approximation, insatiable. Understandably, today's efforts to create new values for consumers concentrates on these impalpables, which offer the highest potential value-added relative to costs in physical resources and human effort. Unbundling the particular characteristics of each good or service facilitates maximizing its value to each individual. Some individuals place more value on, and are willing to pay more for, style y rather than style x, whereas others prefer x. Producing both x and y enhances overall consumer well-being. Fifty years ago, only x was feasible. This striving to expand the options for satisfying the particular needs of individuals inevitably results in a shift toward value created through the exploitation of ideas and concepts -- or, more generally, information -- from the more straightforward utilization of physical resources and manual labor. Thus, it should come as no surprise that, over the past century, by far the largest part of the growth in America's real gross domestic product is the result of new insights and, more broadly, new information about how to rearrange physical reality to achieve ever-higher standards of living. The amount of physical input into our real GDP, measured in bulk or weight, has contributed only modestly to economic growth since the turn of the century. We have, for example, dramatically reduced the physical bulk of our radios, by substituting transistors for vacuum tubes. Thin fiber optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same amount of space, but with far less physical material than was required, say, 50 or 100 years ago. Most recently, mobile phones have become significantly downsized as they have been improved. As it became technologically possible to differentiate output to meet the increasingly calibrated choices that consumers now regularly make, the value of information creation and its transfer was expanded. Hence, it is understandable that our advanced computer and telecommunications products have been accorded particularly high value and, thus, why computer and telecommunications companies that successfully innovate in this field exhibit particularly elevated stock market values. Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. We could expect the widespread and effective application of information and other technologies to significantly increase productivity and reduce business costs. Certainly, we can already see dramatic improvements in quality control that have sharply reduced costly product rejects and lost time, while computer and satellite technology has markedly improved the efficiencies of moving goods through even more sophisticated, just-in-time, inventory systems. With computer-assisted design, experiments can be evaluated in a virtual reality setting, where mistakes can be readily corrected without the misuse of time and materials. And new technologies have had extensive applications in the services sector -- for example, in health services, where improvements in both diagnosis and treatment have been singularly impressive; in airline efficiency and safety; and in secretarial services now dominated by word processing, faxes, and voice and electronic mail. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, products more customized, and markets more intensely competitive. The scope and size of our financial sector has grown rapidly because of its ability to facilitate the financing of products and services that are themselves valued highly in the marketplace. Our nation's financial institutions, as a consequence, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will depend greatly on our capacity to develop and to apply new technology. Unfortunately, we have found that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and our ability to gain from that knowledge. For instance, Alexander Graham Bell initially viewed the telephone solely as a business instrument -- merely an enhancement of the telegraph for use in transmitting very specific messages. Indeed, he offered to sell his telephone patent to Western Union for only $100,000, but he was turned down. Similarly, Marconi, at first, overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. Moreover, we must recognize that an innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. America's continued success in garnering the benefits of technological advance will depend on the ability of our businesses to deal with risk and uncertainty. Moreover, our ability to remain in the forefront of new ideas and products will be ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. Even if the most recent, tentative indications that productivity growth may be speeding up were to turn out to be less than we had hoped, it is possible that the big increases in efficiency growing out of the introduction of computers and communications systems may still lie ahead. Past innovations, such as the advent of electricity or the invention of the gasoline-powered motor, required the development of considerable infrastructure before their full potential could be realized. Electricity, when it substituted for steam power late last century, was applied to production processes that had been developed for steam. For example, gravity was used to move goods vertically in the steam environment, and that setup did not initially change with the advent of electric power. Only much later -- when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system -- did productivity clearly accelerate. Similarly, only when highways and gasoline service stations became extensive was the lower cost of motor vehicle transportation achieved. In addition, full effectiveness in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. The growth of the conceptual component of output has brought with it accelerating demands for workers who are equipped not simply with technical know-how, but with the ability to create, analyze, and transform information and to interact effectively with others. A popular term for the type of human capital that firms are today employing to a greater degree is "functional literacy,"1 which perhaps sounds deceptively simple when one considers the complex of attributes necessary to transform information into economic value. Indeed, the debate about whether the introduction of technology would upgrade or "deskill" the workforce is as old as Adam Smith. Certainly, one can point to some very routine types of jobs, such as those for telephone operators, that have lower skill requirements in today's world of automated communications systems than when more labor-intensive manual phone systems were in place. But, on the whole, the evidence suggests that across a wide range of industries, employers have upgraded their skill mix2. Importantly, these changes represent not simply a shift in the occupational mix, but, to a larger degree, an upgrading of skill requirements of individual jobs for which the range and complexity of tasks and the scope for problem-solving and decision-making has expanded. This process appears to have occurred more rapidly in those businesses with greater computer utilization3. However, this is not to argue that growing use of technology alone can explain the accelerated demand for more skilled workers. A 1994 survey of employers conducted by the Census Bureau for the National Center on the Educational Quality of the Workforce found that rising skill requirements also are more common in firms that have introduced more flexible production systems, adopted team management practices, or reduced the layers of management in the organization. More generally, at the root of both the rise in the demand for workers who embody greater human capital and the increasing application of technology is the realization by businesses that remaining competitive in today's world requires unprecedented flexibility to adapt to change. Traditionally, broader human capital skills have been associated with higher education, and, accordingly, the demand for college-trained workers has been increasing rapidly. The result is that, over the past 15 years, a wide gap has opened up between the earnings of college graduates and those of workers who stopped their formal schooling with a high-school diploma or less. But the dispersion of pay outcomes has also increased within groups of workers with the same levels of education, which suggests that broader cognitive skills and conceptual abilities have become increasingly important on a wide scale, and that basic credentials, by themselves, are not enough to ensure success in the workplace. Clearly our educational institutions will continue to play an important role in preparing workers to meet these demands. And, responding to the strong signals that the returns to formal education have been rising, the supply of college-trained labor has been increasing. School enrollment rates among traditional college-age young people, which were little changed in the 1970s, have moved up sharply since then. At the same time, enrollment rates have picked up noticeably among individuals aged 25 and over. Presumably, many of these older students are striving to keep pace with the new demands evolving in the job market. Indeed, an important aspect of the changing nature of jobs appears to be that an increasing number of workers are facing the likelihood that they will need retooling during their careers. The notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. As a result, education is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits have begun to recognize that maintaining their human capital will require persistent hard work and flexibility. Economists have long argued that more than half of the market human capital produced in a worker's lifetime is produced on the job4. Several decades ago, much of that on-the-job training was acquired through work experience; today we are seeing greater emphasis on the value of formal education and training programs for workers. Developing human capital is perceived by many corporations as adding to shareholder value. If idea creation is increasingly the factor that engenders value-added, then training and education are crucial to the growth of company value-added and profitability. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics and by the Department of Education indicate that the provision of education on the job has risen markedly in recent years. In 1995, the BLS report showed that 70 percent of workers in establishments with 50 or more employees received some formal training during the twelve months preceding the survey. Most often this training was conducted in house by company personnel, but larger firms also relied to a great extent on educational institutions. The information collected by the Department of Education indicated that the percentage of employed individuals who took courses specifically to improve their current job skills rose between 1991 and 1995; by 1995, four of every ten full-time workers aged 35 to 54 had sought to upgrade their skills. The survey shows that growing proportions of workers with a high-school education or less and of those in production and craft jobs sought additional training; however, college graduates and those in professional occupations still reported the highest incidence of additional coursework -- almost 50 percent. Thus, learning does seem to beget perhaps both a capacity as well as a desire for more learning. This finding should underscore the need to begin the learning process as early as possible. In the long run, better child-rearing and better basic education at the elementary and secondary school levels are essential to providing the foundation for a lifetime of learning. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. We must also develop strategies to overcome the education deficiencies of all too many of our young people and to renew the skills of workers who have not kept up with the changing demands of the workplace. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in schools and in the workplace. Expanded linkages between business and education should be encouraged at all levels of our education system. Building bridges between our educational institutions and the private business sector should have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy. Indeed, a recent study argues that we need not rely on colleges and universities to teach "the new basic skills" to prepare workers for jobs in a knowledge-based economy; that foundation could be built in high schools if only more high schools were to ensure that graduates left with not only essential basic reading and computational skills, but also with training in how to solve semi-structured problems, how to make oral presentations, and how to work in diverse groups5. Those researchers argue for a better connection between secondary school curricula and business needs -- "vocational education" in a very broad sense rather than the traditional narrow one. While many debate how to make our elementary and secondary schools more effective in preparing students -- particularly compared with those in other developed countries -- there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. The payoff to advanced training remains high, and even with higher rates of enrollment, the supply of college-trained labor does not appear likely to outstrip the growing demands of a rapidly changing economy. The linkages between the private sector and our colleges and universities have a long tradition, and many schools are endeavoring to extend those connections. Your university's plans for the Connecticut Information Technology Institute embodies this reality. You and your partners in the business community clearly appreciate the mutual benefits that will accrue as technologically advanced learning is grounded in real-world curricula -- beginning with students and continuing for workers seeking to renew their skills. The advent of the twenty-first century will certainly bring new challenges and new possibilities for our businesses, our workers, and our educational system. We cannot know the precise directions in which technological change will take us. As in the past, our economic institutions and our workforce will strive to adjust, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. However, if we are able to boost our investment in people, ideas, and processes as well as in machines, the economy can readily adapt to change, and support ever-rising standards of living.	['mr. greenspan inaugurates a series of economic seminars remarks by the chairman of the board of the us federal reserve system, mr. alan greenspan, at the university of connecticut, storrs, connecticut on 14/10/97.', 'i welcome the opportunity to inaugurate your economic seminar series because i believe that the education community has a crucial role to play in the current era of rapid economic change.', "our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead.", 'our success in preparing workers and managers to harness those forces will be an important element in the outcome.', 'one of the most central dynamic forces is the accelerated expansion of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century.', 'in the short run, however, fast-paced technological change creates an environment in which the stock of plant and equipment with which most managers and workers interact is turning over more rapidly, creating a perception that human skills are becoming obsolete at a rate perhaps unprecedented in american history.', 'i shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, i hope, to explain why education, especially to enhance advanced skills, is so vital to the future growth of our economy.', 'wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value.', 'assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value.', 'more specifically, they seek the added value that customers place on products and services tailored to their particular needs, delivered in shorter time frames, or improved in quality.', 'a century ago, much, if not most, of our effort was expended in producing food, clothing, and shelter.', 'only when crop yields increased, steam power was developed, and textile fabrication became more efficient were available work hours freed for the production and consumption of more discretionary goods and services.', 'we manufactured cars and refrigerators and learned how to produce them with ever less human effort.', 'as those products found their way into most homes, human effort moved on to the creation of values that were less constrained by limits of physical bulk, such as smaller, transistor-based electronics, and beyond to a wide variety of impalpable services -- medical care, education, entertainment, and travel, to name just a few.', 'the demand for a virtually infinite array of impalpable values is, to a first approximation, insatiable.', "understandably, today's efforts to create new values for consumers concentrates on these impalpables, which offer the highest potential value-added relative to costs in physical resources and human effort.", 'unbundling the particular characteristics of each good or service facilitates maximizing its value to each individual.', 'some individuals place more value on, and are willing to pay more for, style y rather than style x, whereas others prefer x. producing both x and y enhances overall consumer well-being.', 'fifty years ago, only x was feasible.', 'this striving to expand the options for satisfying the particular needs of individuals inevitably results in a shift toward value created through the exploitation of ideas and concepts -- or, more generally, information -- from the more straightforward utilization of physical resources and manual labor.', "thus, it should come as no surprise that, over the past century, by far the largest part of the growth in america's real gross domestic product is the result of new insights and, more broadly, new information about how to rearrange physical reality to achieve ever-higher standards of living.", 'the amount of physical input into our real gdp, measured in bulk or weight, has contributed only modestly to economic growth since the turn of the century.', 'we have, for example, dramatically reduced the physical bulk of our radios, by substituting transistors for vacuum tubes.', 'thin fiber optic cable has replaced huge tonnages of copper wire.', 'new architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same amount of space, but with far less physical material than was required, say, 50 or 100 years ago.', 'most recently, mobile phones have become significantly downsized as they have been improved.', 'as it became technologically possible to differentiate output to meet the increasingly calibrated choices that consumers now regularly make, the value of information creation and its transfer was expanded.', 'hence, it is understandable that our advanced computer and telecommunications products have been accorded particularly high value and, thus, why computer and telecommunications companies that successfully innovate in this field exhibit particularly elevated stock market values.', 'breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output.', 'these developments are affecting how we produce output and are demanding greater specialized knowledge.', 'we could expect the widespread and effective application of information and other technologies to significantly increase productivity and reduce business costs.', 'certainly, we can already see dramatic improvements in quality control that have sharply reduced costly product rejects and lost time, while computer and satellite technology has markedly improved the efficiencies of moving goods through even more sophisticated, just-in-time, inventory systems.', 'with computer-assisted design, experiments can be evaluated in a virtual reality setting, where mistakes can be readily corrected without the misuse of time and materials.', 'and new technologies have had extensive applications in the services sector -- for example, in health services, where improvements in both diagnosis and treatment have been singularly impressive; in airline efficiency and safety; and in secretarial services now dominated by word processing, faxes, and voice and electronic mail.', 'the accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks.', 'financial instruments have become increasingly diverse, products more customized, and markets more intensely competitive.', 'the scope and size of our financial sector has grown rapidly because of its ability to facilitate the financing of products and services that are themselves valued highly in the marketplace.', "our nation's financial institutions, as a consequence, are endeavoring to find more effective and efficient ways to deliver their services.", "in this environment, america's prospects for economic growth will depend greatly on our capacity to develop and to apply new technology.", 'unfortunately, we have found that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and our ability to gain from that knowledge.', 'for instance, alexander graham bell initially viewed the telephone solely as a business instrument -- merely an enhancement of the telegraph for use in transmitting very specific messages.', 'indeed, he offered to sell his telephone patent to western union for only $100,000, but he was turned down.', "similarly, marconi, at first, overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible.", "moreover, we must recognize that an innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science.", 'according to charles townes, a nobel prize winner for his work on the laser, the attorneys for bell labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications.', "only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent.", "america's continued success in garnering the benefits of technological advance will depend on the ability of our businesses to deal with risk and uncertainty.", 'moreover, our ability to remain in the forefront of new ideas and products will be ever more difficult because of the rapid international diffusion of technology.', 'nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products.', 'even if the most recent, tentative indications that productivity growth may be speeding up were to turn out to be less than we had hoped, it is possible that the big increases in efficiency growing out of the introduction of computers and communications systems may still lie ahead.', 'past innovations, such as the advent of electricity or the invention of the gasoline-powered motor, required the development of considerable infrastructure before their full potential could be realized.', 'electricity, when it substituted for steam power late last century, was applied to production processes that had been developed for steam.', 'for example, gravity was used to move goods vertically in the steam environment, and that setup did not initially change with the advent of electric power.', 'only much later -- when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system -- did productivity clearly accelerate.', 'similarly, only when highways and gasoline service stations became extensive was the lower cost of motor vehicle transportation achieved.', 'in addition, full effectiveness in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring.', 'the growth of the conceptual component of output has brought with it accelerating demands for workers who are equipped not simply with technical know-how, but with the ability to create, analyze, and transform information and to interact effectively with others.', 'a popular term for the type of human capital that firms are today employing to a greater degree is "functional literacy,"1 which perhaps sounds deceptively simple when one considers the complex of attributes necessary to transform information into economic value.', 'indeed, the debate about whether the introduction of technology would upgrade or "deskill" the workforce is as old as adam smith.', "certainly, one can point to some very routine types of jobs, such as those for telephone operators, that have lower skill requirements in today's world of automated communications systems than when more labor-intensive manual phone systems were in place.", 'but, on the whole, the evidence suggests that across a wide range of industries, employers have upgraded their skill mix2.', 'importantly, these changes represent not simply a shift in the occupational mix, but, to a larger degree, an upgrading of skill requirements of individual jobs for which the range and complexity of tasks and the scope for problem-solving and decision-making has expanded.', 'this process appears to have occurred more rapidly in those businesses with greater computer utilization3.', 'however, this is not to argue that growing use of technology alone can explain the accelerated demand for more skilled workers.', 'a 1994 survey of employers conducted by the census bureau for the national center on the educational quality of the workforce found that rising skill requirements also are more common in firms that have introduced more flexible production systems, adopted team management practices, or reduced the layers of management in the organization.', "more generally, at the root of both the rise in the demand for workers who embody greater human capital and the increasing application of technology is the realization by businesses that remaining competitive in today's world requires unprecedented flexibility to adapt to change.", 'traditionally, broader human capital skills have been associated with higher education, and, accordingly, the demand for college-trained workers has been increasing rapidly.', 'the result is that, over the past 15 years, a wide gap has opened up between the earnings of college graduates and those of workers who stopped their formal schooling with a high-school diploma or less.', 'but the dispersion of pay outcomes has also increased within groups of workers with the same levels of education, which suggests that broader cognitive skills and conceptual abilities have become increasingly important on a wide scale, and that basic credentials, by themselves, are not enough to ensure success in the workplace.', 'clearly our educational institutions will continue to play an important role in preparing workers to meet these demands.', 'and, responding to the strong signals that the returns to formal education have been rising, the supply of college-trained labor has been increasing.', 'school enrollment rates among traditional college-age young people, which were little changed in the 1970s, have moved up sharply since then.', 'at the same time, enrollment rates have picked up noticeably among individuals aged 25 and over.', 'presumably, many of these older students are striving to keep pace with the new demands evolving in the job market.', 'indeed, an important aspect of the changing nature of jobs appears to be that an increasing number of workers are facing the likelihood that they will need retooling during their careers.', "the notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged.", 'as a result, education is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits have begun to recognize that maintaining their human capital will require persistent hard work and flexibility.', "economists have long argued that more than half of the market human capital produced in a worker's lifetime is produced on the job4.", 'several decades ago, much of that on-the-job training was acquired through work experience; today we are seeing greater emphasis on the value of formal education and training programs for workers.', 'developing human capital is perceived by many corporations as adding to shareholder value.', 'if idea creation is increasingly the factor that engenders value-added, then training and education are crucial to the growth of company value-added and profitability.', 'in the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities.', 'some labor unions have done the same.', 'more broadly, recent surveys by the bureau of labor statistics and by the department of education indicate that the provision of education on the job has risen markedly in recent years.', 'in 1995, the bls report showed that 70 percent of workers in establishments with 50 or more employees received some formal training during the twelve months preceding the survey.', 'most often this training was conducted in house by company personnel, but larger firms also relied to a great extent on educational institutions.', 'the information collected by the department of education indicated that the percentage of employed individuals who took courses specifically to improve their current job skills rose between 1991 and 1995; by 1995, four of every ten full-time workers aged 35 to 54 had sought to upgrade their skills.', 'the survey shows that growing proportions of workers with a high-school education or less and of those in production and craft jobs sought additional training; however, college graduates and those in professional occupations still reported the highest incidence of additional coursework -- almost 50 percent.', 'thus, learning does seem to beget perhaps both a capacity as well as a desire for more learning.', 'this finding should underscore the need to begin the learning process as early as possible.', 'in the long run, better child-rearing and better basic education at the elementary and secondary school levels are essential to providing the foundation for a lifetime of learning.', 'at the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind.', 'we must also develop strategies to overcome the education deficiencies of all too many of our young people and to renew the skills of workers who have not kept up with the changing demands of the workplace.', 'the recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in schools and in the workplace.', 'expanded linkages between business and education should be encouraged at all levels of our education system.', 'building bridges between our educational institutions and the private business sector should have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy.', 'indeed, a recent study argues that we need not rely on colleges and universities to teach "the new basic skills" to prepare workers for jobs in a knowledge-based economy; that foundation could be built in high schools if only more high schools were to ensure that graduates left with not only essential basic reading and computational skills, but also with training in how to solve semi-structured problems, how to make oral presentations, and how to work in diverse groups5.', 'those researchers argue for a better connection between secondary school curricula and business needs -- "vocational education" in a very broad sense rather than the traditional narrow one.', 'while many debate how to make our elementary and secondary schools more effective in preparing students -- particularly compared with those in other developed countries -- there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad.', 'the payoff to advanced training remains high, and even with higher rates of enrollment, the supply of college-trained labor does not appear likely to outstrip the growing demands of a rapidly changing economy.', 'the linkages between the private sector and our colleges and universities have a long tradition, and many schools are endeavoring to extend those connections.', "your university's plans for the connecticut information technology institute embodies this reality.", 'you and your partners in the business community clearly appreciate the mutual benefits that will accrue as technologically advanced learning is grounded in real-world curricula -- beginning with students and continuing for workers seeking to renew their skills.', 'the advent of the twenty-first century will certainly bring new challenges and new possibilities for our businesses, our workers, and our educational system.', 'we cannot know the precise directions in which technological change will take us.', 'as in the past, our economic institutions and our workforce will strive to adjust, but we must recognize that adjustment is not automatic.', 'all shifts in the structure of the economy naturally create frictions and human stress, at least temporarily.', 'however, if we are able to boost our investment in people, ideas, and processes as well as in machines, the economy can readily adapt to change, and support ever-rising standards of living.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman	US
https://www.bis.org/review/r971021c.pdf	Mr. Meyer focuses on the effect of globalization on the conduct of US monetary policy (Central Bank Articles and Speeches, 14 Oct 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Institute for Global Management and Research, School of Business and Public Management, The George Washington University, Washington, D.C., on 14/10/97.	1997-10-14 00:00:00	Mr. Meyer focuses on the effect of globalization on the conduct of US monetary policy Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Institute for Global Management and Research, School of Business and Public Management, The George Washington University, Washington, D.C., on 14/10/97. World trade has increased much faster than world output over the last 30 years and international capital flows have expanded at a still more rapid pace. As a result, forecasting and modeling the national economic developments and the conduct of domestic policy has increasingly required more careful attention to the global context. My focus is on how globalization has affected the conduct of U.S. monetary policy. I begin by documenting the trend toward increased openness of the U.S. economy. With that background in place, I turn to the implications of increased openness for the conduct of U.S. monetary policy. The views I present here about the conduct of monetary policy are my own. They should not be interpreted as official policy positions of the Board of Governors or the FOMC. Some of the questions that I address along the way are: Does an open economy introduce either new objectives or new instruments for monetary policy? How does an open economy affect the monetary policy transmission mechanism? Does the rapid growth in cross-border capital flows limit or even eliminate the ability of domestic monetary policy to affect domestic interest rates? How does U.S. monetary policy affect economic conditions in other countries? How does globalization affect the cyclical properties of the U.S. economy, the inflation process, and longer-term trends in the economy? My conclusion is that, while the increasing openness has resulted in some important changes to how the U.S. economy operates, it has not fundamentally altered the determination of output and inflation, introduced new objectives of monetary policy, or offered new instruments to pursue those objectives. Nevertheless, it has importantly affected the monetary policy transmission mechanism and increasingly subjected the domestic economy to the effects of changes in economic conditions abroad. Documenting the trend toward increased openness of the U.S. economy The increased openness has two dimensions -- expanded trade in goods and services and expanded cross-border capital flows. A related indicator of openness is the volume of foreign exchange transactions, since both goods and financial asset transactions typically are preceded by currency conversions. U.S. trade in goods and services has increased about twice as fast as the growth in U.S. GDP over the last 31⁄2 decades. This reflects the effect of both trade liberalization and technological advance, as well as the rapid growth of emerging markets recently. Trade liberalization -- including both a series of multi-lateral efforts through GATT and regional efforts such as NAFTA -- has involved both reduction in tariffs and the elimination of many non-tariff barriers to trade. Technological gains have reduced transportation costs and improved the flow of information about goods around the world. A measure of the openness of the U.S. economy in terms of trade in goods and services is the ratio of the sum of U.S. imports and exports to U.S. GDP. This ratio has almost tripled over the last 31⁄2 decades, from 9% in 1960 to 24% in 1996. Even more striking is the expansion of international capital flows. Financial liberalization, deregulation, and technology, including the information revolution, have contributed to the globalization of asset markets. A measure of the net result of cross-border capital flows, the combined U.S. holdings of foreign securities and foreign holdings of U.S. securities, has increased more than tenfold just from 1980 to 1996. Foreigners now hold 33% of U.S. government securities, 17% of U.S. corporate bonds, and 7% of U.S. corporate stocks. U.S. holdings of foreign securities have also increased. Foreign stocks now make up about 10% of U.S. residents' equity holdings and foreign bonds make up about 4% of U.S. bond holdings. While the increase in cross-border capital flows is impressive, it is nevertheless clear that "home bias," the concentration of domestic wealth in domestic assets, still exists. Another indicator of the increased openness of the U.S. and other economies is the volume of foreign exchange transactions, since these transactions are often the first step in effecting both foreign trade and cross-border capital flows. The daily volume of foreign exchange transactions surveyed in major financial centers doubled over the period from 1989 to 1995 to about $1.2 trillion, and more than four-fifths of these transactions involve dollars. The daily volume of foreign exchange transactions, however, is an imperfect measure of openness of the U.S. economy, because many transactions among other countries involve dollars. Monetary policy in a global economy: responding to external shocks One implication of a global economy is that external shocks, those arising from outside the country, become an additional source of disturbance to the U.S. economy and therefore an additional challenge to which monetary policy must respond. I will consider three types of external shocks: demand, supply, and exchange rate shocks. An example of a demand shock would be an unexpected change in the overall level of economic activity abroad, which would affect the demand for U.S. exports. For example, in the early 1970s, the latter 1970s, and late 1980s, global expansions and the resulting sharp increase in world commodity prices and demand for U.S. exports contributed to the mounting inflationary pressures and overheating in the United States. In the three episodes just noted, commodity price booms were exacerbated by a run-up in oil prices resulting from the disruption of supplies from the Middle East. In the mid-1980s, oil prices plummeted, contributing to a transitory decline in inflation and easing of monetary conditions. Such changes in world oil prices are an example of a supply shock, a change in the price of goods unrelated to the balance between supply and demand in the domestic market. Energy and food prices, in particular, are subject to volatile swings, due to political decisions, weather, or other developments unrelated to overall domestic economic conditions. The United States is vulnerable to oil price shocks both because we have a very high consumption of oil and because we import about 50% of crude petroleum. The rise in oil prices not only has a sharp effect on overall prices in the United States, but, given the relatively inelastic demand for energy, results in an increase in real imports and hence a decline in aggregate demand for domestic output. Even much smaller shocks have had clearly visible effects on the U.S. economy, including the $5 dollar a barrel increase over 1996 and the $5 decline over 1997. Exchange rates move in response to both domestic and foreign economic developments and at times appear to move for reasons not clearly linked to economic fundamentals. The movements that are tied to changes in domestic economic fundamentals are part of the process of income and price determination in open economies, and I will have something to say about this below. But movements related to developments abroad or movements not clearly tied to economic fundamentals are another source of shock to national economies. This is especially important because the empirical linkages between exchange rates and fundamentals are weak, or not as well understood as we might like, so that movements in exchange rates often appear to be exaggerated relative to or seemingly unrelated to changes in fundamentals. Do cross-border capital flows reduce the effectiveness of monetary policy? One of the dimensions of increased openness is the rapid increase in the volume of cross-border capital flows. If foreign and domestic securities are perfect substitutes, the liberalization of cross-border financial transactions could, in principle, result in a single world financial market. This might appear to imply that the interest rate at which citizens and governments of a nation could borrow and lend would then be set on world markets, with little or at least limited influence by national policymakers. A small country, for example, would have no ability to influence world interest rates in this case. A very large country, such as the U.S., would retain some influence, but the influence would be diminished relative to the closed-economy case and would result from its ability to affect the world interest rate. If a country's exchange rate is pegged to the currency of another country (or countries), then its interest rates will move closely in line with those in the country or group of countries to which it is pegged. But for countries with flexible exchange rates, domestic interest rates can move quite independently of interest rates abroad. However, if countries care about the level of their exchange rates, which have implications for aggregate demand and inflation, and adjust monetary policy accordingly, interest rates will, to a degree, move in common across countries. Greater integration of global capital markets does in fact mean that expected returns for holding different assets, with appropriate compensation for differences in risk, should increasingly converge. However, as long as exchange rates can adjust, this does not imply that interest rates across countries must move together. Instead, it is movements in exchange rates which insure convergence of holding period yields across the countries. Before turning to the connection between interest rates and exchange rates, let me note that the evidence does not confirm an increase in correlations in interest rate movements across world asset markets, at least in the 1990s compared to the 1980s. It is true that the levels of long-term interest rates in major industrial countries have tended to converge since the early 1980s. But this is largely accounted for by a convergence of inflation rates. On the other hand, there is little evidence to suggest that correlations between changes in long-term interest rates across these countries have increased over this period. These correlations are a little higher in the 1980s and 1990s than they were in the 1970s, but again have shown no tendency to increase since the early 1980s. At any rate, the correlations between U.S. interest rates and those of major industrial countries suggest that there remains ample room for real interest rates to move differently across the world financial markets and implies that domestic monetary policies remain important tools of macroeconomic policy, at least in countries with flexible exchange rates. While the correlations among changes in interest rates have not increased, changes in interest rates between the U.S. and major industrial counties are correlated. Correlations tend to be about 0.5. This leaves open the question of causality and source of the correlations. It does not mean that higher U.S. interest rates directly raise foreign interest rates by this amount. First, some of the co-movement could reflect synchronous business cycles. Second, some of the co-movement could reflect the spillover effects of a cycle in one country on aggregate demand and hence interest rates in the other countries. In addition, some of the correlation may reflect the effect of the response of monetary policy to exchange rate developments. Perhaps reflecting the latter influence, the correlation between interest rates in the United States and Canada is higher, about 0.8, while that between the United States and Europe is lower, about 0.4. The transmission mechanism in a open economy While cross-border capital flows do not interfere with the ability of U.S. monetary policy to influence the broad spectrum of interest rates in the United States, they do quickly transmit pressures from changes in U.S. interest rates to the exchange rate and thereby broaden the channels through which monetary policy affects aggregate demand. In the closed economy setting, the transmission mechanism runs from increases in the federal funds rate, the short-term interest rate targeted by monetary policy, first to longer-term interest rates and equity prices and then to aggregate demand. Several components of aggregate demand depend importantly on interest rates, particularly longer-term interest rates (specifically, business fixed investment, housing, spending on consumer durables); consumer spending also depends on the net wealth of households and is therefore affected by equity prices. Under floating exchange rates, net exports become another interest-sensitive component of aggregate demand. Higher U.S. (real) interest rates, relative to foreign rates, raise the demand for dollar-denominated assets, and bring about an appreciation of the dollar which, in turn, stimulates imports and restrains exports. Net exports as a result become inversely related to U.S. interest rates. Evidence suggests that the response of net exports to interest rates (via exchange rates) has become larger over time. The open economy version of the monetary policy transmission mechanism involves three steps: from U.S. interest rates to nominal exchange rates; from nominal exchange rates to the absolute and relative prices of imports and exports; and from the prices of imports and exports to the real volumes of imports and exports and domestic prices. From U.S. interest rates to the exchange rate We begin with the link between interest rates in the U.S. and exchange rates. A policy-initiated increase in U.S. short-term rates would, as noted above, generally result in higher U.S. long-term interest rates. At initial levels of foreign interest rates and equity prices, the movement in U.S. rates would make dollar-denominated assets more attractive compared to foreign currency-denominated assets, resulting in shifts in asset demands and either incipient or actual cross-border capital inflows to the U.S. and outflows from foreign economies. These shifts result in an appreciation of the dollar. Indeed, the single most important determinant of short-term movements in exchange rates is the change in real interest rate differentials across countries. A 1% point increase in U.S. long-term (10-year) interest rates, with unchanged foreign rates, will typically induce a 10% increase in the U.S. trade-weighted exchange rate. After the initial jump in the dollar, there will be an expectation of a decline in the dollar by about 1% each year for the next 10 years. The result of the rise in the dollar and the expectations of gradual reversal is what is referred to as international interest rate parity. The holding period yields of U.S. and foreign assets, each denominated in their home currency, are thereby equated, eliminating the incentive for further changes in asset demands or capital flows. That is, the higher interest rate yield on U.S. assets (measured in dollars) is just offset by the expected depreciation in the value of the asset, measured in the foreign currency. This is the mechanism by which holding period yields are equated across countries via international capital flows. By the end of the 10-year period, according to this framework, both interest rates and exchange rate would have returned to their original levels. Evidence suggests that the response of the exchange rate to changes in U.S. interest rates (relative to foreign rates) has increased over time. This likely reflects the removal of capital controls by many major industrial countries during the 1970s and early 1980s that in turn contributed the sharp rise in international capital flows documented above. So, increased integration of financial markets across countries appears to have had a more important effect in raising the responsiveness of exchange rates to interest rate developments than in directly connecting interest rates across countries. From the exchange rate to the relative prices of imports and exports The next step in the transmission mechanism is the pass-through of the exchange rate to the dollar prices of imports and the foreign currency price of U.S. exports. The evidence suggests that the pass-through is much more complete for U.S. exports than for imports, but there is no evidence that these pass-throughs have changed over time. An appreciation of the dollar will be gradually partially passed through over time to the price of imports, lowering their price relative to U.S. produced goods. The corresponding depreciation in other countries' currencies will result in a gradual increase in the foreign currency price of U.S. exports, compared to the prices of foreign produced goods. The result is movements in relative prices that encourage imports and discourage exports. From relative prices to real import and export volumes The final step in the process is from the relative price of imports and exports to the volumes of real imports and exports. This depends on the elasticity of the demands for imports and exports with respect to their relative prices and the size of trade flows relative to GDP. The elasticities of imports and exports with respect to their respective relative prices are estimated to be about unity, and there is no evidence of a shift in this elasticity over the past several decades. A one percentage point increase in the real exchange rate would increase real imports by one percentage point over a three-year period and decrease real exports by a similar percentage. The absolute effect on aggregate demand also depends on initial levels of imports and exports. As import and export volumes have been increasing rapidly, the absolute effect of exchange rate changes on aggregate demand and the contribution of the exchange rate channel to the monetary transmission mechanism has been growing over time. Trends in interest sensitivity If the magnitude of other channels in the transmission mechanism remained unchanged, the growing importance of imports and exports and the increase in the responsiveness of exchange rates to interest rate differentials would have raised the overall responsiveness of aggregate demand to interest rates. However, it appears that the interest sensitivity of residential construction has moderated over time, beginning with the repeal of Regulation Q, and continuing with innovations in housing finance, including adjustable rate mortgages, the broadening of the sources of mortgage lending, and the development of securitization and secondary markets for mortgages. The net result is that the interest responsiveness of aggregate demand appears to have remained reasonably stable over time, although the sectoral distribution of the overall effect of interest rates has shifted toward net exports and away from housing. The response of net exports to changes in U.S. interest rates, via exchange rates, contributes about one-third of the total interest sensitivity of U.S. aggregate demand over both a one-year and three-year interval. It is therefore a very important part of the monetary policy transmission mechanism. How does U.S. monetary policy affect other countries? Just as developments abroad affect the U.S. economy, changes in U.S. economic conditions impact on foreign economies, although the effects are not necessarily symmetric. Because of the large relative size of the U.S. economy, changes in U.S. economic conditions have relatively larger effects on foreign economies, compared to the effect of changing conditions in any one country abroad on the U.S. economy. A change in U.S. monetary policy affects foreign economies in three ways -- via exchange rates, interest rates, and income in the United States. The effects depend critically on the nature of the foreign exchange regime in the foreign country. If the foreign country's currency is pegged to the dollar, for example, there will, of course, be no exchange rate effect vis-à-vis the United States. An increase in U.S. interest rates, however, would put downward pressure on the foreign currency and require the country to raise domestic interest rates to maintain the fixed exchange rate. Therefore, foreign interest rates are very likely to have to rise with U.S. rates in this case. The restraining effect of the rise in foreign interest rates will be reinforced by the effect of the deceleration in U.S. demand for foreign goods induced by the slowdown in U.S. income. As a result, a tightening of monetary policy is likely to have an unambiguously restrictive impact on those countries whose exchange rates are pegged to the dollar. For countries with floating exchange rates, on the other hand, the exchange rate and income effects of rising U.S. interest rates are likely to be offsetting. The appreciation of the dollar, of course, implies a depreciation in other countries' exchange rates; the depreciation will stimulate foreign aggregate demand by raising net exports. Offsetting this will be the effect of the decline in U.S. income on the demand for foreign countries' exports. The net effect, for countries with floating exchange rates, is likely to be small. That is, floating exchange rates tend to insulate a country from monetary shocks abroad. Other effects of globalization on the U.S. economy The increased openness of the U.S. economy has also focused attention on the possible effects of globalization on the macroeconomic performance of the U.S. economy, beyond the effects on the transmission of monetary policy that I have already addressed. I want to focus my attention in this section on the implications of globalization for wage-price dynamics because this has a direct bearing on the conduct of monetary policy. Some have argued that increased global competition has made the United States (and presumably other countries) less inflation prone, so that the U.S. economy can operate at a higher degree of resource utilization without the threat of rising inflation. It is useful to distinguish three ways in which global developments might recently be contributing to restraining inflation in the United States. First, the significant appreciation of the dollar over the last two years has clearly had an important restraining effect on U.S. inflation, both via the direct effect on the prices of imported goods and on the pricing power of domestic firms producing import-competing goods. Second, the absence of synchronous expansions among the major industrial countries -- specifically the much weaker expansions in continental Europe and the still weaker condition of the Japanese economy -- has prevented the pressures on worldwide commodity markets that often accompany U.S. expansions and has perhaps also encouraged greater price competitiveness than would otherwise have been the case. Third, increased international competitive pressures, associated with growing openness of the U.S. economy, might be restraining inflation. But I wonder whether we would be talking about the contribution of globalization to U.S. inflation performance if the dollar had been stable for the last several years and the expansions in Europe and Japan were as robust as in the U.S. I doubt it. Are there additional objectives for monetary policy in a global environment? An interesting question is whether the increased openness of the U.S. and other economies suggests new objectives for domestic monetary policies. It is certainly true that increased globalization has encouraged a proliferation of information-sharing exercises around the world and some increased attention to the coordination of policies across countries. I will comment on this briefly below. Let's start with objectives appropriate in the closed economy context. Congress has set dual objectives for monetary policy in the Federal Reserve Act: price stability and full employment. These objectives relate directly to the performance of the domestic economy and they are also objectives that monetary policy has the ability to pursue in the closed economy setting. The first question is whether the open economy environment reduces the ability of domestic monetary policy to achieve these objectives. I have argued that globalization has not reduced the ability of countries with flexible exchange rates to carry out independent monetary policies and therefore pursue domestic objectives. On the other hand, countries that fix exchange rates do give up much of the independence in their domestic monetary policies. The second issue is whether the open economy setting introduces new objectives, beyond those that motivate policy in the closed economy context. Three possibilities come to mind: the current account and/or trade balance, the exchange rate (or pattern in exchange rates around the world), and economic performance abroad. Even thinking of the external measures as domestic objectives raises questions. With respect to the current account, we should begin by separating cyclical and structural movements. Cyclical movements in net exports contribute the economy's built-in stability and are therefore quite desirable. Changes in the structural current account balance may contribute to or interfere with broader domestic objectives, depending on circumstances. The fundamental source of a structural current account deficit is domestic spending in excess of domestic production. Is this good or bad? The answer is: it depends. An excess of spending over production used to finance business fixed investment could have a payoff in terms of higher future output large enough to service the increased international indebtedness and still leave the country better off. An increase in the current account deficit as a result of increased private or public consumption would, in contrast, require lower future consumption as some of future production would have to be used to service the higher level of foreign debt. In addition, there is an issue of sustainability. International indebtedness can become so large in relation to current production, depending in part on the relationship between the real interest rate on foreign debt and the economy's trend rate of growth, that the current account deficit could increase explosively. If the current account is an objective, durable changes in the structural deficit can only be achieved by fiscal policy. A cut in the structural federal budget deficit for example would increase national saving, lower real interest rates, lead to a depreciation of the dollar, boost net exports, and lower the current account deficit. It is even more difficult to talk about the exchange rate as an objective. The exchange rate is, after all, basically a relative price. We might say that we prefer that an exchange rate that reflect fundamentals. But other than that the exchange rate is a symptom, rather than an outcome. If the current account deficit is wide because of a high dollar, the appropriate question is why is the dollar so high. If the answer is because the federal budget structural deficit is high and has raised real interest rates in the U.S., the offender is not the exchange rate, but the federal budget deficit. If the problem with exchange rates is fundamentals, then it is the fundamentals that need to be changed. Monetary policy can, via its effect on interest rates, influence exchange rates in the short run. But, for monetary policy to target exchange rates, it must give reduced weight to its domestic objectives. When fundamentals are the issue, it is the mix of monetary and fiscal policies that must answer the call. Stabilization policy, for example, calls for a level of aggregate demand consistent with full employment. That level of aggregate demand can be produced by a variety of combinations of monetary and fiscal policies, varying from a very tight fiscal and loose monetary policy to a tight monetary and loose fiscal policy. The difference among these options is interest rates. If fiscal policy, for example, moves to a higher deficit, monetary policy will have to offset the effect on aggregate demand by tightening. The result is higher interest rate, a higher dollar, and ultimately a wider current account deficit. If this outcome is viewed as undesirable, the way to unwind it is by lowering the deficit, accompanied by more accommodative monetary policy. It takes two to do this tango! But I always view fiscal policy as having the first move. Monetary policy's job is to follow the lead of fiscal, so that the resulting mix is appropriate to the requirements of stabilization policy. I am occasionally asked whether I worry about the effect on other countries of changes in U.S. monetary policy. While I do keep in mind the potential international repercussions of U.S. monetary policy actions, I believe that the best way for the U.S. to contribute to the health of the world economy is to pursue prudent domestic policy and achieve maximum sustainable employment and price stability and accommodate the maximum sustainable growth in the U.S. economy. Are there new policy instruments in a global economy? Another question about the conduct of monetary policy in an open economy is whether the open economy offers monetary policy a new instrument that it did not have in the closed economy world. In a closed economy context, monetary policy has a single instrument: open market operations, used to target a short-term interest rate. The obvious candidate for an additional instrument in the open economy case is the exchange rate. I have already argued that monetary policy cannot be used to target the exchange rate. The issue here is whether there are opportunities to exercise direct control of the exchange rate. The obvious option is intervention. Intervention refers to a government buying or selling foreign currency in order to influence the exchange rate. One can identify two reasons for intervening. The first is to calm disorderly markets. That is, an increase in volatility in the foreign exchange market might be damped by intervention. However, most intervention is about affecting the level of the exchange rate, not its volatility, though the rhetoric of disorderly markets often is employed to justify the action. Actions to affect the level can be intended to prevent a further decline (or increase) or to encourage a change in the level. With a daily volume of $1.2 trillion in the foreign exchange markets, and underlying stocks of financial assets that are substantially larger, there is ground for skepticism that intervention, which seldom ranges into the billions of dollars in daily volume, can have more than a marginal and transitory effect. Still, there are examples of modest "successes," especially when intervention is coordinated across countries and well timed. The major opportunity for intervention to succeed is when the exchange rate has diverged to a significant degree from fundamentals and the intervention induces a reconsideration of the market or a refocus of the market on fundamentals. The management of foreign exchange interventions varies around the world. In the United States, this management is shared by the Federal Reserve System and the Treasury Department. In principle, intervention can be initiated by either party, although when the Treasury opts to intervene it is the Federal Reserve Bank of New York that actually does the buying or selling of foreign currency, albeit from an account held in the name of Treasury and at the direction of Treasury. Similarly, when the FOMC makes a decision to intervene, it directs the Federal Reserve Bank of New York to do so, from the account in the name of the Federal Reserve System. The traditional practice is that U.S. intervention exercises are carried out jointly, half from the Federal Reserve's account and half from the Treasury's account. However, in principle, either party could intervene on its own. International information exchange, policy coordination, and crisis management Given the growing interdependence of national economies and macroeconomic policies, the coordination of (or more accurately, mutual consultation about) these policies has taken on increased importance. The Federal Reserve takes part in many international forums to exchange information on economic developments and discuss global economic issues. Examples include the 10 meetings each year among G-10 central bank Governors, under the auspices of the BIS; the twice a year meetings of the Economic Policy Committee of the OECD, meetings of the G-7, IMF, and regional meetings, such as APEC and Governors of the Central Banks of the American Continent. In a	['mr. meyer focuses on the effect of globalization on the conduct of us monetary policy remarks by mr. laurence h. meyer, a member of the board of governors of the us federal reserve system, before the institute for global management and research, school of business and public management, the george washington university, washington, d.c., on 14/10/97.', 'world trade has increased much faster than world output over the last 30 years and international capital flows have expanded at a still more rapid pace.', 'as a result, forecasting and modeling the national economic developments and the conduct of domestic policy has increasingly required more careful attention to the global context.', 'my focus is on how globalization has affected the conduct of u.s. monetary policy.', 'i begin by documenting the trend toward increased openness of the u.s. economy.', 'with that background in place, i turn to the implications of increased openness for the conduct of u.s. monetary policy.', 'the views i present here about the conduct of monetary policy are my own.', 'they should not be interpreted as official policy positions of the board of governors or the fomc.', 'some of the questions that i address along the way are: does an open economy introduce either new objectives or new instruments for monetary policy?', 'how does an open economy affect the monetary policy transmission mechanism?', 'does the rapid growth in cross-border capital flows limit or even eliminate the ability of domestic monetary policy to affect domestic interest rates?', 'how does u.s. monetary policy affect economic conditions in other countries?', 'how does globalization affect the cyclical properties of the u.s. economy, the inflation process, and longer-term trends in the economy?', 'my conclusion is that, while the increasing openness has resulted in some important changes to how the u.s. economy operates, it has not fundamentally altered the determination of output and inflation, introduced new objectives of monetary policy, or offered new instruments to pursue those objectives.', 'nevertheless, it has importantly affected the monetary policy transmission mechanism and increasingly subjected the domestic economy to the effects of changes in economic conditions abroad.', 'documenting the trend toward increased openness of the u.s. economy the increased openness has two dimensions -- expanded trade in goods and services and expanded cross-border capital flows.', 'a related indicator of openness is the volume of foreign exchange transactions, since both goods and financial asset transactions typically are preceded by currency conversions.', 'u.s. trade in goods and services has increased about twice as fast as the growth in u.s. gdp over the last 31⁄2 decades.', 'this reflects the effect of both trade liberalization and technological advance, as well as the rapid growth of emerging markets recently.', 'trade liberalization -- including both a series of multi-lateral efforts through gatt and regional efforts such as nafta -- has involved both reduction in tariffs and the elimination of many non-tariff barriers to trade.', 'technological gains have reduced transportation costs and improved the flow of information about goods around the world.', 'a measure of the openness of the u.s. economy in terms of trade in goods and services is the ratio of the sum of u.s. imports and exports to u.s. gdp.', 'this ratio has almost tripled over the last 31⁄2 decades, from 9% in 1960 to 24% in 1996. even more striking is the expansion of international capital flows.', 'financial liberalization, deregulation, and technology, including the information revolution, have contributed to the globalization of asset markets.', 'a measure of the net result of cross-border capital flows, the combined u.s. holdings of foreign securities and foreign holdings of u.s. securities, has increased more than tenfold just from 1980 to 1996. foreigners now hold 33% of u.s. government securities, 17% of u.s. corporate bonds, and 7% of u.s. corporate stocks.', 'u.s. holdings of foreign securities have also increased.', "foreign stocks now make up about 10% of u.s. residents' equity holdings and foreign bonds make up about 4% of u.s. bond holdings.", 'while the increase in cross-border capital flows is impressive, it is nevertheless clear that "home bias," the concentration of domestic wealth in domestic assets, still exists.', 'another indicator of the increased openness of the u.s. and other economies is the volume of foreign exchange transactions, since these transactions are often the first step in effecting both foreign trade and cross-border capital flows.', 'the daily volume of foreign exchange transactions surveyed in major financial centers doubled over the period from 1989 to 1995 to about $1.2 trillion, and more than four-fifths of these transactions involve dollars.', 'the daily volume of foreign exchange transactions, however, is an imperfect measure of openness of the u.s. economy, because many transactions among other countries involve dollars.', 'monetary policy in a global economy: responding to external shocks one implication of a global economy is that external shocks, those arising from outside the country, become an additional source of disturbance to the u.s. economy and therefore an additional challenge to which monetary policy must respond.', 'i will consider three types of external shocks: demand, supply, and exchange rate shocks.', 'an example of a demand shock would be an unexpected change in the overall level of economic activity abroad, which would affect the demand for u.s. exports.', 'for example, in the early 1970s, the latter 1970s, and late 1980s, global expansions and the resulting sharp increase in world commodity prices and demand for u.s. exports contributed to the mounting inflationary pressures and overheating in the united states.', 'in the three episodes just noted, commodity price booms were exacerbated by a run-up in oil prices resulting from the disruption of supplies from the middle east.', 'in the mid-1980s, oil prices plummeted, contributing to a transitory decline in inflation and easing of monetary conditions.', 'such changes in world oil prices are an example of a supply shock, a change in the price of goods unrelated to the balance between supply and demand in the domestic market.', 'energy and food prices, in particular, are subject to volatile swings, due to political decisions, weather, or other developments unrelated to overall domestic economic conditions.', 'the united states is vulnerable to oil price shocks both because we have a very high consumption of oil and because we import about 50% of crude petroleum.', 'the rise in oil prices not only has a sharp effect on overall prices in the united states, but, given the relatively inelastic demand for energy, results in an increase in real imports and hence a decline in aggregate demand for domestic output.', 'even much smaller shocks have had clearly visible effects on the u.s. economy, including the $5 dollar a barrel increase over 1996 and the $5 decline over 1997. exchange rates move in response to both domestic and foreign economic developments and at times appear to move for reasons not clearly linked to economic fundamentals.', 'the movements that are tied to changes in domestic economic fundamentals are part of the process of income and price determination in open economies, and i will have something to say about this below.', 'but movements related to developments abroad or movements not clearly tied to economic fundamentals are another source of shock to national economies.', 'this is especially important because the empirical linkages between exchange rates and fundamentals are weak, or not as well understood as we might like, so that movements in exchange rates often appear to be exaggerated relative to or seemingly unrelated to changes in fundamentals.', 'do cross-border capital flows reduce the effectiveness of monetary policy?', 'one of the dimensions of increased openness is the rapid increase in the volume of cross-border capital flows.', 'if foreign and domestic securities are perfect substitutes, the liberalization of cross-border financial transactions could, in principle, result in a single world financial market.', 'this might appear to imply that the interest rate at which citizens and governments of a nation could borrow and lend would then be set on world markets, with little or at least limited influence by national policymakers.', 'a small country, for example, would have no ability to influence world interest rates in this case.', 'a very large country, such as the u.s., would retain some influence, but the influence would be diminished relative to the closed-economy case and would result from its ability to affect the world interest rate.', "if a country's exchange rate is pegged to the currency of another country (or countries), then its interest rates will move closely in line with those in the country or group of countries to which it is pegged.", 'but for countries with flexible exchange rates, domestic interest rates can move quite independently of interest rates abroad.', 'however, if countries care about the level of their exchange rates, which have implications for aggregate demand and inflation, and adjust monetary policy accordingly, interest rates will, to a degree, move in common across countries.', 'greater integration of global capital markets does in fact mean that expected returns for holding different assets, with appropriate compensation for differences in risk, should increasingly converge.', 'however, as long as exchange rates can adjust, this does not imply that interest rates across countries must move together.', 'instead, it is movements in exchange rates which insure convergence of holding period yields across the countries.', 'before turning to the connection between interest rates and exchange rates, let me note that the evidence does not confirm an increase in correlations in interest rate movements across world asset markets, at least in the 1990s compared to the 1980s.', 'it is true that the levels of long-term interest rates in major industrial countries have tended to converge since the early 1980s.', 'but this is largely accounted for by a convergence of inflation rates.', 'on the other hand, there is little evidence to suggest that correlations between changes in long-term interest rates across these countries have increased over this period.', 'these correlations are a little higher in the 1980s and 1990s than they were in the 1970s, but again have shown no tendency to increase since the early 1980s.', 'at any rate, the correlations between u.s. interest rates and those of major industrial countries suggest that there remains ample room for real interest rates to move differently across the world financial markets and implies that domestic monetary policies remain important tools of macroeconomic policy, at least in countries with flexible exchange rates.', 'while the correlations among changes in interest rates have not increased, changes in interest rates between the u.s. and major industrial counties are correlated.', 'correlations tend to be about 0.5. this leaves open the question of causality and source of the correlations.', 'it does not mean that higher u.s. interest rates directly raise foreign interest rates by this amount.', 'first, some of the co-movement could reflect synchronous business cycles.', 'second, some of the co-movement could reflect the spillover effects of a cycle in one country on aggregate demand and hence interest rates in the other countries.', 'in addition, some of the correlation may reflect the effect of the response of monetary policy to exchange rate developments.', 'perhaps reflecting the latter influence, the correlation between interest rates in the united states and canada is higher, about 0.8, while that between the united states and europe is lower, about 0.4. the transmission mechanism in a open economy while cross-border capital flows do not interfere with the ability of u.s. monetary policy to influence the broad spectrum of interest rates in the united states, they do quickly transmit pressures from changes in u.s. interest rates to the exchange rate and thereby broaden the channels through which monetary policy affects aggregate demand.', 'in the closed economy setting, the transmission mechanism runs from increases in the federal funds rate, the short-term interest rate targeted by monetary policy, first to longer-term interest rates and equity prices and then to aggregate demand.', 'several components of aggregate demand depend importantly on interest rates, particularly longer-term interest rates (specifically, business fixed investment, housing, spending on consumer durables); consumer spending also depends on the net wealth of households and is therefore affected by equity prices.', 'under floating exchange rates, net exports become another interest-sensitive component of aggregate demand.', 'higher u.s. (real) interest rates, relative to foreign rates, raise the demand for dollar-denominated assets, and bring about an appreciation of the dollar which, in turn, stimulates imports and restrains exports.', 'net exports as a result become inversely related to u.s. interest rates.', 'evidence suggests that the response of net exports to interest rates (via exchange rates) has become larger over time.', 'the open economy version of the monetary policy transmission mechanism involves three steps: from u.s. interest rates to nominal exchange rates; from nominal exchange rates to the absolute and relative prices of imports and exports; and from the prices of imports and exports to the real volumes of imports and exports and domestic prices.', 'from u.s. interest rates to the exchange rate we begin with the link between interest rates in the u.s. and exchange rates.', 'a policy-initiated increase in u.s. short-term rates would, as noted above, generally result in higher u.s. long-term interest rates.', 'at initial levels of foreign interest rates and equity prices, the movement in u.s. rates would make dollar-denominated assets more attractive compared to foreign currency-denominated assets, resulting in shifts in asset demands and either incipient or actual cross-border capital inflows to the u.s. and outflows from foreign economies.', 'these shifts result in an appreciation of the dollar.', 'indeed, the single most important determinant of short-term movements in exchange rates is the change in real interest rate differentials across countries.', 'a 1% point increase in u.s. long-term (10-year) interest rates, with unchanged foreign rates, will typically induce a 10% increase in the u.s. trade-weighted exchange rate.', 'after the initial jump in the dollar, there will be an expectation of a decline in the dollar by about 1% each year for the next 10 years.', 'the result of the rise in the dollar and the expectations of gradual reversal is what is referred to as international interest rate parity.', 'the holding period yields of u.s. and foreign assets, each denominated in their home currency, are thereby equated, eliminating the incentive for further changes in asset demands or capital flows.', 'that is, the higher interest rate yield on u.s. assets (measured in dollars) is just offset by the expected depreciation in the value of the asset, measured in the foreign currency.', 'this is the mechanism by which holding period yields are equated across countries via international capital flows.', 'by the end of the 10-year period, according to this framework, both interest rates and exchange rate would have returned to their original levels.', 'evidence suggests that the response of the exchange rate to changes in u.s. interest rates (relative to foreign rates) has increased over time.', 'this likely reflects the removal of capital controls by many major industrial countries during the 1970s and early 1980s that in turn contributed the sharp rise in international capital flows documented above.', 'so, increased integration of financial markets across countries appears to have had a more important effect in raising the responsiveness of exchange rates to interest rate developments than in directly connecting interest rates across countries.', 'from the exchange rate to the relative prices of imports and exports the next step in the transmission mechanism is the pass-through of the exchange rate to the dollar prices of imports and the foreign currency price of u.s. exports.', 'the evidence suggests that the pass-through is much more complete for u.s. exports than for imports, but there is no evidence that these pass-throughs have changed over time.', 'an appreciation of the dollar will be gradually partially passed through over time to the price of imports, lowering their price relative to u.s. produced goods.', "the corresponding depreciation in other countries' currencies will result in a gradual increase in the foreign currency price of u.s. exports, compared to the prices of foreign produced goods.", 'the result is movements in relative prices that encourage imports and discourage exports.', 'from relative prices to real import and export volumes the final step in the process is from the relative price of imports and exports to the volumes of real imports and exports.', 'this depends on the elasticity of the demands for imports and exports with respect to their relative prices and the size of trade flows relative to gdp.', 'the elasticities of imports and exports with respect to their respective relative prices are estimated to be about unity, and there is no evidence of a shift in this elasticity over the past several decades.', 'a one percentage point increase in the real exchange rate would increase real imports by one percentage point over a three-year period and decrease real exports by a similar percentage.', 'the absolute effect on aggregate demand also depends on initial levels of imports and exports.', 'as import and export volumes have been increasing rapidly, the absolute effect of exchange rate changes on aggregate demand and the contribution of the exchange rate channel to the monetary transmission mechanism has been growing over time.', 'trends in interest sensitivity if the magnitude of other channels in the transmission mechanism remained unchanged, the growing importance of imports and exports and the increase in the responsiveness of exchange rates to interest rate differentials would have raised the overall responsiveness of aggregate demand to interest rates.', 'however, it appears that the interest sensitivity of residential construction has moderated over time, beginning with the repeal of regulation q, and continuing with innovations in housing finance, including adjustable rate mortgages, the broadening of the sources of mortgage lending, and the development of securitization and secondary markets for mortgages.', 'the net result is that the interest responsiveness of aggregate demand appears to have remained reasonably stable over time, although the sectoral distribution of the overall effect of interest rates has shifted toward net exports and away from housing.', 'the response of net exports to changes in u.s. interest rates, via exchange rates, contributes about one-third of the total interest sensitivity of u.s. aggregate demand over both a one-year and three-year interval.', 'it is therefore a very important part of the monetary policy transmission mechanism.', 'how does u.s. monetary policy affect other countries?', 'just as developments abroad affect the u.s. economy, changes in u.s. economic conditions impact on foreign economies, although the effects are not necessarily symmetric.', 'because of the large relative size of the u.s. economy, changes in u.s. economic conditions have relatively larger effects on foreign economies, compared to the effect of changing conditions in any one country abroad on the u.s. economy.', 'a change in u.s. monetary policy affects foreign economies in three ways -- via exchange rates, interest rates, and income in the united states.', 'the effects depend critically on the nature of the foreign exchange regime in the foreign country.', "if the foreign country's currency is pegged to the dollar, for example, there will, of course, be no exchange rate effect vis-à-vis the united states.", 'an increase in u.s. interest rates, however, would put downward pressure on the foreign currency and require the country to raise domestic interest rates to maintain the fixed exchange rate.', 'therefore, foreign interest rates are very likely to have to rise with u.s. rates in this case.', 'the restraining effect of the rise in foreign interest rates will be reinforced by the effect of the deceleration in u.s. demand for foreign goods induced by the slowdown in u.s. income.', 'as a result, a tightening of monetary policy is likely to have an unambiguously restrictive impact on those countries whose exchange rates are pegged to the dollar.', 'for countries with floating exchange rates, on the other hand, the exchange rate and income effects of rising u.s. interest rates are likely to be offsetting.', "the appreciation of the dollar, of course, implies a depreciation in other countries' exchange rates; the depreciation will stimulate foreign aggregate demand by raising net exports.", "offsetting this will be the effect of the decline in u.s. income on the demand for foreign countries' exports.", 'the net effect, for countries with floating exchange rates, is likely to be small.', 'that is, floating exchange rates tend to insulate a country from monetary shocks abroad.', 'other effects of globalization on the u.s. economy the increased openness of the u.s. economy has also focused attention on the possible effects of globalization on the macroeconomic performance of the u.s. economy, beyond the effects on the transmission of monetary policy that i have already addressed.', 'i want to focus my attention in this section on the implications of globalization for wage-price dynamics because this has a direct bearing on the conduct of monetary policy.', 'some have argued that increased global competition has made the united states (and presumably other countries) less inflation prone, so that the u.s. economy can operate at a higher degree of resource utilization without the threat of rising inflation.', 'it is useful to distinguish three ways in which global developments might recently be contributing to restraining inflation in the united states.', 'first, the significant appreciation of the dollar over the last two years has clearly had an important restraining effect on u.s. inflation, both via the direct effect on the prices of imported goods and on the pricing power of domestic firms producing import-competing goods.', 'second, the absence of synchronous expansions among the major industrial countries -- specifically the much weaker expansions in continental europe and the still weaker condition of the japanese economy -- has prevented the pressures on worldwide commodity markets that often accompany u.s. expansions and has perhaps also encouraged greater price competitiveness than would otherwise have been the case.', 'third, increased international competitive pressures, associated with growing openness of the u.s. economy, might be restraining inflation.', 'but i wonder whether we would be talking about the contribution of globalization to u.s. inflation performance if the dollar had been stable for the last several years and the expansions in europe and japan were as robust as in the u.s. i doubt it.', 'are there additional objectives for monetary policy in a global environment?', 'an interesting question is whether the increased openness of the u.s. and other economies suggests new objectives for domestic monetary policies.', 'it is certainly true that increased globalization has encouraged a proliferation of information-sharing exercises around the world and some increased attention to the coordination of policies across countries.', 'i will comment on this briefly below.', "let's start with objectives appropriate in the closed economy context.", 'congress has set dual objectives for monetary policy in the federal reserve act: price stability and full employment.', 'these objectives relate directly to the performance of the domestic economy and they are also objectives that monetary policy has the ability to pursue in the closed economy setting.', 'the first question is whether the open economy environment reduces the ability of domestic monetary policy to achieve these objectives.', 'i have argued that globalization has not reduced the ability of countries with flexible exchange rates to carry out independent monetary policies and therefore pursue domestic objectives.', 'on the other hand, countries that fix exchange rates do give up much of the independence in their domestic monetary policies.', 'the second issue is whether the open economy setting introduces new objectives, beyond those that motivate policy in the closed economy context.', 'three possibilities come to mind: the current account and/or trade balance, the exchange rate (or pattern in exchange rates around the world), and economic performance abroad.', 'even thinking of the external measures as domestic objectives raises questions.', 'with respect to the current account, we should begin by separating cyclical and structural movements.', "cyclical movements in net exports contribute the economy's built-in stability and are therefore quite desirable.", 'changes in the structural current account balance may contribute to or interfere with broader domestic objectives, depending on circumstances.', 'the fundamental source of a structural current account deficit is domestic spending in excess of domestic production.', 'is this good or bad?', 'the answer is: it depends.', 'an excess of spending over production used to finance business fixed investment could have a payoff in terms of higher future output large enough to service the increased international indebtedness and still leave the country better off.', 'an increase in the current account deficit as a result of increased private or public consumption would, in contrast, require lower future consumption as some of future production would have to be used to service the higher level of foreign debt.', 'in addition, there is an issue of sustainability.', "international indebtedness can become so large in relation to current production, depending in part on the relationship between the real interest rate on foreign debt and the economy's trend rate of growth, that the current account deficit could increase explosively.", 'if the current account is an objective, durable changes in the structural deficit can only be achieved by fiscal policy.', 'a cut in the structural federal budget deficit for example would increase national saving, lower real interest rates, lead to a depreciation of the dollar, boost net exports, and lower the current account deficit.', 'it is even more difficult to talk about the exchange rate as an objective.', 'the exchange rate is, after all, basically a relative price.', 'we might say that we prefer that an exchange rate that reflect fundamentals.', 'but other than that the exchange rate is a symptom, rather than an outcome.', 'if the current account deficit is wide because of a high dollar, the appropriate question is why is the dollar so high.', 'if the answer is because the federal budget structural deficit is high and has raised real interest rates in the u.s., the offender is not the exchange rate, but the federal budget deficit.', 'if the problem with exchange rates is fundamentals, then it is the fundamentals that need to be changed.', 'monetary policy can, via its effect on interest rates, influence exchange rates in the short run.', 'but, for monetary policy to target exchange rates, it must give reduced weight to its domestic objectives.', 'when fundamentals are the issue, it is the mix of monetary and fiscal policies that must answer the call.', 'stabilization policy, for example, calls for a level of aggregate demand consistent with full employment.', 'that level of aggregate demand can be produced by a variety of combinations of monetary and fiscal policies, varying from a very tight fiscal and loose monetary policy to a tight monetary and loose fiscal policy.', 'the difference among these options is interest rates.', 'if fiscal policy, for example, moves to a higher deficit, monetary policy will have to offset the effect on aggregate demand by tightening.', 'the result is higher interest rate, a higher dollar, and ultimately a wider current account deficit.', 'if this outcome is viewed as undesirable, the way to unwind it is by lowering the deficit, accompanied by more accommodative monetary policy.', 'it takes two to do this tango!', 'but i always view fiscal policy as having the first move.', "monetary policy's job is to follow the lead of fiscal, so that the resulting mix is appropriate to the requirements of stabilization policy.", 'i am occasionally asked whether i worry about the effect on other countries of changes in u.s. monetary policy.', 'while i do keep in mind the potential international repercussions of u.s. monetary policy actions, i believe that the best way for the u.s. to contribute to the health of the world economy is to pursue prudent domestic policy and achieve maximum sustainable employment and price stability and accommodate the maximum sustainable growth in the u.s. economy.', 'are there new policy instruments in a global economy?', 'another question about the conduct of monetary policy in an open economy is whether the open economy offers monetary policy a new instrument that it did not have in the closed economy world.', 'in a closed economy context, monetary policy has a single instrument: open market operations, used to target a short-term interest rate.', 'the obvious candidate for an additional instrument in the open economy case is the exchange rate.', 'i have already argued that monetary policy cannot be used to target the exchange rate.', 'the issue here is whether there are opportunities to exercise direct control of the exchange rate.', 'the obvious option is intervention.', 'intervention refers to a government buying or selling foreign currency in order to influence the exchange rate.', 'one can identify two reasons for intervening.', 'the first is to calm disorderly markets.', 'that is, an increase in volatility in the foreign exchange market might be damped by intervention.', 'however, most intervention is about affecting the level of the exchange rate, not its volatility, though the rhetoric of disorderly markets often is employed to justify the action.', 'actions to affect the level can be intended to prevent a further decline (or increase) or to encourage a change in the level.', 'with a daily volume of $1.2 trillion in the foreign exchange markets, and underlying stocks of financial assets that are substantially larger, there is ground for skepticism that intervention, which seldom ranges into the billions of dollars in daily volume, can have more than a marginal and transitory effect.', 'still, there are examples of modest "successes," especially when intervention is coordinated across countries and well timed.', 'the major opportunity for intervention to succeed is when the exchange rate has diverged to a significant degree from fundamentals and the intervention induces a reconsideration of the market or a refocus of the market on fundamentals.', 'the management of foreign exchange interventions varies around the world.', 'in the united states, this management is shared by the federal reserve system and the treasury department.', 'in principle, intervention can be initiated by either party, although when the treasury opts to intervene it is the federal reserve bank of new york that actually does the buying or selling of foreign currency, albeit from an account held in the name of treasury and at the direction of treasury.', 'similarly, when the fomc makes a decision to intervene, it directs the federal reserve bank of new york to do so, from the account in the name of the federal reserve system.', "the traditional practice is that u.s. intervention exercises are carried out jointly, half from the federal reserve's account and half from the treasury's account.", 'however, in principle, either party could intervene on its own.', 'international information exchange, policy coordination, and crisis management given the growing interdependence of national economies and macroeconomic policies, the coordination of (or more accurately, mutual consultation about) these policies has taken on increased importance.', 'the federal reserve takes part in many international forums to exchange information on economic developments and discuss global economic issues.', 'examples include the 10 meetings each year among g-10 central bank governors, under the auspices of the bis; the twice a year meetings of the economic policy committee of the oecd, meetings of the g-7, imf, and regional meetings, such as apec and governors of the central banks of the american continent.']	Laurence H Meyer	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r971021b.pdf	Mr. Greenspan considers the globalization of finance (Central Bank Articles and Speeches, 14 Oct 97)	Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Annual Monetary Conference of the Cato Institute, Washington, D.C., on 14/10/97.	1997-10-14 00:00:00	Remarks by the Chairman Mr. Greenspan considers the globalization of finance of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Annual Monetary Conference of the Cato Institute, Washington, D.C., on 14/10/97. Globalization of Finance As a result of very rapid increases in telecommunications and computer-based technologies and products, a dramatic expansion in cross-border financial flows and within countries has emerged. The pace has become truly remarkable. These technology-based developments have so expanded the breadth and depth of markets that governments, even reluctant ones, increasingly have felt they have had little alternative but to deregulate and free up internal credit and financial markets. In recent years global economic integration has accelerated on a multitude of fronts. While trade liberalization, which has been ongoing for a longer period, has continued, more dramatic changes have occurred in the financial sphere. World financial markets undoubtedly are far more efficient today than ever before. Changes in communications and information technology, and the new instruments and risk-management techniques they have made possible, enable an ever wider range of financial and non-financial firms today to manage their financial risks more effectively. As a consequence, they can now concentrate on managing the economic risks associated with their primary businesses. The solid profitability of new financial products in the face of their huge proliferation attests to the increasing effectiveness of financial markets in facilitating the flow of trade and direct investment, which are so patently contributing to ever higher standards of living around the world. Complex financial instruments -- derivative instruments, in one form or another -- are being developed to take advantage of the gains in communications and information technology. Such instruments would not have flourished as they have without the technological advances of the past several decades. They could not be priced properly, the markets they involve could not be arbitraged properly, and the risks they give rise to could not be managed at all, to say nothing of properly, without high-powered data processing and communications capabilities. Still, for central bankers with responsibilities for financial market stability, the new technologies and new instruments have presented new challenges. Some argue that market dynamics have been altered in ways that increase the likelihood of significant market disruptions. Whatever the merits of this argument, there is a clear sense that the new technologies, and the financial instruments and techniques they have made possible, have strengthened interdependencies between markets and market participants, both within and across national boundaries. As a result, a disturbance in one market segment or one country is likely to be transmitted far more rapidly throughout the world economy than was evident in previous eras. In earlier generations information moved slowly, constrained by the primitive state of communications. Financial crises in the early nineteenth century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss. As the nineteenth century unfolded, communications speeded up. By the turn of the century events moved more rapidly, but their speed was at most a crawl by the standard of today's financial markets. The environment now facing the world's central banks -- and, of course, private participants in financial markets as well -- is characterized by instant communication. This morning I should like to take a few minutes to trace the roots of this extraordinary expansion of global finance, endeavor to assess its benefits and risks, and suggest some avenues that can usefully be explored in order to contain some of its potentially adverse consequences. A global financial system, of course, is not an end in itself. It is the institutional structure that has been developed over the centuries to facilitate the production of goods and services. Accordingly, we can better understand the evolution of today's burgeoning global financial markets by parsing the extraordinary changes that have emerged, in the past century or more, in what we conventionally call the real side of economies: the production of goods and services. The same technological forces currently driving finance were first evident in the production process and have had a profound effect on what we produce, how we produce it, and how it is financed. Technological change or, more generally, ideas have significantly altered the nature of output so that it has become increasingly conceptual and less physical. A much smaller proportion of the measured real gross domestic product constitutes physical bulk today than in past generations. The increasing substitution of concepts for physical effort in the creation of economic value also has affected how we produce that economic output; computer-assisted design systems, machine tools, and inventory control systems provide examples. Offices are now routinely outfitted with high-speed information-processing technology. Because the accretion of knowledge is, with rare exceptions, irreversible, this trend almost surely will continue into the twenty-first century and beyond. Value creation at the turn of the twenty-first century will surely involve the transmission of information and ideas, generally over complex telecommunication networks. This will create considerably greater flexibility of where services are produced and where employees do their work. The transmission of ideas, or more broadly information, places it where it can be employed in maximum value creation. A century earlier, transportation of goods to their most value-creating locations served the same purpose for an economy whose value creation still rested heavily on physical, bulky output. Not unexpectedly, as goods and services have moved across borders, the necessity to finance them has increased dramatically. But what is particularly startling is how large the expansion in cross-border finance has become, relative to the trade it finances. To be sure, much cross-border finance supports investment portfolios, doubtless some largely speculative. But at bottom, even they are part of the support systems for efficient international movement of goods and services. The rapid expansion in cross-border banking and finance should not be surprising given the extent to which low-cost information processing and communications technology have improved the ability of customers in one part of the world to avail themselves of borrowing, depositing, or risk-management opportunities offered anywhere in the world on a real-time basis. These developments enhance the process whereby an excess of saving over investment in one country finds an appropriate outlet in another. In short, they facilitate the drive to equate risk-adjusted rates of return on investments worldwide. They thereby improve the worldwide allocation of scarce capital and, in the process, engender a huge increase in risk dispersion and hedging opportunities. But there is still evidence of less than full arbitrage of risk-adjusted rates of return on a worldwide basis. This suggests the potential for a far larger world financial system than currently exists. If we can resist protectionist pressures in our societies in the financial arena as well as in the interchange of goods and services, we can look forward to the benefits of the international division of labor on a much larger scale in the 21st century. What we don't know for sure, but strongly suspect, is that the accelerating expansion of global finance may be indispensable to the continued rapid growth in world trade in goods and services. It is becoming increasingly evident that many layers of financial intermediation will be required if we are to capture the full benefits of our advances in finance. Certainly, the emergence of a highly liquid foreign exchange market has facilitated basic forex transactions, and the availability of more complex hedging strategies enables producers and investors to achieve their desired risk positions. This owes largely to the ability of modern financial products to unbundle complex risks in ways that enable each counterparty to choose the combination of risks necessary to advance its business strategy, and to eschew those that do not. This process enhances cross-border trade in goods and services, facilitates cross-border portfolio investment strategies, enhances the lower-cost financing of real capital formation on a worldwide basis and, hence, leads to an expansion of international trade and rising standards of living. But achieving those benefits surely will require the maintenance of a stable macroeconomic environment. An environment conducive to stable product prices and to maintaining sustainable economic growth has become a prime responsibility of governments and, of course, central banks. It was not always thus. In the last comparable period of open international trade a century ago the gold standard prevailed. The roles of central banks, where they existed (remember the United States did not have one), were then quite different from today. International stabilization was implemented by more or less automatic gold flows from those financial markets where conditions were lax, to those where liquidity was in short supply. To some, myself included, the system appears to have worked rather well. To others, the gold standard was perceived as too rigid or unstable, and in any event the inability to finance discretionary policy, both monetary and fiscal, led first to a further compromise of the gold standard system after World War I, and by the 1930s it had been essentially abandoned. The fiat money systems that emerged have given considerable power and responsibility to central banks to manage the sovereign credit of nations. Under a gold standard, money creation was at the limit tied to changes in gold reserves. The discretionary range of monetary policy was relatively narrow. Today's central banks have the capability of creating or destroying unlimited supplies of money and credit. Clearly, how well we take our responsibilities in this modern world has profound implications for participants in financial markets. We provide the backdrop against which individual market participants make their decisions. As a consequence, it is incumbent upon us to endeavor to produce the same non-inflationary environment as existed a century ago, if we seek maximum sustainable growth. In this regard, doubtless, the most important development that has occurred in recent years has been the shift from an environment of inflationary expectations built into both business planning and financial contracts toward an environment of lower inflation. It is important that that progress continue and that we maintain a credible long-run commitment to price stability. While there can be little doubt that the extraordinary changes in global finance on balance have been beneficial in facilitating significant improvements in economic structures and living standards throughout the world, they also have the potential for some negative consequences. In fact, while the speed of transmission of positive economic events has been an important plus for the world economy in recent years, it is becoming increasingly obvious, as evidenced by recent events in Thailand and its neighbors and several years ago in Mexico, that significant macroeconomic policy mistakes also reverberate around the world at a prodigious pace. In any event, technological progress is not reversible. We must learn to live with it. In the context of rapid changes affecting financial markets, disruptions are inevitable. The turmoil in the European Exchange Rate mechanism in 1992, the plunge in the exchange value of the Mexican peso at the end of 1994 and early 1995, and the recent sharp exchange rate adjustments in a number of Asian economies have shown how the new world of financial trading can punish policy misalignments, actual or perceived, with amazing alacrity. This is new. Even as recently as 15 or 20 years ago, the size of the international financial system was a fraction of what it is today. Contagion effects were more limited, and, thus, breakdowns carried fewer negative consequences. In both new and old environments, the economic consequences of disruptions are minimized if they are not further compounded by financial instability associated with underlying inflation trends. The recent financial turmoil in some Asian financial markets, and similar events elsewhere previously, confirm that in a world of increasing capital mobility there is a premium on governments maintaining sound macroeconomic policies and allowing exchange rates to provide appropriate signals for the broader pricing structure of the economy. These countries became vulnerable as markets became increasingly aware of a buildup of excesses, including overvalued exchange rates, bulging current account deficits, and sharp increases in asset values. In many cases, these were the consequence of poor investment judgements in seeking to employ huge increases in portfolios for investment. In some cases, these excesses were fed by unsound real estate and other lending activity by various financial institutions in these countries, which, in turn, undermined the soundness of these countries' financial systems. As a consequence, these countries lost the confidence of both domestic and international investors, with resulting disturbances in their financial markets. The resort to capital controls to deal with financial market disturbances of the sort a number of emerging economies have experienced would be a step backwards from the trend toward financial market liberalization, and in the end would not be effective. The maintenance of financial stability in an environment of global capital markets, therefore, calls for greater attention by governments to the soundness of public policy. Governments are beginning to recognize that the release of timely and accurate economic and financial data is a critical element to the maintenance of financial stability. We do not know what the appropriate amount of disclosure is, but it is pretty clear from the Mexican experience in 1994 and the recent Thai experience that the level of disclosure was too little. More comprehensive public information on the financial condition of a country, including current data on commitments by governments to buy or sell currencies in the future and on non-performing loans of a country's financial institutions, would allow investors -- both domestic and international -- to make more rational investment decisions. Such disclosure would help to avoid sudden and sharp reversals in the investment positions of investors once they become aware of the true status of a country's and a banking system's financial health. More timely and more comprehensive disclosure of financial data also would help sensitize the principal economic policymakers of a country to the potential emerging threats to its financial stability. Thus, as international financial markets continue to expand, central banks have twin objectives: achieving macroeconomic stability and a safe and sound financial system that can take advantage of stability while exploiting the inevitable new technological advances. The changing dynamics of modern global financial systems also require that central banks address the inevitable increase of systemic risk. It is probably fair to say that the very efficiency of global financial markets, engendered by the rapid proliferation of financial products, also has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the nineteenth century. Today's technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. Moreover, increasing global financial efficiency, by creating the mechanisms for mistakes to ricochet throughout the global financial system, has patently increased the potential for systemic risk. Why not then, one might ask, bar or contain the expansion of global finance by capital controls, transaction taxes, or other market inhibiting initiatives? Why not return to the less hectic and seemingly less threatening markets of, say, the 1950s? Endeavoring to thwart technological advance and new knowledge and innovation through the erection of barriers to the spread of knowledge would, as history amply demonstrates, have large, often adverse, unintended consequences. Suppressed markets in one location would be rapidly displaced by others outside the reach of government controls and taxes. Of greater importance, risk taking, so indispensable to the creation of wealth, would undoubtedly be curbed, to the detriment of rising living standards. We cannot turn back the clock on technology -- and we should not try to do so. Rather, we should recognize that, if it is technology that has imparted the current stress to markets, technology can be employed to contain it. Enhancements to financial institutions' internal risk-management systems arguably constitute the most effective countermeasure to the increased potential instability of the global financial system. Improving the efficiency of the world's payment systems is clearly another. The availability of new technology and new derivative financial instruments clearly has facilitated new, more rigorous approaches to the conceptualization, measurement, and management of risk for such systems. There are, however, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions. Hence, human judgements, based on analytically looser but far more realistic evaluations of what the future may hold, are of critical importance in risk management. Although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades and of the customers it serves is turning out to be far more important. In these and other ways, we must assure that our rapidly changing global financial system retains the capacity to contain market shocks. This is a never-ending process that requires never-ending vigilance.	['remarks by the chairman mr. greenspan considers the globalization of finance of the board of the us federal reserve system, mr. alan greenspan, at the 15th annual monetary conference of the cato institute, washington, d.c., on 14/10/97.', 'globalization of finance as a result of very rapid increases in telecommunications and computer-based technologies and products, a dramatic expansion in cross-border financial flows and within countries has emerged.', 'the pace has become truly remarkable.', 'these technology-based developments have so expanded the breadth and depth of markets that governments, even reluctant ones, increasingly have felt they have had little alternative but to deregulate and free up internal credit and financial markets.', 'in recent years global economic integration has accelerated on a multitude of fronts.', 'while trade liberalization, which has been ongoing for a longer period, has continued, more dramatic changes have occurred in the financial sphere.', 'world financial markets undoubtedly are far more efficient today than ever before.', 'changes in communications and information technology, and the new instruments and risk-management techniques they have made possible, enable an ever wider range of financial and non-financial firms today to manage their financial risks more effectively.', 'as a consequence, they can now concentrate on managing the economic risks associated with their primary businesses.', 'the solid profitability of new financial products in the face of their huge proliferation attests to the increasing effectiveness of financial markets in facilitating the flow of trade and direct investment, which are so patently contributing to ever higher standards of living around the world.', 'complex financial instruments -- derivative instruments, in one form or another -- are being developed to take advantage of the gains in communications and information technology.', 'such instruments would not have flourished as they have without the technological advances of the past several decades.', 'they could not be priced properly, the markets they involve could not be arbitraged properly, and the risks they give rise to could not be managed at all, to say nothing of properly, without high-powered data processing and communications capabilities.', 'still, for central bankers with responsibilities for financial market stability, the new technologies and new instruments have presented new challenges.', 'some argue that market dynamics have been altered in ways that increase the likelihood of significant market disruptions.', 'whatever the merits of this argument, there is a clear sense that the new technologies, and the financial instruments and techniques they have made possible, have strengthened interdependencies between markets and market participants, both within and across national boundaries.', 'as a result, a disturbance in one market segment or one country is likely to be transmitted far more rapidly throughout the world economy than was evident in previous eras.', 'in earlier generations information moved slowly, constrained by the primitive state of communications.', 'financial crises in the early nineteenth century, for example, particularly those associated with the napoleonic wars, were often related to military and other events in faraway places.', "an investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss.", 'as the nineteenth century unfolded, communications speeded up.', "by the turn of the century events moved more rapidly, but their speed was at most a crawl by the standard of today's financial markets.", "the environment now facing the world's central banks -- and, of course, private participants in financial markets as well -- is characterized by instant communication.", 'this morning i should like to take a few minutes to trace the roots of this extraordinary expansion of global finance, endeavor to assess its benefits and risks, and suggest some avenues that can usefully be explored in order to contain some of its potentially adverse consequences.', 'a global financial system, of course, is not an end in itself.', 'it is the institutional structure that has been developed over the centuries to facilitate the production of goods and services.', "accordingly, we can better understand the evolution of today's burgeoning global financial markets by parsing the extraordinary changes that have emerged, in the past century or more, in what we conventionally call the real side of economies: the production of goods and services.", 'the same technological forces currently driving finance were first evident in the production process and have had a profound effect on what we produce, how we produce it, and how it is financed.', 'technological change or, more generally, ideas have significantly altered the nature of output so that it has become increasingly conceptual and less physical.', 'a much smaller proportion of the measured real gross domestic product constitutes physical bulk today than in past generations.', 'the increasing substitution of concepts for physical effort in the creation of economic value also has affected how we produce that economic output; computer-assisted design systems, machine tools, and inventory control systems provide examples.', 'offices are now routinely outfitted with high-speed information-processing technology.', 'because the accretion of knowledge is, with rare exceptions, irreversible, this trend almost surely will continue into the twenty-first century and beyond.', 'value creation at the turn of the twenty-first century will surely involve the transmission of information and ideas, generally over complex telecommunication networks.', 'this will create considerably greater flexibility of where services are produced and where employees do their work.', 'the transmission of ideas, or more broadly information, places it where it can be employed in maximum value creation.', 'a century earlier, transportation of goods to their most value-creating locations served the same purpose for an economy whose value creation still rested heavily on physical, bulky output.', 'not unexpectedly, as goods and services have moved across borders, the necessity to finance them has increased dramatically.', 'but what is particularly startling is how large the expansion in cross-border finance has become, relative to the trade it finances.', 'to be sure, much cross-border finance supports investment portfolios, doubtless some largely speculative.', 'but at bottom, even they are part of the support systems for efficient international movement of goods and services.', 'the rapid expansion in cross-border banking and finance should not be surprising given the extent to which low-cost information processing and communications technology have improved the ability of customers in one part of the world to avail themselves of borrowing, depositing, or risk-management opportunities offered anywhere in the world on a real-time basis.', 'these developments enhance the process whereby an excess of saving over investment in one country finds an appropriate outlet in another.', 'in short, they facilitate the drive to equate risk-adjusted rates of return on investments worldwide.', 'they thereby improve the worldwide allocation of scarce capital and, in the process, engender a huge increase in risk dispersion and hedging opportunities.', 'but there is still evidence of less than full arbitrage of risk-adjusted rates of return on a worldwide basis.', 'this suggests the potential for a far larger world financial system than currently exists.', 'if we can resist protectionist pressures in our societies in the financial arena as well as in the interchange of goods and services, we can look forward to the benefits of the international division of labor on a much larger scale in the 21st century.', "what we don't know for sure, but strongly suspect, is that the accelerating expansion of global finance may be indispensable to the continued rapid growth in world trade in goods and services.", 'it is becoming increasingly evident that many layers of financial intermediation will be required if we are to capture the full benefits of our advances in finance.', 'certainly, the emergence of a highly liquid foreign exchange market has facilitated basic forex transactions, and the availability of more complex hedging strategies enables producers and investors to achieve their desired risk positions.', 'this owes largely to the ability of modern financial products to unbundle complex risks in ways that enable each counterparty to choose the combination of risks necessary to advance its business strategy, and to eschew those that do not.', 'this process enhances cross-border trade in goods and services, facilitates cross-border portfolio investment strategies, enhances the lower-cost financing of real capital formation on a worldwide basis and, hence, leads to an expansion of international trade and rising standards of living.', 'but achieving those benefits surely will require the maintenance of a stable macroeconomic environment.', 'an environment conducive to stable product prices and to maintaining sustainable economic growth has become a prime responsibility of governments and, of course, central banks.', 'it was not always thus.', 'in the last comparable period of open international trade a century ago the gold standard prevailed.', 'the roles of central banks, where they existed (remember the united states did not have one), were then quite different from today.', 'international stabilization was implemented by more or less automatic gold flows from those financial markets where conditions were lax, to those where liquidity was in short supply.', 'to some, myself included, the system appears to have worked rather well.', 'to others, the gold standard was perceived as too rigid or unstable, and in any event the inability to finance discretionary policy, both monetary and fiscal, led first to a further compromise of the gold standard system after world war i, and by the 1930s it had been essentially abandoned.', 'the fiat money systems that emerged have given considerable power and responsibility to central banks to manage the sovereign credit of nations.', 'under a gold standard, money creation was at the limit tied to changes in gold reserves.', 'the discretionary range of monetary policy was relatively narrow.', "today's central banks have the capability of creating or destroying unlimited supplies of money and credit.", 'clearly, how well we take our responsibilities in this modern world has profound implications for participants in financial markets.', 'we provide the backdrop against which individual market participants make their decisions.', 'as a consequence, it is incumbent upon us to endeavor to produce the same non-inflationary environment as existed a century ago, if we seek maximum sustainable growth.', 'in this regard, doubtless, the most important development that has occurred in recent years has been the shift from an environment of inflationary expectations built into both business planning and financial contracts toward an environment of lower inflation.', 'it is important that that progress continue and that we maintain a credible long-run commitment to price stability.', 'while there can be little doubt that the extraordinary changes in global finance on balance have been beneficial in facilitating significant improvements in economic structures and living standards throughout the world, they also have the potential for some negative consequences.', 'in fact, while the speed of transmission of positive economic events has been an important plus for the world economy in recent years, it is becoming increasingly obvious, as evidenced by recent events in thailand and its neighbors and several years ago in mexico, that significant macroeconomic policy mistakes also reverberate around the world at a prodigious pace.', 'in any event, technological progress is not reversible.', 'we must learn to live with it.', 'in the context of rapid changes affecting financial markets, disruptions are inevitable.', 'the turmoil in the european exchange rate mechanism in 1992, the plunge in the exchange value of the mexican peso at the end of 1994 and early 1995, and the recent sharp exchange rate adjustments in a number of asian economies have shown how the new world of financial trading can punish policy misalignments, actual or perceived, with amazing alacrity.', 'even as recently as 15 or 20 years ago, the size of the international financial system was a fraction of what it is today.', 'contagion effects were more limited, and, thus, breakdowns carried fewer negative consequences.', 'in both new and old environments, the economic consequences of disruptions are minimized if they are not further compounded by financial instability associated with underlying inflation trends.', 'the recent financial turmoil in some asian financial markets, and similar events elsewhere previously, confirm that in a world of increasing capital mobility there is a premium on governments maintaining sound macroeconomic policies and allowing exchange rates to provide appropriate signals for the broader pricing structure of the economy.', 'these countries became vulnerable as markets became increasingly aware of a buildup of excesses, including overvalued exchange rates, bulging current account deficits, and sharp increases in asset values.', 'in many cases, these were the consequence of poor investment judgements in seeking to employ huge increases in portfolios for investment.', "in some cases, these excesses were fed by unsound real estate and other lending activity by various financial institutions in these countries, which, in turn, undermined the soundness of these countries' financial systems.", 'as a consequence, these countries lost the confidence of both domestic and international investors, with resulting disturbances in their financial markets.', 'the resort to capital controls to deal with financial market disturbances of the sort a number of emerging economies have experienced would be a step backwards from the trend toward financial market liberalization, and in the end would not be effective.', 'the maintenance of financial stability in an environment of global capital markets, therefore, calls for greater attention by governments to the soundness of public policy.', 'governments are beginning to recognize that the release of timely and accurate economic and financial data is a critical element to the maintenance of financial stability.', 'we do not know what the appropriate amount of disclosure is, but it is pretty clear from the mexican experience in 1994 and the recent thai experience that the level of disclosure was too little.', "more comprehensive public information on the financial condition of a country, including current data on commitments by governments to buy or sell currencies in the future and on non-performing loans of a country's financial institutions, would allow investors -- both domestic and international -- to make more rational investment decisions.", "such disclosure would help to avoid sudden and sharp reversals in the investment positions of investors once they become aware of the true status of a country's and a banking system's financial health.", 'more timely and more comprehensive disclosure of financial data also would help sensitize the principal economic policymakers of a country to the potential emerging threats to its financial stability.', 'thus, as international financial markets continue to expand, central banks have twin objectives: achieving macroeconomic stability and a safe and sound financial system that can take advantage of stability while exploiting the inevitable new technological advances.', 'the changing dynamics of modern global financial systems also require that central banks address the inevitable increase of systemic risk.', 'it is probably fair to say that the very efficiency of global financial markets, engendered by the rapid proliferation of financial products, also has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the nineteenth century.', "today's technology enables single individuals to initiate massive transactions with very rapid execution.", 'clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate.', 'moreover, increasing global financial efficiency, by creating the mechanisms for mistakes to ricochet throughout the global financial system, has patently increased the potential for systemic risk.', 'why not then, one might ask, bar or contain the expansion of global finance by capital controls, transaction taxes, or other market inhibiting initiatives?', 'why not return to the less hectic and seemingly less threatening markets of, say, the 1950s?', 'endeavoring to thwart technological advance and new knowledge and innovation through the erection of barriers to the spread of knowledge would, as history amply demonstrates, have large, often adverse, unintended consequences.', 'suppressed markets in one location would be rapidly displaced by others outside the reach of government controls and taxes.', 'of greater importance, risk taking, so indispensable to the creation of wealth, would undoubtedly be curbed, to the detriment of rising living standards.', 'we cannot turn back the clock on technology -- and we should not try to do so.', 'rather, we should recognize that, if it is technology that has imparted the current stress to markets, technology can be employed to contain it.', "enhancements to financial institutions' internal risk-management systems arguably constitute the most effective countermeasure to the increased potential instability of the global financial system.", "improving the efficiency of the world's payment systems is clearly another.", 'the availability of new technology and new derivative financial instruments clearly has facilitated new, more rigorous approaches to the conceptualization, measurement, and management of risk for such systems.', 'there are, however, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions.', 'hence, human judgements, based on analytically looser but far more realistic evaluations of what the future may hold, are of critical importance in risk management.', 'although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades and of the customers it serves is turning out to be far more important.', 'in these and other ways, we must assure that our rapidly changing global financial system retains the capacity to contain market shocks.', 'this is a never-ending process that requires never-ending vigilance.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman	US
https://www.bis.org/review/r971021a.pdf	Mr. Thiessen discusses some important issues and challenges facing monetary policy in Canada in the period ahead (Central Bank Articles and Speeches, 7 Oct 97)	Notes for remarks by the Governor of the Bank of Canada, Mr. Gordon Thiessen, to the Vancouver Board of Trade in Vancouver, British Columbia, on 7/10/97.	1997-10-07 00:00:00	Mr. Thiessen discusses some important issues and challenges facing monetary Notes for remarks by the Governor of the Bank of Canada, policy in Canada in the period ahead Mr. Gordon Thiessen, to the Vancouver Board of Trade in Vancouver, British Columbia, on 7/10/97. The challenges ahead for monetary policy Today, I would like to talk about some of the important issues and challenges facing monetary policy in the period ahead and how the Bank of Canada proposes to deal with them. This is not an unusual topic for me since the business of central banking is seldom without challenges. But what a difference the past two years have made to the challenges we face! Let me remind you that it was in late 1995, when investors' concerns about Canada's fiscal and political problems finally began to recede, that the Bank of Canada was able to take action to provide substantial monetary support to the economy. This action, which continued over the next year or so, was designed to offset both the direct impact on the economy of fiscal restraint and the effects on consumer confidence of the difficulties and uncertainties arising from the major restructurings that were necessary in both the private and public sectors. In response to the monetary stimulus, the economy has gathered momentum and finally seems to have pulled free from the difficulties associated with the restructuring. Indeed, economic activity has accelerated this year and has expanded by about 4 per cent over the course of the past 12 months. With the economic momentum expected to continue at a solid pace in the period ahead, monetary policy now faces new challenges. Over the next year or two, as the remaining slack is absorbed and we move towards full use of the economy's capacity to produce, the issue for monetary policy will be to try to ensure that this process goes smoothly and that inflationary pressures do not re-emerge. Further down the road, we will also have to concern ourselves with the conduct of monetary policy as the economy operates under conditions of full capacity. With all the structural changes that have taken place in Canada and around the world in recent years, one important issue will be to gauge just how rapidly our economy can grow on a sustainable basis -- that is, without generating inflation pressures -- and what this implies for the employment picture in Canada. The challenge for monetary policy at that stage will be how best to deal with the uncertainty surrounding estimates of the economy's potential to produce. The conduct of monetary policy through the economic upswing and then under conditions of full capacity are the two topics I would like to discuss with you today. Returning to full capacity Let me start with the immediate challenge for monetary policy -- to promote monetary conditions that will preserve Canada's good inflation performance through the current economic upswing, thereby helping to make this economic expansion a long-lasting one. As I mentioned, monetary conditions in Canada have been very stimulative for over a year. With growing evidence that economic activity was expanding smartly, the Bank of Canada began reminding Canadians that, as slack in the economy is taken up, there would be a need to move to less-stimulative monetary conditions. We took a step in that direction last week when we raised our Bank Rate by 1⁄4 of a percentage point to 33⁄4 per cent. This kind of action can set off alarm bells in the minds of some people. They may wonder why the Bank of Canada is "slamming on the brakes" when the economy has only just begun to pick up and the unemployment rate is still high. I would like to respond to any such concerns by explaining what Canadians can expect from their central bank in the period ahead and why. But before I do so, I would like to remind you that, when we at the Bank talk about how stimulative monetary conditions have been, we are not just looking at short-term interest rates (which are still near their lowest levels in decades and well below comparable U.S. rates). Monetary conditions also take into account the effects on the economy of changes in the exchange rate for the Canadian dollar. For example, the relatively low value of our dollar has been a major source of stimulus for Canada's export sector. So a proper assessment of the degree of monetary ease in the economy has to consider both our low interest rates and the relatively low Canadian dollar. Now, what about the perception that any move by the Bank of Canada to less-stimulative monetary conditions means "slamming on the brakes" for our economy? Let me stay with the automobile analogy for a moment. To get the economy moving, the Bank has been pressing hard on the monetary accelerator. But once the economy picks up speed, just as with a car, you need to ease off gradually on the accelerator and steady your cruising speed at a safe level. If you press hard on the accelerator for too long, you will reach speeds that are unsafe. You risk losing control and getting into serious trouble. The same holds true for the economy. Too much monetary stimulus can lead to an exhilarating temporary burst of economic activity. But it will almost certainly also lead to inflation-related distortions that undermine both the expansion and the economy's efficiency over the longer term. The end result, as we know only too well from past experience, is high interest rates, punishing debt loads, recession, and higher unemployment. A further complication is that it takes between a year to a year and a half for the economy to fully respond to changes in the degree of monetary stimulus. In this sense, the economy is like a car that doesn't respond immediately when you ease off on the accelerator but only a mile or so further down the road. With such a car, you want to be able to look a long way ahead to see what is coming, and you want to take action early to ensure that your speed is appropriate. This is why monetary policy must focus on the future, rather than the present, and why the Bank must act in a forward-looking, pre-emptive manner. In other words, if we want our economy to reach full capacity relatively smoothly, without the risk of repeating the painful, inflation-related boom and bust cycles of the past, we must be ready to take timely action. If we wait to act until the economy is going flat out and pressing hard on the limits of its capacity to produce, we will have waited too long. Thus, some combination of a further rise in short-term interest rates and an increase in the value of the Canadian dollar will likely be necessary in coming months. I hasten to add that such a rise in short-term rates is the best way to preserve medium- and long-term rates at low levels. And it is these longer-term rates that are so important for the investments in new technology and other initiatives to increase productivity that Canadian businesses need to stay competitive. Let me reassure you that we are not talking about anything like the short-term interest rate increases that we saw in the 1970s and 1980s, or even in 1995. In an environment of low inflation and improved fiscal health, interest rates should not have to get that high again. You will not be surprised that I cannot give you in advance precise information about any further action the Bank may take to reduce the amount of monetary stimulus in the economy. What I can tell you is that it is the strength of the momentum of demand, and thus how quickly the economy approaches the limits of its capacity to meet that demand, that will determine the timing and extent of our response. Close monitoring of the strength of demand in the economy, and timely, measured steps in the right direction, will help us avoid the more substantial, and potentially more disruptive, tightening that would be required later on if monetary policy actions were unduly delayed. Moreover, the magnitude of the increase in short-term interest rates will be influenced by the extent of the exchange rate response. I hope this makes it clear that what the Bank of Canada has in mind, and is aiming for, is a "gradual easing off on the accelerator" in the months ahead, so that there will be no need to "slam on the brakes" later on. Making the most of the economy's production potential Next, let me say a few words about the challenges that await us further down the road. One of the more remarkable international economic developments of the past few years has been the performance of the U.S. economy. That economy has had six years of solid economic expansion, with high rates of job creation and low inflation. In the late 1980s, when the U.S. unemployment rate dipped below 6 per cent, there were strong inflationary pressures. Compare this with the present situation: the U.S. economy has been expanding at an average rate of about 31⁄2 per cent for 8 quarters, current levels of demand are above most estimates of its capacity to produce, and the unemployment rate has been at or below 5 per cent for several months. Yet inflation has remained well behaved. What is happening? Are we operating in a different environment? There are, of course, some temporary factors -- such as the appreciation of the U.S. dollar, the decline in energy prices, and the slack in overseas economies -- that are currently helping to suppress inflationary pressures in the United States. However, a number of observers are suggesting that other, more permanent factors may also be contributing. One possibility, which has been rather widely discussed recently, is that all the structural changes that have taken place in the United States have raised the production capacity of the economy and reduced the risk of inflation. I believe that another important factor in this success story has been the strong credibility of monetary policy in the United States. By persuading Americans that it is determined to maintain low inflation, the U.S. Federal Reserve has given itself room to test the potential of the economy without triggering the quick response in wages and prices from worried workers and businesses that we saw during the years of high inflation. How does this U.S. experience relate to Canada? Can we also look forward to an improvement in the longer-term performance of our economy? Unfortunately, it is not possible to make that judgement in advance, given the complexity of the factors affecting economic performance. How rapid growth can be and still be sustainable, and how low our unemployment rate will go, will ultimately depend on the flexibility, efficiency, and productivity of Canadian enterprises. I am referring here to the effective use of new technology; the skills, training, and adaptability of our labour force; our ability to control costs; and the initiative and ability of Canadian businesses to find and develop new and expanded foreign markets for their products. The contribution that monetary policy can make towards realizing this potential is to ensure that the pace of economic expansion remains sustainable. This essentially means encouraging monetary conditions that will allow the economy to test the limits of its capacity to expand, but without setting off inflation and the costly boom and bust cycles of the past two decades. As in the United States, the problem in Canada is that there is considerable uncertainty regarding the level of economic activity that can be accommodated by our capacity to produce and how rapidly this capacity will expand over time. This is where the Bank of Canada's inflation-control target should prove useful as we try to steer the economy along a sustainable growth path. That target is to hold inflation inside a range of 1 to 3 per cent. One of the advantages of such an explicit target is that it provides a ready measure of the state of the economy by comparing the actual trend of inflation against the target range. If the trend of inflation looks as though it will be pushing through the top of the target range, this implies that demand in the economy has been unsustainably strong, and monetary conditions must be tightened. But if inflation is persistently lower than past history and the existing levels of demand would suggest, and it is tending to press the bottom of the range, chances are that there is more room for the economy to expand than previously thought, and monetary conditions can be easier. However, if the Bank of Canada is going to respond to such signals, we must ensure that our inflation-control strategy is a credible one. It is by conducting monetary policy in a prudent manner during the economic upswing that the Bank can provide Canadians with assurance that inflation will remain under control when the economy begins to operate at levels that push against the limits of capacity. If businesses, individuals, and investors are persuaded that inflation will stay low, they will not respond immediately to signs of strong demand pressures by seeking to raise prices and wages and by pushing up interest rates. Such an environment provides the flexibility necessary for the economy to test the limits of growth and employment without immediately putting the economic expansion at risk. Concluding remarks In conclusion, let me just say that the period ahead will be an exciting one. At no time since the 1960s have we had in place the conditions that would permit the Canadian economy to fully realize its potential. With inflation under control and increasingly favourable fiscal positions, we now have an opportunity to see what our economy is capable of delivering, in terms of sustained growth in output and employment and improving standards of living. The Bank of Canada's role is to make sure that monetary policy provides the right background -- a stable, low-inflation environment.	['mr. thiessen discusses some important issues and challenges facing monetary notes for remarks by the governor of the bank of canada, policy in canada in the period ahead mr. gordon thiessen, to the vancouver board of trade in vancouver, british columbia, on 7/10/97.', 'the challenges ahead for monetary policy today, i would like to talk about some of the important issues and challenges facing monetary policy in the period ahead and how the bank of canada proposes to deal with them.', 'this is not an unusual topic for me since the business of central banking is seldom without challenges.', 'but what a difference the past two years have made to the challenges we face!', "let me remind you that it was in late 1995, when investors' concerns about canada's fiscal and political problems finally began to recede, that the bank of canada was able to take action to provide substantial monetary support to the economy.", 'this action, which continued over the next year or so, was designed to offset both the direct impact on the economy of fiscal restraint and the effects on consumer confidence of the difficulties and uncertainties arising from the major restructurings that were necessary in both the private and public sectors.', 'in response to the monetary stimulus, the economy has gathered momentum and finally seems to have pulled free from the difficulties associated with the restructuring.', 'indeed, economic activity has accelerated this year and has expanded by about 4 per cent over the course of the past 12 months.', 'with the economic momentum expected to continue at a solid pace in the period ahead, monetary policy now faces new challenges.', "over the next year or two, as the remaining slack is absorbed and we move towards full use of the economy's capacity to produce, the issue for monetary policy will be to try to ensure that this process goes smoothly and that inflationary pressures do not re-emerge.", 'further down the road, we will also have to concern ourselves with the conduct of monetary policy as the economy operates under conditions of full capacity.', 'with all the structural changes that have taken place in canada and around the world in recent years, one important issue will be to gauge just how rapidly our economy can grow on a sustainable basis -- that is, without generating inflation pressures -- and what this implies for the employment picture in canada.', "the challenge for monetary policy at that stage will be how best to deal with the uncertainty surrounding estimates of the economy's potential to produce.", 'the conduct of monetary policy through the economic upswing and then under conditions of full capacity are the two topics i would like to discuss with you today.', "returning to full capacity let me start with the immediate challenge for monetary policy -- to promote monetary conditions that will preserve canada's good inflation performance through the current economic upswing, thereby helping to make this economic expansion a long-lasting one.", 'as i mentioned, monetary conditions in canada have been very stimulative for over a year.', 'with growing evidence that economic activity was expanding smartly, the bank of canada began reminding canadians that, as slack in the economy is taken up, there would be a need to move to less-stimulative monetary conditions.', 'we took a step in that direction last week when we raised our bank rate by 1⁄4 of a percentage point to 33⁄4 per cent.', 'this kind of action can set off alarm bells in the minds of some people.', 'they may wonder why the bank of canada is "slamming on the brakes" when the economy has only just begun to pick up and the unemployment rate is still high.', 'i would like to respond to any such concerns by explaining what canadians can expect from their central bank in the period ahead and why.', 'but before i do so, i would like to remind you that, when we at the bank talk about how stimulative monetary conditions have been, we are not just looking at short-term interest rates (which are still near their lowest levels in decades and well below comparable u.s. rates).', 'monetary conditions also take into account the effects on the economy of changes in the exchange rate for the canadian dollar.', "for example, the relatively low value of our dollar has been a major source of stimulus for canada's export sector.", 'so a proper assessment of the degree of monetary ease in the economy has to consider both our low interest rates and the relatively low canadian dollar.', 'now, what about the perception that any move by the bank of canada to less-stimulative monetary conditions means "slamming on the brakes" for our economy?', 'let me stay with the automobile analogy for a moment.', 'to get the economy moving, the bank has been pressing hard on the monetary accelerator.', 'but once the economy picks up speed, just as with a car, you need to ease off gradually on the accelerator and steady your cruising speed at a safe level.', 'if you press hard on the accelerator for too long, you will reach speeds that are unsafe.', 'you risk losing control and getting into serious trouble.', 'the same holds true for the economy.', 'too much monetary stimulus can lead to an exhilarating temporary burst of economic activity.', "but it will almost certainly also lead to inflation-related distortions that undermine both the expansion and the economy's efficiency over the longer term.", 'the end result, as we know only too well from past experience, is high interest rates, punishing debt loads, recession, and higher unemployment.', 'a further complication is that it takes between a year to a year and a half for the economy to fully respond to changes in the degree of monetary stimulus.', "in this sense, the economy is like a car that doesn't respond immediately when you ease off on the accelerator but only a mile or so further down the road.", 'with such a car, you want to be able to look a long way ahead to see what is coming, and you want to take action early to ensure that your speed is appropriate.', 'this is why monetary policy must focus on the future, rather than the present, and why the bank must act in a forward-looking, pre-emptive manner.', 'in other words, if we want our economy to reach full capacity relatively smoothly, without the risk of repeating the painful, inflation-related boom and bust cycles of the past, we must be ready to take timely action.', 'if we wait to act until the economy is going flat out and pressing hard on the limits of its capacity to produce, we will have waited too long.', 'thus, some combination of a further rise in short-term interest rates and an increase in the value of the canadian dollar will likely be necessary in coming months.', 'i hasten to add that such a rise in short-term rates is the best way to preserve medium- and long-term rates at low levels.', 'and it is these longer-term rates that are so important for the investments in new technology and other initiatives to increase productivity that canadian businesses need to stay competitive.', 'let me reassure you that we are not talking about anything like the short-term interest rate increases that we saw in the 1970s and 1980s, or even in 1995. in an environment of low inflation and improved fiscal health, interest rates should not have to get that high again.', 'you will not be surprised that i cannot give you in advance precise information about any further action the bank may take to reduce the amount of monetary stimulus in the economy.', 'what i can tell you is that it is the strength of the momentum of demand, and thus how quickly the economy approaches the limits of its capacity to meet that demand, that will determine the timing and extent of our response.', 'close monitoring of the strength of demand in the economy, and timely, measured steps in the right direction, will help us avoid the more substantial, and potentially more disruptive, tightening that would be required later on if monetary policy actions were unduly delayed.', 'moreover, the magnitude of the increase in short-term interest rates will be influenced by the extent of the exchange rate response.', 'i hope this makes it clear that what the bank of canada has in mind, and is aiming for, is a "gradual easing off on the accelerator" in the months ahead, so that there will be no need to "slam on the brakes" later on.', "making the most of the economy's production potential next, let me say a few words about the challenges that await us further down the road.", 'one of the more remarkable international economic developments of the past few years has been the performance of the u.s. economy.', 'that economy has had six years of solid economic expansion, with high rates of job creation and low inflation.', 'in the late 1980s, when the u.s. unemployment rate dipped below 6 per cent, there were strong inflationary pressures.', 'compare this with the present situation: the u.s. economy has been expanding at an average rate of about 31⁄2 per cent for 8 quarters, current levels of demand are above most estimates of its capacity to produce, and the unemployment rate has been at or below 5 per cent for several months.', 'yet inflation has remained well behaved.', 'are we operating in a different environment?', 'there are, of course, some temporary factors -- such as the appreciation of the u.s. dollar, the decline in energy prices, and the slack in overseas economies -- that are currently helping to suppress inflationary pressures in the united states.', 'however, a number of observers are suggesting that other, more permanent factors may also be contributing.', 'one possibility, which has been rather widely discussed recently, is that all the structural changes that have taken place in the united states have raised the production capacity of the economy and reduced the risk of inflation.', 'i believe that another important factor in this success story has been the strong credibility of monetary policy in the united states.', 'by persuading americans that it is determined to maintain low inflation, the u.s. federal reserve has given itself room to test the potential of the economy without triggering the quick response in wages and prices from worried workers and businesses that we saw during the years of high inflation.', 'how does this u.s. experience relate to canada?', 'can we also look forward to an improvement in the longer-term performance of our economy?', 'unfortunately, it is not possible to make that judgement in advance, given the complexity of the factors affecting economic performance.', 'how rapid growth can be and still be sustainable, and how low our unemployment rate will go, will ultimately depend on the flexibility, efficiency, and productivity of canadian enterprises.', 'i am referring here to the effective use of new technology; the skills, training, and adaptability of our labour force; our ability to control costs; and the initiative and ability of canadian businesses to find and develop new and expanded foreign markets for their products.', 'the contribution that monetary policy can make towards realizing this potential is to ensure that the pace of economic expansion remains sustainable.', 'this essentially means encouraging monetary conditions that will allow the economy to test the limits of its capacity to expand, but without setting off inflation and the costly boom and bust cycles of the past two decades.', 'as in the united states, the problem in canada is that there is considerable uncertainty regarding the level of economic activity that can be accommodated by our capacity to produce and how rapidly this capacity will expand over time.', "this is where the bank of canada's inflation-control target should prove useful as we try to steer the economy along a sustainable growth path.", 'that target is to hold inflation inside a range of 1 to 3 per cent.', 'one of the advantages of such an explicit target is that it provides a ready measure of the state of the economy by comparing the actual trend of inflation against the target range.', 'if the trend of inflation looks as though it will be pushing through the top of the target range, this implies that demand in the economy has been unsustainably strong, and monetary conditions must be tightened.', 'but if inflation is persistently lower than past history and the existing levels of demand would suggest, and it is tending to press the bottom of the range, chances are that there is more room for the economy to expand than previously thought, and monetary conditions can be easier.', 'however, if the bank of canada is going to respond to such signals, we must ensure that our inflation-control strategy is a credible one.', 'it is by conducting monetary policy in a prudent manner during the economic upswing that the bank can provide canadians with assurance that inflation will remain under control when the economy begins to operate at levels that push against the limits of capacity.', 'if businesses, individuals, and investors are persuaded that inflation will stay low, they will not respond immediately to signs of strong demand pressures by seeking to raise prices and wages and by pushing up interest rates.', 'such an environment provides the flexibility necessary for the economy to test the limits of growth and employment without immediately putting the economic expansion at risk.', 'concluding remarks in conclusion, let me just say that the period ahead will be an exciting one.', 'at no time since the 1960s have we had in place the conditions that would permit the canadian economy to fully realize its potential.', 'with inflation under control and increasingly favourable fiscal positions, we now have an opportunity to see what our economy is capable of delivering, in terms of sustained growth in output and employment and improving standards of living.', "the bank of canada's role is to make sure that monetary policy provides the right background -- a stable, low-inflation environment."]	Gordon Thiessen	Bank of Canada	Governor	Canada
https://www.bis.org/review/r971010d.pdf	Mr. Greenspan's testimony before the US House of Representatives Committee on the Budget (Central Bank Articles and Speeches, 8 Oct 97)	Testimony by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, in Washington on 8/10/97.	1997-10-08 00:00:00	Mr. Greenspan's testimony before the US House of Representatives Committee Testimony by the Chairman of the Board of Governors of the US Federal Reserve on the Budget System, Mr. Alan Greenspan, in Washington on 8/10/97. After decades of budgetary imprudence, there has been a growing recognition of our fiscal problems in recent years and an increased willingness of Presidents and Congresses to address them. The capping of discretionary programs and the first steps to deal with entitlement programs are encouraging, as, unquestionably, is the slower pace at which we are creating new entitlement programs. But it is important to place this improvement in the context of the decades-long deterioration in our fiscal position; we have stopped the erosion for now, but we have made only a downpayment on the longer-range problem confronting us. Moreover, much of the fiscal improvement of recent years is less the result of a return to the prudent attitudes and actions of earlier generations, than the emergence of benevolent forces largely external to the fiscal process. The end of the Cold War has yielded a substantial peace dividend, and the best economic performance in decades has augmented tax revenues far beyond expectations while restraining countercyclically sensitive outlays. The payout of the peace dividend is coming to an end. Defense outlays have fallen from 6.2 percent of GDP in 1985 to 3.4 percent this year. Further cuts may be difficult to achieve, for even if we are fortunate enough to enjoy a relatively tranquil world, spending will tend to be buoyed by the need to replace technologically obsolescent equipment, as well as by the usual political pressures. The long-term outlook for the American economy presents us with, perhaps, even greater uncertainties. There can be little doubt that the American economy in the last several years has performed far better than the history of business expansions would have led us to expect. Labor markets have tightened considerably without inflation emerging as it has in the past. Encouraged by these results, financial markets seem to have priced in an optimistic outlook, characterized by a significant reduction in risk and an increasingly benevolent inflation process. For example, in equity markets, continual upward revisions of longer-term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of an economic expansion. Contributing to the expected increases in profits is a perceived marked increase in the prospective rate of return on new business ventures. This is evidenced by the sharp increase in capital investment since early 1993, especially in hi-tech equipment, which has persisted and even accelerated in recent quarters. Underlying this apparent bulge in expected profitability and rates of return, as I suggested in my July Humphrey-Hawkins testimony, may be a maturing of major technologies in recent years. The synergies of lasers and fiber optics have spurred large increases in communications investments. The continued extraordinary spread of computer-related applications, as costs of manipulating data and other information fall, has also been a major factor in increased investment outlays. The combination of advancing telecommunications and computer technologies have induced large investment outlays to support the Internet and utilize it to realize efficiencies in purchasing, production, and marketing. This dramatic change in technology, as I pointed out in earlier testimony, has markedly shortened the lead times in bringing new production facilities on line to meet increased demand, and has accordingly significantly reduced longer-term bottlenecks and materials shortages, phenomena often leading to inflation in the past. Indeed, this faster response of facility capacity, coupled with dramatic declines in transportation costs owing to a downsizing of products, has led to speculation that we are operating with a new "paradigm," where price pressures need rarely ever arise because low-cost capacity, both here and abroad, can be brought on sufficiently rapidly when demand accelerates. Before we go too far in this direction, however, we need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector. Though less extensive than in years past at similarly high levels of capacity utilization, they were nonetheless putting visible upward pressures on prices at early stages of the production chain. Further strides toward greater flexibility of facilities have occurred since 1994, but this is clearly an evolutionary, not a revolutionary, process. At least for the foreseeable future, it will still take time to bring many types of new facilities into the production process, and productive capacity will still impose limits on meeting large unexpected increases in demand in a short period. More relevant, by far, however, is that technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility through increased use of outsourcing and temporary workers. In addition, smaller work teams may be able to adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Its lead time reflects biology, not technology. Of course, the demand for capital facilities and labor are not entirely independent. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts often can expand output without significant addition to facilities. Similarly, more labor-saving equipment can permit production to be increased with the same level of employment, an outcome that we would observe as increased labor productivity. As I will be discussing in a moment, we are seeing some favorable signs in this regard, but they are only suggestive, and the potential for increased productivity to enhance the effective supply of labor is limited. The fact is, that despite large additions to the capital stock in recent years, the supply of labor has kept pace with the demand for goods and services and the labor to produce them only by reducing the margin of slack in labor markets. Of the more than two million net new hires at an annual rate from early 1994 through the third quarter of this year, little more than half came from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining one million per year increase in employment was pulled from those who had been reported as unemployed (nearly 700 thousand annually) and those who wanted, but had not actively sought, a job (more than 300 thousand annually). The latter, of course, are not in the official unemployment count. The key point is that continuously digging ever deeper into the available working-age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit, if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment, and includes people whose skills are not well adapted to work today and would be very costly to employ. In addition, there is a limit on how many of the millions who wanted a job but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number whose availability is limited by their enrollment in school, and those who may lack the necessary skills or may face other barriers to taking jobs. The number of people saying they would like a job, but have not been engaged in active job search, declined dramatically in 1996. But, despite increasingly favorable labor markets, few more of these 5 million individuals have been added to payrolls in 1997. This group of potential workers, on balance, is at its lowest level relative to the working-age population since at least 1970. As a source of new workers we may have reached about as far as is feasible into this group of the population. Presumably, some of the early retirees, students, or homemakers who do not now profess to want to work could be lured to the job market. Rewards sufficient to make jobs attractive, however, could conceivably also engender upward pressures on labor costs that would trigger renewed price pressures, undermining the expansion. Thus, there would seem to be emerging constraints on potential labor input. If the recent 2 million plus annual pace of job creation were to continue, the pressures on wages and other costs of hiring large numbers of such individuals could escalate more rapidly. To be sure, job growth slowed significantly in August and September, but it did not slow enough to close, from the demand side alone, the gap of the demand for labor over the supply from increases in the working-age population. Thus, the performance of the labor markets this year suggests that the economy has been on an unsustainable track. That the marked rate of absorption of potential workers since 1994 has not induced a more dramatic increase in employee compensation per hour and price inflation has come as a major surprise to most analysts. The strengthened exchange value of the dollar, which has helped contain price increases, is certainly one factor in explaining business reluctance to grant wage increases. Another explanation I have offered in the past is that the acceleration in technology and capital investment, in part by engendering important changes in the types of facilities with which people work on a day-by-day basis, has also induced a discernible increase in fear of job skill obsolescence and, hence, an increasing willingness to seek job security in lieu of wage gains. Certainly, the dramatic rise in recent years of on-the-job training and a substantial increase in people returning to school -- especially those aged twenty-five to thirty-four, mainly at the college level -- suggests significant concerns about skills. But the force of insecurity may be fading. Public opinion polls, which recorded a marked increase in fear of job loss from 1991 to 1995, a period of tightening labor markets, now indicate a partial reversal of that uptrend. To be sure, there is still little evidence of wage acceleration. To believe, however, that wage pressures will not intensify as the group of people who are not working, but who would like to, rapidly diminishes, strains credibility. The law of supply and demand has not been repealed. If labor demand continues to outpace sustainable increases in supply, the question is surely when, not whether, labor costs will escalate more rapidly. Of course, a fall-off in the current pace of demand for goods and services could close the gap and avoid the emergence of inflationary pressures. So could a sharp improvement in productivity growth, which would reduce the pace of new hiring required to produce a given rate of growth of real output. Productivity growth in manufacturing, as best we can measure it, apparently did pick up some in the third quarter and the broader measures of productivity growth have exhibited a modest quickening this year. Certainly, the persistence, even acceleration, of commitments to invest in new facilities suggests that the actual profitability of recent past investments, and by extension increased productivity, has already been achieved to some degree rather than being merely prospective. However, to reduce the recent two million plus annual rate of job gains to the one million rate consistent with long-term population growth would require, all else equal, a full percentage point increase in the rate of productivity growth. While not inconceivable, such a rapid change is rare in the annals of business history, especially for a mature industrial society of our breadth and scope. Clearly, impressive new technologies have imparted a sense of change in which previous economic relationships are seen as being less reliable now. Improvements in productivity are possible if worker skills increase, but gains come slowly through experience, education, and on-the-job training. They are also possible as capital substitutes for labor, but that is limited by the state of current technology. Very significant advances in productivity require technological breakthroughs that alter fundamentally the efficiency with which we use our labor and capital resources. But at the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won. Short of a marked slowing in the demand for goods and services and, hence, labor -- or a degree of acceleration of productivity growth that appears unlikely -- the imbalance between the growth in labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence and, with it, the solid growth of real activity. In this context, the economic outlook sketched out for the United States by both the Office of Management and Budget and the Congressional Budget Office is realistic, even in some sense conservative. But you should recognize the range of possible long-term outcomes, both significantly better or worse, has risen markedly in the last year. An acceleration of productivity growth, should it materialize, would put the economy on a higher trend growth path than they have projected. The development of inflationary pressures, on the other hand, would doubtless create an environment of slower growth in real output than that projected by OMB or CBO. A re-emergence of inflation is, without question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades. In this regard, we at the Federal Reserve recognize that how we handle monetary policy will be a significant factor influencing the path of economic growth and, hence, fiscal outcomes. Given the wider range of possible outcomes that we face for long-term economic growth, the corresponding ranges of possible budget outcomes over the next five to ten years also has widened appreciably. In addition to the uncertainties associated with economic outcomes, questions may be raised about other assumptions behind both projected receipts and outlays. With regard to the former, it is difficult to believe that our much higher-than-expected income tax receipts of late are unrelated to the huge increase in capital gains, which since 1995 have totaled the equivalent of one-third of national income. Aside from the question of whether stock prices will rise or fall, it clearly would be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years. On the outlay side, the recently enacted budget agreement relies importantly on significant, but as-yet-unspecified, restraints on discretionary spending to be made in the years 2001, 2002, and thereafter. Supporters of each program expect the restraints to fall elsewhere. Inevitably, the eventual publication of the detail will expose deep political divisions, which could make the realization of the budget projections less likely. In addition, while the budget agreement included significant cuts in Medicare spending, past experience has shown us how difficult Medicare is to control, raising the possibility that savings will never be realized. More generally, I wonder whether there is enough funding slack to accommodate contingencies, or the inevitable new, but as yet unidentified, spending programs. Budget forecasts are understandably subject to fairly large errors. Seemingly small changes in receipts and outlays are magnified in the budget deficit. For example, during the 1990s, the average absolute error in the projections of February for receipts and outlays in the fiscal years starting the subsequent October has been greater than four percent. A four percent error in both outlays and receipts in opposite directions amounts to more than $125 billion annually. Indeed, the uncertainty of budget forecasts is no better illustrated than by an admittedly extreme case. During the last two and a half years the projection of the fiscal balance, excluding new initiatives, for the year 2002 has changed by about $250 billion. While all this fortunately has been in the direction of smaller deficits, the degree of uncertainty suggests that the error could just as easily be on the other side. With this high level of uncertainty in projecting budget totals and associated deficits, the Congress needs to evaluate the consequences to long-term economic growth of errors in fiscal policy. A base issue in such an evaluation is whether we are better off to be targeting a large deficit, balance, or a chronic surplus in our unified budget. There is nothing special about budget balance per se, except that it is far superior to deficits. I have always emphasized the value of a budgetary surplus in increasing national savings, especially when American private domestic savings is low, as it is today. Higher national savings lead in the long run to higher investment and living standards. They also foster low inflation. Low inflation itself may be responsible, in part, for higher productivity growth and larger gains in standards of living. If economic growth and rising living standards, fostered by investment and price stability, are our goal, fiscal policy in my judgment will need to be biased toward surpluses in the years immediately ahead. This is especially so given the inexorable demographic trends that threaten huge increases in outlays beyond 2010. We should view the recent budget agreement, even if receipts and outlays evolve as expected, as only an important downpayment on the larger steps we need to take to solve the harder problem -- putting our entitlement programs on a sound financial footing for the 21st century. Moreover, targeted surpluses could hopefully help to offset the inbuilt political bias in favor of budget deficits. I have been in too many budget meetings in the last three decades not to have learned that the ideal fiscal initiative from a political perspective is one that creates visible benefits for one group of constituents without a perceived cost to anybody else, a form of political single-entry bookkeeping. To be sure, in recent years we have been showing some real restraint in our approach to fiscal policy. Yet, despite terminating a number of programs, the ratio of federal nondefense, noninterest, spending to GDP still stands at nearly 14 percent, double what it was in the 1950s. This may be one reason why inflation premiums, embodied in long-term interest rates, still are significant. There is, thus, doubtless a lot of catching up to do. The current initiatives toward welfare, social security, and Medicare reform are clearly steps in the right direction, but far more is required. Let us not squander years of efforts to balance the budget and the benefits of ideal economic conditions by failing to address our long-term imbalances. A critical imbalance is the one faced by social security. Its fund's reported imbalance stems primarily from the fact that, until very recently, the payments into the social security trust accounts by the average employee, plus employer contributions and interest earned, were inadequate, at retirement, to fund the total of retirement benefits. This has started to change. Under the most recent revisions to the law, and presumably conservative economic and demographic assumptions, today's younger workers will be paying social security taxes over their working years that appear sufficient to fund their benefits during retirement. However, the huge liability for current retirees, as well as for much of the work force closer to retirement, leaves the system, as a whole, badly underfunded. The official unfunded liability for the Old Age, Survivors and Disability funds, which takes into account expected future tax payments and benefits out to the year 2070, has reached a staggering $3 trillion. This issue of funding underscores the critical elements in the forthcoming debate on social security reform, because it focusses on the core of any retirement system, private or public. Simply put, enough must be set aside over a lifetime of work to fund the excess of consumption over claims on production a retiree may enjoy. At the most rudimentary level, one could envision households saving by actually storing goods purchased during their working years for consumption during retirement. Even better, the resources that would have otherwise gone into the stored goods could be diverted to the production of new capital assets, which would, cumulatively, over a working lifetime, produce an even greater quantity of goods and services to be consumed in retirement. In the latter case, we would be getting more output per worker, our traditional measure of productivity, and a factor that is central in all calculations of long-term social security trust fund financing. Hence, the bottom line in all retirement programs is physical resource availability. The finance of any system is merely to facilitate the underlying system of allocating real resources that fund retirement consumption of goods and services. Unless social security savings are increased by higher taxes (with negative consequences for growth) or lowered benefits, domestic savings must be augmented by greater private saving or surpluses in the rest of the government budget to help ensure that there is enough savings to finance adequate productive capacity down the road to meet the consumption needs of both retirees and active workers. The basic premise of our current largely pay-as-you-go social security system is that future productivity growth will be sufficient to supply promised retirement benefits for current workers. However, even supposing some acceleration in long-term productivity growth from recent experience, at existing rates of domestic saving and capital investment this is becoming increasingly dubious. Accordingly, short of a far more general reform of the system, there are a number of initiatives, at a minimum, that should be addressed. As I argued at length in the Social Security Commission deliberations of 1983, with only marginal effect, some delaying of the age of eligibility for retirement benefits will become increasingly pressing. For example, adjusting the full-benefits retirement age to keep pace with increases in life expectancy in a way that would keep the ratio of retirement years to expected life span approximately constant would help to significantly narrow the funding gap. Such an initiative will become easier to implement as fewer and fewer of our older citizens retire from physically arduous work. Hopefully, other modifications to social security, such as improved cost of living indexing, will be instituted. There are a number of thoughtful reform initiatives that, through the process of privatization, could increase domestic saving rates. These are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization is that replacing the current underfunded system with a fully funded one could boost domestic saving. But, we must remember it is because privatization plans might increase savings that makes them potentially valuable, not their particular form of financing. As I have argued elsewhere, unless national savings is increased, shifting social security trust funds to private securities, while increasing government retirement system income, will lower retirement incomes in the private sector to an offsetting degree. This would not be an improvement to our overall retirement system. The types of changes that will be required to restore fiscal balance to our social security accounts, in the broader scheme of things, are significant but manageable. More important, most entail changes that are less unsettling if they are enacted soon, even if their effects are significantly delayed, rather than waiting five or ten years or longer for legislation. Minimizing the potential disruptions associated with the inevitable changes to social security is made all the more essential because of the pressing financial problems in the Medicare system, social security's companion program for retirees. Medicare as you are well aware is in an even more precarious position than social security. The financing of Medicare faces some of the same problems associated with demographics and productivity as social security but faces different, and currently greater, pressures owing to the behavior of medical costs and utilization rates. Reform of the Medicare system will require more immediate and potentially more dramatic changes than those necessary to reform social security. We owe it to those who will retire after the turn of the century to be given sufficient advance notice to make what alterations in retirement planning may be required. The longer we wait to make what are surely inevitable adjustments, the more difficult they will become. If we procrastinate too long, the adjustments could be truly wrenching. Our senior citizens, both current and future, deserve better.	["mr. greenspan's testimony before the us house of representatives committee testimony by the chairman of the board of governors of the us federal reserve on the budget system, mr. alan greenspan, in washington on 8/10/97.", 'after decades of budgetary imprudence, there has been a growing recognition of our fiscal problems in recent years and an increased willingness of presidents and congresses to address them.', 'the capping of discretionary programs and the first steps to deal with entitlement programs are encouraging, as, unquestionably, is the slower pace at which we are creating new entitlement programs.', 'but it is important to place this improvement in the context of the decades-long deterioration in our fiscal position; we have stopped the erosion for now, but we have made only a downpayment on the longer-range problem confronting us.', 'moreover, much of the fiscal improvement of recent years is less the result of a return to the prudent attitudes and actions of earlier generations, than the emergence of benevolent forces largely external to the fiscal process.', 'the end of the cold war has yielded a substantial peace dividend, and the best economic performance in decades has augmented tax revenues far beyond expectations while restraining countercyclically sensitive outlays.', 'the payout of the peace dividend is coming to an end.', 'defense outlays have fallen from 6.2 percent of gdp in 1985 to 3.4 percent this year.', 'further cuts may be difficult to achieve, for even if we are fortunate enough to enjoy a relatively tranquil world, spending will tend to be buoyed by the need to replace technologically obsolescent equipment, as well as by the usual political pressures.', 'the long-term outlook for the american economy presents us with, perhaps, even greater uncertainties.', 'there can be little doubt that the american economy in the last several years has performed far better than the history of business expansions would have led us to expect.', 'labor markets have tightened considerably without inflation emerging as it has in the past.', 'encouraged by these results, financial markets seem to have priced in an optimistic outlook, characterized by a significant reduction in risk and an increasingly benevolent inflation process.', 'for example, in equity markets, continual upward revisions of longer-term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of an economic expansion.', 'contributing to the expected increases in profits is a perceived marked increase in the prospective rate of return on new business ventures.', 'this is evidenced by the sharp increase in capital investment since early 1993, especially in hi-tech equipment, which has persisted and even accelerated in recent quarters.', 'underlying this apparent bulge in expected profitability and rates of return, as i suggested in my july humphrey-hawkins testimony, may be a maturing of major technologies in recent years.', 'the synergies of lasers and fiber optics have spurred large increases in communications investments.', 'the continued extraordinary spread of computer-related applications, as costs of manipulating data and other information fall, has also been a major factor in increased investment outlays.', 'the combination of advancing telecommunications and computer technologies have induced large investment outlays to support the internet and utilize it to realize efficiencies in purchasing, production, and marketing.', 'this dramatic change in technology, as i pointed out in earlier testimony, has markedly shortened the lead times in bringing new production facilities on line to meet increased demand, and has accordingly significantly reduced longer-term bottlenecks and materials shortages, phenomena often leading to inflation in the past.', 'indeed, this faster response of facility capacity, coupled with dramatic declines in transportation costs owing to a downsizing of products, has led to speculation that we are operating with a new "paradigm," where price pressures need rarely ever arise because low-cost capacity, both here and abroad, can be brought on sufficiently rapidly when demand accelerates.', 'before we go too far in this direction, however, we need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector.', 'though less extensive than in years past at similarly high levels of capacity utilization, they were nonetheless putting visible upward pressures on prices at early stages of the production chain.', 'further strides toward greater flexibility of facilities have occurred since 1994, but this is clearly an evolutionary, not a revolutionary, process.', 'at least for the foreseeable future, it will still take time to bring many types of new facilities into the production process, and productive capacity will still impose limits on meeting large unexpected increases in demand in a short period.', 'more relevant, by far, however, is that technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand.', 'to be sure, individual firms have acquired additional flexibility through increased use of outsourcing and temporary workers.', 'in addition, smaller work teams may be able to adapt more readily to variations in order flows.', 'while these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor.', 'that supply is sensitive to changes in demand, but to a far more limited extent than facilities.', 'new plants can almost always be built.', 'but labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past.', 'its lead time reflects biology, not technology.', 'of course, the demand for capital facilities and labor are not entirely independent.', 'within limits, labor and capital are substitutes, and slack in one market can offset tightness in another.', 'for example, additional work shifts often can expand output without significant addition to facilities.', 'similarly, more labor-saving equipment can permit production to be increased with the same level of employment, an outcome that we would observe as increased labor productivity.', 'as i will be discussing in a moment, we are seeing some favorable signs in this regard, but they are only suggestive, and the potential for increased productivity to enhance the effective supply of labor is limited.', 'the fact is, that despite large additions to the capital stock in recent years, the supply of labor has kept pace with the demand for goods and services and the labor to produce them only by reducing the margin of slack in labor markets.', 'of the more than two million net new hires at an annual rate from early 1994 through the third quarter of this year, little more than half came from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants.', 'the remaining one million per year increase in employment was pulled from those who had been reported as unemployed (nearly 700 thousand annually) and those who wanted, but had not actively sought, a job (more than 300 thousand annually).', 'the latter, of course, are not in the official unemployment count.', 'the key point is that continuously digging ever deeper into the available working-age population is not a sustainable trajectory for job creation.', 'the unemployment rate has a downside limit, if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment, and includes people whose skills are not well adapted to work today and would be very costly to employ.', 'in addition, there is a limit on how many of the millions who wanted a job but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number whose availability is limited by their enrollment in school, and those who may lack the necessary skills or may face other barriers to taking jobs.', 'the number of people saying they would like a job, but have not been engaged in active job search, declined dramatically in 1996. but, despite increasingly favorable labor markets, few more of these 5 million individuals have been added to payrolls in 1997. this group of potential workers, on balance, is at its lowest level relative to the working-age population since at least 1970. as a source of new workers we may have reached about as far as is feasible into this group of the population.', 'presumably, some of the early retirees, students, or homemakers who do not now profess to want to work could be lured to the job market.', 'rewards sufficient to make jobs attractive, however, could conceivably also engender upward pressures on labor costs that would trigger renewed price pressures, undermining the expansion.', 'thus, there would seem to be emerging constraints on potential labor input.', 'if the recent 2 million plus annual pace of job creation were to continue, the pressures on wages and other costs of hiring large numbers of such individuals could escalate more rapidly.', 'to be sure, job growth slowed significantly in august and september, but it did not slow enough to close, from the demand side alone, the gap of the demand for labor over the supply from increases in the working-age population.', 'thus, the performance of the labor markets this year suggests that the economy has been on an unsustainable track.', 'that the marked rate of absorption of potential workers since 1994 has not induced a more dramatic increase in employee compensation per hour and price inflation has come as a major surprise to most analysts.', 'the strengthened exchange value of the dollar, which has helped contain price increases, is certainly one factor in explaining business reluctance to grant wage increases.', 'another explanation i have offered in the past is that the acceleration in technology and capital investment, in part by engendering important changes in the types of facilities with which people work on a day-by-day basis, has also induced a discernible increase in fear of job skill obsolescence and, hence, an increasing willingness to seek job security in lieu of wage gains.', 'certainly, the dramatic rise in recent years of on-the-job training and a substantial increase in people returning to school -- especially those aged twenty-five to thirty-four, mainly at the college level -- suggests significant concerns about skills.', 'but the force of insecurity may be fading.', 'public opinion polls, which recorded a marked increase in fear of job loss from 1991 to 1995, a period of tightening labor markets, now indicate a partial reversal of that uptrend.', 'to be sure, there is still little evidence of wage acceleration.', 'to believe, however, that wage pressures will not intensify as the group of people who are not working, but who would like to, rapidly diminishes, strains credibility.', 'the law of supply and demand has not been repealed.', 'if labor demand continues to outpace sustainable increases in supply, the question is surely when, not whether, labor costs will escalate more rapidly.', 'of course, a fall-off in the current pace of demand for goods and services could close the gap and avoid the emergence of inflationary pressures.', 'so could a sharp improvement in productivity growth, which would reduce the pace of new hiring required to produce a given rate of growth of real output.', 'productivity growth in manufacturing, as best we can measure it, apparently did pick up some in the third quarter and the broader measures of productivity growth have exhibited a modest quickening this year.', 'certainly, the persistence, even acceleration, of commitments to invest in new facilities suggests that the actual profitability of recent past investments, and by extension increased productivity, has already been achieved to some degree rather than being merely prospective.', 'however, to reduce the recent two million plus annual rate of job gains to the one million rate consistent with long-term population growth would require, all else equal, a full percentage point increase in the rate of productivity growth.', 'while not inconceivable, such a rapid change is rare in the annals of business history, especially for a mature industrial society of our breadth and scope.', 'clearly, impressive new technologies have imparted a sense of change in which previous economic relationships are seen as being less reliable now.', 'improvements in productivity are possible if worker skills increase, but gains come slowly through experience, education, and on-the-job training.', 'they are also possible as capital substitutes for labor, but that is limited by the state of current technology.', 'very significant advances in productivity require technological breakthroughs that alter fundamentally the efficiency with which we use our labor and capital resources.', 'but at the cutting edge of technology, where america finds itself, major improvements cannot be produced on demand.', 'new ideas that matter are hard won.', 'short of a marked slowing in the demand for goods and services and, hence, labor -- or a degree of acceleration of productivity growth that appears unlikely -- the imbalance between the growth in labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence and, with it, the solid growth of real activity.', 'in this context, the economic outlook sketched out for the united states by both the office of management and budget and the congressional budget office is realistic, even in some sense conservative.', 'but you should recognize the range of possible long-term outcomes, both significantly better or worse, has risen markedly in the last year.', 'an acceleration of productivity growth, should it materialize, would put the economy on a higher trend growth path than they have projected.', 'the development of inflationary pressures, on the other hand, would doubtless create an environment of slower growth in real output than that projected by omb or cbo.', 'a re-emergence of inflation is, without question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades.', 'in this regard, we at the federal reserve recognize that how we handle monetary policy will be a significant factor influencing the path of economic growth and, hence, fiscal outcomes.', 'given the wider range of possible outcomes that we face for long-term economic growth, the corresponding ranges of possible budget outcomes over the next five to ten years also has widened appreciably.', 'in addition to the uncertainties associated with economic outcomes, questions may be raised about other assumptions behind both projected receipts and outlays.', 'with regard to the former, it is difficult to believe that our much higher-than-expected income tax receipts of late are unrelated to the huge increase in capital gains, which since 1995 have totaled the equivalent of one-third of national income.', 'aside from the question of whether stock prices will rise or fall, it clearly would be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years.', 'on the outlay side, the recently enacted budget agreement relies importantly on significant, but as-yet-unspecified, restraints on discretionary spending to be made in the years 2001, 2002, and thereafter.', 'supporters of each program expect the restraints to fall elsewhere.', 'inevitably, the eventual publication of the detail will expose deep political divisions, which could make the realization of the budget projections less likely.', 'in addition, while the budget agreement included significant cuts in medicare spending, past experience has shown us how difficult medicare is to control, raising the possibility that savings will never be realized.', 'more generally, i wonder whether there is enough funding slack to accommodate contingencies, or the inevitable new, but as yet unidentified, spending programs.', 'budget forecasts are understandably subject to fairly large errors.', 'seemingly small changes in receipts and outlays are magnified in the budget deficit.', 'for example, during the 1990s, the average absolute error in the projections of february for receipts and outlays in the fiscal years starting the subsequent october has been greater than four percent.', 'a four percent error in both outlays and receipts in opposite directions amounts to more than $125 billion annually.', 'indeed, the uncertainty of budget forecasts is no better illustrated than by an admittedly extreme case.', 'during the last two and a half years the projection of the fiscal balance, excluding new initiatives, for the year 2002 has changed by about $250 billion.', 'while all this fortunately has been in the direction of smaller deficits, the degree of uncertainty suggests that the error could just as easily be on the other side.', 'with this high level of uncertainty in projecting budget totals and associated deficits, the congress needs to evaluate the consequences to long-term economic growth of errors in fiscal policy.', 'a base issue in such an evaluation is whether we are better off to be targeting a large deficit, balance, or a chronic surplus in our unified budget.', 'there is nothing special about budget balance per se, except that it is far superior to deficits.', 'i have always emphasized the value of a budgetary surplus in increasing national savings, especially when american private domestic savings is low, as it is today.', 'higher national savings lead in the long run to higher investment and living standards.', 'they also foster low inflation.', 'low inflation itself may be responsible, in part, for higher productivity growth and larger gains in standards of living.', 'if economic growth and rising living standards, fostered by investment and price stability, are our goal, fiscal policy in my judgment will need to be biased toward surpluses in the years immediately ahead.', 'this is especially so given the inexorable demographic trends that threaten huge increases in outlays beyond 2010. we should view the recent budget agreement, even if receipts and outlays evolve as expected, as only an important downpayment on the larger steps we need to take to solve the harder problem -- putting our entitlement programs on a sound financial footing for the 21st century.', 'moreover, targeted surpluses could hopefully help to offset the inbuilt political bias in favor of budget deficits.', 'i have been in too many budget meetings in the last three decades not to have learned that the ideal fiscal initiative from a political perspective is one that creates visible benefits for one group of constituents without a perceived cost to anybody else, a form of political single-entry bookkeeping.', 'to be sure, in recent years we have been showing some real restraint in our approach to fiscal policy.', 'yet, despite terminating a number of programs, the ratio of federal nondefense, noninterest, spending to gdp still stands at nearly 14 percent, double what it was in the 1950s.', 'this may be one reason why inflation premiums, embodied in long-term interest rates, still are significant.', 'there is, thus, doubtless a lot of catching up to do.', 'the current initiatives toward welfare, social security, and medicare reform are clearly steps in the right direction, but far more is required.', 'let us not squander years of efforts to balance the budget and the benefits of ideal economic conditions by failing to address our long-term imbalances.', 'a critical imbalance is the one faced by social security.', "its fund's reported imbalance stems primarily from the fact that, until very recently, the payments into the social security trust accounts by the average employee, plus employer contributions and interest earned, were inadequate, at retirement, to fund the total of retirement benefits.", 'this has started to change.', "under the most recent revisions to the law, and presumably conservative economic and demographic assumptions, today's younger workers will be paying social security taxes over their working years that appear sufficient to fund their benefits during retirement.", 'however, the huge liability for current retirees, as well as for much of the work force closer to retirement, leaves the system, as a whole, badly underfunded.', 'the official unfunded liability for the old age, survivors and disability funds, which takes into account expected future tax payments and benefits out to the year 2070, has reached a staggering $3 trillion.', 'this issue of funding underscores the critical elements in the forthcoming debate on social security reform, because it focusses on the core of any retirement system, private or public.', 'simply put, enough must be set aside over a lifetime of work to fund the excess of consumption over claims on production a retiree may enjoy.', 'at the most rudimentary level, one could envision households saving by actually storing goods purchased during their working years for consumption during retirement.', 'even better, the resources that would have otherwise gone into the stored goods could be diverted to the production of new capital assets, which would, cumulatively, over a working lifetime, produce an even greater quantity of goods and services to be consumed in retirement.', 'in the latter case, we would be getting more output per worker, our traditional measure of productivity, and a factor that is central in all calculations of long-term social security trust fund financing.', 'hence, the bottom line in all retirement programs is physical resource availability.', 'the finance of any system is merely to facilitate the underlying system of allocating real resources that fund retirement consumption of goods and services.', 'unless social security savings are increased by higher taxes (with negative consequences for growth) or lowered benefits, domestic savings must be augmented by greater private saving or surpluses in the rest of the government budget to help ensure that there is enough savings to finance adequate productive capacity down the road to meet the consumption needs of both retirees and active workers.', 'the basic premise of our current largely pay-as-you-go social security system is that future productivity growth will be sufficient to supply promised retirement benefits for current workers.', 'however, even supposing some acceleration in long-term productivity growth from recent experience, at existing rates of domestic saving and capital investment this is becoming increasingly dubious.', 'accordingly, short of a far more general reform of the system, there are a number of initiatives, at a minimum, that should be addressed.', 'as i argued at length in the social security commission deliberations of 1983, with only marginal effect, some delaying of the age of eligibility for retirement benefits will become increasingly pressing.', 'for example, adjusting the full-benefits retirement age to keep pace with increases in life expectancy in a way that would keep the ratio of retirement years to expected life span approximately constant would help to significantly narrow the funding gap.', 'such an initiative will become easier to implement as fewer and fewer of our older citizens retire from physically arduous work.', 'hopefully, other modifications to social security, such as improved cost of living indexing, will be instituted.', 'there are a number of thoughtful reform initiatives that, through the process of privatization, could increase domestic saving rates.', 'these are clearly worthy of intensive evaluation.', 'perhaps the strongest argument for privatization is that replacing the current underfunded system with a fully funded one could boost domestic saving.', 'but, we must remember it is because privatization plans might increase savings that makes them potentially valuable, not their particular form of financing.', 'as i have argued elsewhere, unless national savings is increased, shifting social security trust funds to private securities, while increasing government retirement system income, will lower retirement incomes in the private sector to an offsetting degree.', 'this would not be an improvement to our overall retirement system.', 'the types of changes that will be required to restore fiscal balance to our social security accounts, in the broader scheme of things, are significant but manageable.', 'more important, most entail changes that are less unsettling if they are enacted soon, even if their effects are significantly delayed, rather than waiting five or ten years or longer for legislation.', "minimizing the potential disruptions associated with the inevitable changes to social security is made all the more essential because of the pressing financial problems in the medicare system, social security's companion program for retirees.", 'medicare as you are well aware is in an even more precarious position than social security.', 'the financing of medicare faces some of the same problems associated with demographics and productivity as social security but faces different, and currently greater, pressures owing to the behavior of medical costs and utilization rates.', 'reform of the medicare system will require more immediate and potentially more dramatic changes than those necessary to reform social security.', 'we owe it to those who will retire after the turn of the century to be given sufficient advance notice to make what alterations in retirement planning may be required.', 'the longer we wait to make what are surely inevitable adjustments, the more difficult they will become.', 'if we procrastinate too long, the adjustments could be truly wrenching.', 'our senior citizens, both current and future, deserve better.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman of the Board of Governors	US
https://www.bis.org/review/r971010c.pdf	Ms. Phillips' testimony before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the U.S. House of Representatives (Central Bank Articles and Speeches, 8 Oct 97)	Testimony of a member of the Board of Governors of the US Federal Reserve System, Ms. Susan M. Phillips in Washington, on 8/10/97.	1997-10-08 00:00:00	Ms. Phillips' testimony before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the U.S. House of Testimony of a member of the Board of Governors of the US Federal Reserve Representatives System, Ms. Susan M. Phillips in Washington, on 8/10/97. Madam Chairwoman and members of the Subcommittee, I am pleased to be here today to discuss the Federal Reserve's efforts in recent years to strengthen its supervisory processes and also to share with you the Board's views about what challenges lie ahead, both for the banking system and the supervisory process. As you know, the U.S. economy and its banking system have enjoyed half a decade of improving strength in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While we can take comfort and, to some degree, satisfaction in these events, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Our goal as regulators is to identify weak banking practices early so that small or emerging problems can be addressed before they become large and costly -- either to the insurance fund or the financial system as a whole. We believe that progress made in recent years to focus our examinations on the areas of highest risk at banking organizations places us in a better position to identify problems early, control systemic risk, and maintain financial stability. That goal and the need to adapt the supervisory process to the potentially rapidly changing conditions in banking and financial markets underlies our decision to pursue a more risk-focused supervisory approach. We are well underway in implementing this new supervisory framework, and initial indications about that process from both the Federal Reserve's supervisory staff and the banking industry, itself, have been favorable. The risk-focused approach reflects our supervisory response to the effects that technology and financial innovation have had on the pace of change in banking organizations, the nature of U.S. and world financial markets, and the techniques employed for managing and controlling risk. As banking practices and markets continue to evolve, our emphasis on risk-focused supervision will be even more necessary in the years to come. The Federal Reserve's Oversight Role As the primary federal supervisor of U.S. bank holding companies, state member banks, and most U.S. offices of foreign banks, the Federal Reserve has sought to apply effective supervision and contain excessive risks to the federal safety net, while also ensuring that banks adequately serve their communities and accommodate economic growth. As the nation's central bank, the Federal Reserve brings a different, important perspective to the supervisory process through its attention to the broad and long-term consequences of supervisory actions on the financial system and the economy. Significantly, the practical, hands-on involvement which the Federal Reserve gains through its supervisory function supports and complements our other central bank responsibilities, including fostering a safe and efficient payment system and ensuring the stability of the financial system. Past studies of bank failures have cited a number of contributing factors including, but certainly not limited to, inadequate supervisory staffing and antiquated examination procedures. Over the years, as it has supervised and regulated banking organizations, the Federal Reserve has emphasized periodic, on-site examinations that entail substantive loan portfolio reviews and significant transaction testing to identify emerging problems. In that connection, the Federal Reserve has sought to maintain a sufficient number and quality of supervisory personnel to conduct examinations with appropriate frequency and depth. That approach appears to have provided us with some consistent success. As conditions within the industry have substantially improved, the Board has been mindful of the cost of conducting its supervisory activities and has worked to contain those costs in the face of increased responsibilities. Throughout this period we have recognized the need to maintain stability in our work force, and have sought to avoid excessive build-ups or periods of disruptive retrenchment. That approach has enabled us to maintain what we believe has been an adequate and consistent level of oversight of banking organizations under our supervision during both good times and bad. Developments Driving Change During the past decade, the U.S. banking system has experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with oil and agriculture sector difficulties or accumulating commercial real estate problems. These and other difficulties took a heavy toll. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 other problem banks. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to build their capital and reserves, strengthen their internal controls, and improve practices for identifying, underwriting and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these largely domestic, institutional events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought many benefits that facilitate more efficient markets and, in turn, greater international trade and economic growth. They may also, however, have raised macro-stability concerns by concentrating the growing volume and complexity of certain activities within a small number of truly global institutions. It is essential that these largest firms adequately manage the related risks of these activities and that they remain adequately supervised. For it is these institutions that have the potential to disrupt worldwide payment systems and contribute most to systemic risk. In addition to the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by the strong counterparty discipline being brought to bear world wide on banks and other financial institutions dealing in these new products. The scrutiny among counterparties in the global market place has contributed to improvements in capital positions and in overall risk management practices. In many ways, U.S. banks have been in the vanguard in applying technological advances to their products, distribution systems, and management processes, with such applications and innovations as ATMs, home banking, securitizations and credit derivatives. Such efforts, combined with greater attention to pricing their services and measuring their risks, have had material effects on the increased strength and profitability that our banks have seen. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, with the number of independent commercial banking organizations declining from 12,400 in 1980 to 7,400 in June of this year.1 That structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. The challenge going forward for many of these institutions may be in managing the growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand, particularly through acquisitions, into more diverse or nontraditional banking activities. That growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers while competing effectively with other regulated and unregulated firms. However, the managerial implications of rapid growth and growth into new activities should not be overlooked, either by the institutions or their supervisors. Supervisory Challenges Ahead There is also no shortage of tasks facing the Federal Reserve as a bank supervisor, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of technological improvements and financial techniques so that our oversight is not only effective, but also as unobtrusive and appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach issues such as measuring capital adequacy and how we seek convergence on bank supervisory standards worldwide. Risk-focused examinations Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, we have found that the increased range of products and the greater depth and liquidity of financial markets permit banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's processes for managing risk. Recognition of the need for that balance is at the heart of the risk-focused examination approach. The risk-focused approach, by definition, entails a more formal risk assessment planning phase that identifies those areas and activities that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and target areas of the portfolio for review. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of its information systems. The review of the information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding risk assumption. 1 "Independent commercial banking organizations" is defined as the sum of all bank holding companies and independent banks. Multi-bank holding companies are, therefore, considered as a single organization. As in the past, performance of substantive checks on the reliability of a bank's controls remains today a cornerstone of the examination process, albeit in a more automated and advanced form. For example, automated loan sampling is performed for the purpose of generating statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is getting an accurate indication of the bank's condition. Toward that end, Board staff is working to refine loan-sampling procedures that should further boost examiner productivity and accomplish other supervisory goals. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high-priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and senior examiners is ongoing between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18-month examinations. Such an approach strengthens our ability to respond promptly if conditions deteriorate. Another benefit of the risk-focused approach has been a greater amount of planning, analysis, and information gathering at Reserve Banks prior to the on-site portion of the examination. Far from reducing our hands-on knowledge of the institution, this approach has ensured that when we are on-site, we are reviewing and analyzing the right areas, talking to the right people and making better use of our time and that of the bank's management and employees. In addition to improving productivity, it has also reduced our travel costs and improved employee morale. Examination staff at the Reserve Banks indicate that this process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Federal Reserve personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked Federal Reserve examiners to provide a specific supervisory rating for a bank's risk management process. More recently, the CAMEL rating system, too, has been revised by the banking agencies to place more emphasis on the adequacy of a bank's risk management practices and was expanded to include a specific "S" rating for an institution's sensitivity to market risk. As you may know, the Federal Reserve has also, for some time, used a rating scheme that focuses heavily on managerial procedures and controls in its oversight of U.S. branches and agencies of foreign banks. How effective is the risk-focused process? Since economic and industry conditions have been generally favorable for the past several years, there has not been a sufficiently stressful economic downturn to test fully bank risk management systems or supervisory practices. The market volatility beginning in 1994 did, however, provide some tests for the risk management systems of the larger banks with active trading desks. Nevertheless, there are many indications that bank and supervisory practices are materially better than they were in the 1980s and early 1990s. For example, the risk-focused approach is helping to identify certain deficiencies before they show up in a bank's financial condition. These are evidenced by instances where ratings for the quality of bank management are lower than those for capital, asset quality, or earnings. Because managerial weaknesses eventually show up in a bank's financial condition, it is important to identify and resolve those weaknesses early. In that regard, the risk-focused approach endeavors to prevent problems from developing to the point that they cause unnecessary losses that impair the institution's capital and require resolution under the Prompt Corrective Action mandate. One example of how the risk-focused approach is helping to identify and address deficiencies is our supervisory experience with the U.S. branches of foreign banks. Subsequent to the enactment of the Foreign Bank Supervision Enhancement Act of 1991, which gave the Federal Reserve greater supervisory authority over foreign branches, our examinations uncovered a number of entities with internal control and audit weaknesses. This result was not completely unexpected, as these foreign banking organizations were not previously subject to the same level of oversight as our domestic organizations. Recognizing the seriousness of these weaknesses and their potential for causing problems in the future, the Federal Reserve has taken a number of steps to ensure that practices are materially upgraded at foreign branches and that any weaknesses continue to be uncovered. In addition to identifying and addressing internal control and audit weaknesses through examinations and supervisory follow-up, these efforts include ensuring that the foreign bank provides the necessary managerial support to its U.S. branches, including adequate systems of controls and audit. To place even more emphasis on internal controls and audit systems, the foreign branch rating system was revised in 1994. Furthermore, in 1996 additional steps were taken to ensure that internal control weaknesses are corrected and will not cause financial harm by adopting requirements for audit procedures in situations where significant control weaknesses are detected. These efforts to detect problems at their early stages and resolve them appear to be having positive effects. After peaking in 1993, there has been a steady decline in the number of U.S. branches and agencies with an overall examination rating of fair or lower and a rating of fair or lower in an examination component substantively affected by internal control and audit weaknesses. We believe that our continued efforts in this area will lead to further improvements in the internal control and audit practices of foreign banking organizations Implementing the risk-focused approach has not been an easy task. It has required a significant revision of our broad and specialized training programs, including expansion of capital markets, information technology, and global trading activities, as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion provided to examiners to focus on areas of highest risk, ensuring the consistency and quality of examinations has increased in importance. Fortunately, new training courses and improved examination platforms, tools, and programs that guide examiners through the appropriate selection of examination procedures will help. In addition, our ability to evaluate more thoroughly the quality of an examination has improved with the greater depth of analysis provided in supporting examination materials such as the written risk assessments and analysis of exam findings. Those materials are allowing us to perform comparative reviews of examinations across institutions of similar size, risk profile and complexity, to ensure quality and consistency. So far we have been able to evaluate the effectiveness of our examination programs by identifying whether problems are identified early and resolved in a timely fashion, by evaluating whether examination reports and findings provide clear feedback to management and identify areas of highest risk, and by monitoring the extent to which our examinations are complying with statutory mandates for the frequency of examinations. Based on those criteria, I believe our examination program has been generally successful. Application of technology to supervisory process The Federal Reserve has also done much to increase its own use of technology in an effort to improve examiner productivity, enhance analyses, and reduce burden on banks. Much of this effort has been conducted on an inter-agency basis, particularly in cooperation with the FDIC and state banking departments with whom we share supervision of state-chartered banks. Specific results include the development of a personal computer, lap-top workstation that provides examiners with a decision tree framework to assist them through the necessary procedures. The workstation also helps them document their work and prepare exam reports more efficiently. In addition, a software program has also been developed for receiving and analyzing loan portfolio data transmitted electronically from financial institutions. This process not only saves time but also improves the examiner's understanding of the risks presented by individual portfolios. The Federal Reserve is also developing an electronic examination tool for large domestic and foreign banking organizations that enhances our ability to share examination analysis and findings and other pertinent supervisory information among our Reserve Banks and with other supervisory authorities. This platform should substantively improve our ability to provide comprehensive oversight to those firms that are most prominent in the payment system and global financial markets. In addition to examination tools, the Federal Reserve has for many years maintained a comprehensive source of banking structure, financial, and examination data in its National Information Center. By year-end, we will have completed significant enhancements to the tools that provide examiners and analysts at the federal and state banking agencies with access to those data. The Year 2000 One of the clearest reminders that managing technology is a challenge of its own is the need for banks to resolve the "Year 2000" problem. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. This process should be complete by the middle of next year so that any detected deficiencies may be addressed in time. Meeting the demands of this review and ensuring proper remedies both before and after the year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Through the Bank for International Settlements and other international forums, the Federal Reserve and other U.S. banking agencies have emphasized the need for all institutions to recognize this issue and to address it actively. Importantly, century date compliance is gaining more attention internationally, and the Basle Supervisors Committee is taking steps to address this matter. Banks and others need to address year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. Efforts to Accommodate Industry Growth and Innovation Another goal of the Federal Reserve's supervisory approach is to remove unnecessary barriers that might hinder the industry's ability to grow, innovate, and remain competitive. Recently, the Board refined its application process to ensure that well-run, well capitalized banking organizations may apply to acquire banks and nonbanks in a more streamlined fashion and commence certain types of new activities without prior approval. The Board also significantly revised various rules for section 20 companies and scaled back or removed many redundant firewalls. While these refinements require some changes to the supervisory process, we firmly believe that removing barriers to these lower risk activities is essential to maintaining the industry's health and competitiveness and its ability to serve its customers and the community. Supervising nationwide and international institutions The consolidation and transformation of the U.S. banking system resulting from evolving market, statutory, and regulatory changes are also requiring the Federal Reserve to adapt to new conditions. As previously noted, we are working closely with the FDIC and state banking agencies to deal with the challenges presented by interstate banking and branching to ensure that the dual banking system remains viable in future years. To address that goal, the FDIC, the Federal Reserve, and the state banking departments began on October 1 a common risk-focused process for the examination of state-chartered community banks. Another initiative has been the State/Federal Supervisory Protocol, which commits the various banking agencies to work toward a "seamless" and minimally burdensome oversight process. In short, it sets forth a process in which state banking supervisors will accept the supervisory reports of other agencies for banks operating in their states through branches, but headquartered elsewhere. The fact that the plan has been accepted by all involved parties is encouraging. We now need to ensure that it is implemented as intended, as banks make use of their broader branching powers. Similar coordination efforts are necessary and underway in an international context. Through the Bank for International Settlements, for example, the Federal Reserve and the other U.S. banking agencies participate with supervisors from other G-10 countries to develop not only prudential capital and other regulatory standards, but also to promote sound practices over a broad range of banking issues. In this regard, the Basle Committee on Banking Supervision, with the approval of the central bank Governors of the G-10 countries, recently issued three documents: one dealing with the management of interest rate risk by banks, one dealing with the Year 2000 problems, and another identifying 25 "core principles" of effective supervision that is directed at bank supervisors worldwide. The Basle Committee is also working to improve international risk disclosure practices of banks, and has created the new market risk capital standard that is based on banks' internal value-at-risk models. That standard goes into effect in January of next year. Beyond the work of the Basle Committee and the banking agencies, we are also meeting with the SEC and international securities and insurance regulators to identify common issues, and to bring about greater convergence in our respective regulatory frameworks. That effort also has links to the Committee's efforts and should prove helpful in strengthening the oversight and regulation of financial institutions throughout the world that provide a broad range of financial products. Successful groundwork from this effort could also have implications for moving forward domestically in an era of financial reform. Guidance as well as supervisory and regulatory standards such as these -- whether developed in a domestic or international context -- are soon incorporated into examination procedures and help examiners in their reviews of many of the more complex activities of global banking organizations. These global institutions are perhaps the most challenging to supervise. Since it is not feasible for supervisors to review all locations of a global banking organization, emphasis is placed on the integrity of risk management and internal control systems, coordination with international supervisors, strong capital standards, and improved disclosures. Staffing the Supervisory Process A final supervisory challenge relates to the Federal Reserve's need to continue attracting, training, and retaining expert staff. Retaining sufficient numbers of individuals with the expertise to evaluate fully the risks in a rapidly changing banking industry is a major priority for the Federal Reserve and figures prominently in the bank supervision function's strategic plan. Particularly challenging is attracting and retaining specialists in the areas of capital markets and information technology where we have experienced increased turnover. We will continue efforts to attract and retain both specialists and generalists who are qualified to address issues as the industry evolves. As I have outlined in my testimony, the Federal Reserve's supervisory strategy is to maintain staff who can adequately evaluate the general soundness of banking activities by placing strong emphasis on the bank's management processes, systems, and controls. I believe such an approach will serve us well as the industry continues to evolve either by expanding the scope of its activities or through broader structural changes from financial modernization legislation. Nevertheless, developing the supervisory techniques, and attracting and training the personnel to do the job will pose a continuing challenge in the years ahead. Conclusion The history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection reflecting the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. As supervisors, we must prepare for such developments. In many ways, however, the banking and financial system have changed dramatically in the past decade both in terms of structure and diversity of activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years specifically about the need to actively monitor, manage and control risks. Nevertheless, conditions can always change, and the risk-focused approach will be continually challenged to anticipate and avoid new kinds of problems. We must recognize that a risk-focused approach to supervision is a developing process and however successful it may be, there will again be bank failures. Indeed, having no bank failures may suggest inadequate risk-taking by banks and less economic growth. Through our supervisory process, the Federal Reserve seeks to maintain the proper balance -- permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Devoting adequate attention to banking practices and conditions and responding promptly as events unfold is the key. We intend to do that now and in the years ahead.	["ms. phillips' testimony before the subcommittee on financial institutions and consumer credit of the committee on banking and financial services of the u.s. house of testimony of a member of the board of governors of the us federal reserve representatives system, ms. susan m. phillips in washington, on 8/10/97.", "madam chairwoman and members of the subcommittee, i am pleased to be here today to discuss the federal reserve's efforts in recent years to strengthen its supervisory processes and also to share with you the board's views about what challenges lie ahead, both for the banking system and the supervisory process.", 'as you know, the u.s. economy and its banking system have enjoyed half a decade of improving strength in which u.s. banks have become better capitalized and more profitable than they have been in generations.', 'moreover, in the past 13 months not a single insured bank has failed, and the bank insurance fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance.', 'while we can take comfort and, to some degree, satisfaction in these events, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems.', 'as i begin my remarks, i would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail.', 'our goal as regulators is to identify weak banking practices early so that small or emerging problems can be addressed before they become large and costly -- either to the insurance fund or the financial system as a whole.', 'we believe that progress made in recent years to focus our examinations on the areas of highest risk at banking organizations places us in a better position to identify problems early, control systemic risk, and maintain financial stability.', 'that goal and the need to adapt the supervisory process to the potentially rapidly changing conditions in banking and financial markets underlies our decision to pursue a more risk-focused supervisory approach.', "we are well underway in implementing this new supervisory framework, and initial indications about that process from both the federal reserve's supervisory staff and the banking industry, itself, have been favorable.", 'the risk-focused approach reflects our supervisory response to the effects that technology and financial innovation have had on the pace of change in banking organizations, the nature of u.s. and world financial markets, and the techniques employed for managing and controlling risk.', 'as banking practices and markets continue to evolve, our emphasis on risk-focused supervision will be even more necessary in the years to come.', "the federal reserve's oversight role as the primary federal supervisor of u.s. bank holding companies, state member banks, and most u.s. offices of foreign banks, the federal reserve has sought to apply effective supervision and contain excessive risks to the federal safety net, while also ensuring that banks adequately serve their communities and accommodate economic growth.", "as the nation's central bank, the federal reserve brings a different, important perspective to the supervisory process through its attention to the broad and long-term consequences of supervisory actions on the financial system and the economy.", 'significantly, the practical, hands-on involvement which the federal reserve gains through its supervisory function supports and complements our other central bank responsibilities, including fostering a safe and efficient payment system and ensuring the stability of the financial system.', 'past studies of bank failures have cited a number of contributing factors including, but certainly not limited to, inadequate supervisory staffing and antiquated examination procedures.', 'over the years, as it has supervised and regulated banking organizations, the federal reserve has emphasized periodic, on-site examinations that entail substantive loan portfolio reviews and significant transaction testing to identify emerging problems.', 'in that connection, the federal reserve has sought to maintain a sufficient number and quality of supervisory personnel to conduct examinations with appropriate frequency and depth.', 'that approach appears to have provided us with some consistent success.', 'as conditions within the industry have substantially improved, the board has been mindful of the cost of conducting its supervisory activities and has worked to contain those costs in the face of increased responsibilities.', 'throughout this period we have recognized the need to maintain stability in our work force, and have sought to avoid excessive build-ups or periods of disruptive retrenchment.', 'that approach has enabled us to maintain what we believe has been an adequate and consistent level of oversight of banking organizations under our supervision during both good times and bad.', 'developments driving change during the past decade, the u.s. banking system has experienced a great deal of turmoil, stress, and change.', "ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans.", 'at the same time, many of these institutions and smaller regional banks were struggling with oil and agriculture sector difficulties or accumulating commercial real estate problems.', 'these and other difficulties took a heavy toll.', 'by the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 other problem banks.', 'this experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs.', 'for their part, bankers recognized the need to build their capital and reserves, strengthen their internal controls, and improve practices for identifying, underwriting and managing risk.', 'supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well.', 'the fdic improvement act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge.', 'beyond these largely domestic, institutional events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets.', 'these technologies have brought many benefits that facilitate more efficient markets and, in turn, greater international trade and economic growth.', 'they may also, however, have raised macro-stability concerns by concentrating the growing volume and complexity of certain activities within a small number of truly global institutions.', 'it is essential that these largest firms adequately manage the related risks of these activities and that they remain adequately supervised.', 'for it is these institutions that have the potential to disrupt worldwide payment systems and contribute most to systemic risk.', 'in addition to the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by the strong counterparty discipline being brought to bear world wide on banks and other financial institutions dealing in these new products.', 'the scrutiny among counterparties in the global market place has contributed to improvements in capital positions and in overall risk management practices.', 'in many ways, u.s. banks have been in the vanguard in applying technological advances to their products, distribution systems, and management processes, with such applications and innovations as atms, home banking, securitizations and credit derivatives.', 'such efforts, combined with greater attention to pricing their services and measuring their risks, have had material effects on the increased strength and profitability that our banks have seen.', 'within the united states, our banking system has also experienced a dramatic consolidation in the number of banking institutions, with the number of independent commercial banking organizations declining from 12,400 in 1980 to 7,400 in june of this year.1 that structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs.', 'the challenge going forward for many of these institutions may be in managing the growth and the continuing process of industry consolidation.', 'this challenge may be greatest as banking organizations expand, particularly through acquisitions, into more diverse or nontraditional banking activities.', 'that growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers while competing effectively with other regulated and unregulated firms.', 'however, the managerial implications of rapid growth and growth into new activities should not be overlooked, either by the institutions or their supervisors.', 'supervisory challenges ahead there is also no shortage of tasks facing the federal reserve as a bank supervisor, despite the virtually unprecedented strong condition of the u.s. banking system today.', 'we, too, must deal with the evolving financial markets and advances in technology.', 'at the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of technological improvements and financial techniques so that our oversight is not only effective, but also as unobtrusive and appropriate as possible.', 'these tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach issues such as measuring capital adequacy and how we seek convergence on bank supervisory standards worldwide.', 'risk-focused examinations constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the federal reserve and an objective we have sought to advance with our emphasis on risk-focused examinations.', 'particularly in the past decade, we have found that the increased range of products and the greater depth and liquidity of financial markets permit banking organizations to change their risk profiles more rapidly than ever before.', "that possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's processes for managing risk.", 'recognition of the need for that balance is at the heart of the risk-focused examination approach.', 'the risk-focused approach, by definition, entails a more formal risk assessment planning phase that identifies those areas and activities that warrant the most extensive review.', "this pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and target areas of the portfolio for review.", "once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems.", "as a result, the federal reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of its information systems.", "the review of the information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding risk assumption.", '1 "independent commercial banking organizations" is defined as the sum of all bank holding companies and independent banks.', 'multi-bank holding companies are, therefore, considered as a single organization.', "as in the past, performance of substantive checks on the reliability of a bank's controls remains today a cornerstone of the examination process, albeit in a more automated and advanced form.", "for example, automated loan sampling is performed for the purpose of generating statistically valid conclusions about the accuracy of a bank's internal loan review process.", "to the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is getting an accurate indication of the bank's condition.", 'toward that end, board staff is working to refine loan-sampling procedures that should further boost examiner productivity and accomplish other supervisory goals.', "moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high-priority aspects of the institution's operations.", "a significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and senior examiners is ongoing between examinations.", 'that approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18-month examinations.', 'such an approach strengthens our ability to respond promptly if conditions deteriorate.', 'another benefit of the risk-focused approach has been a greater amount of planning, analysis, and information gathering at reserve banks prior to the on-site portion of the examination.', "far from reducing our hands-on knowledge of the institution, this approach has ensured that when we are on-site, we are reviewing and analyzing the right areas, talking to the right people and making better use of our time and that of the bank's management and employees.", 'in addition to improving productivity, it has also reduced our travel costs and improved employee morale.', 'examination staff at the reserve banks indicate that this process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of federal reserve personnel by perhaps 10 percent.', 'while those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications.', "complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management.", "since 1995, we have asked federal reserve examiners to provide a specific supervisory rating for a bank's risk management process.", 'more recently, the camel rating system, too, has been revised by the banking agencies to place more emphasis on the adequacy of a bank\'s risk management practices and was expanded to include a specific "s" rating for an institution\'s sensitivity to market risk.', 'as you may know, the federal reserve has also, for some time, used a rating scheme that focuses heavily on managerial procedures and controls in its oversight of u.s. branches and agencies of foreign banks.', 'how effective is the risk-focused process?', 'since economic and industry conditions have been generally favorable for the past several years, there has not been a sufficiently stressful economic downturn to test fully bank risk management systems or supervisory practices.', 'the market volatility beginning in 1994 did, however, provide some tests for the risk management systems of the larger banks with active trading desks.', 'nevertheless, there are many indications that bank and supervisory practices are materially better than they were in the 1980s and early 1990s.', "for example, the risk-focused approach is helping to identify certain deficiencies before they show up in a bank's financial condition.", 'these are evidenced by instances where ratings for the quality of bank management are lower than those for capital, asset quality, or earnings.', "because managerial weaknesses eventually show up in a bank's financial condition, it is important to identify and resolve those weaknesses early.", "in that regard, the risk-focused approach endeavors to prevent problems from developing to the point that they cause unnecessary losses that impair the institution's capital and require resolution under the prompt corrective action mandate.", 'one example of how the risk-focused approach is helping to identify and address deficiencies is our supervisory experience with the u.s. branches of foreign banks.', 'subsequent to the enactment of the foreign bank supervision enhancement act of 1991, which gave the federal reserve greater supervisory authority over foreign branches, our examinations uncovered a number of entities with internal control and audit weaknesses.', 'this result was not completely unexpected, as these foreign banking organizations were not previously subject to the same level of oversight as our domestic organizations.', 'recognizing the seriousness of these weaknesses and their potential for causing problems in the future, the federal reserve has taken a number of steps to ensure that practices are materially upgraded at foreign branches and that any weaknesses continue to be uncovered.', 'in addition to identifying and addressing internal control and audit weaknesses through examinations and supervisory follow-up, these efforts include ensuring that the foreign bank provides the necessary managerial support to its u.s. branches, including adequate systems of controls and audit.', 'to place even more emphasis on internal controls and audit systems, the foreign branch rating system was revised in 1994. furthermore, in 1996 additional steps were taken to ensure that internal control weaknesses are corrected and will not cause financial harm by adopting requirements for audit procedures in situations where significant control weaknesses are detected.', 'these efforts to detect problems at their early stages and resolve them appear to be having positive effects.', 'after peaking in 1993, there has been a steady decline in the number of u.s. branches and agencies with an overall examination rating of fair or lower and a rating of fair or lower in an examination component substantively affected by internal control and audit weaknesses.', 'we believe that our continued efforts in this area will lead to further improvements in the internal control and audit practices of foreign banking organizations implementing the risk-focused approach has not been an easy task.', 'it has required a significant revision of our broad and specialized training programs, including expansion of capital markets, information technology, and global trading activities, as well as courses devoted exclusively to internal controls.', 'these education programs will, of course, need to be continually updated as industry activities and conditions evolve.', 'with the greater discretion provided to examiners to focus on areas of highest risk, ensuring the consistency and quality of examinations has increased in importance.', 'fortunately, new training courses and improved examination platforms, tools, and programs that guide examiners through the appropriate selection of examination procedures will help.', 'in addition, our ability to evaluate more thoroughly the quality of an examination has improved with the greater depth of analysis provided in supporting examination materials such as the written risk assessments and analysis of exam findings.', 'those materials are allowing us to perform comparative reviews of examinations across institutions of similar size, risk profile and complexity, to ensure quality and consistency.', 'so far we have been able to evaluate the effectiveness of our examination programs by identifying whether problems are identified early and resolved in a timely fashion, by evaluating whether examination reports and findings provide clear feedback to management and identify areas of highest risk, and by monitoring the extent to which our examinations are complying with statutory mandates for the frequency of examinations.', 'based on those criteria, i believe our examination program has been generally successful.', 'application of technology to supervisory process the federal reserve has also done much to increase its own use of technology in an effort to improve examiner productivity, enhance analyses, and reduce burden on banks.', 'much of this effort has been conducted on an inter-agency basis, particularly in cooperation with the fdic and state banking departments with whom we share supervision of state-chartered banks.', 'specific results include the development of a personal computer, lap-top workstation that provides examiners with a decision tree framework to assist them through the necessary procedures.', 'the workstation also helps them document their work and prepare exam reports more efficiently.', 'in addition, a software program has also been developed for receiving and analyzing loan portfolio data transmitted electronically from financial institutions.', "this process not only saves time but also improves the examiner's understanding of the risks presented by individual portfolios.", 'the federal reserve is also developing an electronic examination tool for large domestic and foreign banking organizations that enhances our ability to share examination analysis and findings and other pertinent supervisory information among our reserve banks and with other supervisory authorities.', 'this platform should substantively improve our ability to provide comprehensive oversight to those firms that are most prominent in the payment system and global financial markets.', 'in addition to examination tools, the federal reserve has for many years maintained a comprehensive source of banking structure, financial, and examination data in its national information center.', 'by year-end, we will have completed significant enhancements to the tools that provide examiners and analysts at the federal and state banking agencies with access to those data.', 'the year 2000 one of the clearest reminders that managing technology is a challenge of its own is the need for banks to resolve the "year 2000" problem.', 'u.s. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans.', 'the federal reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made.', 'this process should be complete by the middle of next year so that any detected deficiencies may be addressed in time.', 'meeting the demands of this review and ensuring proper remedies both before and after the year 2000 will be a significant and costly task to both the industry and the banking agencies.', 'however, even within the context of banking, the scope of the year 2000 problem extends far beyond u.s. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties.', 'through the bank for international settlements and other international forums, the federal reserve and other u.s. banking agencies have emphasized the need for all institutions to recognize this issue and to address it actively.', 'importantly, century date compliance is gaining more attention internationally, and the basle supervisors committee is taking steps to address this matter.', 'banks and others need to address year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability.', 'at a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium.', 'if nothing else, it is simply good business.', "efforts to accommodate industry growth and innovation another goal of the federal reserve's supervisory approach is to remove unnecessary barriers that might hinder the industry's ability to grow, innovate, and remain competitive.", 'recently, the board refined its application process to ensure that well-run, well capitalized banking organizations may apply to acquire banks and nonbanks in a more streamlined fashion and commence certain types of new activities without prior approval.', 'the board also significantly revised various rules for section 20 companies and scaled back or removed many redundant firewalls.', "while these refinements require some changes to the supervisory process, we firmly believe that removing barriers to these lower risk activities is essential to maintaining the industry's health and competitiveness and its ability to serve its customers and the community.", 'supervising nationwide and international institutions the consolidation and transformation of the u.s. banking system resulting from evolving market, statutory, and regulatory changes are also requiring the federal reserve to adapt to new conditions.', 'as previously noted, we are working closely with the fdic and state banking agencies to deal with the challenges presented by interstate banking and branching to ensure that the dual banking system remains viable in future years.', 'to address that goal, the fdic, the federal reserve, and the state banking departments began on october 1 a common risk-focused process for the examination of state-chartered community banks.', 'another initiative has been the state/federal supervisory protocol, which commits the various banking agencies to work toward a "seamless" and minimally burdensome oversight process.', 'in short, it sets forth a process in which state banking supervisors will accept the supervisory reports of other agencies for banks operating in their states through branches, but headquartered elsewhere.', 'the fact that the plan has been accepted by all involved parties is encouraging.', 'we now need to ensure that it is implemented as intended, as banks make use of their broader branching powers.', 'similar coordination efforts are necessary and underway in an international context.', 'through the bank for international settlements, for example, the federal reserve and the other u.s. banking agencies participate with supervisors from other g-10 countries to develop not only prudential capital and other regulatory standards, but also to promote sound practices over a broad range of banking issues.', 'in this regard, the basle committee on banking supervision, with the approval of the central bank governors of the g-10 countries, recently issued three documents: one dealing with the management of interest rate risk by banks, one dealing with the year 2000 problems, and another identifying 25 "core principles" of effective supervision that is directed at bank supervisors worldwide.', "the basle committee is also working to improve international risk disclosure practices of banks, and has created the new market risk capital standard that is based on banks' internal value-at-risk models.", 'that standard goes into effect in january of next year.', 'beyond the work of the basle committee and the banking agencies, we are also meeting with the sec and international securities and insurance regulators to identify common issues, and to bring about greater convergence in our respective regulatory frameworks.', "that effort also has links to the committee's efforts and should prove helpful in strengthening the oversight and regulation of financial institutions throughout the world that provide a broad range of financial products.", 'successful groundwork from this effort could also have implications for moving forward domestically in an era of financial reform.', 'guidance as well as supervisory and regulatory standards such as these -- whether developed in a domestic or international context -- are soon incorporated into examination procedures and help examiners in their reviews of many of the more complex activities of global banking organizations.', 'these global institutions are perhaps the most challenging to supervise.', 'since it is not feasible for supervisors to review all locations of a global banking organization, emphasis is placed on the integrity of risk management and internal control systems, coordination with international supervisors, strong capital standards, and improved disclosures.', "staffing the supervisory process a final supervisory challenge relates to the federal reserve's need to continue attracting, training, and retaining expert staff.", "retaining sufficient numbers of individuals with the expertise to evaluate fully the risks in a rapidly changing banking industry is a major priority for the federal reserve and figures prominently in the bank supervision function's strategic plan.", 'particularly challenging is attracting and retaining specialists in the areas of capital markets and information technology where we have experienced increased turnover.', 'we will continue efforts to attract and retain both specialists and generalists who are qualified to address issues as the industry evolves.', "as i have outlined in my testimony, the federal reserve's supervisory strategy is to maintain staff who can adequately evaluate the general soundness of banking activities by placing strong emphasis on the bank's management processes, systems, and controls.", 'i believe such an approach will serve us well as the industry continues to evolve either by expanding the scope of its activities or through broader structural changes from financial modernization legislation.', 'nevertheless, developing the supervisory techniques, and attracting and training the personnel to do the job will pose a continuing challenge in the years ahead.', 'conclusion the history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection reflecting the role of banks in the credit intermediation process.', 'we can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change.', 'as supervisors, we must prepare for such developments.', 'in many ways, however, the banking and financial system have changed dramatically in the past decade both in terms of structure and diversity of activities.', 'risk management practices have also advanced, helped by technological and financial innovations.', 'i believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years specifically about the need to actively monitor, manage and control risks.', 'nevertheless, conditions can always change, and the risk-focused approach will be continually challenged to anticipate and avoid new kinds of problems.', 'we must recognize that a risk-focused approach to supervision is a developing process and however successful it may be, there will again be bank failures.', 'indeed, having no bank failures may suggest inadequate risk-taking by banks and less economic growth.', 'through our supervisory process, the federal reserve seeks to maintain the proper balance -- permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability.', 'devoting adequate attention to banking practices and conditions and responding promptly as events unfold is the key.', 'we intend to do that now and in the years ahead.']	Susan M Phillips	Board of Governors of the US Federal Reserve System	Member of the Board of Governors	US
https://www.bis.org/review/r971010b.pdf	Mr. Greenspan considers some of the effects of technological change (Central Bank Articles and Speeches, 5 Oct 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Convention of the American Bankers Association in Boston, on 5/10/97.	1997-10-05 00:00:00	Mr. Greenspan considers some of the effects of technological change Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Convention of the American Bankers Association in Boston, on 5/10/97. It is always with mixed feelings of pleasure and trepidation that I accept an invitation to speak at the American Bankers Association annual convention. I still have a disconcerted remembrance of my acceptance of your first invitation, which had been scheduled for October 20, 1987. That speech had to be scratched at the last minute as the result of a certain adversity in stock price adjustments the day before. Experience suggests, however, that history does not repeat with a fixed periodicity and, besides, I have crossed my fingers. The theme of your convention this year is timely. It is exactly when rapid innovation and institutional and technological change are taking place that market participants should take time to contemplate the opportunities and the risks, what to retain and what to change. Only then can the banking industry create the most value-added for customers, employees, and society, and as a consequence, for shareholders. As in recent years, the future role of banks and other providers of financial services will surely be significantly affected by the same basic forces that have shaped the real and financial economy world-wide: relentless technological change. This morning, I would like to describe some of the effects of technological change in both the financial and nonfinancial sectors and discuss a few of their more important implications. I will begin with the real economy. Technological Change and the Real Economy The most important single characteristic of the changes in U.S. technology in recent years is the ever expanding conceptualization of our Gross Domestic Product. We are witnessing the substitution of ideas for physical matter in the creation of economic value -- a shift from hardware to software, as it were. The roots of increasing conceptualization of output lie deep in human history, but the pace of such substitution probably picked up in the early stages of the industrial revolution, when science and machines created new leverage for human energy and ideas. Nonetheless, even as recently as the middle of this century, the symbols of American economic strength were our outputs of such physical products as steel, motor vehicles, and heavy machinery -- items for which sizable proportions of production costs reflected the exploitation of raw materials and the sheer manual labor required to manipulate them. However, today's views of economic leadership focus increasingly on downsized, smaller, less palpable evidence of weight and bulk, requiring more technologically sophisticated labor input. Examples of this trend permeate our daily lives. Radios used to be activated by large vacuum tubes; today we have elegantly designed pocked-sized transistors to perform the same function -- but with the higher quality of sound and greater reliability that consumers now expect. Thin fiber optic cable has replaced huge tonnages of copper wire. Owing to advances in metallurgy, engineering, and architectural design, we now can construct buildings that enclose as much or more space with fewer materials. A number of commentators, particularly Professor Paul David of Stanford University, have suggested that, despite the benefits we have seen this decade, it may be that the truly significant increases in living standards resulting from the introduction of computers and communications equipment still lie ahead. If true, this would not be unusual. Past innovations, such as the introduction of the dynamo or the invention of the gasoline-powered motor, required considerable infrastructure investment before their full potential could be realized. Electricity, when it substituted for steam power late last century, was initially applied to production processes suited to steam. Gravity was used to move goods vertically in the steam environment, and that could not immediately change with the advent of electric power. It was only when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system many years after electricity's initial introduction, that national productivity clearly accelerated. Similarly, it was only when modern highways and gasoline service stations became extensive that the lower cost of motor vehicle transportation became evident. Technological Change and the Financial Economy It is surely not news to a group of bankers that the same forces that have been reshaping the real economy have also been transforming the financial services industry. Once again, perhaps the most profound development has been the rapid growth of computer and telecommunications technology. The advent of such technology has lowered the costs, reduced the risks, and broadened the scope of financial services, making it increasingly possible for borrowers and lenders to transact directly, and for a wide variety of financial products to be tailored for very specific purposes. As a result, competitive pressures in the financial services industry are probably greater than ever before. As is true in the real economy, it is difficult to overestimate the importance of education and ongoing training to the advancement of technology and product innovation in the financial sector. I doubt that I need to tell any of you about the importance of education and training for employees. But the same is almost surely true for your customers. Surveys repeatedly indicate that users of electronic banking products are typically very well educated. For example, data from the Federal Reserve Board's Survey of Consumer Finances suggest that a higher level of education significantly increases the chances that a household consumer will use an electronic banking product. Indeed, this survey indicates that, in late 1995, the median user of an electronic source of information for savings or borrowing decisions had a college degree -- a level of education currently achieved by less than one-third of American households. Technological innovation and more sophisticated users have accelerated the second major trend -- financial globalization -- which has been reshaping our financial system, not to mention the real economy, for at least three decades. Both developments have expanded cross-border asset holding, trading, and credit flows and, in response, both securities firms and U.S. and foreign banks have increased their cross-border operations. Once again, a critical result has been greatly increased competition both at home and abroad. A third development reshaping financial markets -- deregulation -- has been as much a reaction to technological change and globalization as an independent factor. Moreover, the continuing evolution of markets suggests that it will be literally impossible to maintain some of the remaining rules and regulations established for previous economic environments. While the ultimate public policy goals of economic growth and stability will remain unchanged, market forces will continue to make it impossible to sustain outdated restrictions, as we have recently seen with respect to interstate banking and branching. In such an environment, I share your frustration with the pace of legislative reform and revision to statutorily mandated regulations. Nonetheless, we should not lose sight of the remarkable degree of re-codification of law and regulation to make banking rules more consistent with market realities that has occurred in recent years. Deposit and other interest rate ceilings have been eliminated, geographical restrictions have been virtually removed, many banking organizations can do a fairly broadly based securities underwriting and dealing business, many can do insurance sales, and those with the resources and skill are authorized to virtually match foreign bank competition abroad. Moreover, it seems clear that there is recognition by the Congress that the basic financial framework has to be adjusted further. The process, as you know, is not easy when the results of regulatory relief create both a new competitive landscape and new supervisory and stability challenges. Change will, I believe, ultimately occur because the pressures unleashed by technology, globalization, and deregulation have inexorably eroded the traditional institutional differences among financial firms. Examples abound. Securities firms have for some time offered checking-like accounts linked to mutual funds, and their affiliates routinely extend significant credit directly to business. On the bank side, the economics of a typical bank loan syndication do not differ essentially from the economics of a best-efforts securities underwriting. Indeed, investment banks are themselves becoming increasingly important in the syndicated loan market. With regard to derivatives instruments, the expertise required to manage prudently the writing of over-the-counter derivatives, a business dominated by banks, is similar to that required for using exchange-traded futures and options, instruments used extensively by both commercial and investment banks. The writing of a put option by a bank is economically indistinguishable from the issuance of an insurance policy. The list could go on. It is sufficient to say that a strong case can be made that the evolution of financial technology alone has changed forever our ability to place commercial banking, investment banking, insurance underwriting, and insurance sales into neat separate boxes. Nonetheless, not all financial institutions would prosper as, nor desire to be, financial supermarkets. Many specialized providers of financial services are successful today and will be so in the future because of their advantages in specific areas. Moreover, especially at commercial banks, the demand for traditional services by smaller businesses and by households is likely to continue for some time. And the information revolution, while it has deprived banks of some of the traditional lending business with their best customers, has also benefitted banks by making it less costly for them to assess the credit and other risks of customers they previously would have shunned. Thus, it seems most likely that banks of all types will continue to engage in a substantial amount of traditional banking, delivered, of course, by ever improving technology. Community banks, in particular, are likely to provide loans and payments services via traditional on-balance sheet banking. Indeed, smaller banks have repeatedly demonstrated their ability to survive and prosper in the face of major technological and structural change by providing traditional banking services to their customers. The evidence is clear that well-managed smaller banks can and will exist side by side with larger banks, often maintaining or increasing local market share. Technological change has facilitated this process by providing smaller banks with low-cost access to new products and services. In short, the record shows that well-managed smaller banks have nothing to fear from technology, globalization, or deregulation. For all size entities, however, technological change is blurring not only traditional distinctions between the banking, securities, and insurance business, but is also having a profound effect on historical separations between financial and nonfinancial businesses. Most of us are aware of software companies interested in the financial services business, but some financial firms, leveraging off their own internal skills, are also seeking to produce software for third parties. Shipping companies' tracking software lends itself to payment services. Manufacturers have financed their customers' purchases for a long time, but now increasingly are using the resultant financial skills to finance noncustomers. Moreover, many nonbank financial institutions are now profitably engaged in nonfinancial activities. Current facts and expected future trends, in short, are creating market pressures to permit the common ownership of financial and nonfinancial firms. In my judgement, it is quite likely that in future years it will be close to impossible to distinguish where one type of activity ends and another begins. Nonetheless, it seems wise to move with caution in addressing the removal of the current legal barriers between commerce and banking, since the unrestricted association of banking and commerce would be a profound and surely irreversible structural change in the American economy. Were we fully confident of how emerging technologies would affect the evolution of our economic and financial structure, we could presumably develop today the regulations which would foster that evolution. But we are not, and history suggests we cannot, be confident of how our real and financial economies will evolve. If we act too quickly, we run the risk of locking in a set of inappropriate rules that could adversely alter the development of market structures. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive. As Professor Nathan Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Indeed, Professor Rosenberg suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable. He notes at least two sources of this uncertainty. First, the range of applications for a new technology may not be immediately apparent. For instance, Alexander Graham Bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract. Indeed, he offered to sell his telephone patent to Western Union for only $100,000, but was turned down. Similarly, Marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. A second source of technological uncertainty reflects the possibility that an innovation's full potential may be realized only after extensive improvements, or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially refused, in the late 1960s, to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. It's not hard to find examples of such uncertainties within the financial services industry. The evolution of the over-the-counter derivatives market over the past decade has been nothing less than spectacular. But as the theoretical underpinnings of financial arbitrage were being published in the academic journals in the late 1950s, few observers could have predicted how the scholars' insights would eventually revolutionize global financial markets. Not only were additional theoretical and empirical research necessary, but, in addition, several generations of advances in computer and communications technologies were necessary to make these concepts computationally practicable. All these examples, and more, suggest, that if we dramatically change the rules now about banking and commerce, with what is great uncertainty about future synergies between finance and nonfinance, we may well end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly, if at all. Modifications of such a fundamental structural rule as the separation of banking and commerce accordingly should proceed at a deliberate pace in order to test the response of markets and technological innovations to the altered rules in the years ahead. The need for caution and humility with respect to our ability to predict the future is highly relevant for how banking supervision should evolve. As I proposed to this audience last year, regulators are beginning to understand that the supervision of a financial institution is, of necessity, a continually evolving process reflecting the continually changing financial landscape. Increasingly, supervisory techniques and requirements try to harness both the new technologies and market incentives to improve oversight while reducing regulatory burden, burdens that are becoming progressively obsolescent and counterproductive. Concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards. In the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations. Largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process rather than through the writing of regulations. Conclusion In conclusion, it is clear that both the real and the financial economies have been, and will continue to be, changed dramatically by the forces of technological progress. Banks will be under constant challenge to harness these forces to meet the ever-shifting competition. In such an environment, many existing rules and regulations will, if not modified, increasingly bind those banks seeking to respond, let alone innovate. Thus, there is a profound need for legislators and banking supervisors also to adapt to the changing realities. But do keep in mind that the government has an obligation to limit systemic risk exposure, and centuries of experience teach us the critical role that financial stability plays in the stability of the real economy. Bankers also have an obligation to their shareholders and creditors to measure and manage risk appropriately. In short, the regulators and the industry both want the same things -- financial innovation, creative change, responsible risk-taking, and growth. The market forces at work will get us there, perhaps not as rapidly as some banks may desire, but get there we will.	['mr. greenspan considers some of the effects of technological change remarks by the chairman of the board of governors of the us federal reserve system, mr. alan greenspan, at the annual convention of the american bankers association in boston, on 5/10/97.', 'it is always with mixed feelings of pleasure and trepidation that i accept an invitation to speak at the american bankers association annual convention.', 'i still have a disconcerted remembrance of my acceptance of your first invitation, which had been scheduled for october 20, 1987. that speech had to be scratched at the last minute as the result of a certain adversity in stock price adjustments the day before.', 'experience suggests, however, that history does not repeat with a fixed periodicity and, besides, i have crossed my fingers.', 'the theme of your convention this year is timely.', 'it is exactly when rapid innovation and institutional and technological change are taking place that market participants should take time to contemplate the opportunities and the risks, what to retain and what to change.', 'only then can the banking industry create the most value-added for customers, employees, and society, and as a consequence, for shareholders.', 'as in recent years, the future role of banks and other providers of financial services will surely be significantly affected by the same basic forces that have shaped the real and financial economy world-wide: relentless technological change.', 'this morning, i would like to describe some of the effects of technological change in both the financial and nonfinancial sectors and discuss a few of their more important implications.', 'i will begin with the real economy.', 'technological change and the real economy the most important single characteristic of the changes in u.s. technology in recent years is the ever expanding conceptualization of our gross domestic product.', 'we are witnessing the substitution of ideas for physical matter in the creation of economic value -- a shift from hardware to software, as it were.', 'the roots of increasing conceptualization of output lie deep in human history, but the pace of such substitution probably picked up in the early stages of the industrial revolution, when science and machines created new leverage for human energy and ideas.', 'nonetheless, even as recently as the middle of this century, the symbols of american economic strength were our outputs of such physical products as steel, motor vehicles, and heavy machinery -- items for which sizable proportions of production costs reflected the exploitation of raw materials and the sheer manual labor required to manipulate them.', "however, today's views of economic leadership focus increasingly on downsized, smaller, less palpable evidence of weight and bulk, requiring more technologically sophisticated labor input.", 'examples of this trend permeate our daily lives.', 'radios used to be activated by large vacuum tubes; today we have elegantly designed pocked-sized transistors to perform the same function -- but with the higher quality of sound and greater reliability that consumers now expect.', 'thin fiber optic cable has replaced huge tonnages of copper wire.', 'owing to advances in metallurgy, engineering, and architectural design, we now can construct buildings that enclose as much or more space with fewer materials.', 'a number of commentators, particularly professor paul david of stanford university, have suggested that, despite the benefits we have seen this decade, it may be that the truly significant increases in living standards resulting from the introduction of computers and communications equipment still lie ahead.', 'if true, this would not be unusual.', 'past innovations, such as the introduction of the dynamo or the invention of the gasoline-powered motor, required considerable infrastructure investment before their full potential could be realized.', 'electricity, when it substituted for steam power late last century, was initially applied to production processes suited to steam.', 'gravity was used to move goods vertically in the steam environment, and that could not immediately change with the advent of electric power.', "it was only when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system many years after electricity's initial introduction, that national productivity clearly accelerated.", 'similarly, it was only when modern highways and gasoline service stations became extensive that the lower cost of motor vehicle transportation became evident.', 'technological change and the financial economy it is surely not news to a group of bankers that the same forces that have been reshaping the real economy have also been transforming the financial services industry.', 'once again, perhaps the most profound development has been the rapid growth of computer and telecommunications technology.', 'the advent of such technology has lowered the costs, reduced the risks, and broadened the scope of financial services, making it increasingly possible for borrowers and lenders to transact directly, and for a wide variety of financial products to be tailored for very specific purposes.', 'as a result, competitive pressures in the financial services industry are probably greater than ever before.', 'as is true in the real economy, it is difficult to overestimate the importance of education and ongoing training to the advancement of technology and product innovation in the financial sector.', 'i doubt that i need to tell any of you about the importance of education and training for employees.', 'but the same is almost surely true for your customers.', 'surveys repeatedly indicate that users of electronic banking products are typically very well educated.', "for example, data from the federal reserve board's survey of consumer finances suggest that a higher level of education significantly increases the chances that a household consumer will use an electronic banking product.", 'indeed, this survey indicates that, in late 1995, the median user of an electronic source of information for savings or borrowing decisions had a college degree -- a level of education currently achieved by less than one-third of american households.', 'technological innovation and more sophisticated users have accelerated the second major trend -- financial globalization -- which has been reshaping our financial system, not to mention the real economy, for at least three decades.', 'both developments have expanded cross-border asset holding, trading, and credit flows and, in response, both securities firms and u.s. and foreign banks have increased their cross-border operations.', 'once again, a critical result has been greatly increased competition both at home and abroad.', 'a third development reshaping financial markets -- deregulation -- has been as much a reaction to technological change and globalization as an independent factor.', 'moreover, the continuing evolution of markets suggests that it will be literally impossible to maintain some of the remaining rules and regulations established for previous economic environments.', 'while the ultimate public policy goals of economic growth and stability will remain unchanged, market forces will continue to make it impossible to sustain outdated restrictions, as we have recently seen with respect to interstate banking and branching.', 'in such an environment, i share your frustration with the pace of legislative reform and revision to statutorily mandated regulations.', 'nonetheless, we should not lose sight of the remarkable degree of re-codification of law and regulation to make banking rules more consistent with market realities that has occurred in recent years.', 'deposit and other interest rate ceilings have been eliminated, geographical restrictions have been virtually removed, many banking organizations can do a fairly broadly based securities underwriting and dealing business, many can do insurance sales, and those with the resources and skill are authorized to virtually match foreign bank competition abroad.', 'moreover, it seems clear that there is recognition by the congress that the basic financial framework has to be adjusted further.', 'the process, as you know, is not easy when the results of regulatory relief create both a new competitive landscape and new supervisory and stability challenges.', 'change will, i believe, ultimately occur because the pressures unleashed by technology, globalization, and deregulation have inexorably eroded the traditional institutional differences among financial firms.', 'securities firms have for some time offered checking-like accounts linked to mutual funds, and their affiliates routinely extend significant credit directly to business.', 'on the bank side, the economics of a typical bank loan syndication do not differ essentially from the economics of a best-efforts securities underwriting.', 'indeed, investment banks are themselves becoming increasingly important in the syndicated loan market.', 'with regard to derivatives instruments, the expertise required to manage prudently the writing of over-the-counter derivatives, a business dominated by banks, is similar to that required for using exchange-traded futures and options, instruments used extensively by both commercial and investment banks.', 'the writing of a put option by a bank is economically indistinguishable from the issuance of an insurance policy.', 'the list could go on.', 'it is sufficient to say that a strong case can be made that the evolution of financial technology alone has changed forever our ability to place commercial banking, investment banking, insurance underwriting, and insurance sales into neat separate boxes.', 'nonetheless, not all financial institutions would prosper as, nor desire to be, financial supermarkets.', 'many specialized providers of financial services are successful today and will be so in the future because of their advantages in specific areas.', 'moreover, especially at commercial banks, the demand for traditional services by smaller businesses and by households is likely to continue for some time.', 'and the information revolution, while it has deprived banks of some of the traditional lending business with their best customers, has also benefitted banks by making it less costly for them to assess the credit and other risks of customers they previously would have shunned.', 'thus, it seems most likely that banks of all types will continue to engage in a substantial amount of traditional banking, delivered, of course, by ever improving technology.', 'community banks, in particular, are likely to provide loans and payments services via traditional on-balance sheet banking.', 'indeed, smaller banks have repeatedly demonstrated their ability to survive and prosper in the face of major technological and structural change by providing traditional banking services to their customers.', 'the evidence is clear that well-managed smaller banks can and will exist side by side with larger banks, often maintaining or increasing local market share.', 'technological change has facilitated this process by providing smaller banks with low-cost access to new products and services.', 'in short, the record shows that well-managed smaller banks have nothing to fear from technology, globalization, or deregulation.', 'for all size entities, however, technological change is blurring not only traditional distinctions between the banking, securities, and insurance business, but is also having a profound effect on historical separations between financial and nonfinancial businesses.', 'most of us are aware of software companies interested in the financial services business, but some financial firms, leveraging off their own internal skills, are also seeking to produce software for third parties.', "shipping companies' tracking software lends itself to payment services.", "manufacturers have financed their customers' purchases for a long time, but now increasingly are using the resultant financial skills to finance noncustomers.", 'moreover, many nonbank financial institutions are now profitably engaged in nonfinancial activities.', 'current facts and expected future trends, in short, are creating market pressures to permit the common ownership of financial and nonfinancial firms.', 'in my judgement, it is quite likely that in future years it will be close to impossible to distinguish where one type of activity ends and another begins.', 'nonetheless, it seems wise to move with caution in addressing the removal of the current legal barriers between commerce and banking, since the unrestricted association of banking and commerce would be a profound and surely irreversible structural change in the american economy.', 'were we fully confident of how emerging technologies would affect the evolution of our economic and financial structure, we could presumably develop today the regulations which would foster that evolution.', 'but we are not, and history suggests we cannot, be confident of how our real and financial economies will evolve.', 'if we act too quickly, we run the risk of locking in a set of inappropriate rules that could adversely alter the development of market structures.', 'our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive.', 'as professor nathan rosenberg of stanford university has pointed out, ".', 'mistaken forecasts of future structure litter our financial landscape."', "indeed, professor rosenberg suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable.", 'he notes at least two sources of this uncertainty.', 'first, the range of applications for a new technology may not be immediately apparent.', 'for instance, alexander graham bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract.', 'indeed, he offered to sell his telephone patent to western union for only $100,000, but was turned down.', "similarly, marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible.", "a second source of technological uncertainty reflects the possibility that an innovation's full potential may be realized only after extensive improvements, or after complementary innovations in other fields of science.", 'according to charles townes, a nobel prize winner for his work on the laser, the attorneys for bell labs initially refused, in the late 1960s, to patent the laser because they believed it had no applications in the field of telecommunications.', "only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent.", "it's not hard to find examples of such uncertainties within the financial services industry.", 'the evolution of the over-the-counter derivatives market over the past decade has been nothing less than spectacular.', "but as the theoretical underpinnings of financial arbitrage were being published in the academic journals in the late 1950s, few observers could have predicted how the scholars' insights would eventually revolutionize global financial markets.", 'not only were additional theoretical and empirical research necessary, but, in addition, several generations of advances in computer and communications technologies were necessary to make these concepts computationally practicable.', 'all these examples, and more, suggest, that if we dramatically change the rules now about banking and commerce, with what is great uncertainty about future synergies between finance and nonfinance, we may well end up doing more harm than good.', 'and, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly, if at all.', 'modifications of such a fundamental structural rule as the separation of banking and commerce accordingly should proceed at a deliberate pace in order to test the response of markets and technological innovations to the altered rules in the years ahead.', 'the need for caution and humility with respect to our ability to predict the future is highly relevant for how banking supervision should evolve.', 'as i proposed to this audience last year, regulators are beginning to understand that the supervision of a financial institution is, of necessity, a continually evolving process reflecting the continually changing financial landscape.', 'increasingly, supervisory techniques and requirements try to harness both the new technologies and market incentives to improve oversight while reducing regulatory burden, burdens that are becoming progressively obsolescent and counterproductive.', 'concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards.', 'in the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations.', 'largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process rather than through the writing of regulations.', 'conclusion in conclusion, it is clear that both the real and the financial economies have been, and will continue to be, changed dramatically by the forces of technological progress.', 'banks will be under constant challenge to harness these forces to meet the ever-shifting competition.', 'in such an environment, many existing rules and regulations will, if not modified, increasingly bind those banks seeking to respond, let alone innovate.', 'thus, there is a profound need for legislators and banking supervisors also to adapt to the changing realities.', 'but do keep in mind that the government has an obligation to limit systemic risk exposure, and centuries of experience teach us the critical role that financial stability plays in the stability of the real economy.', 'bankers also have an obligation to their shareholders and creditors to measure and manage risk appropriately.', 'in short, the regulators and the industry both want the same things -- financial innovation, creative change, responsible risk-taking, and growth.', 'the market forces at work will get us there, perhaps not as rapidly as some banks may desire, but get there we will.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman of the Board of Governors	US
https://www.bis.org/review/r971010a.pdf	Mr. Brash asks how fast the New Zealand economy can grow (Central Bank Articles and Speeches, 6 Oct 97)	Address by the Governor of the Reserve Bank of New Zealand, Mr. Donald T. Brash, to the Rotary Club in Auckland, on 6/10/97.	1997-10-06 00:00:00	Mr. Brash asks how fast the New Zealand economy can grow Address by the Governor of the Reserve Bank of New Zealand, Mr. Donald T. Brash, to the Rotary Club in Auckland, on 6/10/97. Introduction: economic growth is important Ladies and gentlemen, I am delighted to be addressing the Auckland Rotary Club today. Just 15 years ago I was a member of this Club, and I look back to that time with very warm memories. When I was invited to speak to you, I was given a clean slate: I was essentially allowed to choose my own subject. And I want to use that freedom to go beyond my usual territory, of monetary policy, interest rates, exchanges rates, MCIs and all the rest, to talk about a broader issue, namely New Zealand's future economic growth -- what it may be, what is constraining it, and how it can be enhanced. And I want to do that for two reasons. First, because economic growth is the ultimate objective of much public policy, and that in turn because it is economic growth which gives us choices -- the ability to enjoy better quality housing, the ability to have better health care, the option of choosing more leisure, the ability to invest in environmentally-friendly production techniques, the freedom to choose between an array of options denied to those where economic growth is low or non-existent. And secondly I want to talk about economic growth because there is still a great deal of public misunderstanding about the role of the Reserve Bank and monetary policy in encouraging or discouraging economic growth. There is still quite a widespread view that the Reserve Bank's exclusive focus on delivering predictably low inflation involves a cost in economic growth, and that if only the Bank were not so obsessive about its inflation objective the New Zealand economy could grow much more quickly. People look back to the 5, 6 and 7 percent growth rates achieved just a few years ago, and wonder why we can't return to those growth rates. They look at our Asian neighbours expanding with breathtaking speed, and wonder why we can't emulate them. They reflect on the painful restructuring that the New Zealand economy underwent from 1984, and ask if it was all worthwhile. Some people suspect that perhaps the Reserve Bank has denied us the benefits which should have been available. So today I want to discuss the issue of economic growth in the broadest terms. My aim is to provide a framework for thinking about what is a reasonable expectation for New Zealand's growth, to identify some of the factors that will determine whether we are able to achieve that potential, and to discuss the linkage between growth and the Reserve Bank's interest, namely inflation. Running the economy is like running a marathon Let me start by reminding you of the challenge facing a marathon runner. The objective is to go as fast as possible over the full distance. It makes no sense to sprint, 'hit the wall', and simply not finish the race, or spend much of the time on hands and knees recovering from that initial bout of excessive enthusiasm. Nor does it make any sense to walk most of the way, finishing the race with unused reserves of energy. Neither approach is likely to lead to running the race in a personal best time. And that is why experienced athletes constantly check their pace, making sure it is neither too fast nor too slow. In terms of an economy, going too fast also leads to 'hitting the wall', with symptoms typically being a burst of inflation, a deterioration in the balance of payments position, perhaps an asset price boom, signs of difficulty in finding skilled employees, and very often a sense of euphoria ('look how fast I'm going and I still feel good!'). The results of hitting the wall are typically a sharp recession -- sharper still if overcooked asset prices are collapsing. To complete the analogy, in any long distance race you will find several runners who have paced themselves correctly, but who complete the race in very different times. Each may have done a personal best time, but those personal bests will be very different. So it is with economies. Some economies will be able to sustain a much faster pace than others without running into the too-fast danger territory; some will naturally grow more slowly than others, without leaving large amounts of unused energy or potential. And it is not necessarily a question of one economy being better than another; it's just a question of being different. If that thought surprises, I'd simply note that the 'best', most highly productive, economy in the world -- the United States -- is also one of the slower growing economies, and has been now for some decades. What is it that determines why some economies can achieve sustainably faster growth than others? Potential growth ultimately depends on two things: quantity and quality. The quantity of people and capital, in the form of factories, forests, trucks, roads, and all the rest. And the quality of those same things. Countries that have faster potential growth rates have faster trend growth in the quantity of people and capital at work in the economy, and/or faster trend growth in the quality or productivity of those things. New Zealand's sustainable growth now about 3 percent annually So how fast can New Zealand grow in a sustainable, or 'long-term average', sense? Looking forward, we estimate New Zealand's potential growth rate currently to be around 3 percent annually -- a result of trend growth in the working age population of 1.5 percent and trend growth in output per person also of about 1.5 percent. That growth in real output per person comes from a combination of growth in the quantity of capital, and growth in the quality of that capital and the way we use it. In other words, we should expect our growth rate to average about 3 percent annually over the course of our usual economic cycles, with outcomes for any given year ranging from about 1 percent at the trough to, perhaps, 4 or 5 percent at the peak. If a 3 percent average growth rate does not sound very exciting, let's put that into a broader context. Sustained growth of 3 percent is clearly well ahead of our experience in the seventies and eighties. Indeed, between 1975 and 1990, growth averaged less than 1 percent annually. Of course occasionally we grew more quickly than that, but those periods of faster growth were typically short-lived, and associated with unsustainably large fiscal and balance of payments deficits and rapidly increasing inflationary pressures. And the difference between a 1 percent average growth rate and a 3 percent average growth rate adds up to an enormous difference in the volume of goods and services available to New Zealanders if the difference is sustained for, say, 10 years. Today, our economy is producing goods and services totalling about $100 billion each year. If that total grows by only 1 percent a year for a decade, in 10 years' time we will be producing goods and services of $110 billion. If the total grows at an average of 3 percent a year, in 10 years' time we will be producing goods and services of $134 billion. The difference of $24 billion annually is a lot of additional hospital operations, or tertiary education, or restaurant meals, or overseas holidays. But what about the much more rapid growth of the 1993 to 1995 period, during which at one point growth exceeded 7 percent? Surely that shows that we are capable of much faster growth than 3 percent? Clearly we can grow faster than 3 percent at times, and we are likely to do so, just as the marathon runner can occasionally sprint. Equally clearly, however, growing at 5, 6, or 7 percent for a brief period tells us nothing about how fast we can grow on average over a longer period of time. The rapid growth which we experienced for a brief period in the 1993 to 1995 period was the result in part of adding more capital and of improving productivity, but was fundamentally the result of being able to bring back into employment the large number of people who had become unemployed during the recession of the late eighties and early nineties. You will recall that unemployment reached 11 percent of the labour force in the early nineties, and fell to 6 percent by the mid-nineties. Everybody hopes that unemployment falls below its present level, of almost 7 percent of the labour force. Growth rates aside, lower unemployment implies a huge improvement in well-being, both for the individuals concerned and for society as a whole. It is conceivable, although unlikely during the next two or three years, that we could reduce unemployment by 5 percent of the labour force again. But it is clearly inconceivable that we can do that repeatedly, since that would quickly imply negative unemployment. To the extent that the very rapid growth of the mid-nineties was a result of being able to 'mine' the unemployment rolls for additional workers, it is not something which can be repeated indefinitely. 3 percent growth looks good by the standards of other developed countries If we look at other countries, we find that, by the standards of the developed world, our 3 percent looks reasonably attractive. For example, the United States is generally estimated to have a growth potential of a little over 2 percent, being 1 percent labour force growth, and 1 percent annual productivity gain. Over recent months, some US commentators have wondered whether the US productivity trend has lifted -- largely as a consequence of the impact of new computer technology -- but the jury is still out on this question. Certainly the fact that US unemployment has recently been falling markedly, and now stands at 4.9 percent, its lowest level in nearly a quarter of a century, strongly suggests that recent US growth has also been dependent on 'mining' the unemployment rolls for additional workers, and is likely to slow as finding additional workers becomes increasingly difficult. It is also interesting to recall that, while some people have questioned why New Zealand can not achieve US growth rates, over the six years to March 1997 New Zealand grew at an average rate of 3.1 percent annually, slightly faster than the US economy grew over the same period (2.7 percent). Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, noted in a recent speech that, between June 1991 and December 1996, both New Zealand and Australia had enjoyed economic growth of 3.6 percent, and that that growth had been faster than growth in any of the other 16 developed countries against which he compared us, with the exception of Norway and Ireland. (Speech to the Australia-Israel Chamber of Commerce in Melbourne on 15 May 1997.) In other words, although it is too early to be dogmatic -- given the influence of cyclical factors on growth rates measured over relatively short periods -- New Zealand does appear to have made a significant gain in its growth potential in recent years, and to have lifted its performance from near the bottom of the class to somewhere rather closer to the top of the class of developed countries. Why do the Asian Tigers seem so much more successful? So where do the Asian Tigers fit in -- countries that have been routinely achieving growth rates of 8 to 10 percent per annum -- and why can't New Zealand be more like them? That's a question that has challenged economists around the world for some time. It would be misleading to claim that any sort of consensus has been arrived at -- indeed, the debate on the sources of these extraordinary growth rates still rages. But it seems likely that the very rapid growth achieved by the Asian Tiger economies, and by China, can be explained very readily in conventional terms, by looking at growth in the inputs of labour and capital, and at productivity improvements. Thus demographics and migration trends are obviously important in determining how fast a labour force will grow. And Asian economies have experienced very rapid increases in their effective labour forces in recent years. Singapore, for example, almost doubled the proportion of its population engaged in the formal labour force between 1960 and 1990. That increase accounts for close to one-third of Singapore's remarkable average growth rate of 8.5 percent over that period. Similarly, a few decades ago many Asian economies operated with little in the way of modern tools and machinery. In recent years, the growth in the quantity of capital has been huge. Annual investment in Singapore has consistently exceeded 30 percent of GDP, and rose to almost 50 percent at times during the seventies. Those very high rates of investment, and the ability of traditionally poor, often agricultural, economies to pick up, off the shelf, very much more productive technologies from other countries have in turn made it possible to achieve extremely rapid improvements in labour productivity. Thus for example, taking a peasant farmer employing a water buffalo and a wooden plough and giving him either a modern tractor and a plough, or a modern computerised lathe, is likely to see an extremely large increase in output per person. It seems clear that if a country has available some under-utilised labour, large amounts of capital and an ability to adopt the latest technology, perhaps through being open to foreign direct investment, it is possible to grow very quickly indeed during a 'catch-up' phase. But once a country reaches the developed country norms in terms of labour force participation rates, standards of education, and available technology, growth rates will also tend to slow to match the developed country norms. Japan seems to have undergone that transformation in recent years. After growing at a very rapid pace that enabled it to transform itself over the post-war period from a rather poor and war-devastated country to one having per capita incomes amongst the highest in the world, Japan's growth rate over the past few years has been much closer to that of the 'more established' developed economies. Lessons for New Zealand: immigration policy, benefit policies, and education policy are all important What can we learn from this survey of growth in other countries that is relevant to New Zealand today? The most important lesson is that if we wish to lift our long term growth rate -- our sustainable average growth rate -- we have to look to those factors that are important determinants of long term growth, namely the quantity and quality of the labour force, the quantity and quality of investment, and the other factors which determine the productivity with which labour and capital are combined. The supply of labour is largely determined by population growth and the proportion of the population which is engaged in employment. We can influence population growth to some extent, by our policy on immigration. The experience of Australia, Canada and the United States -- indeed of New Zealand -- suggests that a well-considered immigration policy can have a significantly beneficial effect on an economy's long-term growth rate not only by increasing the labour force but by bringing skills, market knowledge and capital. The proportion of the population engaged in formal employment (the participation rate) can be influenced by policy even more substantively. For example, pension and entitlement rules which impose very high effective tax rates on low income people contemplating staying in, or re-entering, the work force tend to reduce participation rates. This makes the current discussion about reforming the benefit system of direct relevance to potential growth. With an ageing population and sensible policies on retirement income, we can expect a greater proportion of the population to remain in work beyond the current retirement age and, with some evidence that people remain healthier, both physically and mentally, when they are employed, that is almost certainly something to be welcomed for reasons going well beyond potential growth rates. Moreover, we can probably expect the trend towards higher participation rates for women to continue, and this too will mean that the labour force is likely to grow rather more quickly in the years ahead than does the population generally. The quality of our labour force can also be influenced through public policy choices, but only slowly. It is abundantly clear that the process of economic development and growth goes hand in hand with enhanced educational standards. We in New Zealand once routinely listed 'a well-educated labour force' as one of the clearly identifiable strengths of our economy. We can no longer be so confident on that front. The capacity of today's high school graduates to write grammatical English seems to be disappointing to a great many employers, while international studies comparing the ability of New Zealand students in mathematics and science with that of students in other countries suggest that we no longer have anything of which to be terribly proud. In the Third International Maths and Science study, New Zealand ranked 22nd out of 41 countries in science and 24th in maths. By contrast, the top four countries in maths were Singapore, South Korea, Japan, and Hong Kong, with Singapore, South Korea and Japan also occupying three of the top four positions in science. As a general proposition, those economies which have been out-performing us in terms of per capita growth have typically also been out-performing us in educational effort. Whether that is because those countries have better educational structures, or just have people who are more convinced of the crucial importance of a good education, I do not know. But the result is that the quality of their labour force is rapidly improving, whereas ours is improving rather more slowly. For the longer term, it may well be that the most important policy area relevant to improving our sustainable growth rate is education policy. The quality of management also matters, and in this regard I have no doubt that the opening up of the New Zealand economy during the last decade or so has been a catalyst for improved business management in New Zealand. Certainly poor management is no longer sheltered by regulations and tariffs which keep competitors at bay. Similarly, economies that grow strongly typically have good industrial relations. Here too we have made progress in recent years. The less centralised structures we now have for negotiating pay and conditions have been beneficial from the standpoint of encouraging both employers and employees to focus on their mutual stake in staying up with, if not ahead of, the competition. At the very least, nobody seems to want to go back to the very highly centralised industrial relations structures we had in the seventies and eighties. And the number of 'days lost' as the result of strikes is well down on what used to be regarded as normal. These things are all helping our growth performance. Lessons for New Zealand: policies which distort investment decisions damage our growth prospects Additional investment, so that each person employed is teamed with a greater amount of physical capital, is also crucial to our growth performance. But in some ways the quality of additional investment is even more important than its quantity. When we look at New Zealand's slow growth period -- through the seventies and eighties -- we find that the ratio of investment to GDP was quite respectable by comparison with other developed countries. What was impeding growth was not so much an inadequate level of investment as a persistent tendency to direct capital into low-yielding activities. Perhaps the best-known examples of low-yielding investment were the 'Think Big' projects of the late seventies and early eighties, but a great many could also be found in the private sector. Partly because of the distortions caused by inflation, much investment was channelled into real estate investment, sometimes well ahead of demand. Partly because of subsidies, capital was invested in the production of sheepmeat for which there was no market. Largely because of quantitative import restrictions and high tariffs, a great deal of capital was invested in activities which, while profitable to the investors, added little or nothing to output valued at international prices. Worse, in some highly protected industries, when measured at international prices the value of output was actually negative. In other words, the cost of inputs, at world prices, exceeded the value of outputs at world prices. It is with those considerations in mind that countries seeking to boost their growth performance look to micro-economic reforms -- to reduced protection, to deregulation, to flatter and broader tax structures, and to increased market flexibility -- to encourage available resources of labour and capital to move into those activities where private financial returns and national economic returns are similarly high. With that, of course, goes the requirement that those same resources are permitted to move away from activities in which the returns are low. Allowing industries which depend for their continued existence on protection from imports to continue operating indefinitely may be doing a favour to the subsidised few, but it certainly does not help our growth potential. (It surprises me that we still hear, occasionally, a manufacturer argue that we should not reduce tariffs in New Zealand because other countries use tariffs to protect the internationally uncompetitive parts of their economies. Since tariffs are essentially a tax on exports, and our export industries are almost by definition those which are the most efficient in international terms, why we should tax such industries just because other countries tax their export industries is frankly beyond me.) Lessons for New Zealand: growth affected by high taxation? Attention is also increasingly focusing on the role which the total size of government plays in influencing an economy's growth rate. In recent months, a series of studies commissioned by the Inland Revenue Department has reached the conclusion that when a government's total tax revenue exceeds about 20 percent of GDP the impact on growth is negative. Another study commissioned by the Treasury has cast some doubt on the methodology used in the studies commissioned by the IRD, but suggests that the optimum level of taxation, relative to GDP and from a growth point of view, is probably below 20 percent. Why? Presumably because with low tax rates fewer resources are squandered in trying to minimise tax obligations, and the disincentive effects of taxation on effort and risk-taking are reduced. I myself do not know why countries with relatively low tax burdens appear to grow more quickly than those with relatively high tax burdens, or indeed whether there is any causal relationship between low tax levels and high growth. But it does seem clear that the East Asian countries where economic growth has recently been most rapid are also countries where the ratio of tax revenue to GDP is very much lower than it is in New Zealand or other developed economies. Lessons for New Zealand: growth remains heavily dependent on foreign savings One other issue deserves mention. Before a country can invest it must have access to savings -- either its own domestically-generated savings, or the savings of other countries. New Zealand has a long record of relying on the savings of others. That was hardly surprising when, as a colonial outpost, we drew on the capital of Britain to fund our development. We also relied on a flow of migrants to boost the available labour force. Together, those imported resources were combined to generate growth and wealth at a rate that was probably similar to that achieved by the Asian Tigers in the last decade or so. While the flow of migrants is generally rather smaller in modern New Zealand than was the case during the late nineteenth century, we've never fully weaned ourselves from a relatively heavy dependence on the savings of others. We appear to see nothing unusual, let alone undesirable, in continuing to do so indefinitely. It is not at all obvious that we would invest more, or would invest more efficiently, if we generated more savings domestically. But it seems to me, as someone who believes that our being open to international capital markets has been hugely beneficial to our economy and to our society, that we would probably face a more stable and perhaps more secure future if our dependence on the savings of others were reduced. At the very least, we need to recognise that there is little point in decrying the degree of foreign ownership of New Zealand businesses and assets if we are not also ready to decry the paucity of New Zealand savings. Growth and monetary policy So where does monetary policy fit into this growth story? It may surprise you to hear me contend that, as a determinant of long term growth potential, monetary policy has a relatively modest and indirect influence. I say that because, as I have explained, long term growth is a product of labour and capital, and how productively those two factors work together. The things which I have described as being crucial here are essentially 'supply-side' matters -- the rate of growth of the labour force, the quality of the education system, the extent to which government policies distort the allocation of investment, and all the rest. These are the crucial determinants of our sustainable growth rate. But monetary policy can help in two ways. First, by keeping inflation stable it can, as a by-product, assist in moderating economic cycles -- restraining demand when it threatens to exceed the economy's capacity to supply and encouraging demand to increase when it threatens to fall short of capacity. In other words, successful monetary policy aimed at keeping inflation stable also keeps the economy's pace as close to the optimum as possible. In the marathon analogy, successful monetary policy avoids the economy 'hitting the wall', but also avoids it 'running too slowly', with unused reserves of labour and capital. Secondly, there is now strong evidence that high inflation positively damages sustainable growth, and growing evidence that there is some damage caused even by quite low rates of inflation. Nobody argues that price stability will create a major improvement in an economy's sustainable growth rate -- that growth rate depends primarily, as indicated, on all the real factors I have already discussed. But it now seems beyond reasonable doubt that keeping the general price level stable is the best contribution which monetary policy can make to the way in which the economy operates, and therefore the best contribution to the economy's sustainable growth rate. In an inflation-free environment, investors and the public generally get their best shot at reading accurately the signals that markets are delivering -- which goods and services represent best value, where the best returns on investment may be found, how much to consume and how much to save. Price stability is not a sufficient condition for strong growth. It is not even a necessary condition for strong growth. It is just the best contribution which monetary policy can make.	['mr. brash asks how fast the new zealand economy can grow address by the governor of the reserve bank of new zealand, mr. donald t. brash, to the rotary club in auckland, on 6/10/97.', 'introduction: economic growth is important ladies and gentlemen, i am delighted to be addressing the auckland rotary club today.', 'just 15 years ago i was a member of this club, and i look back to that time with very warm memories.', 'when i was invited to speak to you, i was given a clean slate: i was essentially allowed to choose my own subject.', "and i want to use that freedom to go beyond my usual territory, of monetary policy, interest rates, exchanges rates, mcis and all the rest, to talk about a broader issue, namely new zealand's future economic growth -- what it may be, what is constraining it, and how it can be enhanced.", 'and i want to do that for two reasons.', 'first, because economic growth is the ultimate objective of much public policy, and that in turn because it is economic growth which gives us choices -- the ability to enjoy better quality housing, the ability to have better health care, the option of choosing more leisure, the ability to invest in environmentally-friendly production techniques, the freedom to choose between an array of options denied to those where economic growth is low or non-existent.', 'and secondly i want to talk about economic growth because there is still a great deal of public misunderstanding about the role of the reserve bank and monetary policy in encouraging or discouraging economic growth.', "there is still quite a widespread view that the reserve bank's exclusive focus on delivering predictably low inflation involves a cost in economic growth, and that if only the bank were not so obsessive about its inflation objective the new zealand economy could grow much more quickly.", "people look back to the 5, 6 and 7 percent growth rates achieved just a few years ago, and wonder why we can't return to those growth rates.", "they look at our asian neighbours expanding with breathtaking speed, and wonder why we can't emulate them.", 'they reflect on the painful restructuring that the new zealand economy underwent from 1984, and ask if it was all worthwhile.', 'some people suspect that perhaps the reserve bank has denied us the benefits which should have been available.', 'so today i want to discuss the issue of economic growth in the broadest terms.', "my aim is to provide a framework for thinking about what is a reasonable expectation for new zealand's growth, to identify some of the factors that will determine whether we are able to achieve that potential, and to discuss the linkage between growth and the reserve bank's interest, namely inflation.", 'running the economy is like running a marathon let me start by reminding you of the challenge facing a marathon runner.', 'the objective is to go as fast as possible over the full distance.', "it makes no sense to sprint, 'hit the wall', and simply not finish the race, or spend much of the time on hands and knees recovering from that initial bout of excessive enthusiasm.", 'nor does it make any sense to walk most of the way, finishing the race with unused reserves of energy.', 'neither approach is likely to lead to running the race in a personal best time.', 'and that is why experienced athletes constantly check their pace, making sure it is neither too fast nor too slow.', "in terms of an economy, going too fast also leads to 'hitting the wall', with symptoms typically being a burst of inflation, a deterioration in the balance of payments position, perhaps an asset price boom, signs of difficulty in finding skilled employees, and very often a sense of euphoria ('look how fast i'm going and i still feel good!').", 'the results of hitting the wall are typically a sharp recession -- sharper still if overcooked asset prices are collapsing.', 'to complete the analogy, in any long distance race you will find several runners who have paced themselves correctly, but who complete the race in very different times.', 'each may have done a personal best time, but those personal bests will be very different.', 'so it is with economies.', 'some economies will be able to sustain a much faster pace than others without running into the too-fast danger territory; some will naturally grow more slowly than others, without leaving large amounts of unused energy or potential.', "and it is not necessarily a question of one economy being better than another; it's just a question of being different.", "if that thought surprises, i'd simply note that the 'best', most highly productive, economy in the world -- the united states -- is also one of the slower growing economies, and has been now for some decades.", 'what is it that determines why some economies can achieve sustainably faster growth than others?', 'potential growth ultimately depends on two things: quantity and quality.', 'the quantity of people and capital, in the form of factories, forests, trucks, roads, and all the rest.', 'and the quality of those same things.', 'countries that have faster potential growth rates have faster trend growth in the quantity of people and capital at work in the economy, and/or faster trend growth in the quality or productivity of those things.', "new zealand's sustainable growth now about 3 percent annually so how fast can new zealand grow in a sustainable, or 'long-term average', sense?", "looking forward, we estimate new zealand's potential growth rate currently to be around 3 percent annually -- a result of trend growth in the working age population of 1.5 percent and trend growth in output per person also of about 1.5 percent.", 'that growth in real output per person comes from a combination of growth in the quantity of capital, and growth in the quality of that capital and the way we use it.', 'in other words, we should expect our growth rate to average about 3 percent annually over the course of our usual economic cycles, with outcomes for any given year ranging from about 1 percent at the trough to, perhaps, 4 or 5 percent at the peak.', "if a 3 percent average growth rate does not sound very exciting, let's put that into a broader context.", 'sustained growth of 3 percent is clearly well ahead of our experience in the seventies and eighties.', 'indeed, between 1975 and 1990, growth averaged less than 1 percent annually.', 'of course occasionally we grew more quickly than that, but those periods of faster growth were typically short-lived, and associated with unsustainably large fiscal and balance of payments deficits and rapidly increasing inflationary pressures.', 'and the difference between a 1 percent average growth rate and a 3 percent average growth rate adds up to an enormous difference in the volume of goods and services available to new zealanders if the difference is sustained for, say, 10 years.', 'today, our economy is producing goods and services totalling about $100 billion each year.', "if that total grows by only 1 percent a year for a decade, in 10 years' time we will be producing goods and services of $110 billion.", "if the total grows at an average of 3 percent a year, in 10 years' time we will be producing goods and services of $134 billion.", 'the difference of $24 billion annually is a lot of additional hospital operations, or tertiary education, or restaurant meals, or overseas holidays.', 'but what about the much more rapid growth of the 1993 to 1995 period, during which at one point growth exceeded 7 percent?', 'surely that shows that we are capable of much faster growth than 3 percent?', 'clearly we can grow faster than 3 percent at times, and we are likely to do so, just as the marathon runner can occasionally sprint.', 'equally clearly, however, growing at 5, 6, or 7 percent for a brief period tells us nothing about how fast we can grow on average over a longer period of time.', 'the rapid growth which we experienced for a brief period in the 1993 to 1995 period was the result in part of adding more capital and of improving productivity, but was fundamentally the result of being able to bring back into employment the large number of people who had become unemployed during the recession of the late eighties and early nineties.', 'you will recall that unemployment reached 11 percent of the labour force in the early nineties, and fell to 6 percent by the mid-nineties.', 'everybody hopes that unemployment falls below its present level, of almost 7 percent of the labour force.', 'growth rates aside, lower unemployment implies a huge improvement in well-being, both for the individuals concerned and for society as a whole.', 'it is conceivable, although unlikely during the next two or three years, that we could reduce unemployment by 5 percent of the labour force again.', 'but it is clearly inconceivable that we can do that repeatedly, since that would quickly imply negative unemployment.', "to the extent that the very rapid growth of the mid-nineties was a result of being able to 'mine' the unemployment rolls for additional workers, it is not something which can be repeated indefinitely.", '3 percent growth looks good by the standards of other developed countries if we look at other countries, we find that, by the standards of the developed world, our 3 percent looks reasonably attractive.', 'for example, the united states is generally estimated to have a growth potential of a little over 2 percent, being 1 percent labour force growth, and 1 percent annual productivity gain.', 'over recent months, some us commentators have wondered whether the us productivity trend has lifted -- largely as a consequence of the impact of new computer technology -- but the jury is still out on this question.', "certainly the fact that us unemployment has recently been falling markedly, and now stands at 4.9 percent, its lowest level in nearly a quarter of a century, strongly suggests that recent us growth has also been dependent on 'mining' the unemployment rolls for additional workers, and is likely to slow as finding additional workers becomes increasingly difficult.", 'it is also interesting to recall that, while some people have questioned why new zealand can not achieve us growth rates, over the six years to march 1997 new zealand grew at an average rate of 3.1 percent annually, slightly faster than the us economy grew over the same period (2.7 percent).', 'mr ian macfarlane, governor of the reserve bank of australia, noted in a recent speech that, between june 1991 and december 1996, both new zealand and australia had enjoyed economic growth of 3.6 percent, and that that growth had been faster than growth in any of the other 16 developed countries against which he compared us, with the exception of norway and ireland.', '(speech to the australia-israel chamber of commerce in melbourne on 15 may 1997.)', 'in other words, although it is too early to be dogmatic -- given the influence of cyclical factors on growth rates measured over relatively short periods -- new zealand does appear to have made a significant gain in its growth potential in recent years, and to have lifted its performance from near the bottom of the class to somewhere rather closer to the top of the class of developed countries.', 'why do the asian tigers seem so much more successful?', "so where do the asian tigers fit in -- countries that have been routinely achieving growth rates of 8 to 10 percent per annum -- and why can't new zealand be more like them?", "that's a question that has challenged economists around the world for some time.", 'it would be misleading to claim that any sort of consensus has been arrived at -- indeed, the debate on the sources of these extraordinary growth rates still rages.', 'but it seems likely that the very rapid growth achieved by the asian tiger economies, and by china, can be explained very readily in conventional terms, by looking at growth in the inputs of labour and capital, and at productivity improvements.', 'thus demographics and migration trends are obviously important in determining how fast a labour force will grow.', 'and asian economies have experienced very rapid increases in their effective labour forces in recent years.', "singapore, for example, almost doubled the proportion of its population engaged in the formal labour force between 1960 and 1990. that increase accounts for close to one-third of singapore's remarkable average growth rate of 8.5 percent over that period.", 'similarly, a few decades ago many asian economies operated with little in the way of modern tools and machinery.', 'in recent years, the growth in the quantity of capital has been huge.', 'annual investment in singapore has consistently exceeded 30 percent of gdp, and rose to almost 50 percent at times during the seventies.', 'those very high rates of investment, and the ability of traditionally poor, often agricultural, economies to pick up, off the shelf, very much more productive technologies from other countries have in turn made it possible to achieve extremely rapid improvements in labour productivity.', 'thus for example, taking a peasant farmer employing a water buffalo and a wooden plough and giving him either a modern tractor and a plough, or a modern computerised lathe, is likely to see an extremely large increase in output per person.', "it seems clear that if a country has available some under-utilised labour, large amounts of capital and an ability to adopt the latest technology, perhaps through being open to foreign direct investment, it is possible to grow very quickly indeed during a 'catch-up' phase.", 'but once a country reaches the developed country norms in terms of labour force participation rates, standards of education, and available technology, growth rates will also tend to slow to match the developed country norms.', 'japan seems to have undergone that transformation in recent years.', "after growing at a very rapid pace that enabled it to transform itself over the post-war period from a rather poor and war-devastated country to one having per capita incomes amongst the highest in the world, japan's growth rate over the past few years has been much closer to that of the 'more established' developed economies.", 'lessons for new zealand: immigration policy, benefit policies, and education policy are all important what can we learn from this survey of growth in other countries that is relevant to new zealand today?', 'the most important lesson is that if we wish to lift our long term growth rate -- our sustainable average growth rate -- we have to look to those factors that are important determinants of long term growth, namely the quantity and quality of the labour force, the quantity and quality of investment, and the other factors which determine the productivity with which labour and capital are combined.', 'the supply of labour is largely determined by population growth and the proportion of the population which is engaged in employment.', 'we can influence population growth to some extent, by our policy on immigration.', "the experience of australia, canada and the united states -- indeed of new zealand -- suggests that a well-considered immigration policy can have a significantly beneficial effect on an economy's long-term growth rate not only by increasing the labour force but by bringing skills, market knowledge and capital.", 'the proportion of the population engaged in formal employment (the participation rate) can be influenced by policy even more substantively.', 'for example, pension and entitlement rules which impose very high effective tax rates on low income people contemplating staying in, or re-entering, the work force tend to reduce participation rates.', 'this makes the current discussion about reforming the benefit system of direct relevance to potential growth.', 'with an ageing population and sensible policies on retirement income, we can expect a greater proportion of the population to remain in work beyond the current retirement age and, with some evidence that people remain healthier, both physically and mentally, when they are employed, that is almost certainly something to be welcomed for reasons going well beyond potential growth rates.', 'moreover, we can probably expect the trend towards higher participation rates for women to continue, and this too will mean that the labour force is likely to grow rather more quickly in the years ahead than does the population generally.', 'the quality of our labour force can also be influenced through public policy choices, but only slowly.', 'it is abundantly clear that the process of economic development and growth goes hand in hand with enhanced educational standards.', "we in new zealand once routinely listed 'a well-educated labour force' as one of the clearly identifiable strengths of our economy.", 'we can no longer be so confident on that front.', "the capacity of today's high school graduates to write grammatical english seems to be disappointing to a great many employers, while international studies comparing the ability of new zealand students in mathematics and science with that of students in other countries suggest that we no longer have anything of which to be terribly proud.", 'in the third international maths and science study, new zealand ranked 22nd out of 41 countries in science and 24th in maths.', 'by contrast, the top four countries in maths were singapore, south korea, japan, and hong kong, with singapore, south korea and japan also occupying three of the top four positions in science.', 'as a general proposition, those economies which have been out-performing us in terms of per capita growth have typically also been out-performing us in educational effort.', 'whether that is because those countries have better educational structures, or just have people who are more convinced of the crucial importance of a good education, i do not know.', 'but the result is that the quality of their labour force is rapidly improving, whereas ours is improving rather more slowly.', 'for the longer term, it may well be that the most important policy area relevant to improving our sustainable growth rate is education policy.', 'the quality of management also matters, and in this regard i have no doubt that the opening up of the new zealand economy during the last decade or so has been a catalyst for improved business management in new zealand.', 'certainly poor management is no longer sheltered by regulations and tariffs which keep competitors at bay.', 'similarly, economies that grow strongly typically have good industrial relations.', 'here too we have made progress in recent years.', 'the less centralised structures we now have for negotiating pay and conditions have been beneficial from the standpoint of encouraging both employers and employees to focus on their mutual stake in staying up with, if not ahead of, the competition.', 'at the very least, nobody seems to want to go back to the very highly centralised industrial relations structures we had in the seventies and eighties.', "and the number of 'days lost' as the result of strikes is well down on what used to be regarded as normal.", 'these things are all helping our growth performance.', 'lessons for new zealand: policies which distort investment decisions damage our growth prospects additional investment, so that each person employed is teamed with a greater amount of physical capital, is also crucial to our growth performance.', 'but in some ways the quality of additional investment is even more important than its quantity.', "when we look at new zealand's slow growth period -- through the seventies and eighties -- we find that the ratio of investment to gdp was quite respectable by comparison with other developed countries.", 'what was impeding growth was not so much an inadequate level of investment as a persistent tendency to direct capital into low-yielding activities.', "perhaps the best-known examples of low-yielding investment were the 'think big' projects of the late seventies and early eighties, but a great many could also be found in the private sector.", 'partly because of the distortions caused by inflation, much investment was channelled into real estate investment, sometimes well ahead of demand.', 'partly because of subsidies, capital was invested in the production of sheepmeat for which there was no market.', 'largely because of quantitative import restrictions and high tariffs, a great deal of capital was invested in activities which, while profitable to the investors, added little or nothing to output valued at international prices.', 'worse, in some highly protected industries, when measured at international prices the value of output was actually negative.', 'in other words, the cost of inputs, at world prices, exceeded the value of outputs at world prices.', 'it is with those considerations in mind that countries seeking to boost their growth performance look to micro-economic reforms -- to reduced protection, to deregulation, to flatter and broader tax structures, and to increased market flexibility -- to encourage available resources of labour and capital to move into those activities where private financial returns and national economic returns are similarly high.', 'with that, of course, goes the requirement that those same resources are permitted to move away from activities in which the returns are low.', 'allowing industries which depend for their continued existence on protection from imports to continue operating indefinitely may be doing a favour to the subsidised few, but it certainly does not help our growth potential.', '(it surprises me that we still hear, occasionally, a manufacturer argue that we should not reduce tariffs in new zealand because other countries use tariffs to protect the internationally uncompetitive parts of their economies.', 'since tariffs are essentially a tax on exports, and our export industries are almost by definition those which are the most efficient in international terms, why we should tax such industries just because other countries tax their export industries is frankly beyond me.)', 'lessons for new zealand: growth affected by high taxation?', "attention is also increasingly focusing on the role which the total size of government plays in influencing an economy's growth rate.", "in recent months, a series of studies commissioned by the inland revenue department has reached the conclusion that when a government's total tax revenue exceeds about 20 percent of gdp the impact on growth is negative.", 'another study commissioned by the treasury has cast some doubt on the methodology used in the studies commissioned by the ird, but suggests that the optimum level of taxation, relative to gdp and from a growth point of view, is probably below 20 percent.', 'presumably because with low tax rates fewer resources are squandered in trying to minimise tax obligations, and the disincentive effects of taxation on effort and risk-taking are reduced.', 'i myself do not know why countries with relatively low tax burdens appear to grow more quickly than those with relatively high tax burdens, or indeed whether there is any causal relationship between low tax levels and high growth.', 'but it does seem clear that the east asian countries where economic growth has recently been most rapid are also countries where the ratio of tax revenue to gdp is very much lower than it is in new zealand or other developed economies.', 'lessons for new zealand: growth remains heavily dependent on foreign savings one other issue deserves mention.', 'before a country can invest it must have access to savings -- either its own domestically-generated savings, or the savings of other countries.', 'new zealand has a long record of relying on the savings of others.', 'that was hardly surprising when, as a colonial outpost, we drew on the capital of britain to fund our development.', 'we also relied on a flow of migrants to boost the available labour force.', 'together, those imported resources were combined to generate growth and wealth at a rate that was probably similar to that achieved by the asian tigers in the last decade or so.', "while the flow of migrants is generally rather smaller in modern new zealand than was the case during the late nineteenth century, we've never fully weaned ourselves from a relatively heavy dependence on the savings of others.", 'we appear to see nothing unusual, let alone undesirable, in continuing to do so indefinitely.', 'it is not at all obvious that we would invest more, or would invest more efficiently, if we generated more savings domestically.', 'but it seems to me, as someone who believes that our being open to international capital markets has been hugely beneficial to our economy and to our society, that we would probably face a more stable and perhaps more secure future if our dependence on the savings of others were reduced.', 'at the very least, we need to recognise that there is little point in decrying the degree of foreign ownership of new zealand businesses and assets if we are not also ready to decry the paucity of new zealand savings.', 'growth and monetary policy so where does monetary policy fit into this growth story?', 'it may surprise you to hear me contend that, as a determinant of long term growth potential, monetary policy has a relatively modest and indirect influence.', 'i say that because, as i have explained, long term growth is a product of labour and capital, and how productively those two factors work together.', "the things which i have described as being crucial here are essentially 'supply-side' matters -- the rate of growth of the labour force, the quality of the education system, the extent to which government policies distort the allocation of investment, and all the rest.", 'these are the crucial determinants of our sustainable growth rate.', 'but monetary policy can help in two ways.', "first, by keeping inflation stable it can, as a by-product, assist in moderating economic cycles -- restraining demand when it threatens to exceed the economy's capacity to supply and encouraging demand to increase when it threatens to fall short of capacity.", "in other words, successful monetary policy aimed at keeping inflation stable also keeps the economy's pace as close to the optimum as possible.", "in the marathon analogy, successful monetary policy avoids the economy 'hitting the wall', but also avoids it 'running too slowly', with unused reserves of labour and capital.", 'secondly, there is now strong evidence that high inflation positively damages sustainable growth, and growing evidence that there is some damage caused even by quite low rates of inflation.', "nobody argues that price stability will create a major improvement in an economy's sustainable growth rate -- that growth rate depends primarily, as indicated, on all the real factors i have already discussed.", "but it now seems beyond reasonable doubt that keeping the general price level stable is the best contribution which monetary policy can make to the way in which the economy operates, and therefore the best contribution to the economy's sustainable growth rate.", 'in an inflation-free environment, investors and the public generally get their best shot at reading accurately the signals that markets are delivering -- which goods and services represent best value, where the best returns on investment may be found, how much to consume and how much to save.', 'price stability is not a sufficient condition for strong growth.', 'it is not even a necessary condition for strong growth.', 'it is just the best contribution which monetary policy can make.']	Donald T Brash	Reserve Bank of New Zealand	Governor	New Zealand
https://www.bis.org/review/r971007c.pdf	Mr. Yam gives a broadbrush picture of Asian monetary co-operation (Central Bank Articles and Speeches, 21 Sep 97)	Per Jacobsson Lecture given by Mr. Joseph Yam J.P., Chief Executive of the Hong Kong Monetary Authority in Hong Kong, on 21/9/97.	1997-09-21 00:00:00	Per Mr. Yam gives a broadbrush picture of Asian monetary co-operation Jacobsson Lecture given by Mr. Joseph Yam J.P., Chief Executive of the Hong Kong Monetary Authority in Hong Kong, on 21/9/97. Introduction 1. Good afternoon. On behalf of the people of Hong Kong, particularly those of us at the Hong Kong Monetary Authority, let me extend my warmest welcome to all of you to Hong Kong. For those of you who have visited Hong Kong before, perhaps many times, I hope you are pleased to see that Hong Kong, as a Special Administrative Region of the People's Republic of China, remains as vibrant and dynamic as you have known in the past, retaining much of its free market characteristics, under the principle of "one country, two systems". 2. It is a great honour and privilege for me to be invited to give this year's Per Jacobsson Lecture. As a Managing Director of the International Monetary Fund (IMF), Mr Per Jacobsson led a life that was dedicated to the promotion of both European and later international monetary co-operation. It is only befitting that a lecture held in Asia in memory of this great man should address the topic of Asian monetary co-operation. This is also a subject that has been brought to sharp focus in the light of the recent turmoil in the currency markets of Asia. 3. What I intend to do this afternoon is first to define what international monetary co-operation is about, and in this connection, survey the attitudes of the parties that should have an interest in such co-operation and discuss the form of this co-operation. I wish to point out that these attitudes have, perhaps unintentionally, led to international monetary co-operation being regionalized. I shall then focus specifically on Asian monetary co-operation, covering the history, or the lack of it, and the monetary problems, current and potential ones, that Asian economies face. I shall then make a case for much greater monetary co-operation in Asia. I shall also suggest a way forward for Asian monetary co-operation, with a strategy and a list of issues to be addressed in such co-operation. Monetary Co-operation 4. Let me start now by attempting a definition on what monetary co-operation is about. The Oxford Dictionary defines "co-operation" as "working together to the same end". So I suppose monetary co-operation can simply be defined as working together to the same monetary end. This then leads to the questions as to what that same monetary end should be, who should be working together and the form in which they should best work together, particularly when one is talking about monetary co-operation across monetary systems on a global or regional dimension. 5. The Articles of Agreement of the IMF provide some guidance on what that same monetary end should be. In defining the purposes of the IMF in Article I to be, among other things, "to promote international monetary co-operation", the term "consultation and collaboration on international monetary problems" is used. So it would be appropriate to describe that same monetary end as the prevention and cure of monetary problems. Indeed, the rapid pace of financial liberalization and the associated globalization of financial markets have meant that monetary problems, when they arise, can be highly contagious on the global and particularly on a regional dimension. And if they are to be properly handled, by way of prevention or cure, there is a clear need for international monetary co-operation. 6. As to who should be working together, it is quite obvious that the interested parties would necessarily include the monetary authorities of economies facing or potentially exposed to monetary problems. The increasing realization of this need to work together has led to the formation of various, mostly regional, forums where monetary authorities gather to discuss issues of common interest. 7. Insofar as the Asian region is concerned, these forums are proving to be quite useful, but there is regrettably also some resistance in making further and the much needed progress because of, believe it or not, turf issues between ministries of finance and central banks, or perceived excessive rivalry on the part of individual economies in vying for the lead and influence in the co-operative effort. But these are facts of life that hopefully should not stand too much in the way of progress for the benefit of all in the longer term. It is also a fact of life regrettably that minds do not normally become adequately focused until they are jostled by damaging crises. 8. There are of course the multilateral institutions like the IMF and the Bank for International Settlements (BIS), and a number of international groupings of experts, who have a clear mandate or a keen interest in, among other things, promoting international monetary co-operation. They have been invaluable in providing the necessary support and guidance to monetary co-operation in Asia. 9. Nevertheless, some in this region have felt that such support and guidance, particularly from the multilateral institutions, have been less forthcoming than they would have liked, comparing for example the support given to Thailand with Mexico. They also feel that the special circumstances and interests of economies in the region have not been adequately taken into account. Nor do their voices count for enough. 10. Whether or not this feeling is justified, one consequence is for regional initiatives to surface. This is no bad thing and perhaps the pragmatic way forward, given the need realistically to address regional disparities in financial markets, infrastructure and degrees of financial liberalization. But the down side risk which all of us should be aware of is the possibility that the global financial market may then become segmented into regional blocs which may result in more competition and friction, rather than co-operation. 11. On the form of monetary co-operation, there is a wide spectrum of experience on the basis of current practice. There is on the one extreme the simple exchange of information and expertise amongst monetary authorities helpful to the management of the domestic monetary system generally, covering the whole range of central banking functions in the management of the currency, the supervision of financial institutions, the development of the financial infrastructure, the management of foreign reserves, etc. On the other extreme, there is monetary co-operation to the extent of achieving monetary union or integration. 12. In between the two extremes there are arrangements for policy co-ordination at the macro level initiated on the realization of increasing international, particularly regional, economic interdependence. There are also the more focused schemes for mutual assistance in the provision of liquidity to facilitate effective monetary management, which may or may not involve the assumption of credit risks between governments. There have also been considerable efforts spent in supervisory co-operation towards the standardization of supervisory practices in order to promote international financial stability, again in recognition of the possibility of the damaging contagion effect of financial crises across financial systems. Then there are the more forward-looking arrangements for the development and linkages of elements of the financial infrastructure to facilitate the efficient and safe financial intermediation across monetary systems. 13. Obviously no one point on this wide spectrum of international monetary co-operation can be considered as the ideal situation. Much depends on the needs arising from the circumstances, and the circumstances are changing all the time. But along with financial liberalization and the globalization of financial markets, the trend, to the extent that one can be ascertained, seems clearly to be one of increasing monetary co-operation. As is well known, European monetary co-operation is aiming for monetary integration by 1999, having moved in the past 50 years from information exchange to policy co-ordination. Whether this could be achieved on time or not, and whether monetary integration should necessarily then be considered as the final goal of monetary co-operation in other regions, we shall have to wait and see. But one has to admire the vision of the pioneer thinkers. I understand that the French economist Jacques Rueff actually declared way back in the 1950s that "Europe will be created via a currency or not at all". 14. By contrast, Asian monetary co-operation is considerably less well structured. There is traditionally some exchange of information, mostly on a bilateral basis, through meetings conducted annually, and largely prior to a game of golf or even on the golf course. There is little, if any, policy co-ordination amongst Asian economies, not to mention any interest in monetary integration. It is not clear whether this is a reflection of reluctance to subject domestic policy decisions to external influence. Indeed, until recently the majority of the economies in the region seemed happy to concede their sovereign right over monetary policy to the central banks of their major trading partners, notably the United States, through maintaining a stable exchange rate against the US dollar by varying degrees. But whatever the reason for the relative lack of monetary co-operation in the past, there have been significant changes recently, spurred by the events surrounding Mexico which affected the region and those of Thailand which is right in the middle of our region. There is serious and continuing discussion on the subject of Asian monetary co-operation. Hong Kong stands ready to contribute to this discussion and I very much hope that a long term strategy could come out of this. History of Asian Monetary Co-operation 15. Let me now describe briefly to you the history of Asian monetary co-operation. In the post-war period, many Asian central banks evolved from colonial currency boards, which practised the virtue of stable money fixed to an international reserve currency. As a result of this monetary discipline, supported by sound fiscal discipline, Asia has enjoyed stable growth with low inflation. As Asian economies gradually opened their markets to international trade and competition, with Hong Kong setting a good example of how free markets work, the existence of stable exchange rates, largely linked to the US dollar, formed the anchor of Asian growth. The need for monetary co-operation amongst Asian economies, therefore, did not matter much as long as each traded mainly with Europe or America using the US dollar as the main currency of trade. 16. This was the reason why the work of the principal forum for central bank discussions in the late 1950s called SEANZA (South East Asia, New Zealand and Australia) focused mainly at providing training for central bankers. The 18 members of this group cover a geographical area that spans the whole of Asia-Pacific from India to New Zealand. Training and research was also the primary focus of another central bank forum founded in 1966. This is SEACEN (Southeast Asian Central Banks), comprising ten central bank members with a research and training centre in Kuala Lumpur. 17. In the 1990s, the number of Asia Pacific groupings increased, partly as a result of accelerating intra-regional trade. The establishment of APEC (Asia Pacific Economic Co-operation) in 1989 promoted trade and investment amongst the 18 member economies, but there were only ancillary discussions on monetary co-operation. In February 1991, nevertheless, Asian monetary co-operation took a quiet but significant step forward with the creation of EMEAP (Executives' Meeting of East Asia Pacific Central Banks). This 11-member group of central banks was initiated by the Bank of Japan. At the beginning, EMEAP concentrated on the exchange of information on market developments in the economies of members and was the forum for the Bank of Japan to brief others on G-7 discussions. But it has since evolved into quite a productive, and certainly the most active, forum for central banking discussions in the region to date through its biannual meetings of deputy governors and an annual meeting of governors. 18. The discussion in EMEAP now has a sharp focus on Asian monetary co-operation. This need was perhaps crystallized by the Mexican crisis, which rippled to Asian currencies in January 1995. In its wake, I convened an informal meeting of several EMEAP central banks that experienced speculative activity. There was immediate agreement that it would be useful to exchange market intelligence and to share knowledge and techniques on monetary operations helpful to the maintenance of monetary stability. Out of this meeting also evolved the package of bilateral repurchase agreements of US Treasuries signed by five central banks in Hong Kong on 20 November 1995 and aimed at the enhancement of the liquidity of the foreign reserves that they hold -- a historic landmark in Asian monetary co-operation that eventually expanded to cover all the eleven EMEAP members. 19. In this connection, I should pay tribute to the foresight of Bernie Fraser, then Governor of the Reserve Bank of Australia, who called for the establishment of a new regional institution -- for want of a better name, an Asian BIS -- to promote Asian monetary co-operation. Bernie saw quite rightly that "globalisation is elevating the international dimension of monetary co-operation". In response to his call, EMEAP convened a working group to study the proposals and, at its first Governors' Meeting in Tokyo in July 1996, further established two working groups and a study group to share knowledge and expertise on financial market development, central bank operations and banking supervision issues respectively. Although the question on the establishment of a regional institution to further Asian monetary co-operation has been put aside for the time being, the progress achieved by the various groups was commendable, with ambitious plans to produce the Asian equivalent of the Green Book on banking supervision, the Red Book on payment systems and a Gold Book on reserve management practices. 20. Meanwhile, greater international monetary co-operation involving the Asian economies was also advanced when the BIS admitted the People's Bank of China, the Reserve Bank of India, the Hong Kong Monetary Authority, the Monetary Authority of Singapore and the Bank of Korea, among others, to its membership in 1996, the first new Asian members after the Bank of Japan. 21. All these initiatives were unfortunately overshadowed by the advent of the Thai crisis, which erupted in May this year. But it was still to EMEAP's credit that in the second Governors' meeting in Shanghai in July, the group called for the creation of an Asian facility to supplement the IMF in providing assistance to member economies in Asia to make structural adjustments. That historic decision paved the way for the smooth meeting organized by the Fund in Tokyo two weeks later in August when more than US$10 billion out of a total package of US$17 billion facility to Thailand was amassed from EMEAP members with almost no fuss. Meanwhile, the call for an Asian facility is still being considered. Discussions are continuing amongst the interested parties, whenever opportunities present themselves. Asian Monetary Problems 22. It is perhaps one of the ironies of the post-Bretton Woods era that the modern world is no longer generally short of liquidity, and indeed is arguably at present overflush with liquidity. Yet amidst all this liquidity and prosperity, liquidity crunches can even test the solvency of nations. The currency turbulence in Asia has prompted a realization of this irony and consequently much soul searching on the appropriateness of exchange rate and other monetary arrangements, macroeconomic and structural adjustment policies, the adequacy of financial market regulation and banking supervision, the pace of financial liberalization, etc. Many words of wisdom are being offered. While some are critical of the wisdom of fixed exchange rate systems, others blame volatile capital flows and currency speculators for the currency crises in rather strong and emotive terms. Still others fault inappropriate government policies and perhaps complacency in not taking early action. All in all a rather confusing picture. At the risk of causing even greater confusion, let me try to identify and articulate the monetary problems that Asian economies have been facing. 23. Capital inflow must be at the top of the list. At the beginning of the decade, net capital inflow to emerging markets was less than US$50 billion a year. By 1996, however, this had increased to US$245 billion. Asia has received roughly half of this capital inflow, thanks to the rather attractive basic economic fundamentals. These fundamentals, incidentally, have remained attractive today, notwithstanding the recent turmoil in Asian financial markets. The key factors that contributed to the surge in capital flows into the region include Japan's willingness to export capital as a result of sustained and large current account surpluses. The rising costs of production in Japan, associated with the appreciation of the yen have forced many Japanese firms to relocate their production to the rest of Asia. Also contributing was the low interest rate policy in the industrial economies, particularly in Japan in the post-bubble phase, which has flooded the global market with liquidity. Increasing amounts of mutual funds and pension funds of these economies looked for higher returns in the emerging markets. Clearly, Asian economies have benefited much from such capital inflows, but at the same time they have exposed themselves to the threat of a sudden loss of market confidence and hence large outflows of funds due to policy mistakes or shifts in the international economic environment. This is particularly true if a large proportion of inflows are volatile portfolio investment or short-term borrowing. 24. The next monetary problem concerns current account deficits. A number of Asian economies were able to run larger than normal current account deficits in the balance of payments because they were easily funded by capital inflows. The bad news about large capital inflows is that they might allow investment and even consumption to expand without enduring the pain of overheating or loss of competitiveness. Higher levels of domestic credit, consumption, investment, growth and even budget revenues can be sustained at the cost of rapid accumulation of foreign debt. To make matters worse, over 80% of the current account deficits of selected Asian economies was funded from short-term bank debt. In hindsight, the ready availability of short-term external financing might have delayed the necessary policy adjustments in face of cyclical and structural changes in the domestic and international economic environment. In short, we can all easily make the mistake of taking capital inflows for granted. 25. Then there is asset price inflation which is a rather common consequence of capital inflows. In an open economic environment, capital inflows may not lead to consumer price inflation, since imports would alleviate excess demand. However, if the domestic financial system is underdeveloped and financial institutions are not adequately supervised, as external hot money increases the deposit base of domestic banks they may be lured into fueling domestic asset price bubbles. These have two major consequences. First, asset price inflation eventually leads to domestic inflation and erodes external competitiveness. Second, excessive lending concentration in real estate exposes financial institutions to large non-performing loans when oversupply of property emerges. Indeed, banks are absorbing credit risk on top of interest rate and exchange rate risks. In some Asian economies, weakness of the financial system has constrained the ability of the monetary authorities to raise interest rates to defend their currencies when the exchange rates are under pressure. Conversely, to allow the currency to depreciate exposes banks and other borrowers to exchange losses on their unhedged foreign currency liabilities. 26. At the same time, the external environment has been changing. Whilst Asia was enjoying an unprecedented boom, the global competitive environment was subtly but surely shifting, which led to portfolio rebalancing by global asset managers. The adjustments in the US economy, through fiscal and monetary tightening, and technology and corporate restructuring, had brought substantial benefits in the form of lower budget deficits, and the lowest levels of unemployment and inflation for decades. In case anyone forgets, the US equity market has in the last three years outperformed almost all Asian equity markets with the exception of that of China. Funds have been attracted back to the US markets which at the same time strengthened the US dollar, adding to the momentum of that flow. It was a pure case of risk versus return. 27. In addition, growing competition at the low-wage end of industries came from other Asian and non-Asian economies. In Europe, cheaper production came from the restructuring economies of Eastern Europe. Competition came from the revival of Latin American economies with improved access to the US market through NAFTA. In Asia, India and China are emerging as major exporters. As a result, exports in Asia suffered a downturn, while imports continued to rise, leading to growing levels of current account deficits. 28. Then came problems on the exchange rate front. The volatility of key exchange rates, particularly that of the yen against the US dollar, has placed the balance of payments of some Asian economies under considerable stress. For instance, since most Asian currencies are explicitly or implicitly linked to the US dollar, the appreciation of the US dollar severely squeezed the exporters, who have to compete with their rivals in Japan and the emerging economies in other parts of the world. The weakness of the yen revived Japanese exports, placing Japan in direct competition with its major trading partners in Asia, as the cheaper yen stimulated exports of Japanese durable goods and capital goods to Asia, while reducing imports from the region. It did not make sense to export out of the subsidiaries in ASEAN when it was cheaper to buy directly from the plant in Japan. The weaker yen also has a tendency to slow foreign direct investment from Japan, as it is no longer so expensive to produce in Japan. 29. As we are all aware, this combination of Asian monetary problems has recently put tremendous pressure on the financial markets, in particular the foreign exchange markets, in the region. This was compounded by speculators who took advantage of these market developments to set up their attacks, resulting in the currency turmoil in Asian currencies that we have seen. 30. Here I cannot possibly resist the temptation to offer a few comments. There is a common perception that the adoption of more flexible exchange rate regimes by a number of Asian economies implied a failure of fixed exchange rate systems. This is in my view a mistaken perception. As all central bankers are aware, there is no one perfect exchange rate regime. One of the dilemmas of any exchange rate regime is how the exchange rate can reflect the underlying economic conditions, which are constantly changing, so that external balance can be achieved. A fixed exchange rate regime can function well if there is strict financial and fiscal discipline, and flexibility of domestic goods and services markets to adjust for any structural changes in the economy. On the other hand, a flexible exchange rate regime can also work, provided that the policy package is correct and there is a well functioning foreign exchange and financial market. But it would be a mistake to think devaluation can substitute for fundamental policy adjustments to correct a structural external imbalance. Competitive devaluations are "beggar-thy-neighbour" policies that are self defeating. 31. Indeed, the adoption of more flexible exchange rate systems by some Asian economies has not meant they can avoid the adjustments that are currently being undertaken. With a fixed exchange rate under a very strong and disciplined regime in the form of a currency board system, Hong Kong focused precisely on our underlying productivity, maintaining strict financial and fiscal discipline, and also prudent banking supervision, in order to enhance the resilience of the linked exchange rate system, and minimize and manage the downside risks of overheating in the economy. 32. Let me also put the currency adjustments in their proper perspective. In the last few years, the currencies with the greatest adjustments and volatility have been the G-3 currencies, rather than the Asian currencies. The yen has depreciated by 50% against the US dollar from its peak in 1995. The deutschemark has likewise fallen by over 30%. In comparison, the Asian currencies have until recently remained relatively stable. The Hong Kong dollar has been the most stable of Asian currencies, moving less than 1% against the US dollar. It is the greater volatility of G-3 currencies that ultimately contributed to, if not caused, the volatility in smaller regional currencies. 33. There is yet another Asian monetary problem and this is one of a different nature. It concerns the effectiveness of financial intermediation in this region. Asia needs substantial investments in the economic infrastructure to prevent bottlenecks from hindering sustained growth. The World Bank has estimated that for East Asia alone, projected infrastructure investments amount to US$1.5 trillion between 1995-2004. If other forms of capital investment are included, the figure rises to a staggering $8 trillion. At the same time, Asian economies also have very high savings rates, some as high as 30% to 50%. The aging population in Northern Asia, for example, will be ploughing increasing savings into institutionalized retirement funds, which are risk-averse and would need to be invested in markets generating, other things being equal, higher returns, lower risks and greater liquidity. Japan, for example, has an estimated ¥1200 trillion outstanding in private savings that must be invested. When the Hong Kong Mandatory Provident Fund comes into operation by the year 2000, about 4% of Hong Kong's GDP would be added annually to institutional investments. But the question is why Asian savings do not seem to have been adequately and effectively channeled into Asian investments in a manner more conducive to ensuring monetary and financial stability. 34. Much of Asian savings, in particular official sector savings and private sector savings that have been institutionalized, are still invested in assets of OECD countries, although the trend has been a gradually falling one. I cannot speak for other economies, but insofar as Hong Kong is concerned, in excess of 95% of our US$85 billion of foreign reserves are invested outside Asia. Specifically, in the management of our foreign reserves, we work against a preferred neutral position of about 75% in US dollar assets, mostly in US Treasury securities. I understand also that more than 80% of total Asian foreign exchange reserves amounting to US$600 billion are invested largely in North America and Europe. At the same time, there has been much foreign direct investment and foreign portfolio investment from OECD countries in Asia. It can be argued therefore that Asia is financing much of the budget deficits of developed economies, particularly the United States, but has to try hard to attract money back into the region through foreign investments. And the volatility of foreign portfolio investments has been a major cause of disruptions to the monetary and financial systems of the Asian economies. Some have even gone as far as to say that the Asian economies are providing the funding to hedge funds in non-Asian centres to play havoc with their currencies and financial markets. 35. This comment is perhaps a little unkind, given the important role that is being played by the international financial community in the globalized financial environment. But there certainly is a problem with the effectiveness of financial intermediation in this region which is inhibiting the flow of long-term savings into long-term investments. I believe an important factor behind this is the perceived or actual risks inherent in dealing with the products, the intermediaries and the market that are part of the process of financial intermediation. I also believe that monetary authorities have a responsibility, through concerted efforts in prudential regulation and supervision, and the development of the financial infrastructure, to contain these risks to levels more acceptable to those concerned, including themselves as managers of official foreign reserves. The Case for Asian Monetary Co-operation 36. These Asian monetary problems which I have described can seriously undermine the ability of Asian monetary authorities to deal with shocks, and so when shocks do come they will cause much agony in terms of economic disruptions and painful adjustments. The problems are also highly contagious, transmitted through sudden shifts in the same direction in the perception of risks by international investors, as they looked for worrisome similarities amongst Asian economies, as the recent turmoil in Asian currency markets has shown. The fall in one market may also lead them to look for liquidity in other markets, thus contributing further to the contagion. 37. We are living in an ever more interdependent region. Increasing trade and investment flows, made possible by trade and financial market liberalization, have bound our fates together. A decade ago, we relied heavily on markets outside Asia for our products, sending over three-quarters of exports to those markets. That reliance has been reduced sharply. In 1996, around 35% of trade in East Asia was conducted within the region, compared with the share of 28% with NAFTA countries and 20% with the European Union. 38. On investment and capital flows, the story is similar. As recently as in 1989, equity flows within the Asian region amounted to only US$24 billion. In 1995, the flows had increased three-fold to almost US$80 billion. According to the Asian Development Bank (ADB), the share of foreign direct investment from North America and the European Union in East Asia had fallen from 40% of the total fifteen years ago to 25% by 1993. Now over 50% of foreign direct investment comes from within the region. This trend can only grow, as the population giants of China and India increasingly become more engaged in trade and investment (see Table 5). 39. Much greater interdependence of course means that policies in one economy can have important implications for others. A more liberalized financial environment also means that policy mistakes can be punished almost instantaneously by the market and that monetary problems in one economy can easily spread to others. So, referring again to one of the purposes of the IMF, as defined in its Articles of Agreement, there is a clear need "to promote international monetary co-operation" through "consultation and collaboration" on these "international monetary problems" that we now face in the Asian region. The Way Forward 40. I would like now to spell out how I think monetary co-operation in this region should proceed. In order to have effective monetary co-operation, we must have clearly defined and realistic goals. Over-ambitious goals may not be credible, and may even be counterproductive. In any case, they may not be politically acceptable to the individual economies. Monetary co-operation, and indeed any type of co-operation, is meaningless when you do not have common goals. 41. Notwithstanding increasing economic integration, one has to accept reality, and this is that the economies in Asia are a very diverse group. There are dramatic differences with regard to political institutions, economic systems, basic infrastructure and any aspect you care to think of. In terms of economic structure, for example, they range from some of the largest agricultural economies in the world to the most urban economies. In terms of economic philosophy, they range from some of the freest economies in the world to economies where there is considerable central planning. In terms of the stage of economic development, they range from economies with the highest per capita incomes to t	['per mr. yam gives a broadbrush picture of asian monetary co-operation jacobsson lecture given by mr. joseph yam j.p., chief executive of the hong kong monetary authority in hong kong, on 21/9/97.', 'introduction 1. good afternoon.', 'on behalf of the people of hong kong, particularly those of us at the hong kong monetary authority, let me extend my warmest welcome to all of you to hong kong.', 'for those of you who have visited hong kong before, perhaps many times, i hope you are pleased to see that hong kong, as a special administrative region of the people\'s republic of china, remains as vibrant and dynamic as you have known in the past, retaining much of its free market characteristics, under the principle of "one country, two systems".', "2. it is a great honour and privilege for me to be invited to give this year's per jacobsson lecture.", 'as a managing director of the international monetary fund (imf), mr per jacobsson led a life that was dedicated to the promotion of both european and later international monetary co-operation.', 'it is only befitting that a lecture held in asia in memory of this great man should address the topic of asian monetary co-operation.', 'this is also a subject that has been brought to sharp focus in the light of the recent turmoil in the currency markets of asia.', '3. what i intend to do this afternoon is first to define what international monetary co-operation is about, and in this connection, survey the attitudes of the parties that should have an interest in such co-operation and discuss the form of this co-operation.', 'i wish to point out that these attitudes have, perhaps unintentionally, led to international monetary co-operation being regionalized.', 'i shall then focus specifically on asian monetary co-operation, covering the history, or the lack of it, and the monetary problems, current and potential ones, that asian economies face.', 'i shall then make a case for much greater monetary co-operation in asia.', 'i shall also suggest a way forward for asian monetary co-operation, with a strategy and a list of issues to be addressed in such co-operation.', 'monetary co-operation 4. let me start now by attempting a definition on what monetary co-operation is about.', 'the oxford dictionary defines "co-operation" as "working together to the same end".', 'so i suppose monetary co-operation can simply be defined as working together to the same monetary end.', 'this then leads to the questions as to what that same monetary end should be, who should be working together and the form in which they should best work together, particularly when one is talking about monetary co-operation across monetary systems on a global or regional dimension.', '5. the articles of agreement of the imf provide some guidance on what that same monetary end should be.', 'in defining the purposes of the imf in article i to be, among other things, "to promote international monetary co-operation", the term "consultation and collaboration on international monetary problems" is used.', 'so it would be appropriate to describe that same monetary end as the prevention and cure of monetary problems.', 'indeed, the rapid pace of financial liberalization and the associated globalization of financial markets have meant that monetary problems, when they arise, can be highly contagious on the global and particularly on a regional dimension.', 'and if they are to be properly handled, by way of prevention or cure, there is a clear need for international monetary co-operation.', '6. as to who should be working together, it is quite obvious that the interested parties would necessarily include the monetary authorities of economies facing or potentially exposed to monetary problems.', 'the increasing realization of this need to work together has led to the formation of various, mostly regional, forums where monetary authorities gather to discuss issues of common interest.', '7. insofar as the asian region is concerned, these forums are proving to be quite useful, but there is regrettably also some resistance in making further and the much needed progress because of, believe it or not, turf issues between ministries of finance and central banks, or perceived excessive rivalry on the part of individual economies in vying for the lead and influence in the co-operative effort.', 'but these are facts of life that hopefully should not stand too much in the way of progress for the benefit of all in the longer term.', 'it is also a fact of life regrettably that minds do not normally become adequately focused until they are jostled by damaging crises.', '8. there are of course the multilateral institutions like the imf and the bank for international settlements (bis), and a number of international groupings of experts, who have a clear mandate or a keen interest in, among other things, promoting international monetary co-operation.', 'they have been invaluable in providing the necessary support and guidance to monetary co-operation in asia.', '9. nevertheless, some in this region have felt that such support and guidance, particularly from the multilateral institutions, have been less forthcoming than they would have liked, comparing for example the support given to thailand with mexico.', 'they also feel that the special circumstances and interests of economies in the region have not been adequately taken into account.', 'nor do their voices count for enough.', '10. whether or not this feeling is justified, one consequence is for regional initiatives to surface.', 'this is no bad thing and perhaps the pragmatic way forward, given the need realistically to address regional disparities in financial markets, infrastructure and degrees of financial liberalization.', 'but the down side risk which all of us should be aware of is the possibility that the global financial market may then become segmented into regional blocs which may result in more competition and friction, rather than co-operation.', '11. on the form of monetary co-operation, there is a wide spectrum of experience on the basis of current practice.', 'there is on the one extreme the simple exchange of information and expertise amongst monetary authorities helpful to the management of the domestic monetary system generally, covering the whole range of central banking functions in the management of the currency, the supervision of financial institutions, the development of the financial infrastructure, the management of foreign reserves, etc.', 'on the other extreme, there is monetary co-operation to the extent of achieving monetary union or integration.', '12. in between the two extremes there are arrangements for policy co-ordination at the macro level initiated on the realization of increasing international, particularly regional, economic interdependence.', 'there are also the more focused schemes for mutual assistance in the provision of liquidity to facilitate effective monetary management, which may or may not involve the assumption of credit risks between governments.', 'there have also been considerable efforts spent in supervisory co-operation towards the standardization of supervisory practices in order to promote international financial stability, again in recognition of the possibility of the damaging contagion effect of financial crises across financial systems.', 'then there are the more forward-looking arrangements for the development and linkages of elements of the financial infrastructure to facilitate the efficient and safe financial intermediation across monetary systems.', '13. obviously no one point on this wide spectrum of international monetary co-operation can be considered as the ideal situation.', 'much depends on the needs arising from the circumstances, and the circumstances are changing all the time.', 'but along with financial liberalization and the globalization of financial markets, the trend, to the extent that one can be ascertained, seems clearly to be one of increasing monetary co-operation.', 'as is well known, european monetary co-operation is aiming for monetary integration by 1999, having moved in the past 50 years from information exchange to policy co-ordination.', 'whether this could be achieved on time or not, and whether monetary integration should necessarily then be considered as the final goal of monetary co-operation in other regions, we shall have to wait and see.', 'but one has to admire the vision of the pioneer thinkers.', 'i understand that the french economist jacques rueff actually declared way back in the 1950s that "europe will be created via a currency or not at all".', '14. by contrast, asian monetary co-operation is considerably less well structured.', 'there is traditionally some exchange of information, mostly on a bilateral basis, through meetings conducted annually, and largely prior to a game of golf or even on the golf course.', 'there is little, if any, policy co-ordination amongst asian economies, not to mention any interest in monetary integration.', 'it is not clear whether this is a reflection of reluctance to subject domestic policy decisions to external influence.', 'indeed, until recently the majority of the economies in the region seemed happy to concede their sovereign right over monetary policy to the central banks of their major trading partners, notably the united states, through maintaining a stable exchange rate against the us dollar by varying degrees.', 'but whatever the reason for the relative lack of monetary co-operation in the past, there have been significant changes recently, spurred by the events surrounding mexico which affected the region and those of thailand which is right in the middle of our region.', 'there is serious and continuing discussion on the subject of asian monetary co-operation.', 'hong kong stands ready to contribute to this discussion and i very much hope that a long term strategy could come out of this.', 'history of asian monetary co-operation 15. let me now describe briefly to you the history of asian monetary co-operation.', 'in the post-war period, many asian central banks evolved from colonial currency boards, which practised the virtue of stable money fixed to an international reserve currency.', 'as a result of this monetary discipline, supported by sound fiscal discipline, asia has enjoyed stable growth with low inflation.', 'as asian economies gradually opened their markets to international trade and competition, with hong kong setting a good example of how free markets work, the existence of stable exchange rates, largely linked to the us dollar, formed the anchor of asian growth.', 'the need for monetary co-operation amongst asian economies, therefore, did not matter much as long as each traded mainly with europe or america using the us dollar as the main currency of trade.', '16. this was the reason why the work of the principal forum for central bank discussions in the late 1950s called seanza (south east asia, new zealand and australia) focused mainly at providing training for central bankers.', 'the 18 members of this group cover a geographical area that spans the whole of asia-pacific from india to new zealand.', 'training and research was also the primary focus of another central bank forum founded in 1966. this is seacen (southeast asian central banks), comprising ten central bank members with a research and training centre in kuala lumpur.', '17. in the 1990s, the number of asia pacific groupings increased, partly as a result of accelerating intra-regional trade.', 'the establishment of apec (asia pacific economic co-operation) in 1989 promoted trade and investment amongst the 18 member economies, but there were only ancillary discussions on monetary co-operation.', "in february 1991, nevertheless, asian monetary co-operation took a quiet but significant step forward with the creation of emeap (executives' meeting of east asia pacific central banks).", 'this 11-member group of central banks was initiated by the bank of japan.', 'at the beginning, emeap concentrated on the exchange of information on market developments in the economies of members and was the forum for the bank of japan to brief others on g-7 discussions.', 'but it has since evolved into quite a productive, and certainly the most active, forum for central banking discussions in the region to date through its biannual meetings of deputy governors and an annual meeting of governors.', '18. the discussion in emeap now has a sharp focus on asian monetary co-operation.', 'this need was perhaps crystallized by the mexican crisis, which rippled to asian currencies in january 1995. in its wake, i convened an informal meeting of several emeap central banks that experienced speculative activity.', 'there was immediate agreement that it would be useful to exchange market intelligence and to share knowledge and techniques on monetary operations helpful to the maintenance of monetary stability.', 'out of this meeting also evolved the package of bilateral repurchase agreements of us treasuries signed by five central banks in hong kong on 20 november 1995 and aimed at the enhancement of the liquidity of the foreign reserves that they hold -- a historic landmark in asian monetary co-operation that eventually expanded to cover all the eleven emeap members.', '19. in this connection, i should pay tribute to the foresight of bernie fraser, then governor of the reserve bank of australia, who called for the establishment of a new regional institution -- for want of a better name, an asian bis -- to promote asian monetary co-operation.', 'bernie saw quite rightly that "globalisation is elevating the international dimension of monetary co-operation".', "in response to his call, emeap convened a working group to study the proposals and, at its first governors' meeting in tokyo in july 1996, further established two working groups and a study group to share knowledge and expertise on financial market development, central bank operations and banking supervision issues respectively.", 'although the question on the establishment of a regional institution to further asian monetary co-operation has been put aside for the time being, the progress achieved by the various groups was commendable, with ambitious plans to produce the asian equivalent of the green book on banking supervision, the red book on payment systems and a gold book on reserve management practices.', "20. meanwhile, greater international monetary co-operation involving the asian economies was also advanced when the bis admitted the people's bank of china, the reserve bank of india, the hong kong monetary authority, the monetary authority of singapore and the bank of korea, among others, to its membership in 1996, the first new asian members after the bank of japan.", '21. all these initiatives were unfortunately overshadowed by the advent of the thai crisis, which erupted in may this year.', "but it was still to emeap's credit that in the second governors' meeting in shanghai in july, the group called for the creation of an asian facility to supplement the imf in providing assistance to member economies in asia to make structural adjustments.", 'that historic decision paved the way for the smooth meeting organized by the fund in tokyo two weeks later in august when more than us$10 billion out of a total package of us$17 billion facility to thailand was amassed from emeap members with almost no fuss.', 'meanwhile, the call for an asian facility is still being considered.', 'discussions are continuing amongst the interested parties, whenever opportunities present themselves.', 'asian monetary problems 22. it is perhaps one of the ironies of the post-bretton woods era that the modern world is no longer generally short of liquidity, and indeed is arguably at present overflush with liquidity.', 'yet amidst all this liquidity and prosperity, liquidity crunches can even test the solvency of nations.', 'the currency turbulence in asia has prompted a realization of this irony and consequently much soul searching on the appropriateness of exchange rate and other monetary arrangements, macroeconomic and structural adjustment policies, the adequacy of financial market regulation and banking supervision, the pace of financial liberalization, etc.', 'many words of wisdom are being offered.', 'while some are critical of the wisdom of fixed exchange rate systems, others blame volatile capital flows and currency speculators for the currency crises in rather strong and emotive terms.', 'still others fault inappropriate government policies and perhaps complacency in not taking early action.', 'all in all a rather confusing picture.', 'at the risk of causing even greater confusion, let me try to identify and articulate the monetary problems that asian economies have been facing.', '23. capital inflow must be at the top of the list.', 'at the beginning of the decade, net capital inflow to emerging markets was less than us$50 billion a year.', 'by 1996, however, this had increased to us$245 billion.', 'asia has received roughly half of this capital inflow, thanks to the rather attractive basic economic fundamentals.', 'these fundamentals, incidentally, have remained attractive today, notwithstanding the recent turmoil in asian financial markets.', "the key factors that contributed to the surge in capital flows into the region include japan's willingness to export capital as a result of sustained and large current account surpluses.", 'the rising costs of production in japan, associated with the appreciation of the yen have forced many japanese firms to relocate their production to the rest of asia.', 'also contributing was the low interest rate policy in the industrial economies, particularly in japan in the post-bubble phase, which has flooded the global market with liquidity.', 'increasing amounts of mutual funds and pension funds of these economies looked for higher returns in the emerging markets.', 'clearly, asian economies have benefited much from such capital inflows, but at the same time they have exposed themselves to the threat of a sudden loss of market confidence and hence large outflows of funds due to policy mistakes or shifts in the international economic environment.', 'this is particularly true if a large proportion of inflows are volatile portfolio investment or short-term borrowing.', '24. the next monetary problem concerns current account deficits.', 'a number of asian economies were able to run larger than normal current account deficits in the balance of payments because they were easily funded by capital inflows.', 'the bad news about large capital inflows is that they might allow investment and even consumption to expand without enduring the pain of overheating or loss of competitiveness.', 'higher levels of domestic credit, consumption, investment, growth and even budget revenues can be sustained at the cost of rapid accumulation of foreign debt.', 'to make matters worse, over 80% of the current account deficits of selected asian economies was funded from short-term bank debt.', 'in hindsight, the ready availability of short-term external financing might have delayed the necessary policy adjustments in face of cyclical and structural changes in the domestic and international economic environment.', 'in short, we can all easily make the mistake of taking capital inflows for granted.', '25. then there is asset price inflation which is a rather common consequence of capital inflows.', 'in an open economic environment, capital inflows may not lead to consumer price inflation, since imports would alleviate excess demand.', 'however, if the domestic financial system is underdeveloped and financial institutions are not adequately supervised, as external hot money increases the deposit base of domestic banks they may be lured into fueling domestic asset price bubbles.', 'these have two major consequences.', 'first, asset price inflation eventually leads to domestic inflation and erodes external competitiveness.', 'second, excessive lending concentration in real estate exposes financial institutions to large non-performing loans when oversupply of property emerges.', 'indeed, banks are absorbing credit risk on top of interest rate and exchange rate risks.', 'in some asian economies, weakness of the financial system has constrained the ability of the monetary authorities to raise interest rates to defend their currencies when the exchange rates are under pressure.', 'conversely, to allow the currency to depreciate exposes banks and other borrowers to exchange losses on their unhedged foreign currency liabilities.', '26. at the same time, the external environment has been changing.', 'whilst asia was enjoying an unprecedented boom, the global competitive environment was subtly but surely shifting, which led to portfolio rebalancing by global asset managers.', 'the adjustments in the us economy, through fiscal and monetary tightening, and technology and corporate restructuring, had brought substantial benefits in the form of lower budget deficits, and the lowest levels of unemployment and inflation for decades.', 'in case anyone forgets, the us equity market has in the last three years outperformed almost all asian equity markets with the exception of that of china.', 'funds have been attracted back to the us markets which at the same time strengthened the us dollar, adding to the momentum of that flow.', 'it was a pure case of risk versus return.', '27. in addition, growing competition at the low-wage end of industries came from other asian and non-asian economies.', 'in europe, cheaper production came from the restructuring economies of eastern europe.', 'competition came from the revival of latin american economies with improved access to the us market through nafta.', 'in asia, india and china are emerging as major exporters.', 'as a result, exports in asia suffered a downturn, while imports continued to rise, leading to growing levels of current account deficits.', '28. then came problems on the exchange rate front.', 'the volatility of key exchange rates, particularly that of the yen against the us dollar, has placed the balance of payments of some asian economies under considerable stress.', 'for instance, since most asian currencies are explicitly or implicitly linked to the us dollar, the appreciation of the us dollar severely squeezed the exporters, who have to compete with their rivals in japan and the emerging economies in other parts of the world.', 'the weakness of the yen revived japanese exports, placing japan in direct competition with its major trading partners in asia, as the cheaper yen stimulated exports of japanese durable goods and capital goods to asia, while reducing imports from the region.', 'it did not make sense to export out of the subsidiaries in asean when it was cheaper to buy directly from the plant in japan.', 'the weaker yen also has a tendency to slow foreign direct investment from japan, as it is no longer so expensive to produce in japan.', '29. as we are all aware, this combination of asian monetary problems has recently put tremendous pressure on the financial markets, in particular the foreign exchange markets, in the region.', 'this was compounded by speculators who took advantage of these market developments to set up their attacks, resulting in the currency turmoil in asian currencies that we have seen.', '30. here i cannot possibly resist the temptation to offer a few comments.', 'there is a common perception that the adoption of more flexible exchange rate regimes by a number of asian economies implied a failure of fixed exchange rate systems.', 'this is in my view a mistaken perception.', 'as all central bankers are aware, there is no one perfect exchange rate regime.', 'one of the dilemmas of any exchange rate regime is how the exchange rate can reflect the underlying economic conditions, which are constantly changing, so that external balance can be achieved.', 'a fixed exchange rate regime can function well if there is strict financial and fiscal discipline, and flexibility of domestic goods and services markets to adjust for any structural changes in the economy.', 'on the other hand, a flexible exchange rate regime can also work, provided that the policy package is correct and there is a well functioning foreign exchange and financial market.', 'but it would be a mistake to think devaluation can substitute for fundamental policy adjustments to correct a structural external imbalance.', 'competitive devaluations are "beggar-thy-neighbour" policies that are self defeating.', '31. indeed, the adoption of more flexible exchange rate systems by some asian economies has not meant they can avoid the adjustments that are currently being undertaken.', 'with a fixed exchange rate under a very strong and disciplined regime in the form of a currency board system, hong kong focused precisely on our underlying productivity, maintaining strict financial and fiscal discipline, and also prudent banking supervision, in order to enhance the resilience of the linked exchange rate system, and minimize and manage the downside risks of overheating in the economy.', '32. let me also put the currency adjustments in their proper perspective.', 'in the last few years, the currencies with the greatest adjustments and volatility have been the g-3 currencies, rather than the asian currencies.', 'the yen has depreciated by 50% against the us dollar from its peak in 1995. the deutschemark has likewise fallen by over 30%.', 'in comparison, the asian currencies have until recently remained relatively stable.', 'the hong kong dollar has been the most stable of asian currencies, moving less than 1% against the us dollar.', 'it is the greater volatility of g-3 currencies that ultimately contributed to, if not caused, the volatility in smaller regional currencies.', '33. there is yet another asian monetary problem and this is one of a different nature.', 'it concerns the effectiveness of financial intermediation in this region.', 'asia needs substantial investments in the economic infrastructure to prevent bottlenecks from hindering sustained growth.', 'the world bank has estimated that for east asia alone, projected infrastructure investments amount to us$1.5 trillion between 1995-2004. if other forms of capital investment are included, the figure rises to a staggering $8 trillion.', 'at the same time, asian economies also have very high savings rates, some as high as 30% to 50%.', 'the aging population in northern asia, for example, will be ploughing increasing savings into institutionalized retirement funds, which are risk-averse and would need to be invested in markets generating, other things being equal, higher returns, lower risks and greater liquidity.', 'japan, for example, has an estimated ¥1200 trillion outstanding in private savings that must be invested.', "when the hong kong mandatory provident fund comes into operation by the year 2000, about 4% of hong kong's gdp would be added annually to institutional investments.", 'but the question is why asian savings do not seem to have been adequately and effectively channeled into asian investments in a manner more conducive to ensuring monetary and financial stability.', '34. much of asian savings, in particular official sector savings and private sector savings that have been institutionalized, are still invested in assets of oecd countries, although the trend has been a gradually falling one.', 'i cannot speak for other economies, but insofar as hong kong is concerned, in excess of 95% of our us$85 billion of foreign reserves are invested outside asia.', 'specifically, in the management of our foreign reserves, we work against a preferred neutral position of about 75% in us dollar assets, mostly in us treasury securities.', 'i understand also that more than 80% of total asian foreign exchange reserves amounting to us$600 billion are invested largely in north america and europe.', 'at the same time, there has been much foreign direct investment and foreign portfolio investment from oecd countries in asia.', 'it can be argued therefore that asia is financing much of the budget deficits of developed economies, particularly the united states, but has to try hard to attract money back into the region through foreign investments.', 'and the volatility of foreign portfolio investments has been a major cause of disruptions to the monetary and financial systems of the asian economies.', 'some have even gone as far as to say that the asian economies are providing the funding to hedge funds in non-asian centres to play havoc with their currencies and financial markets.', '35. this comment is perhaps a little unkind, given the important role that is being played by the international financial community in the globalized financial environment.', 'but there certainly is a problem with the effectiveness of financial intermediation in this region which is inhibiting the flow of long-term savings into long-term investments.', 'i believe an important factor behind this is the perceived or actual risks inherent in dealing with the products, the intermediaries and the market that are part of the process of financial intermediation.', 'i also believe that monetary authorities have a responsibility, through concerted efforts in prudential regulation and supervision, and the development of the financial infrastructure, to contain these risks to levels more acceptable to those concerned, including themselves as managers of official foreign reserves.', 'the case for asian monetary co-operation 36. these asian monetary problems which i have described can seriously undermine the ability of asian monetary authorities to deal with shocks, and so when shocks do come they will cause much agony in terms of economic disruptions and painful adjustments.', 'the problems are also highly contagious, transmitted through sudden shifts in the same direction in the perception of risks by international investors, as they looked for worrisome similarities amongst asian economies, as the recent turmoil in asian currency markets has shown.', 'the fall in one market may also lead them to look for liquidity in other markets, thus contributing further to the contagion.', '37. we are living in an ever more interdependent region.', 'increasing trade and investment flows, made possible by trade and financial market liberalization, have bound our fates together.', 'a decade ago, we relied heavily on markets outside asia for our products, sending over three-quarters of exports to those markets.', 'that reliance has been reduced sharply.', 'in 1996, around 35% of trade in east asia was conducted within the region, compared with the share of 28% with nafta countries and 20% with the european union.', '38. on investment and capital flows, the story is similar.', 'as recently as in 1989, equity flows within the asian region amounted to only us$24 billion.', 'in 1995, the flows had increased three-fold to almost us$80 billion.', 'according to the asian development bank (adb), the share of foreign direct investment from north america and the european union in east asia had fallen from 40% of the total fifteen years ago to 25% by 1993. now over 50% of foreign direct investment comes from within the region.', 'this trend can only grow, as the population giants of china and india increasingly become more engaged in trade and investment (see table 5).', '39. much greater interdependence of course means that policies in one economy can have important implications for others.', 'a more liberalized financial environment also means that policy mistakes can be punished almost instantaneously by the market and that monetary problems in one economy can easily spread to others.', 'so, referring again to one of the purposes of the imf, as defined in its articles of agreement, there is a clear need "to promote international monetary co-operation" through "consultation and collaboration" on these "international monetary problems" that we now face in the asian region.', 'the way forward 40. i would like now to spell out how i think monetary co-operation in this region should proceed.', 'in order to have effective monetary co-operation, we must have clearly defined and realistic goals.', 'over-ambitious goals may not be credible, and may even be counterproductive.', 'in any case, they may not be politically acceptable to the individual economies.', 'monetary co-operation, and indeed any type of co-operation, is meaningless when you do not have common goals.', '41. notwithstanding increasing economic integration, one has to accept reality, and this is that the economies in asia are a very diverse group.', 'there are dramatic differences with regard to political institutions, economic systems, basic infrastructure and any aspect you care to think of.', 'in terms of economic structure, for example, they range from some of the largest agricultural economies in the world to the most urban economies.', 'in terms of economic philosophy, they range from some of the freest economies in the world to economies where there is considerable central planning.', 'in terms of the stage of economic development, they range from economies with the highest per capita incomes to t']	Joseph Yam	Hong Kong Monetary Authority	Chief Executive	Hong Kong
https://www.bis.org/review/r971007b.pdf	Ms. Phillips discusses the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities (Central Bank Articles and Speeches, 1 Oct 97)	Testimony of Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, on 1/10/97.	1997-10-01 00:00:00	Ms. Phillips discusses the Federal Reserve Board's views on proposed Testimony of Ms. Susan accounting standards for derivatives and risk management activities M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, on 1/10/97. I welcome this opportunity to discuss the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities issued by the Financial Accounting Standards Board (FASB). In approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements. Thus, the desirability of meaningful disclosure is not the issue. All would agree, I think, that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline. With respect to financial disclosures, the interests of most firm managers, investors, and other market participants are essentially the same. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of their counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect their lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess their fundamental financial strength. While most market participants favor sound accounting standards and meaningful disclosure, a key question is how to ensure that accounting practices and techniques reflect, and are consistent with, how a business is run, that is, its overall business strategy. Indeed, accounting methodology should measure the results of a business purpose or strategy, and not be an end in itself. For example, in the case of a company that actively trades financial instruments or other products to profit from short-term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment. However, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the primary financial statements may not accurately reflect business strategies or appropriately measure the firm's underlying performance and condition. In these cases, although information about fair value can be useful in supplemental disclosures, it is questionable whether there is widespread demand for market value accounting to become the basis for the preparation of the primary financial statements. Although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm. The application of market value accounting to business strategies where it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets -- volatility that is not consistent with firm's risk positions -- can also impose significant costs without offsetting benefits. These problems can be minimized by placing market values in meaningful supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements. Of course, financial statements and supplemental disclosures must be accurate and not misrepresent a firm's financial circumstances -- a problem that can be minimized when financial reports are subject to thorough review by management and external auditors. Federal Reserve's Experience The Federal Reserve Board has a long-standing interest in the quality of financial reporting. This arises from our role as the nation's central bank, and as the supervisor of bank holding companies, state member banks, and the U.S. operations of foreign banking organizations (FBOs). The Federal Reserve and other bank supervisors are responsible for assessing the safety and soundness of the institutions they regulate. In this regard, the Federal Reserve relies on off-site monitoring, on-site supervision, capital and other regulatory requirements, and policies that encourage sound risk management practices. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complement these supervisory efforts by fostering healthy financial institutions and efficient capital markets. In the course of supervising financial institutions, the Federal Reserve has developed considerable familiarity with financial instruments, both derivative and non-derivative, that are characterized by a wide range of complexity and risk. We have learned that in supervising trading and derivatives activities it is the underlying characteristics of a financial instrument -- and how it contributes to the overall risk profile of the firm -- that are important, not the instrument's name. Two instruments that differ in name only may have entirely different treatment under existing legal and accounting frameworks, even though the economic risks (including market, credit, liquidity, operational, and reputational risks) they embody are identical. Financial engineering can certainly create derivative instruments that combine risks in complex ways. But the same engineers can create cash instruments that appear simple and traditional, but may have greater risk than many instruments labeled "derivative." Indeed, placing financial instruments in regulatory or accounting pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management. The Federal Reserve is increasingly emphasizing the need for institutions to manage the aggregate or portfolio risks of banking and de-emphasizing a focus on specific instruments. Risk should be measured and managed comprehensively. That is, an institution should manage the dynamics of its portfolio rather than manage specific instruments. A focus on individual transactions can ignore the interaction of the specified instrument with other instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. For example, past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. The Federal Reserve is increasingly recognizing the need for supervisory and regulatory policies to be more "incentive-compatible," in that they encourage sound risk management within an institution. Furthermore, supervisory and regulatory policies are placing increasing emphasis on minimizing burden by using internal risk measurement systems, and by reinforcing supervisory objectives through market forces. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complements our supervisory efforts by fostering strong financial institutions and efficient capital markets. We believe this approach is more constructive than rote adherence to rules and regulations that may not be consistent with the firm's own risk management systems. Consistent with these policies, the Federal Reserve and other banking supervisors have explored regulatory approaches that encourage more use of market-value-based measures in risk management approaches. For example, beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal value-at-risk (VaR) measures. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. Other initiatives have improved the focus of our supervision policies and examination practices on institutions' risk profiles and risk management activities in ways that emphasize sound practices and strong internal controls. Moreover, the Federal Reserve has called for improved U.S. accounting and disclosure standards and has had a key role in sponsoring major international initiatives to encourage improved disclosures by the largest banks and securities firms of their trading and derivatives activities. For example, our 1995 and 1996 analyses of the derivatives disclosure by the top ten U.S. dealer banks were used as models for the joint reports by the Basle Committee on Banking Supervision and the International Organization of Securities Commissions, which covered a sample of the largest banks and securities firms in the G-10 countries. These studies revealed major differences in disclosure among the participating countries and highlighted the greater level of disclosure by U.S. dealer banks. In addition, a representative of the Federal Reserve chaired an international working group of the Euro-currency Standing Committee that recommended in 1994 improvements to disclosure by financial intermediaries of the credit and market risks of their trading activities. The Federal Reserve and the other federal banking agencies also developed improvements in derivatives disclosure standards for regulatory reports that are similar to disclosure requirements issued at the same time by FASB in Statement No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." Specific Issues Raised by the Derivatives Proposal We share several objectives with the FASB for improving financial reporting. For example, we both support the fundamental objectives of promoting clear and understandable financial reports that increase the transparency of companies' activities. We also share the view that accounting and disclosure standards which faithfully represent financial condition and performance can improve investor and counterparty decisions, thus improving market discipline on banking organizations and other companies. Further, we also agree that current accounting and disclosure standards for derivatives -- as well as for other financial instruments -- should be improved. We recognize the difficult task that FASB has in developing a standard that is acceptable to its many constituents. In this regard, we understand that FASB has considered and rejected a number of approaches to hedge accounting for derivatives because particular problems were identified with each approach. We also believe that the approach of reporting all financial instruments at fair value in the primary set of financial instruments, while having some theoretical appeal at least for some types of firms, is not an appropriate solution in the near term. In this regard, fair value estimation techniques are not yet sufficiently robust for exclusive reliance in financial statements. For example, difficult valuation issues arise for highly illiquid instruments for which fair value is based on models rather than observed prices, core deposits with varying durations, and the liabilities of a firm whose credit quality has weakened. Furthermore, fair value estimates can be highly subjective, and little guidance is available for measuring fair values in the financial statements. Another difficult issue relates to whether fair value is the most relevant measurement for commercial banks and other firms that are in the business of holding illiquid loans and other assets for the long term. The success or failure of such a strategy is not measured by evaluating such loans on the basis of a price that indicates value in the context of immediate delivery. In this regard, an appropriate value for many bank loans and off-balance-sheet commitments -- the one that reflect the nature of a bank's business -- is the original acquisition price adjusted for the expectation of performance at maturity. Given the many difficulties of FASB's task, it is not surprising that their proposal raises a number of complex issues. For example, the proposal is likely to lead to increased volatility in income and stockholders equity by companies that manage risk with derivatives. This volatility could be artificial due to the piecemeal approach of marking certain risk positions to fair value, but not all positions contributing to the risk. As a result, there could be accounting volatility that bears little relation to an institution's overall risk position. Supervisors and analysts will have to strip out the artificially created volatility to assess the true performance of the firm. On the other hand, companies that do not manage their risks, or manage their risks solely through cash instruments that are not covered by the standard, would not reflect similar volatility. A simple example might illustrate this concern. Assume a company's activities consist solely of lending long term at fixed rates and funding these loans with variable-rate deposits. I think we can all agree that this company has a significant exposure to interest rate risk. If the company does not manage its risk with derivatives, it would not be affected by the derivatives accounting proposal and would not report any volatility from fair value changes in its financial statements. If, however, the company has a strategy to use derivatives to reduce its interest rate risk and move it closer to a match-funded position, the company may report greater volatility in income and stockholders' equity -- a result not consistent with its reduced risk exposure. For example, if the company specified under the framework set forth in the FASB proposal that the derivatives are "cash flow" hedges of variable rate liabilities, the company would have volatility in equity or earnings based on the specifically linked effectiveness tests set forth by the proposal. Thus, the firm in using derivatives reduces its economic volatility, yet increases its accounting volatility. More important, by taking a transaction level approach to hedging, the proposal would not describe well the efforts of more sophisticated market participants to hedge their risks on a comprehensive, portfolio basis. Thus, these firms would effectively be required to keep different sets of books, and their financial reporting may not be consistent with the derivatives' intended use. This leads me to conclude that the proposal could discourage or constrain prudent risk management practices that rely on derivatives. Furthermore, it may not improve transparency of financial information. The proposal also introduces into the financial statements an untested method for reporting loans, deposits, and other assets and liabilities being hedged. These assets and liabilities would be valued at a "hybrid" historical cost and fair value amount on the balance sheet when they are hedged with derivatives that are designated as fair value hedges. For example, generally, the historical cost values of these assets and liabilities would be adjusted for changes in fair value related to the risk being hedged. However, certain other changes in fair value would not be recognized (such as those that arise from other risks, that are the results of an ineffective hedge, or that do not offset a gain or loss on the hedging instrument). These hybrid amounts could differ significantly from -- and potentially exceed -- fair values. They may also be difficult to verify by auditors and examiners, thus reducing the reliability of amounts reported in the financial statements. The proposed approach is complex, which may increase related developmental systems costs. In this regard, the proposal may cause significant systems changes for institutions that hedge with derivatives. At the same time institutions are making these systems changes, they need to upgrade their systems to address Year 2000 issues. The cost of systems changes arising from the derivatives proposal should be evaluated along with other costs and benefits arising from the proposal. This is particularly important since the derivatives proposal is intended by the FASB to be an interim treatment, and its long-term goal is to measure all financial instruments at fair value. Indeed, the FASB already has under way a project that is evaluating issues related to that goal.	["ms. phillips discusses the federal reserve board's views on proposed testimony of ms. susan accounting standards for derivatives and risk management activities m. phillips, a member of the board of governors of the us federal reserve system, before the subcommittee on capital markets, securities and government sponsored enterprises of the committee on banking and financial services, u.s. house of representatives, on 1/10/97.", "i welcome this opportunity to discuss the federal reserve board's views on proposed accounting standards for derivatives and risk management activities issued by the financial accounting standards board (fasb).", 'in approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements.', 'thus, the desirability of meaningful disclosure is not the issue.', 'all would agree, i think, that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline.', 'with respect to financial disclosures, the interests of most firm managers, investors, and other market participants are essentially the same.', 'market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of their counterparties and competitors.', "investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential.", 'sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect their lower risk profiles.', 'inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess their fundamental financial strength.', 'while most market participants favor sound accounting standards and meaningful disclosure, a key question is how to ensure that accounting practices and techniques reflect, and are consistent with, how a business is run, that is, its overall business strategy.', 'indeed, accounting methodology should measure the results of a business purpose or strategy, and not be an end in itself.', 'for example, in the case of a company that actively trades financial instruments or other products to profit from short-term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment.', "however, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the primary financial statements may not accurately reflect business strategies or appropriately measure the firm's underlying performance and condition.", 'in these cases, although information about fair value can be useful in supplemental disclosures, it is questionable whether there is widespread demand for market value accounting to become the basis for the preparation of the primary financial statements.', 'although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm.', "the application of market value accounting to business strategies where it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm's condition and performance.", 'requiring companies to adopt market value accounting where it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance.', "moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets -- volatility that is not consistent with firm's risk positions -- can also impose significant costs without offsetting benefits.", 'these problems can be minimized by placing market values in meaningful supplemental disclosures rather than by forcing their use in the primary financial statements.', 'such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements.', "of course, financial statements and supplemental disclosures must be accurate and not misrepresent a firm's financial circumstances -- a problem that can be minimized when financial reports are subject to thorough review by management and external auditors.", "federal reserve's experience the federal reserve board has a long-standing interest in the quality of financial reporting.", "this arises from our role as the nation's central bank, and as the supervisor of bank holding companies, state member banks, and the u.s. operations of foreign banking organizations (fbos).", 'the federal reserve and other bank supervisors are responsible for assessing the safety and soundness of the institutions they regulate.', 'in this regard, the federal reserve relies on off-site monitoring, on-site supervision, capital and other regulatory requirements, and policies that encourage sound risk management practices.', 'we believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complement these supervisory efforts by fostering healthy financial institutions and efficient capital markets.', 'in the course of supervising financial institutions, the federal reserve has developed considerable familiarity with financial instruments, both derivative and non-derivative, that are characterized by a wide range of complexity and risk.', "we have learned that in supervising trading and derivatives activities it is the underlying characteristics of a financial instrument -- and how it contributes to the overall risk profile of the firm -- that are important, not the instrument's name.", 'two instruments that differ in name only may have entirely different treatment under existing legal and accounting frameworks, even though the economic risks (including market, credit, liquidity, operational, and reputational risks) they embody are identical.', 'financial engineering can certainly create derivative instruments that combine risks in complex ways.', 'but the same engineers can create cash instruments that appear simple and traditional, but may have greater risk than many instruments labeled "derivative."', 'indeed, placing financial instruments in regulatory or accounting pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management.', 'the federal reserve is increasingly emphasizing the need for institutions to manage the aggregate or portfolio risks of banking and de-emphasizing a focus on specific instruments.', 'risk should be measured and managed comprehensively.', 'that is, an institution should manage the dynamics of its portfolio rather than manage specific instruments.', 'a focus on individual transactions can ignore the interaction of the specified instrument with other instruments.', 'although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy.', 'for example, past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios.', 'the federal reserve is increasingly recognizing the need for supervisory and regulatory policies to be more "incentive-compatible," in that they encourage sound risk management within an institution.', 'furthermore, supervisory and regulatory policies are placing increasing emphasis on minimizing burden by using internal risk measurement systems, and by reinforcing supervisory objectives through market forces.', 'we believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complements our supervisory efforts by fostering strong financial institutions and efficient capital markets.', "we believe this approach is more constructive than rote adherence to rules and regulations that may not be consistent with the firm's own risk management systems.", 'consistent with these policies, the federal reserve and other banking supervisors have explored regulatory approaches that encourage more use of market-value-based measures in risk management approaches.', 'for example, beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal value-at-risk (var) measures.', 'a significant effort that could increase supervisory reliance on market discipline in the future is the federal reserve\'s so-called "pre-commitment" approach to determining capital for market risk.', 'it seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management.', "other initiatives have improved the focus of our supervision policies and examination practices on institutions' risk profiles and risk management activities in ways that emphasize sound practices and strong internal controls.", 'moreover, the federal reserve has called for improved u.s. accounting and disclosure standards and has had a key role in sponsoring major international initiatives to encourage improved disclosures by the largest banks and securities firms of their trading and derivatives activities.', 'for example, our 1995 and 1996 analyses of the derivatives disclosure by the top ten u.s. dealer banks were used as models for the joint reports by the basle committee on banking supervision and the international organization of securities commissions, which covered a sample of the largest banks and securities firms in the g-10 countries.', 'these studies revealed major differences in disclosure among the participating countries and highlighted the greater level of disclosure by u.s. dealer banks.', 'in addition, a representative of the federal reserve chaired an international working group of the euro-currency standing committee that recommended in 1994 improvements to disclosure by financial intermediaries of the credit and market risks of their trading activities.', 'the federal reserve and the other federal banking agencies also developed improvements in derivatives disclosure standards for regulatory reports that are similar to disclosure requirements issued at the same time by fasb in statement no.', '119, "disclosure about derivative financial instruments and fair value of financial instruments."', 'specific issues raised by the derivatives proposal we share several objectives with the fasb for improving financial reporting.', "for example, we both support the fundamental objectives of promoting clear and understandable financial reports that increase the transparency of companies' activities.", 'we also share the view that accounting and disclosure standards which faithfully represent financial condition and performance can improve investor and counterparty decisions, thus improving market discipline on banking organizations and other companies.', 'further, we also agree that current accounting and disclosure standards for derivatives -- as well as for other financial instruments -- should be improved.', 'we recognize the difficult task that fasb has in developing a standard that is acceptable to its many constituents.', 'in this regard, we understand that fasb has considered and rejected a number of approaches to hedge accounting for derivatives because particular problems were identified with each approach.', 'we also believe that the approach of reporting all financial instruments at fair value in the primary set of financial instruments, while having some theoretical appeal at least for some types of firms, is not an appropriate solution in the near term.', 'in this regard, fair value estimation techniques are not yet sufficiently robust for exclusive reliance in financial statements.', 'for example, difficult valuation issues arise for highly illiquid instruments for which fair value is based on models rather than observed prices, core deposits with varying durations, and the liabilities of a firm whose credit quality has weakened.', 'furthermore, fair value estimates can be highly subjective, and little guidance is available for measuring fair values in the financial statements.', 'another difficult issue relates to whether fair value is the most relevant measurement for commercial banks and other firms that are in the business of holding illiquid loans and other assets for the long term.', 'the success or failure of such a strategy is not measured by evaluating such loans on the basis of a price that indicates value in the context of immediate delivery.', "in this regard, an appropriate value for many bank loans and off-balance-sheet commitments -- the one that reflect the nature of a bank's business -- is the original acquisition price adjusted for the expectation of performance at maturity.", "given the many difficulties of fasb's task, it is not surprising that their proposal raises a number of complex issues.", 'for example, the proposal is likely to lead to increased volatility in income and stockholders equity by companies that manage risk with derivatives.', 'this volatility could be artificial due to the piecemeal approach of marking certain risk positions to fair value, but not all positions contributing to the risk.', "as a result, there could be accounting volatility that bears little relation to an institution's overall risk position.", 'supervisors and analysts will have to strip out the artificially created volatility to assess the true performance of the firm.', 'on the other hand, companies that do not manage their risks, or manage their risks solely through cash instruments that are not covered by the standard, would not reflect similar volatility.', 'a simple example might illustrate this concern.', "assume a company's activities consist solely of lending long term at fixed rates and funding these loans with variable-rate deposits.", 'i think we can all agree that this company has a significant exposure to interest rate risk.', 'if the company does not manage its risk with derivatives, it would not be affected by the derivatives accounting proposal and would not report any volatility from fair value changes in its financial statements.', "if, however, the company has a strategy to use derivatives to reduce its interest rate risk and move it closer to a match-funded position, the company may report greater volatility in income and stockholders' equity -- a result not consistent with its reduced risk exposure.", 'for example, if the company specified under the framework set forth in the fasb proposal that the derivatives are "cash flow" hedges of variable rate liabilities, the company would have volatility in equity or earnings based on the specifically linked effectiveness tests set forth by the proposal.', 'thus, the firm in using derivatives reduces its economic volatility, yet increases its accounting volatility.', 'more important, by taking a transaction level approach to hedging, the proposal would not describe well the efforts of more sophisticated market participants to hedge their risks on a comprehensive, portfolio basis.', "thus, these firms would effectively be required to keep different sets of books, and their financial reporting may not be consistent with the derivatives' intended use.", 'this leads me to conclude that the proposal could discourage or constrain prudent risk management practices that rely on derivatives.', 'furthermore, it may not improve transparency of financial information.', 'the proposal also introduces into the financial statements an untested method for reporting loans, deposits, and other assets and liabilities being hedged.', 'these assets and liabilities would be valued at a "hybrid" historical cost and fair value amount on the balance sheet when they are hedged with derivatives that are designated as fair value hedges.', 'for example, generally, the historical cost values of these assets and liabilities would be adjusted for changes in fair value related to the risk being hedged.', 'however, certain other changes in fair value would not be recognized (such as those that arise from other risks, that are the results of an ineffective hedge, or that do not offset a gain or loss on the hedging instrument).', 'these hybrid amounts could differ significantly from -- and potentially exceed -- fair values.', 'they may also be difficult to verify by auditors and examiners, thus reducing the reliability of amounts reported in the financial statements.', 'the proposed approach is complex, which may increase related developmental systems costs.', 'in this regard, the proposal may cause significant systems changes for institutions that hedge with derivatives.', 'at the same time institutions are making these systems changes, they need to upgrade their systems to address year 2000 issues.', 'the cost of systems changes arising from the derivatives proposal should be evaluated along with other costs and benefits arising from the proposal.', 'this is particularly important since the derivatives proposal is intended by the fasb to be an interim treatment, and its long-term goal is to measure all financial instruments at fair value.', 'indeed, the fasb already has under way a project that is evaluating issues related to that goal.']	Susan M Phillips	Board of Governors of the US Federal Reserve System	Member of the Board of Governors	US
https://www.bis.org/review/r971007a.pdf	Mr. Macfarlane draws some conclusions about the direction in which monetary policy regimes are likely to evolve (Central Bank Articles and Speeches, 29 Sep 97)	Talk given by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the 26th Conference of Economists in Hobart on 29/9/97.	1997-09-29 00:00:00	Mr. Macfarlane draws some conclusions about the direction in which monetary Talk given by the Governor of the Reserve Bank of Australia, policy regimes are likely to evolve Mr. I.J. Macfarlane, to the 26th Conference of Economists in Hobart on 29/9/97. Introduction It is a pleasure to be speaking at this year's Conference of Economists on a subject which has been central to my own career. I thought of calling the speech "Monetary Regimes I Have Known", but that would have given too historical an emphasis. While history is extremely important, and provides a useful antidote to excessively abstract thinking, more is needed to satisfy the Conference theme of "policy challenges of the new century". I have therefore attempted to respond in a forward-looking way, by drawing some conclusions about the direction in which monetary policy regimes are likely to evolve. Historical overview In broad outline, Australia's post-war monetary policy experience has much in common with that of other countries in the developed world. Certainly the starting point -- a fixed exchange rate under the Bretton Woods system -- was the same, and several of the subsequent phases have been common to a significant number of countries. We can usefully divide the post-war monetary policy experience in Australia into four main parts: the fixed exchange rate period, which lasted until the early 1970s; a period of monetary targeting between 1976 and 1985; a transitional period which followed the demise of monetary targeting and lasted until the early 1990s; and the inflation-targeting regime, in place since around 1993. While every country has its own particular story to tell, something similar to this four-part schema, with suitable adjustments as to timing, could probably be applied to quite a wide range of other countries over the same period. In making this classification of policy regimes, it is wise to avoid being overly precise about dates. Sometimes regime shifts are quite dramatic and can be precisely dated -- for example, the ending of US dollar convertibility into gold, and the United Kingdom's exit from the European exchange rate mechanism -- but this is not invariably the case. In Australia, the movement between regimes has tended to be evolutionary, and it is not always possible or helpful to date them precisely. How did these four regimes perform, and what were the critical factors that led to the move from each regime to its successor? To answer these questions we need to have in mind some criteria against which the performance of a monetary policy regime can be assessed. Most practitioners and theorists would, I think, agree on two desirable characteristics of a monetary policy regime. First, policy needs to provide a nominal anchor for the economy: the policy regime must have the characteristic that it systematically resists excessive inflation or deflation, and thereby delivers a satisfactory degree of price stability in the long run. The second objective is to provide a degree of stabilisation in the short to medium term in response to shocks, which includes resisting adverse shocks to output and employment. This objective might be met either through the capacity of a regime to undertake deliberate policy responses when shocks occur, or through automatic stabilisers inherent in the regime. The fixed exchange rate period The longest lasting of the four regimes, by a large margin, was the fixed exchange rate, also known as the Bretton Woods system, or the gold exchange standard. At the start of the post-war period, the Australian currency had already been fixed to sterling at an unchanged rate since 1931. Subsequently, there were only two major changes to Australia's international parities until the 1970s: the first, in 1949, when Australia followed a sterling devaluation against gold and the US dollar, and the second, in 1967, when sterling was further devalued, but Australia did not follow. Thus, Australia's exchange rate against sterling remained unchanged from 1931 to 1967, while the rate against the US dollar -- which is more important for current purposes -- was unchanged from 1949 to 1971. As was the case for most other countries, the Bretton Woods system of "fixed but adjustable" exchange rates was operated in practice in Australia in the 1950s and 1960s as a firm commitment to fixed parities. The fixed exchange rate was effectively the linchpin of the monetary policy regime. While it is not possible to pinpoint an exact date at which this ceased to be the case, parity adjustments became much more frequent after the next Australian dollar realignment occurred in 1971. Rather than being the anchor of policy, the exchange rate henceforward was increasingly viewed as an adjustable policy instrument. There were six parity changes in the years from 1971 to the adoption of the crawling peg system in November 1976; and this more flexible system, in turn, gave way to the float in December 1983. The history can thus be characterised as involving essentially fixed parities up until 1971, followed by a gradual transition to greater flexibility and a stronger internal policy focus in the years that followed. An important characteristic of a fixed exchange rate system, of course, is that it provides a nominal anchor, as long as the monetary policy of the country to which the exchange rate is fixed is itself conducted in a way that is consistent with reasonable price stability. This was indeed the case for most of the period up to around 1970. Under the Bretton Woods or gold exchange standard, most currencies were pegged to the US dollar, whose value was in turn tied to gold. The central role of the US dollar in the system placed a strong discipline on the macro-economic policies of other countries. Unless countries were prepared to make significant unilateral exchange rate adjustments, which happened only rarely, their inflation performances in the longer run were effectively determined by US monetary policy. Private Consumption Deflator Four-quarter-ended percentage change % OPEC I % (Oct-73) 15 15 10 10 Australia 5 5 United States 0 0 -5 -5 1960 1962 1964 1966 1968 1970 1972 1974 1976 As I have argued elsewhere, this system worked reasonably well until the second half of the 1960s. The United States for the most part conducted conservative monetary and fiscal policies that kept budgets close to balance and inflation low, and this underpinned a period of sustained low inflation in other countries. In Australia, apart from some periods influenced by sharp commodity price movements, inflation was generally low and close to US rates. This situation began to change from around the mid 1960s. Tax cuts in the 1964 and 1965 budgets, and subsequent increases in defence spending associated with the Vietnam War, shifted US fiscal policy to an expansionary position. Inflation began to increase, albeit from very low levels, after about 1965, and balance of payments deficits run by the United States meant that a number of other countries began accumulating substantial dollar reserves. This fed the process of money creation in these countries and relaxed the constraints on their domestic macro-economic policies, with the result in many cases that inflation rates increased. Causes of the eventual breakdown of the Bretton Woods system in the face of these pressures have been much debated, but the core of most explanations is that the system lost its capacity to provide effective policy discipline. This, in turn, reflected the loss of suitability of the US dollar as the system's nominal anchor, the role it had played so effectively over the two previous decades. It is interesting to note that the policy debate in Australia in the 1950s and 1960s paid little or no explicit attention to the nominal anchoring role of the monetary regime. That is not because the problem of inflation was thought to be unimportant -- on the contrary, the need to control inflation was well recognised. Nonetheless the main focus, both of practitioners and of the economics profession more widely, was on the second of the two roles of monetary policy that I outlined earlier, namely its role in responding to shorter-term shocks. In fact, many commentators talked of monetary policy as though it was totally discretionary and free to pursue whatever domestic objective it thought most worthy (see next section on Phillips curve). Perhaps the most important reason for this misapprehension was that the existence of the long-run anchor was simply taken for granted. Policy did not need to focus on achieving a good longer-run inflation performance because the fixed exchange rate regime delivered this result in a semi-automatic fashion. In this environment it was natural to focus on shorter-term objectives, with the balance of payments serving as an important barometer of the need for policy action: whenever domestic demand was too strong, this would quickly show up in a payments deficit which needed to be corrected by tighter policy, and vice versa. In this way, the policy regime ensured that actions taken in response to short-term demand pressures had the effect of consistently tying the economy in to the long-run anchor. The eventual failure of the fixed exchange rate system to ensure continued good macro-economic performance reflected a combination of circumstances. The expansionary shift in US policy, to which I have already referred, meant that the external anchor became increasingly a source of inflationary pressure rather than of price stability. This was the case not just for Australia, but worldwide. In Australia's case, however, the effect was amplified in the early 1970s by the related phenomenon of rising commodity prices, which had a disproportionate effect on Australia, given our high commodity export exposure. The effect was to relax the balance of payments constraint and allow a further loosening of domestic policy discipline, with the result that the rise in Australia's inflation rate soon overtook that in the United States. The role of the 1973 oil shock in all of this was also important, but it should be remembered that inflation in Australia had already reached double-digit rates before the oil shock occurred. The rise and fall of the Phillips curve The early to mid 1970s was a period of re-evaluation of the earlier conventional thinking about monetary policy, prompted by the experience of a number of years of rising inflation. It is interesting to focus on the nature of that re-evaluation because it remains relevant to policy today. In the 1960s, the conventional thinking was summed up in the widely-influential notion of a stable downward-sloping Phillips curve. Inflation was thought of in terms of demand-driven processes that would move the economy along the curve, so that high levels of demand would produce a combination of high inflation and low unemployment, and low levels of demand the reverse. The role of policy was to manage aggregate demand so as to achieve a preferred combination of outcomes, taking the position of the Phillips curve as given. Of course, not all economists subscribed to this simplistic world view, but I think it is a fair representation of the consensus among those economists who were most influential and among a broad range of other policy makers, politicians and journalists. There was considerable confidence for a time that policy could effectively manage the trade-off. Policy before about 1970 had been quite successful: periods of clearly excessive inflation had been rare, and were quickly reversed when they occurred. But there developed a general tendency among policy-makers in the late 1960s and early 1970s to try to exploit the trade-off to extract more growth, in the belief that the cost in terms of inflation would not be too great. The experience of the 1970s -- the simultaneous rise in inflation and unemployment, and their persistence at high levels -- proved this understanding of the economy to be too simplistic and an inadequate guide for policy. To a mindset based on the stable Phillips curve, the combination of high inflation and high unemployment could not be readily explained. Indeed, it appeared internally contradictory, since inflation was thought of as a symptom of excess demand while high unemployment signalled that demand was deficient. Two factors needed to be brought into the conventional model in order to understand the 1970s experience. The first, which had been emphasised both by Friedman and by Phelps, was the role of expectations. The short-run Phillips curve was to be thought of not as a permanent trade-off, but as conditional on the expected rate of inflation. Expansionary demand conditions were associated with higher-than-expected inflation, rather than high inflation per se, so the trade-off of higher inflation for lower unemployment could only be exploited over the limited period in which inflation expectations did not fully adjust to the new higher rate. In the longer run, when expectations had adjusted, high inflation would have no stimulatory impact. In Friedman's words, "a rising rate of inflation may reduce unemployment, a high rate will not". The operation of this principle had not previously been observable because inflation had never stayed high for long enough to be built into expectations. The second, and related, factor to be brought into the conventional model was the importance of supply shocks. These could be thought of as shocks which reduced the sustainable levels of output and employment consistent with steady inflation. For much of the world the quintessential supply shocks were rises in oil prices but, for Australia, the real wages shock of 1974 was probably at least as important. Recognition of the importance of supply shocks implied a corresponding recognition of the limitations on what could be achieved through conventional demand-management policies. Although economic thinking has advanced in a number of ways since the 1970s, these two basic lessons from the period remain relevant, and often need repeating. While the economics profession was quick to take up the stable Phillips curve, it was also quick in dropping it as a policy prescription. But there are still some in the policy debate -- particularly among politicians, lobbyists and journalists -- who think of the economy in terms of a stable Phillips curve, and who would like us to choose a higher inflation rate on the assumption that this would produce a sustained lift in growth and employment. But that is not the choice we face. Higher inflation can deliver at best only a temporary stimulus to growth and, in the longer run, is more likely to be detrimental. The move to monetary targeting In the light of the early 1970s experience, economists stopped assuming a stable Phillips curve and started looking for ways to anchor monetary policy decisions. The Friedman suggestion of a steady growth of the money supply sufficient to accommodate normal economic growth and low inflation found favour in a number of countries. Several had been focusing on monetary aggregates since the early 1970s and, by 1975, a number, including the United States, Germany, the United Kingdom and Switzerland were announcing monetary targets. Australia followed suit in 1976 by beginning to announce forecasts for the growth of M3. These were subsequently announced each year in the federal budget until the practice was discontinued in 1985. The nature of the targets was somewhat different to what is often assumed in the textbooks or in the somewhat idealised notions of monetary theorists. In no country were targets adhered to with the sort of mechanical precision envisaged in Friedman's Program for Monetary Stability, the classic statement of the case for monetary targeting. They were usually seen as guides to policy, and as vehicles for explaining the rationale of policy actions, rather than being binding constraints on the policy-maker. Monetary targeting regimes had a moderate degree of success in achieving their intermediate monetary objectives, and somewhat greater success in terms of the ultimate objective of reducing inflation. In the heyday of monetary targeting around the world, roughly from 1975 to 1985, some substantial reductions in inflation were achieved. Australia's inflation rate was reduced during this period, but was still a lot higher than the OECD average by the mid 1980s. It would be a mistake to attribute the differences in inflation performance across countries primarily to differing degrees of rigour in the pursuit of monetary targets. The countries that brought inflation under control most quickly were not particularly more successful in hitting their monetary targets than the rest. The general pattern, summarised in Table 1, was that countries achieved their targets about half the time. Australia's success rate was a bit less than that, about a third. On another measure -- the average deviation from the target midpoint -- Australia's record was quite similar to that of several other countries. Table 1: Monetary Targets and Projections Average absolute Proportion of years Country Period deviation from within target range (%) target mid-point Australia 1977-1985 2.6 33.3 Canada 1976-1982 1.3 71.4 France 1977-1996 2.5 50.0 Germany 1975-1996 1.8 54.5 Italy 1975-1996 2.7 31.8 Switzerland 1975-1996 2.6 47.6 United Kingdom 1976-1996 2.7 52.4 United States M2 1975-1996 1.5 63.6 United States M3 1975-1996 1.8 40.9 Source: Edey (1997) The achievement of inflation reduction was a product not so much of the technical merits of monetary targeting as of the general shift in the policy-making consensus towards inflation control. What was critical was the willingness of the authorities to run policies that put a consistent downward pressure on inflation over a period of time. But, that said, the targets did serve a useful purpose. They focused policy on the need to anchor the nominal magnitudes in the economy, and they helped in communicating the anti-inflation strategy to the public and marshalling public acceptance of the required policy actions. The Volcker disinflation period in the United States was a good example of how useful targets could be in this role. Alan Blinder described the monetary target as a "heat shield" which enabled the Fed to maintain a much tougher disinflationary stance than the public would normally have found acceptable. As a result the United States was able to make a definitive transition to low inflation at an early stage. Monetary targeting was always subject to two well-known problems, both of which were important in the Australian experience. The first was the problem of controllability. The fact that targets were often missed was an indication that close control was either not possible, or would have required undesirable movements in the policy instruments. The second was the instability of the relationship between money supply and the ultimate objective of policy such as inflation or nominal GDP. It was this second problem that was decisive in causing most countries to abandon monetary targeting as the basis of their monetary policies. By the mid 1980s, the problem of instability was coming to the fore. The relationship of money to ultimate objectives had always been imprecise, but had been judged to be sufficiently stable to serve as a useful guide to policy. But the structural changes in the financial system that followed deregulation were sufficiently large that this was no longer the case. In Australia, in the mid 1980s, the newly deregulated banks were able to win back market share from other institutions, and the financial system as a whole began to grow more rapidly. To some extent, this was to be expected, but it meant a lengthy period in which the behaviour of the monetary and financial aggregates diverged from inflation or nominal income. In 1985, growth of M3 reached 17.5 per cent, at a time when domestic inflation had been falling. The problem was not unique to Australia. By the time our targets were suspended in February 1985, many other countries had downgraded or abandoned them, for much the same reasons. In the words of Canadian central bank Governor Bouey, "we didn't abandon the monetary aggregates, they abandoned us". The transitional period The move away from monetary targets was followed by a period of transition when policies became more pragmatic and there was a search for alternative guiding principles. Once again, Australia's experience was by no means unique. Virtually all countries were downgrading their monetary targets to one degree or another, and there was no immediately clear direction as to what should be put in their place. Theory offered little help. Some of the alternatives being put up by critics either had already proven unsatisfactory for us -- like a return to fixed exchange rates or forms of monetary targeting -- or were unrealistically radical. Most countries with floating exchange rates developed a pragmatic approach that, broadly speaking, tried to resist excessive inflation and to have some stabilising influence on economic activity in response to shorter-term shocks. Policy in Australia through this transitional period has been criticised for lacking a clear conceptual framework and allowing too much scope for central bank discretion, and there is some validity in these criticisms. In Australia, the policy "checklist", which entered the discussion for a few years following the abandonment of monetary targets, comprised a wide range of variables which were to be consulted in assessing economic conditions and making policy decisions. The list of variables included interest rates, the exchange rate, the monetary aggregates, inflation, the external accounts, asset prices and the general economic outlook -- in short, an amalgam of instruments, intermediate and final policy objectives, and general macro-economic indicators. The checklist conveyed the idea -- sensible as far as it goes -- that policy needs to look at all relevant information. What was missing was some framework for evaluating that information and converting it into an operational guide for policy. Another way of expressing this is to say that monetary policy needed a "nominal anchor". Pure pragmatism was not enough because it could lead to monetary policy aiming to achieve a desired result for a "real variable", which in the long run would be self-defeating. For example, if monetary policy was solely designed to achieve a given unemployment rate (as to some extent it was in the late 1960s/early 1970s in many countries), it would be continually eased whenever the actual unemployment rate was above the desired rate. But if the desired rate was too ambitious, this would be a recipe for continued easing and, in time, continuously rising inflation. At the same time, there would be no guarantee that monetary policy alone would be able to achieve the desired unemployment rate if structural factors were important. Similarly, indeterminacy would arise if monetary policy was directed at the current account of the balance of payments, as a lot of discussion in the late 1980s seemed to suggest. If the current account was too large, should monetary policy be tightened to reduce domestic demand (and imports), or should it be loosened to lower the exchange rate and hence increase competitiveness? These sorts of discussion led policy-makers and academics to again ask the question about what monetary policy could achieve in the long run. The nearly unanimous answer was that it could achieve a desired rate of inflation, but could not, of itself, achieve desired outcomes for real variables like the unemployment rate, the rate of growth, or variables like the balance of payments. Monetary policy can have an influence for good or bad on real variables, particularly in the short run, but it was not appropriate to target it at these variables. As a long-run target, what was needed was a nominal variable like inflation, nominal GDP or the money supply. With the money demand function recognised as being unstable, and nominal GDP being too abstract a concept for easy public perception, attention turned to monetary policy regimes that centred on inflation. Two main alternatives presented themselves: a system where the instrument of monetary policy was operated to achieve a desired result for inflation, without the need for an intermediate target; or a system where the exchange rate was fixed to that of another country which had a good record of maintaining low inflation. In short, the two alternatives which satisfied the condition of providing a "nominal anchor" were inflation targeting or fixing the exchange rate (sometimes called the hard currency option). Australia went down the first path, while most of Europe (including the United Kingdom for a time) went down the second path by tying their currencies to the Deutschemark. Some would argue that this two-way classification of the options is too narrow and that monetary targeting remains a viable third option, at least for some countries. Germany is often cited as an example. This view ignores the reality that the Bundesbank has moved a long way away from strict monetary targeting in recent years, as is evident from the way they move their policy instrument. There is evidence to suggest that prospective inflationary developments are more likely to trigger a monetary policy move than is a deviation of money supply from its target. Inflation targeting Unlike the experience in some other countries like the United Kingdom or New Zealand, where inflation targets came into force in dramatic regime shifts, the elements of Australia's inflation-targeting regime were put in place gradually. There were a number of reasons for this. While inflation targets had considerable conceptual appeal, the models adopted in the pioneering countries - New Zealand and Canada - seemed to us excessively rigid with their narrow bands and low target mid-points. The fact that these were the only working models available at the time tended to polarise debate, and it took some time for the Bank to develop its own more flexible version. Also important was the need to build public support, including political support, for a target, and again this happened gradually rather than in a single, decisive act. Some of the key elements of the inflation-targeting approach were in place quite early. The conceptual basis of such an approach, with a focus on inflation as the policy objective, no intermediate objective, interest rates as the instrument, and a transmission process that works via the effect of interest rates on private demand, had been analysed in a number of pieces that the Bank published in 1989, including its conference volume. What we now consider one of the key elements of the policy framework, the explicit announcements of cash rate changes, with explanations of the reasons for each change, began in January 1990. Over time, the Bank's published commentaries on monetary policy and the economy became more detailed and developed a stronger inflation focus. The numerical objective of 2-3 per cent inflation began appearing in public statements by Governor Fraser in 1992 and 1993. The cumulative effect of all these developments was to establish an inflation-targeting regime broadly comparable to those being developed in a number of other countries around the same time. While there was no individual decisive event, international comparative tables such as those published by the BIS date the change in Australia from 1993. A final element was added with the joint statement on the conduct of monetary policy, made by myself and the Treasurer on my appointment as Governor. The statement gave the Government's formal endorsement to the independence of the Reserve Bank as contained in its Act and to the 2-3 per cent target. It also provided for enhanced accountability through semi-annual statements and parliamentary appearances. Several other countries adopted inflation targets around the same time as Australia. A recent survey by the BIS counts seven inflation targeters, making this currently the most numerically popular regime among medium-sized OECD countries (Table 2). As had been the case with previous regime changes, the immediate reason for change in many cases was either a breakdown of a previous regime or dissatisfaction with its performance. In the United Kingdom, Sweden and Finland, the trigger was the collapse of fixed exchange rate commitments in 1992. New Zealand and Canada adopted their targets in a deliberate strategy of inflation reduction. Australia was somewhat different in that there was no crisis that needed to be responded to, and the target was developed to cement in place an inflation reduction that had already been achieved. Table 2: Inflation Targets Country Target adopted Current target New Zealand March 1990 0-3% Canada February 1991 1-3% United Kingdom October 1992 21⁄2% Sweden January 1993 1-3% Finland February 1993 2% Australia 1993 2-3% Spain Summer 1994 0-3% Source: BIS 1996 Annual Report, updated to incorporate recent changes to targets in the United Kingdom and New Zealand The move to inflation targeting completed a significant conceptual leap from the regimes that had prevailed in the earlier decades. Instead of a focus on intermediate objectives, like the exchange rate or the money supply, the operational framework of policy was now built around a final objective, inflation. In describing inflation as the final objective in this context, I should make clear that inflation control is viewed as a means to an end rather than an end in itself. The reason monetary regimes have been set up to aim for low inflation is that this is the best contribution monetary policy can make in the longer run to growth in output, employment and living standards. In principle, this approach re-establishes a clear nominal anchor while avoiding the main problem of the intermediate-targeting regimes -- namely, that the target variables did not have a sufficiently stable relationship with the final objectives. The approach also preserves, from the transitional period that I described earlier, the common-sense notion of using all relevant information: the difference is that there is now a clear criterion -- the impact on the inflation outlook -- for assessing what the information means for policy. Another property of inflation targets, not always well-recognised, is that they provide scope for counter-cyclical action. This is automatically built into the policy framework if a central bank takes seriously, as we do, both the upper and lower bounds of the target. When the inflation forecast is above the target, the framework requires policy to be tightened, as was the case a couple of years ago, and, when it is below target, policy has to be more expansionary, as at present. In this way the policy framework incorporates a systematic resistance to cyclical demand pressures. I have described this previously by saying that the policy aims to allow the economy to grow as fast as possible, consistent with low inflation, but no faster. Aside from these operational characteristics, an important dimension of the economic rationale for inflation targets is their role as a discipline on the policy process. The academic literature lays great store on this -- particularly in the time inconsistency literature -- although it tends to focus rather too narrowly on the idea of constraining the policy-makers. The targets are seen as correcting an inflationary bias that would otherwise arise from the temptation of central bankers to go for short-term expansion. In this literature, rule-based regimes are said to be superior to discretion because they allow pre-commitment to non-inflationary policies, and thereby overcome the assumed short-termism of the policy-makers. Central bankers are very sceptical of this line of analysis because we do not see ourselves as inherently inflation-prone. But while I think this particular argument for a rule-based approach somewhat misses the point, the ability to specify policy in terms of a relatively simple rule does have some important advantages. In particular, simple rules provide a ready vehicle for accountability and for public communication: they require policy actions to be explained in terms of a clear target, and they help central banks to resist calls for excessively expansionary policies. Also important is that, over time, a simple rule like an inflation target can provide a focal point for inflation expectations by making clear what the central bank is aiming at. One of the reasons that inflation targets have pro	['mr. macfarlane draws some conclusions about the direction in which monetary talk given by the governor of the reserve bank of australia, policy regimes are likely to evolve mr. i.j.', 'macfarlane, to the 26th conference of economists in hobart on 29/9/97.', "introduction it is a pleasure to be speaking at this year's conference of economists on a subject which has been central to my own career.", 'i thought of calling the speech "monetary regimes i have known", but that would have given too historical an emphasis.', 'while history is extremely important, and provides a useful antidote to excessively abstract thinking, more is needed to satisfy the conference theme of "policy challenges of the new century".', 'i have therefore attempted to respond in a forward-looking way, by drawing some conclusions about the direction in which monetary policy regimes are likely to evolve.', "historical overview in broad outline, australia's post-war monetary policy experience has much in common with that of other countries in the developed world.", 'certainly the starting point -- a fixed exchange rate under the bretton woods system -- was the same, and several of the subsequent phases have been common to a significant number of countries.', 'we can usefully divide the post-war monetary policy experience in australia into four main parts: the fixed exchange rate period, which lasted until the early 1970s; a period of monetary targeting between 1976 and 1985; a transitional period which followed the demise of monetary targeting and lasted until the early 1990s; and the inflation-targeting regime, in place since around 1993. while every country has its own particular story to tell, something similar to this four-part schema, with suitable adjustments as to timing, could probably be applied to quite a wide range of other countries over the same period.', 'in making this classification of policy regimes, it is wise to avoid being overly precise about dates.', "sometimes regime shifts are quite dramatic and can be precisely dated -- for example, the ending of us dollar convertibility into gold, and the united kingdom's exit from the european exchange rate mechanism -- but this is not invariably the case.", 'in australia, the movement between regimes has tended to be evolutionary, and it is not always possible or helpful to date them precisely.', 'how did these four regimes perform, and what were the critical factors that led to the move from each regime to its successor?', 'to answer these questions we need to have in mind some criteria against which the performance of a monetary policy regime can be assessed.', 'most practitioners and theorists would, i think, agree on two desirable characteristics of a monetary policy regime.', 'first, policy needs to provide a nominal anchor for the economy: the policy regime must have the characteristic that it systematically resists excessive inflation or deflation, and thereby delivers a satisfactory degree of price stability in the long run.', 'the second objective is to provide a degree of stabilisation in the short to medium term in response to shocks, which includes resisting adverse shocks to output and employment.', 'this objective might be met either through the capacity of a regime to undertake deliberate policy responses when shocks occur, or through automatic stabilisers inherent in the regime.', 'the fixed exchange rate period the longest lasting of the four regimes, by a large margin, was the fixed exchange rate, also known as the bretton woods system, or the gold exchange standard.', "at the start of the post-war period, the australian currency had already been fixed to sterling at an unchanged rate since 1931. subsequently, there were only two major changes to australia's international parities until the 1970s: the first, in 1949, when australia followed a sterling devaluation against gold and the us dollar, and the second, in 1967, when sterling was further devalued, but australia did not follow.", 'thus, australia\'s exchange rate against sterling remained unchanged from 1931 to 1967, while the rate against the us dollar -- which is more important for current purposes -- was unchanged from 1949 to 1971. as was the case for most other countries, the bretton woods system of "fixed but adjustable" exchange rates was operated in practice in australia in the 1950s and 1960s as a firm commitment to fixed parities.', 'the fixed exchange rate was effectively the linchpin of the monetary policy regime.', 'while it is not possible to pinpoint an exact date at which this ceased to be the case, parity adjustments became much more frequent after the next australian dollar realignment occurred in 1971. rather than being the anchor of policy, the exchange rate henceforward was increasingly viewed as an adjustable policy instrument.', 'there were six parity changes in the years from 1971 to the adoption of the crawling peg system in november 1976; and this more flexible system, in turn, gave way to the float in december 1983. the history can thus be characterised as involving essentially fixed parities up until 1971, followed by a gradual transition to greater flexibility and a stronger internal policy focus in the years that followed.', 'an important characteristic of a fixed exchange rate system, of course, is that it provides a nominal anchor, as long as the monetary policy of the country to which the exchange rate is fixed is itself conducted in a way that is consistent with reasonable price stability.', 'this was indeed the case for most of the period up to around 1970. under the bretton woods or gold exchange standard, most currencies were pegged to the us dollar, whose value was in turn tied to gold.', 'the central role of the us dollar in the system placed a strong discipline on the macro-economic policies of other countries.', 'unless countries were prepared to make significant unilateral exchange rate adjustments, which happened only rarely, their inflation performances in the longer run were effectively determined by us monetary policy.', 'private consumption deflator four-quarter-ended percentage change % opec i % (oct-73) 15 15 10 10 australia 5 5 united states 0 0 -5 -5 1960 1962 1964 1966 1968 1970 1972 1974 1976 as i have argued elsewhere, this system worked reasonably well until the second half of the 1960s.', 'the united states for the most part conducted conservative monetary and fiscal policies that kept budgets close to balance and inflation low, and this underpinned a period of sustained low inflation in other countries.', 'in australia, apart from some periods influenced by sharp commodity price movements, inflation was generally low and close to us rates.', 'this situation began to change from around the mid 1960s.', 'tax cuts in the 1964 and 1965 budgets, and subsequent increases in defence spending associated with the vietnam war, shifted us fiscal policy to an expansionary position.', 'inflation began to increase, albeit from very low levels, after about 1965, and balance of payments deficits run by the united states meant that a number of other countries began accumulating substantial dollar reserves.', 'this fed the process of money creation in these countries and relaxed the constraints on their domestic macro-economic policies, with the result in many cases that inflation rates increased.', 'causes of the eventual breakdown of the bretton woods system in the face of these pressures have been much debated, but the core of most explanations is that the system lost its capacity to provide effective policy discipline.', "this, in turn, reflected the loss of suitability of the us dollar as the system's nominal anchor, the role it had played so effectively over the two previous decades.", 'it is interesting to note that the policy debate in australia in the 1950s and 1960s paid little or no explicit attention to the nominal anchoring role of the monetary regime.', 'that is not because the problem of inflation was thought to be unimportant -- on the contrary, the need to control inflation was well recognised.', 'nonetheless the main focus, both of practitioners and of the economics profession more widely, was on the second of the two roles of monetary policy that i outlined earlier, namely its role in responding to shorter-term shocks.', 'in fact, many commentators talked of monetary policy as though it was totally discretionary and free to pursue whatever domestic objective it thought most worthy (see next section on phillips curve).', 'perhaps the most important reason for this misapprehension was that the existence of the long-run anchor was simply taken for granted.', 'policy did not need to focus on achieving a good longer-run inflation performance because the fixed exchange rate regime delivered this result in a semi-automatic fashion.', 'in this environment it was natural to focus on shorter-term objectives, with the balance of payments serving as an important barometer of the need for policy action: whenever domestic demand was too strong, this would quickly show up in a payments deficit which needed to be corrected by tighter policy, and vice versa.', 'in this way, the policy regime ensured that actions taken in response to short-term demand pressures had the effect of consistently tying the economy in to the long-run anchor.', 'the eventual failure of the fixed exchange rate system to ensure continued good macro-economic performance reflected a combination of circumstances.', 'the expansionary shift in us policy, to which i have already referred, meant that the external anchor became increasingly a source of inflationary pressure rather than of price stability.', 'this was the case not just for australia, but worldwide.', "in australia's case, however, the effect was amplified in the early 1970s by the related phenomenon of rising commodity prices, which had a disproportionate effect on australia, given our high commodity export exposure.", "the effect was to relax the balance of payments constraint and allow a further loosening of domestic policy discipline, with the result that the rise in australia's inflation rate soon overtook that in the united states.", 'the role of the 1973 oil shock in all of this was also important, but it should be remembered that inflation in australia had already reached double-digit rates before the oil shock occurred.', 'the rise and fall of the phillips curve the early to mid 1970s was a period of re-evaluation of the earlier conventional thinking about monetary policy, prompted by the experience of a number of years of rising inflation.', 'it is interesting to focus on the nature of that re-evaluation because it remains relevant to policy today.', 'in the 1960s, the conventional thinking was summed up in the widely-influential notion of a stable downward-sloping phillips curve.', 'inflation was thought of in terms of demand-driven processes that would move the economy along the curve, so that high levels of demand would produce a combination of high inflation and low unemployment, and low levels of demand the reverse.', 'the role of policy was to manage aggregate demand so as to achieve a preferred combination of outcomes, taking the position of the phillips curve as given.', 'of course, not all economists subscribed to this simplistic world view, but i think it is a fair representation of the consensus among those economists who were most influential and among a broad range of other policy makers, politicians and journalists.', 'there was considerable confidence for a time that policy could effectively manage the trade-off.', 'policy before about 1970 had been quite successful: periods of clearly excessive inflation had been rare, and were quickly reversed when they occurred.', 'but there developed a general tendency among policy-makers in the late 1960s and early 1970s to try to exploit the trade-off to extract more growth, in the belief that the cost in terms of inflation would not be too great.', 'the experience of the 1970s -- the simultaneous rise in inflation and unemployment, and their persistence at high levels -- proved this understanding of the economy to be too simplistic and an inadequate guide for policy.', 'to a mindset based on the stable phillips curve, the combination of high inflation and high unemployment could not be readily explained.', 'indeed, it appeared internally contradictory, since inflation was thought of as a symptom of excess demand while high unemployment signalled that demand was deficient.', 'two factors needed to be brought into the conventional model in order to understand the 1970s experience.', 'the first, which had been emphasised both by friedman and by phelps, was the role of expectations.', 'the short-run phillips curve was to be thought of not as a permanent trade-off, but as conditional on the expected rate of inflation.', 'expansionary demand conditions were associated with higher-than-expected inflation, rather than high inflation per se, so the trade-off of higher inflation for lower unemployment could only be exploited over the limited period in which inflation expectations did not fully adjust to the new higher rate.', 'in the longer run, when expectations had adjusted, high inflation would have no stimulatory impact.', 'in friedman\'s words, "a rising rate of inflation may reduce unemployment, a high rate will not".', 'the operation of this principle had not previously been observable because inflation had never stayed high for long enough to be built into expectations.', 'the second, and related, factor to be brought into the conventional model was the importance of supply shocks.', 'these could be thought of as shocks which reduced the sustainable levels of output and employment consistent with steady inflation.', 'for much of the world the quintessential supply shocks were rises in oil prices but, for australia, the real wages shock of 1974 was probably at least as important.', 'recognition of the importance of supply shocks implied a corresponding recognition of the limitations on what could be achieved through conventional demand-management policies.', 'although economic thinking has advanced in a number of ways since the 1970s, these two basic lessons from the period remain relevant, and often need repeating.', 'while the economics profession was quick to take up the stable phillips curve, it was also quick in dropping it as a policy prescription.', 'but there are still some in the policy debate -- particularly among politicians, lobbyists and journalists -- who think of the economy in terms of a stable phillips curve, and who would like us to choose a higher inflation rate on the assumption that this would produce a sustained lift in growth and employment.', 'but that is not the choice we face.', 'higher inflation can deliver at best only a temporary stimulus to growth and, in the longer run, is more likely to be detrimental.', 'the move to monetary targeting in the light of the early 1970s experience, economists stopped assuming a stable phillips curve and started looking for ways to anchor monetary policy decisions.', 'the friedman suggestion of a steady growth of the money supply sufficient to accommodate normal economic growth and low inflation found favour in a number of countries.', 'several had been focusing on monetary aggregates since the early 1970s and, by 1975, a number, including the united states, germany, the united kingdom and switzerland were announcing monetary targets.', 'australia followed suit in 1976 by beginning to announce forecasts for the growth of m3.', 'these were subsequently announced each year in the federal budget until the practice was discontinued in 1985. the nature of the targets was somewhat different to what is often assumed in the textbooks or in the somewhat idealised notions of monetary theorists.', "in no country were targets adhered to with the sort of mechanical precision envisaged in friedman's program for monetary stability, the classic statement of the case for monetary targeting.", 'they were usually seen as guides to policy, and as vehicles for explaining the rationale of policy actions, rather than being binding constraints on the policy-maker.', 'monetary targeting regimes had a moderate degree of success in achieving their intermediate monetary objectives, and somewhat greater success in terms of the ultimate objective of reducing inflation.', 'in the heyday of monetary targeting around the world, roughly from 1975 to 1985, some substantial reductions in inflation were achieved.', "australia's inflation rate was reduced during this period, but was still a lot higher than the oecd average by the mid 1980s.", 'it would be a mistake to attribute the differences in inflation performance across countries primarily to differing degrees of rigour in the pursuit of monetary targets.', 'the countries that brought inflation under control most quickly were not particularly more successful in hitting their monetary targets than the rest.', 'the general pattern, summarised in table 1, was that countries achieved their targets about half the time.', "australia's success rate was a bit less than that, about a third.", "on another measure -- the average deviation from the target midpoint -- australia's record was quite similar to that of several other countries.", 'table 1: monetary targets and projections average absolute proportion of years country period deviation from within target range (%) target mid-point australia 1977-1985 2.6 33.3 canada 1976-1982 1.3 71.4 france 1977-1996 2.5 50.0 germany 1975-1996 1.8 54.5 italy 1975-1996 2.7 31.8 switzerland 1975-1996 2.6 47.6 united kingdom 1976-1996 2.7 52.4 united states m2 1975-1996 1.5 63.6 united states m3 1975-1996 1.8 40.9 source: edey (1997) the achievement of inflation reduction was a product not so much of the technical merits of monetary targeting as of the general shift in the policy-making consensus towards inflation control.', 'what was critical was the willingness of the authorities to run policies that put a consistent downward pressure on inflation over a period of time.', 'but, that said, the targets did serve a useful purpose.', 'they focused policy on the need to anchor the nominal magnitudes in the economy, and they helped in communicating the anti-inflation strategy to the public and marshalling public acceptance of the required policy actions.', 'the volcker disinflation period in the united states was a good example of how useful targets could be in this role.', 'alan blinder described the monetary target as a "heat shield" which enabled the fed to maintain a much tougher disinflationary stance than the public would normally have found acceptable.', 'as a result the united states was able to make a definitive transition to low inflation at an early stage.', 'monetary targeting was always subject to two well-known problems, both of which were important in the australian experience.', 'the first was the problem of controllability.', 'the fact that targets were often missed was an indication that close control was either not possible, or would have required undesirable movements in the policy instruments.', 'the second was the instability of the relationship between money supply and the ultimate objective of policy such as inflation or nominal gdp.', 'it was this second problem that was decisive in causing most countries to abandon monetary targeting as the basis of their monetary policies.', 'by the mid 1980s, the problem of instability was coming to the fore.', 'the relationship of money to ultimate objectives had always been imprecise, but had been judged to be sufficiently stable to serve as a useful guide to policy.', 'but the structural changes in the financial system that followed deregulation were sufficiently large that this was no longer the case.', 'in australia, in the mid 1980s, the newly deregulated banks were able to win back market share from other institutions, and the financial system as a whole began to grow more rapidly.', 'to some extent, this was to be expected, but it meant a lengthy period in which the behaviour of the monetary and financial aggregates diverged from inflation or nominal income.', 'in 1985, growth of m3 reached 17.5 per cent, at a time when domestic inflation had been falling.', 'the problem was not unique to australia.', 'by the time our targets were suspended in february 1985, many other countries had downgraded or abandoned them, for much the same reasons.', 'in the words of canadian central bank governor bouey, "we didn\'t abandon the monetary aggregates, they abandoned us".', 'the transitional period the move away from monetary targets was followed by a period of transition when policies became more pragmatic and there was a search for alternative guiding principles.', "once again, australia's experience was by no means unique.", 'virtually all countries were downgrading their monetary targets to one degree or another, and there was no immediately clear direction as to what should be put in their place.', 'theory offered little help.', 'some of the alternatives being put up by critics either had already proven unsatisfactory for us -- like a return to fixed exchange rates or forms of monetary targeting -- or were unrealistically radical.', 'most countries with floating exchange rates developed a pragmatic approach that, broadly speaking, tried to resist excessive inflation and to have some stabilising influence on economic activity in response to shorter-term shocks.', 'policy in australia through this transitional period has been criticised for lacking a clear conceptual framework and allowing too much scope for central bank discretion, and there is some validity in these criticisms.', 'in australia, the policy "checklist", which entered the discussion for a few years following the abandonment of monetary targets, comprised a wide range of variables which were to be consulted in assessing economic conditions and making policy decisions.', 'the list of variables included interest rates, the exchange rate, the monetary aggregates, inflation, the external accounts, asset prices and the general economic outlook -- in short, an amalgam of instruments, intermediate and final policy objectives, and general macro-economic indicators.', 'the checklist conveyed the idea -- sensible as far as it goes -- that policy needs to look at all relevant information.', 'what was missing was some framework for evaluating that information and converting it into an operational guide for policy.', 'another way of expressing this is to say that monetary policy needed a "nominal anchor".', 'pure pragmatism was not enough because it could lead to monetary policy aiming to achieve a desired result for a "real variable", which in the long run would be self-defeating.', 'for example, if monetary policy was solely designed to achieve a given unemployment rate (as to some extent it was in the late 1960s/early 1970s in many countries), it would be continually eased whenever the actual unemployment rate was above the desired rate.', 'but if the desired rate was too ambitious, this would be a recipe for continued easing and, in time, continuously rising inflation.', 'at the same time, there would be no guarantee that monetary policy alone would be able to achieve the desired unemployment rate if structural factors were important.', 'similarly, indeterminacy would arise if monetary policy was directed at the current account of the balance of payments, as a lot of discussion in the late 1980s seemed to suggest.', 'if the current account was too large, should monetary policy be tightened to reduce domestic demand (and imports), or should it be loosened to lower the exchange rate and hence increase competitiveness?', 'these sorts of discussion led policy-makers and academics to again ask the question about what monetary policy could achieve in the long run.', 'the nearly unanimous answer was that it could achieve a desired rate of inflation, but could not, of itself, achieve desired outcomes for real variables like the unemployment rate, the rate of growth, or variables like the balance of payments.', 'monetary policy can have an influence for good or bad on real variables, particularly in the short run, but it was not appropriate to target it at these variables.', 'as a long-run target, what was needed was a nominal variable like inflation, nominal gdp or the money supply.', 'with the money demand function recognised as being unstable, and nominal gdp being too abstract a concept for easy public perception, attention turned to monetary policy regimes that centred on inflation.', 'two main alternatives presented themselves: a system where the instrument of monetary policy was operated to achieve a desired result for inflation, without the need for an intermediate target; or a system where the exchange rate was fixed to that of another country which had a good record of maintaining low inflation.', 'in short, the two alternatives which satisfied the condition of providing a "nominal anchor" were inflation targeting or fixing the exchange rate (sometimes called the hard currency option).', 'australia went down the first path, while most of europe (including the united kingdom for a time) went down the second path by tying their currencies to the deutschemark.', 'some would argue that this two-way classification of the options is too narrow and that monetary targeting remains a viable third option, at least for some countries.', 'germany is often cited as an example.', 'this view ignores the reality that the bundesbank has moved a long way away from strict monetary targeting in recent years, as is evident from the way they move their policy instrument.', 'there is evidence to suggest that prospective inflationary developments are more likely to trigger a monetary policy move than is a deviation of money supply from its target.', "inflation targeting unlike the experience in some other countries like the united kingdom or new zealand, where inflation targets came into force in dramatic regime shifts, the elements of australia's inflation-targeting regime were put in place gradually.", 'there were a number of reasons for this.', 'while inflation targets had considerable conceptual appeal, the models adopted in the pioneering countries - new zealand and canada - seemed to us excessively rigid with their narrow bands and low target mid-points.', 'the fact that these were the only working models available at the time tended to polarise debate, and it took some time for the bank to develop its own more flexible version.', 'also important was the need to build public support, including political support, for a target, and again this happened gradually rather than in a single, decisive act.', 'some of the key elements of the inflation-targeting approach were in place quite early.', 'the conceptual basis of such an approach, with a focus on inflation as the policy objective, no intermediate objective, interest rates as the instrument, and a transmission process that works via the effect of interest rates on private demand, had been analysed in a number of pieces that the bank published in 1989, including its conference volume.', "what we now consider one of the key elements of the policy framework, the explicit announcements of cash rate changes, with explanations of the reasons for each change, began in january 1990. over time, the bank's published commentaries on monetary policy and the economy became more detailed and developed a stronger inflation focus.", 'the numerical objective of 2-3 per cent inflation began appearing in public statements by governor fraser in 1992 and 1993. the cumulative effect of all these developments was to establish an inflation-targeting regime broadly comparable to those being developed in a number of other countries around the same time.', 'while there was no individual decisive event, international comparative tables such as those published by the bis date the change in australia from 1993. a final element was added with the joint statement on the conduct of monetary policy, made by myself and the treasurer on my appointment as governor.', "the statement gave the government's formal endorsement to the independence of the reserve bank as contained in its act and to the 2-3 per cent target.", 'it also provided for enhanced accountability through semi-annual statements and parliamentary appearances.', 'several other countries adopted inflation targets around the same time as australia.', 'a recent survey by the bis counts seven inflation targeters, making this currently the most numerically popular regime among medium-sized oecd countries (table 2).', 'as had been the case with previous regime changes, the immediate reason for change in many cases was either a breakdown of a previous regime or dissatisfaction with its performance.', 'in the united kingdom, sweden and finland, the trigger was the collapse of fixed exchange rate commitments in 1992. new zealand and canada adopted their targets in a deliberate strategy of inflation reduction.', 'australia was somewhat different in that there was no crisis that needed to be responded to, and the target was developed to cement in place an inflation reduction that had already been achieved.', 'table 2: inflation targets country target adopted current target new zealand march 1990 0-3% canada february 1991 1-3% united kingdom october 1992 21⁄2% sweden january 1993 1-3% finland february 1993 2% australia 1993 2-3% spain summer 1994 0-3% source: bis 1996 annual report, updated to incorporate recent changes to targets in the united kingdom and new zealand the move to inflation targeting completed a significant conceptual leap from the regimes that had prevailed in the earlier decades.', 'instead of a focus on intermediate objectives, like the exchange rate or the money supply, the operational framework of policy was now built around a final objective, inflation.', 'in describing inflation as the final objective in this context, i should make clear that inflation control is viewed as a means to an end rather than an end in itself.', 'the reason monetary regimes have been set up to aim for low inflation is that this is the best contribution monetary policy can make in the longer run to growth in output, employment and living standards.', 'in principle, this approach re-establishes a clear nominal anchor while avoiding the main problem of the intermediate-targeting regimes -- namely, that the target variables did not have a sufficiently stable relationship with the final objectives.', 'the approach also preserves, from the transitional period that i described earlier, the common-sense notion of using all relevant information: the difference is that there is now a clear criterion -- the impact on the inflation outlook -- for assessing what the information means for policy.', 'another property of inflation targets, not always well-recognised, is that they provide scope for counter-cyclical action.', 'this is automatically built into the policy framework if a central bank takes seriously, as we do, both the upper and lower bounds of the target.', 'when the inflation forecast is above the target, the framework requires policy to be tightened, as was the case a couple of years ago, and, when it is below target, policy has to be more expansionary, as at present.', 'in this way the policy framework incorporates a systematic resistance to cyclical demand pressures.', 'i have described this previously by saying that the policy aims to allow the economy to grow as fast as possible, consistent with low inflation, but no faster.', 'aside from these operational characteristics, an important dimension of the economic rationale for inflation targets is their role as a discipline on the policy process.', 'the academic literature lays great store on this -- particularly in the time inconsistency literature -- although it tends to focus rather too narrowly on the idea of constraining the policy-makers.', 'the targets are seen as correcting an inflationary bias that would otherwise arise from the temptation of central bankers to go for short-term expansion.', 'in this literature, rule-based regimes are said to be superior to discretion because they allow pre-commitment to non-inflationary policies, and thereby overcome the assumed short-termism of the policy-makers.', 'central bankers are very sceptical of this line of analysis because we do not see ourselves as inherently inflation-prone.', 'but while i think this particular argument for a rule-based approach somewhat misses the point, the ability to specify policy in terms of a relatively simple rule does have some important advantages.', 'in particular, simple rules provide a ready vehicle for accountability and for public communication: they require policy actions to be explained in terms of a clear target, and they help central banks to resist calls for excessively expansionary policies.', 'also important is that, over time, a simple rule like an inflation target can provide a focal point for inflation expectations by making clear what the central bank is aiming at.', 'one of the reasons that inflation targets have pro']	Ian J Macfarlane	Reserve Bank of Australia	Governor	Australia
https://www.bis.org/review/r971001h.pdf	Mr. George discusses the advantages and disadvantages of EMU (Central Bank Articles and Speeches, 23 Sep 97)	Speech by the Governor of the Bank of England, Mr. E.A.J. George, to the British Chamber of Commerce in Hong Kong on 23/9/97.	1997-09-23 00:00:00	Mr. George discusses the advantages and disadvantages of EMU Speech by the Governor of the Bank of England, Mr. E.A.J. George, to the British Chamber of Commerce in Hong Kong on 23/9/97. EMU - One currency, fifteen countries? Thank you, Chairman. I am delighted to be here with the British Chamber of Commerce in Hong Kong, and to find that you are so obviously flourishing -- as I had no doubt you would -- in the new environment. I'm delighted too to be able to redeem a promise to speak at one of your lunches which Christopher Hammerbeck alleges I made to him two years ago. I've chosen to speak about EMU -- under the title of "One currency, fifteen countries?" -- and I emphasise the question mark. Let me begin with the pros and cons of EMU, although I think that the economic arguments are now reasonably well understood. On the positive side, although one can hope, by pursuing consistent national macroeconomic policies, to achieve reasonable de facto exchange rate stability within Europe over time, only a single currency can deliver intra-European exchange rate certainty. And exchange rate certainty within a large market area is, of course, a very considerable prize. I don't think one can go so far as to argue that a single European currency is a necessary complement to the European single market -- any more than one can argue that exchange rate fixity is necessary to achieving benefits from free trade internationally. But there is no doubt that the unique, intra-European exchange rate certainty that would be provided by a single currency could nevertheless -- through increased competition as a result of greater price transparency and lower transaction costs, and through the associated improvement in resource allocation -- greatly increase the benefits that are to be derived from the single market. So, on the positive side there is no doubt that it would -- other things equal -- be a very desirable complement to the single market. The problem is that other things may not necessarily prove to be equal. Essentially, the downside is that there is a risk that the single monetary policy -- the single short-term interest rate -- throughout the euro-area, which is a necessary corollary of the single currency, may not, in the event, prove to be appropriate to the domestic needs of each of the participating countries. That risk was quite clearly recognised by the drafters of the Maastricht Treaty. They quite deliberately included in the Treaty the famous convergence criteria in order to ensure that countries wanting to participate in the euro-area should have to demonstrate, before they were allowed to join, at least a minimum degree of sustainable economic convergence precisely in order to reduce the risk of divergent national monetary policy needs once the single currency is introduced. Without that, the potential problems could be serious. The euro-member countries would have no possibility of adjusting either interest rates or their exchange rate independently, and they would have somewhat limited scope for independent fiscal adjustment because the Stability and Growth Pact would constrain the size of overall public sector deficits. And alternative adjustment mechanisms -- such as the labour migration or fiscal redistribution that helps to alleviate similar regional problems within individual countries -- are not well developed at the level of Europe as a whole -- nor are they likely to be, at least in the near future. So the risk is that the one size-fits-all interest rate could result in economic weakness and unemployment in some areas if the European Central Bank pursued a firm monetary policy or unwanted inflation in others if it were more accommodating. Such divergent national monetary policy needs within the euro-area could result from differences in the cyclical position as between one country and another; or from different fiscal positions, - 2 - although these, as I say, should be constrained by the Stability Pact; or they could result from external shocks which had disproportionate effects on some countries as against others. They may be the more likely because Europe starts from a position of generally very high levels of unemployment [ranging from around 7% in the UK, to around 10% in Germany, over 12% in France and Italy, and even more in Spain on a consistent basis]. I do not suggest that this urgent problem of unemployment can be directly addressed by differential macro-economic stimulus -- most commentators agree that it is rather the result of structural, supply-side rigidities and can only be effectively tackled by greater labour market flexibility. The worry is that the necessary structural changes will occur to varying degrees and at a different pace in different countries itself, resulting in different macroeconomic policy needs. This is why meeting the convergence criteria, in economic substance not just in some formal accounting sense, are crucially important. Without genuinely sustainable convergence -- and I emphasise the word sustainable! -- serious tensions could emerge between different countries living with the single monetary policy. It is true that the prospect of EMU has had a powerful effect on countries' behaviour -- causing some of them, for example, to address fiscal problems to a degree that might well not have happened without the external incentive of the Maastricht timetable. And some argue that the disciplines of EMU itself will enforce convergent behaviour, including structural adjustment, so that the regional tensions which I have described will not in practice materialise. I am not convinced that one can simply rely upon that happening -- and the longstanding weakness of the economy in the south of Italy, despite a single currency with the North, or the continuing weakness of the East German economy since currency reunification with Western Germany suggest that such behaviour is by no means certain. There are then real economic risks in the EMU project to be weighed against the potential economic benefits, and striking the balance between them is the task of the European Heads of State as they face their historic decision next May -- just over seven months from now. There is no doubting the political determination of most of Europe's leaders to press ahead. But unless, in any particular case, they are convinced that genuine, sustainable, convergence has indeed been achieved, it is difficult to see why the country in question should want to adopt the euro or indeed why it should be permitted to join, putting others at risk. EMU is, after all, forever -- and that seems a very long time to me. I don't really understand the hurry. The prudent planning assumption is, nonetheless, that EMU will go ahead next spring among at least a core group of countries, and possibly rather more. That certainly is the assumption being made in the financial markets. What it would mean in practical terms is that in early May next year the decision will be made to go ahead and agreement reached on the participating countries. At the same time, the bilateral conversion rates between the participating currencies that will apply irrevocably from 1 January, 1999 will be announced. On that date, the conversion rates between the participating currencies and the new, single currency, the euro, will be fixed such that the value of the euro will equal the then prevailing value of the official ECU. And short-term interest rates throughout the euro-area would be set, identically, by the ECB, that will have been established in the early summer of next year. From 1 January, 1999 the participating central banks would immediately begin to denominate their money and foreign exchange market interventions, on behalf of the ECB, in the new currency. Their national currencies would nevertheless continue to exist for a period of some three years, as broken-amount denominations of the euro, and it will still then be possible, through the payments mechanism, to convert those national currencies into euro and vice versa, effectively automatically, for anyone that wished to do so. The likelihood is that wholesale financial market transactions generally within the euro-area will rapidly switch to the euro-denomination, although that would be up to the operators in those markets. The principle that will apply is one of no compulsion but equally no prohibition. It means that, here in Hong Kong, you should expect to be able to have accounts denominated in euro across which to conduct wholesale, particularly, financial market activity, if you wished to do so, although you would equally be able to continue for the time being to operate across accounts denominated in the national currencies participating in the euro if you preferred. Euro bank notes and coin will not become available until some time probably towards the end of 2001 and it is unlikely that retail transactions denominated in euro will develop much before then. There will then be a maximum six-month period before the national currencies cease to be legal tender, at which point the transition to the euro will have been completed. Again, during this period in relation to the transition of retail transactions the guiding principle will be no compulsion and no prohibition, although collective efforts will no doubt be made by retailers and banks to shorten the period of dual denomination as far as they can. As far as the UK is concerned, the new Government -- while not definitively ruling it out -- has pointed to formidable difficulties in the way of participating in the euro from the beginning, and promised a referendum before the UK could join. A key consideration for us is likely to be whether -- on the basis of our assessment of the extent to which convergence has indeed been achieved -- the euro-area is a safe club to join in its early stages. If the Government were to decide not to join, at least at that point, it will be crucially important -- in our own national economic interest, and in order to avoid creating unnecessary problems for the euro-member countries -- that we continue to pursue, in parallel with those countries, the consensus policies of monetary and fiscal discipline. If EMU goes ahead, whether or not the UK is a part of it, it is clearly in our interest that it should succeed. On that basis, the euro-area would have no reason -- and certainly no right under European legislation -- to seek to act in any discriminatory way. Indeed, it would be economically damaging to both sides if it were to do so. I have no serious concerns on this score. Assuming, as I do, a continuing responsible and constructive relationship -- which, as I say, would clearly be in our mutual interest -- it seems to me that some of the concerns that are occasionally expressed, for example, about the possible loss to the UK of internationally mobile investment, are exaggerated. I would suppose that, in the future as in the past, investment will be located wherever it is expected to earn the highest return -- indeed I would suppose that shareholders would insist that this be the case. And while exchange rate uncertainty may be a factor in such decisions, it is not at all clear that it is likely to be the decisive factor very often, when set, for example, against the whole range of supply-side influences, including labour market flexibility. Similarly, in relation to concerns about the future of the huge UK financial services industry, the reality is that financial activity will be carried on wherever it can be carried on most conveniently, efficiently and profitably. And in this case, too, the question of whether or not the UK is part of the single currency is unlikely to be decisive. The City of London thrives on broad, liquid markets regardless of currency, and provided we are prepared -- as we will be from 1 January, 1999 - to quote, trade and settle in euro, as we are now in dollars or yen or DM, then I am convinced that the broader markets in euro instruments will represent an opportunity rather than a threat to the City. The fact is that overseas-controlled financial institutions are continuing actively to build their presence in the City, notwithstanding expectations that the UK will not be among the initial euro-member countries -- and this suggests very strongly that they take the same view about the City's future. I am quite confident that here in Hong Kong you will continue to be able to conduct your European financial business in euro in London, just as you do now in DM and French francs. So now then, Mr Chairman, should I answer the question in my title? One euro-currency at some point, certainly most probably from 1 January, 1999. Fifteen countries? I doubt it from that date, but eventually who knows?	['mr. george discusses the advantages and disadvantages of emu speech by the governor of the bank of england, mr. e.a.j.', 'george, to the british chamber of commerce in hong kong on 23/9/97.', 'emu - one currency, fifteen countries?', 'i am delighted to be here with the british chamber of commerce in hong kong, and to find that you are so obviously flourishing -- as i had no doubt you would -- in the new environment.', "i'm delighted too to be able to redeem a promise to speak at one of your lunches which christopher hammerbeck alleges i made to him two years ago.", 'i\'ve chosen to speak about emu -- under the title of "one currency, fifteen countries?"', '-- and i emphasise the question mark.', 'let me begin with the pros and cons of emu, although i think that the economic arguments are now reasonably well understood.', 'on the positive side, although one can hope, by pursuing consistent national macroeconomic policies, to achieve reasonable de facto exchange rate stability within europe over time, only a single currency can deliver intra-european exchange rate certainty.', 'and exchange rate certainty within a large market area is, of course, a very considerable prize.', "i don't think one can go so far as to argue that a single european currency is a necessary complement to the european single market -- any more than one can argue that exchange rate fixity is necessary to achieving benefits from free trade internationally.", 'but there is no doubt that the unique, intra-european exchange rate certainty that would be provided by a single currency could nevertheless -- through increased competition as a result of greater price transparency and lower transaction costs, and through the associated improvement in resource allocation -- greatly increase the benefits that are to be derived from the single market.', 'so, on the positive side there is no doubt that it would -- other things equal -- be a very desirable complement to the single market.', 'the problem is that other things may not necessarily prove to be equal.', 'essentially, the downside is that there is a risk that the single monetary policy -- the single short-term interest rate -- throughout the euro-area, which is a necessary corollary of the single currency, may not, in the event, prove to be appropriate to the domestic needs of each of the participating countries.', 'that risk was quite clearly recognised by the drafters of the maastricht treaty.', 'they quite deliberately included in the treaty the famous convergence criteria in order to ensure that countries wanting to participate in the euro-area should have to demonstrate, before they were allowed to join, at least a minimum degree of sustainable economic convergence precisely in order to reduce the risk of divergent national monetary policy needs once the single currency is introduced.', 'without that, the potential problems could be serious.', 'the euro-member countries would have no possibility of adjusting either interest rates or their exchange rate independently, and they would have somewhat limited scope for independent fiscal adjustment because the stability and growth pact would constrain the size of overall public sector deficits.', 'and alternative adjustment mechanisms -- such as the labour migration or fiscal redistribution that helps to alleviate similar regional problems within individual countries -- are not well developed at the level of europe as a whole -- nor are they likely to be, at least in the near future.', 'so the risk is that the one size-fits-all interest rate could result in economic weakness and unemployment in some areas if the european central bank pursued a firm monetary policy or unwanted inflation in others if it were more accommodating.', 'such divergent national monetary policy needs within the euro-area could result from differences in the cyclical position as between one country and another; or from different fiscal positions, - 2 - although these, as i say, should be constrained by the stability pact; or they could result from external shocks which had disproportionate effects on some countries as against others.', 'they may be the more likely because europe starts from a position of generally very high levels of unemployment [ranging from around 7% in the uk, to around 10% in germany, over 12% in france and italy, and even more in spain on a consistent basis].', 'i do not suggest that this urgent problem of unemployment can be directly addressed by differential macro-economic stimulus -- most commentators agree that it is rather the result of structural, supply-side rigidities and can only be effectively tackled by greater labour market flexibility.', 'the worry is that the necessary structural changes will occur to varying degrees and at a different pace in different countries itself, resulting in different macroeconomic policy needs.', 'this is why meeting the convergence criteria, in economic substance not just in some formal accounting sense, are crucially important.', 'without genuinely sustainable convergence -- and i emphasise the word sustainable!', '-- serious tensions could emerge between different countries living with the single monetary policy.', "it is true that the prospect of emu has had a powerful effect on countries' behaviour -- causing some of them, for example, to address fiscal problems to a degree that might well not have happened without the external incentive of the maastricht timetable.", 'and some argue that the disciplines of emu itself will enforce convergent behaviour, including structural adjustment, so that the regional tensions which i have described will not in practice materialise.', 'i am not convinced that one can simply rely upon that happening -- and the longstanding weakness of the economy in the south of italy, despite a single currency with the north, or the continuing weakness of the east german economy since currency reunification with western germany suggest that such behaviour is by no means certain.', 'there are then real economic risks in the emu project to be weighed against the potential economic benefits, and striking the balance between them is the task of the european heads of state as they face their historic decision next may -- just over seven months from now.', "there is no doubting the political determination of most of europe's leaders to press ahead.", 'but unless, in any particular case, they are convinced that genuine, sustainable, convergence has indeed been achieved, it is difficult to see why the country in question should want to adopt the euro or indeed why it should be permitted to join, putting others at risk.', 'emu is, after all, forever -- and that seems a very long time to me.', "i don't really understand the hurry.", 'the prudent planning assumption is, nonetheless, that emu will go ahead next spring among at least a core group of countries, and possibly rather more.', 'that certainly is the assumption being made in the financial markets.', 'what it would mean in practical terms is that in early may next year the decision will be made to go ahead and agreement reached on the participating countries.', 'at the same time, the bilateral conversion rates between the participating currencies that will apply irrevocably from 1 january, 1999 will be announced.', 'on that date, the conversion rates between the participating currencies and the new, single currency, the euro, will be fixed such that the value of the euro will equal the then prevailing value of the official ecu.', 'and short-term interest rates throughout the euro-area would be set, identically, by the ecb, that will have been established in the early summer of next year.', 'from 1 january, 1999 the participating central banks would immediately begin to denominate their money and foreign exchange market interventions, on behalf of the ecb, in the new currency.', 'their national currencies would nevertheless continue to exist for a period of some three years, as broken-amount denominations of the euro, and it will still then be possible, through the payments mechanism, to convert those national currencies into euro and vice versa, effectively automatically, for anyone that wished to do so.', 'the likelihood is that wholesale financial market transactions generally within the euro-area will rapidly switch to the euro-denomination, although that would be up to the operators in those markets.', 'the principle that will apply is one of no compulsion but equally no prohibition.', 'it means that, here in hong kong, you should expect to be able to have accounts denominated in euro across which to conduct wholesale, particularly, financial market activity, if you wished to do so, although you would equally be able to continue for the time being to operate across accounts denominated in the national currencies participating in the euro if you preferred.', 'euro bank notes and coin will not become available until some time probably towards the end of 2001 and it is unlikely that retail transactions denominated in euro will develop much before then.', 'there will then be a maximum six-month period before the national currencies cease to be legal tender, at which point the transition to the euro will have been completed.', 'again, during this period in relation to the transition of retail transactions the guiding principle will be no compulsion and no prohibition, although collective efforts will no doubt be made by retailers and banks to shorten the period of dual denomination as far as they can.', 'as far as the uk is concerned, the new government -- while not definitively ruling it out -- has pointed to formidable difficulties in the way of participating in the euro from the beginning, and promised a referendum before the uk could join.', 'a key consideration for us is likely to be whether -- on the basis of our assessment of the extent to which convergence has indeed been achieved -- the euro-area is a safe club to join in its early stages.', 'if the government were to decide not to join, at least at that point, it will be crucially important -- in our own national economic interest, and in order to avoid creating unnecessary problems for the euro-member countries -- that we continue to pursue, in parallel with those countries, the consensus policies of monetary and fiscal discipline.', 'if emu goes ahead, whether or not the uk is a part of it, it is clearly in our interest that it should succeed.', 'on that basis, the euro-area would have no reason -- and certainly no right under european legislation -- to seek to act in any discriminatory way.', 'indeed, it would be economically damaging to both sides if it were to do so.', 'i have no serious concerns on this score.', 'assuming, as i do, a continuing responsible and constructive relationship -- which, as i say, would clearly be in our mutual interest -- it seems to me that some of the concerns that are occasionally expressed, for example, about the possible loss to the uk of internationally mobile investment, are exaggerated.', 'i would suppose that, in the future as in the past, investment will be located wherever it is expected to earn the highest return -- indeed i would suppose that shareholders would insist that this be the case.', 'and while exchange rate uncertainty may be a factor in such decisions, it is not at all clear that it is likely to be the decisive factor very often, when set, for example, against the whole range of supply-side influences, including labour market flexibility.', 'similarly, in relation to concerns about the future of the huge uk financial services industry, the reality is that financial activity will be carried on wherever it can be carried on most conveniently, efficiently and profitably.', 'and in this case, too, the question of whether or not the uk is part of the single currency is unlikely to be decisive.', 'the city of london thrives on broad, liquid markets regardless of currency, and provided we are prepared -- as we will be from 1 january, 1999 - to quote, trade and settle in euro, as we are now in dollars or yen or dm, then i am convinced that the broader markets in euro instruments will represent an opportunity rather than a threat to the city.', "the fact is that overseas-controlled financial institutions are continuing actively to build their presence in the city, notwithstanding expectations that the uk will not be among the initial euro-member countries -- and this suggests very strongly that they take the same view about the city's future.", 'i am quite confident that here in hong kong you will continue to be able to conduct your european financial business in euro in london, just as you do now in dm and french francs.', 'so now then, mr chairman, should i answer the question in my title?', 'one euro-currency at some point, certainly most probably from 1 january, 1999. fifteen countries?', 'i doubt it from that date, but eventually who knows?']	Edward George	Bank of England	Governor	UK
https://www.bis.org/review/r971001g.pdf	Mr. Thompson gives his views on the changing scene in the banking industry in Australia (Central Bank Articles and Speeches, 25 Sep 97)	Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the First Pacific Stockbrokers Australasian Banking Conference in Melbourne on 25/9/97.	1997-09-25 00:00:00	Mr. Thompson gives his views on the changing scene in the banking industry in Australia Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the First Pacific Stockbrokers Australasian Banking Conference in Melbourne on 25/9/97. It is traditional to open this Conference with a summary of the state of the banking system, as seen from the RBA's perspective. I will therefore do that first. Then I would like to make some points about the prudential supervision of bank capital. Finally, I will draw out some implications of the Government's recent financial system policy announcements for competition in banking and payments. State of the banking industry The banking system remains healthy overall, but banks are under strong pressures from new competitors, the cost of systems development and shifts in the structure of financing. Interest margins have been squeezed further over the past year, both by the continuing, intense competition in home and corporate lending and by the low (and falling) levels of interest rates. Domestic net margins have fallen to just under 4 per cent for the major banks (compared with 5 per cent in the late 1980s), and to around 3 per cent for the regionals. Notwithstanding this squeeze, major banks' after-tax profits were around 17-18 • per cent of shareholders' funds in the first half of 1997, much the same as their 1996 result. However, for regional banks, which are more reliant on home loans, return on equity fell from around 15 per cent to 13.5 per cent. • Capital ratios declined further over the past year -- helping to bolster rates of return -- due to acquisitions, asset growth and capital buy-backs. The average risk-weighted capital ratio across all banks was 10.3 per cent in June, compared with 11.1 per cent in June 1996 and 12.1 per cent in June 1995. (The ratio for the major banks fell from 10.6 per cent to 9.8 per cent over the past year, for the regionals from 12.4 to 10.8 per cent, and for foreign banks from 15.1 to 14.8 per cent.) • Securitisation of bank assets has increased as a means of reducing required capital, or freeing it up for other uses. In the past year and a half around $3 billion of assets have been moved off balance sheets in this way. (Of course, bank balance sheets are only one source of assets for the expanding securitisation market -- total assets in securitisation vehicles would now be over $20 billion, double the level of two years ago.) • Bank credit (net of securitisation) has grown at an annual rate of around 10 per cent so far in 1997, compared with about 12 per cent during 1996. The main categories have all grown at close to this average. Asset quality is in good shape, with impaired assets at 0.8 per cent of assets in • June 1997, compared to 1.1 per cent a year earlier. Loan write-offs have continued to fall, and loans newly identified as impaired each quarter remain both low and steady. Banks are responding to margin squeeze on several fronts. There has been further unwinding of the longstanding cross-subsidisation of transactions and account-keeping services out of interest margins. There is a continuing drive to cut costs -- through rationalising branch networks, trimming management structures and investing in labour-saving technology. This has included closer investigation of the potential savings from outsourcing non-core activities (such as cheque processing and information technology) and sharing basic facilities, and the past year has seen some important initiatives of this kind. - 2 - Regional banks, in particular, are looking to diversify their loan portfolios to reduce their dependence on home lending. But all banks are, to varying extents, pursuing a wider range of revenue sources as competition intensifies in traditional business lines, and areas such as funds management seem to offer better long-term prospects. Through acquisitions and organic growth, the ratio of banks' funds under management to balance sheet assets has risen to around 30 per cent from 20 per cent four years ago. (Despite these efforts, it is interesting that there has been no increase in the ratio of banks' domestic non-interest income to domestic assets.) The closer management of bank capital has been another notable feature of the past year or so. One result has been the major banks' share buy-back programs and the repurchasing/restructuring of subordinated debt. The RBA has a keen interest in these developments, given the centrality of capital in our supervisory system. Closer alignment of capital with risks inherent in a bank's activities (and prospective balance sheet growth) is, of course, not to be discouraged. A banking system with excessive capital will be less efficient and less competitive in performing its financing role for the economy. Supervisors will, however, always wish to be satisfied that capital ratios take full and proper account of all the risks inherent in a bank's business. I will talk more about supervision of capital in a moment. Speculation about a decline in lending standards under competitive pressures has also been topical in the past year. It is very difficult to get any objective reading on this. As I have noted, the statistics on impaired loans show no sign of any such decline. Problems, if there are any, will be revealed in these data only in the future. What our supervisors do have, however, is a clear impression of a fall in lending standards -- an impression based on both market anecdotes and our observations of credit management in practice during visits to banks. Competition has not only whittled away margins but has led to relaxation of conditions placed on borrowers. This applies especially in lending to large corporations. But in the housing market, too, the imperative to maximise volumes or minimise costs in the world of tighter spreads, creates a temptation for banks to take short-cuts. Two of the more common deficiencies we see are the failure to obtain independent confirmation of a borrower's income and failure to test a borrower's capacity to keep making repayments if, over the course of the loan, interest rates were to increase. As competition intensifies, the strength of banks' risk management systems for commercial and consumer loans is likely also to be tested. We have already expressed our concern that some current lending practices do risk sowing the seeds of future credit quality problems for banks. This concern has not increased in recent months. Nor has it diminished. Despite their various and strenuous efforts to maintain recent profit performance, banks' earning rates are likely to remain under strong downward pressure in coming years. Eliminating excess capital and cutting into operating costs cannot provide continuous relief. Indeed, it seems unrealistic to think that average ROEs of over 15 per cent could continue in a world of 2 per cent inflation and a return on long bonds between 6 and 7 per cent. One has to go back to the regulated, less competitive world of the early 1970s to find comparable margins between bank earnings and bond yields. Supervision of bank capital I referred earlier to banks managing their capital more actively. The RBA's main supervision task this year has been extending the capital adequacy rules to cover the market risks in banks' trading books -- that is, the risks from fluctuations in interest rates, exchange rates, equity prices and commodity prices. The new guidelines become effective at the beginning of 1998. The novel feature of the market risk guidelines, which were developed by the Basle Committee on Banking Supervision and are being adopted internationally, is the reliance they allow to be placed on banks' own risk management systems. Banks have the option of using their internal models to calculate required capital, or of employing a standard model specified by the Basle Committee. Of course, internal models need to meet certain minimum standards -- both quantitative and qualitative -- before they will be accepted for supervisory purposes. A bank whose systems are not up to scratch will have to use the standard model. The RBA must sign off on the adequacy of internal systems. But the onus for effective day-to-day risk management will remain squarely with the boards and senior management of banks. As an aside, during the past year we introduced arrangements under which a bank's chief all executive, with the endorsement of the board, must attest to the RBA that key risks have been identified, that systems have been designed to manage those risks, that the descriptions of those systems held by the RBA are current and that the systems are working effectively. We are already seeing important general benefits from these new arrangements. They have resulted in more high-level attention to risk management systems and the system descriptions provided to us. Chief executives now need to see those manuals, which were previously often regarded as an administrative inconvenience for officers handling liaison with the RBA. This has added discipline and rigour to the whole risk management process. Eleven banks have applied to us for internal model status under the market risk rules, and they are all presently upgrading their existing risk measurement and management practices to meet the minimum requirements. As well as to measurement methodology, they are giving attention to such features as the adequacy of separation of front- and back-office operations, procedures to ensure that traders deal only in products for which robust operational and legal arrangements are in place, the rigour of revaluation processes and procedures for stress testing and back testing. We remain hopeful that, by the end of the year, all internal models will have reached a standard with which we can be comfortable, but there is a good deal of work still to be done in some cases. Another eleven banks plan to use the standard model for market risk, while the remainder have insufficient market risks to be affected by the new guidelines or are branches, covered by their home country supervisors. Our assessment remains that the new arrangements will not add materially to required capital for the banking system as a whole. However, the impact on individual capital ratios will vary, depending on the scope of each bank's trading activities. For some there will be an increase. For others, required capital may actually fall, as the benefits from substituting specific market risk charges for existing credit risk capital will outweigh the additional capital needed for general market risks. The next question about supervision of banks' capital is whether the present rules covering credit risk might be replaced by a more sophisticated methodology more in line with the market risk framework. The current rules are relatively crude, in the sense that capital ratios are applied against very broad categories of credit exposure without any firm basis in the actual likelihood of loss. In the way that potential losses from a portfolio of traded instruments can be estimated using historical data on daily price movements, potential losses from a portfolio of loans can, in principle, be estimated from an examination of default histories. Supervisors would add a mark-up for safety to these estimates, as they have in the case of market risk. Lack of reliable data on defaults and credit losses has been a major obstacle to this approach. But banks are working to remedy this, and are making progress toward putting the management of credit risk onto a more objective/scientific basis. Modelling techniques can be applied more easily to some components of a loan portfolio -- such as high-volume, standard housing and credit card receivables -- than to others. For this reason, an incremental approach to recognising models for credit risk supervision is likely to emerge. - 4 - There is probably quite a way to go before credit risk is generally as amenable to modelling as market risk is. And since credit risk remains potentially the greatest threat to the soundness of banks and banking systems, supervisors are likely to be conservative about changes to the present rules, with all their imperfections. Implications of new Government policies There is clearly a lot of market-driven change "in the pipeline" for banks. The Government's policy decisions following the Financial System Inquiry will further alter the environment for banks and others in coming years. Those policy changes, announced by the Treasurer early this month, have many dimensions. I would like to talk about just two of those -- effects on competition in banking and on the payments system. There is no doubt that the proposed policy changes will increase competition, by widening the range of potential players in both deposit-taking and in retail payments. (There will be less change as far as lending is concerned; apart from the need to conform with the consumer protection provisions of the uniform credit laws, there are already few regulatory impediments to the entry of new lenders -- as the recent history of home lending shows clearly enough.) The new rules should add to competition in deposit-taking in several ways. First, creating a single licensing regime for all deposit-taking institutions (DTIs) should help to level the proverbial playing field among credit unions, building societies and banks. A single depositor protection system -- based on depositors having prior claim over the assets of a troubled institution -- will be a key element in this. The actual impact of the new regime on the competitive standing of the various DTI groups will, of course, depend on the effectiveness of the smaller institutions in promoting their new status. Under the single licensing regime banks will still constitute a particular category among deposit-takers, but distinguished primarily by their size. Only institutions with at least $50 million in Tier 1 capital, and having a settlement account with the RBA, will be able to use the label "bank". The single regulatory regime will, in principle, allow smaller DTIs to grow into this status more readily than they can now. Under new policy, mutual organisations will be able to have a banking licence, or to own a bank -- subject, of course, to satisfying prudential qualifications. Previously, it was possible for mutuals to be associated only with non-bank DTIs. It will also be open for banks to be established under non-operating holding company structures. Until now, with limited exceptions, a bank itself has had to be the holding company of a financial group. No doubt some groups will, for one reason or another, see commercial advantage from reorganising an existing operation under a holding company, or in establishing a new bank under such a structure. It seems likely that groups with bancassurance or allfinanz aspirations will go this way. For some financial groups, the possibility in future of having more than one banking authority (or licence), or a banking authority and a non-bank deposit-taking licence, will also be seen as helpful to their competitive position. Moreover, the Government has foreshadowed that the new licensing agency -- the Australian Prudential Regulation Authority (APRA) -- will have a more flexible attitude to the mixing of financial and non-financial activities in the one group. But this does not mean "open slather". The general presumption in favour of dispersed ownership of banks and other deposit-takers will remain -- with individual shareholdings above 15 per cent needing to pass a national interest test. And there will be a "demonstrable congruity" test for non-financial activities to sit alongside a bank in a conglomerate. The interpretation and administration of this test will be for the new agency, but the Treasurer has referred to cases "where financial products can be logically bundled with a supply of non-financial goods and services", and has indicated that APRA's assessment of applications will be guided by international trends. One can readily imagine activities such as information-processing and communication of various kinds passing a congruence test. There could well be others over time. Incidentally, the intention clearly is that licensed deposit-takers will still be distinct legal entities with dedicated capital, separate management systems and so on. A non-financial company might be able to own a bank, but it could not be licensed in its own right as a bank or other deposit-taker. One can only speculate about the exact effects of these reforms on the evolution of banking and finance in Australia over coming years. These effects will be intermingled with those of technological change, global pressures, the administration of merger policy, and so on. But it seems clear enough that more flexibility in entry rules for new players, and more flexibility in corporate structures, will add to competition and make life a little tougher (at least) for the established deposit-takers. This will be another force bearing down on margins and profitability. One should not forget, of course, that these policy reforms will open up opportunities (such as for holding company structures) previously denied to existing players too. And the eventual elimination of the non-callable deposit regime will remove another sort of unevenness in the playing field -- one which currently penalises authorised banks relative to the non-bank DTIs and merchant banks. Let me turn now to the payments system where similar forces will be at work. From the RBA's perspective there are three main changes in store. One is that participants in the payments system, other than deposit-takers, could qualify for an exchange settlement account (ESA) at the RBA. The Treasurer's statement said: "While the immediate scope for greater access is likely to be limited, access will not be constrained to licensed banks or other deposit-taking institutions". New opportunities might, consequently, be available to companies offering payment services based on credit facilities, such as credit cards. With an ESA, they would be able to offer final settlement of payment obligations to other institutions in their own right, rather than having to negotiate an agency arrangement with a bank. While the details are yet to be worked out -- by the RBA in this case -- two prerequisites for ESA access will be: no reduction in the safety and stability of the payments system; and • • access only for institutions which provide, or propose to provide, extensive third party transactions (as opposed to companies making transactions on their own account). Again, we are not talking "free-for-all", but we are talking a markedly broader range of payments opportunities for non-traditional players. A second change is that the RBA will have regulatory power over widely-used stored-value instruments -- such as cards, internet tokens and even travellers cheques -- where their issuer is not a licensed deposit-taker. This will be prudential regulation aimed at reducing systemic risks and preserving public confidence in the various forms of electronic cash. - 6 - The more general, and most significant, reform in payments policy is that the RBA will be given formal, statutory responsibilities for the payments and settlements system, with powers to back them up. Its responsibilities will cover not only issues of stability and safety, but will extend to the efficiency and competitiveness of the system, including questions of fair access for new payments providers. The RBA will be required, for instance, to look into the fees and charges levied by the established players on newcomers wishing to join existing networks, or to use existing infrastructure. To carry out these responsibilities, we will need to develop criteria for assessing the acceptability of membership and third party access provisions in the various payments clearing streams. We will also produce and publish benchmarks for judging the safety and efficiency of Australia's payments system. When the RTGS system commences for high-value payments in the first half of 1998, a major step will have been taken to reduce risk and improve safety in domestic payments. We will be encouraging as many payments as practicable to move onto that system. The next major frontier is to reduce the settlement risks of Australian banks in their international transactions. This will be, if anything, more challenging than domestic RTGS has been, but some progress is being made internationally. I suspect that there is as much to be done to improve the efficiency of the Australian payments system and the "fairness" of access arrangements to retail payments streams. The ACCC has recently found wanting the basis on which smaller players may negotiate participation in the EFTPOS system. I should emphasise that it will be the RBA's intention to adopt as light a regulatory touch as possible over the payments system. There has, after all, been a good deal of recent progress in reforming that system without the Bank having explicit powers. We hope such progress will continue -- through the Australian Payments Clearing Association and other industry-based bodies. Only where payments arrangements fall short of our efficiency and safety benchmarks -- and there are no serious attempts by the industry to rectify that position reasonably quickly -- will we embark on the path of prescriptive regulation. End piece It is a truism that change is always with us. But I suspect that banks face more than their fair share of it in coming years. I hope my remarks will be useful background for your speculation about the details of this change over the next couple of days.	['mr. thompson gives his views on the changing scene in the banking industry in australia speech by the deputy governor of the reserve bank of australia, mr. g.j.', 'thompson, at the first pacific stockbrokers australasian banking conference in melbourne on 25/9/97.', "it is traditional to open this conference with a summary of the state of the banking system, as seen from the rba's perspective.", 'i will therefore do that first.', 'then i would like to make some points about the prudential supervision of bank capital.', "finally, i will draw out some implications of the government's recent financial system policy announcements for competition in banking and payments.", 'state of the banking industry the banking system remains healthy overall, but banks are under strong pressures from new competitors, the cost of systems development and shifts in the structure of financing.', 'interest margins have been squeezed further over the past year, both by the continuing, intense competition in home and corporate lending and by the low (and falling) levels of interest rates.', 'domestic net margins have fallen to just under 4 per cent for the major banks (compared with 5 per cent in the late 1980s), and to around 3 per cent for the regionals.', "notwithstanding this squeeze, major banks' after-tax profits were around 17-18 • per cent of shareholders' funds in the first half of 1997, much the same as their 1996 result.", 'however, for regional banks, which are more reliant on home loans, return on equity fell from around 15 per cent to 13.5 per cent.', '• capital ratios declined further over the past year -- helping to bolster rates of return -- due to acquisitions, asset growth and capital buy-backs.', 'the average risk-weighted capital ratio across all banks was 10.3 per cent in june, compared with 11.1 per cent in june 1996 and 12.1 per cent in june 1995.', '(the ratio for the major banks fell from 10.6 per cent to 9.8 per cent over the past year, for the regionals from 12.4 to 10.8 per cent, and for foreign banks from 15.1 to 14.8 per cent.)', '• securitisation of bank assets has increased as a means of reducing required capital, or freeing it up for other uses.', 'in the past year and a half around $3 billion of assets have been moved off balance sheets in this way.', '(of course, bank balance sheets are only one source of assets for the expanding securitisation market -- total assets in securitisation vehicles would now be over $20 billion, double the level of two years ago.)', '• bank credit (net of securitisation) has grown at an annual rate of around 10 per cent so far in 1997, compared with about 12 per cent during 1996. the main categories have all grown at close to this average.', 'asset quality is in good shape, with impaired assets at 0.8 per cent of assets in • june 1997, compared to 1.1 per cent a year earlier.', 'loan write-offs have continued to fall, and loans newly identified as impaired each quarter remain both low and steady.', 'banks are responding to margin squeeze on several fronts.', 'there has been further unwinding of the longstanding cross-subsidisation of transactions and account-keeping services out of interest margins.', 'there is a continuing drive to cut costs -- through rationalising branch networks, trimming management structures and investing in labour-saving technology.', 'this has included closer investigation of the potential savings from outsourcing non-core activities (such as cheque processing and information technology) and sharing basic facilities, and the past year has seen some important initiatives of this kind.', '- 2 - regional banks, in particular, are looking to diversify their loan portfolios to reduce their dependence on home lending.', 'but all banks are, to varying extents, pursuing a wider range of revenue sources as competition intensifies in traditional business lines, and areas such as funds management seem to offer better long-term prospects.', "through acquisitions and organic growth, the ratio of banks' funds under management to balance sheet assets has risen to around 30 per cent from 20 per cent four years ago.", "(despite these efforts, it is interesting that there has been no increase in the ratio of banks' domestic non-interest income to domestic assets.)", 'the closer management of bank capital has been another notable feature of the past year or so.', "one result has been the major banks' share buy-back programs and the repurchasing/restructuring of subordinated debt.", 'the rba has a keen interest in these developments, given the centrality of capital in our supervisory system.', "closer alignment of capital with risks inherent in a bank's activities (and prospective balance sheet growth) is, of course, not to be discouraged.", 'a banking system with excessive capital will be less efficient and less competitive in performing its financing role for the economy.', "supervisors will, however, always wish to be satisfied that capital ratios take full and proper account of all the risks inherent in a bank's business.", 'i will talk more about supervision of capital in a moment.', 'speculation about a decline in lending standards under competitive pressures has also been topical in the past year.', 'it is very difficult to get any objective reading on this.', 'as i have noted, the statistics on impaired loans show no sign of any such decline.', 'problems, if there are any, will be revealed in these data only in the future.', 'what our supervisors do have, however, is a clear impression of a fall in lending standards -- an impression based on both market anecdotes and our observations of credit management in practice during visits to banks.', 'competition has not only whittled away margins but has led to relaxation of conditions placed on borrowers.', 'this applies especially in lending to large corporations.', 'but in the housing market, too, the imperative to maximise volumes or minimise costs in the world of tighter spreads, creates a temptation for banks to take short-cuts.', "two of the more common deficiencies we see are the failure to obtain independent confirmation of a borrower's income and failure to test a borrower's capacity to keep making repayments if, over the course of the loan, interest rates were to increase.", "as competition intensifies, the strength of banks' risk management systems for commercial and consumer loans is likely also to be tested.", 'we have already expressed our concern that some current lending practices do risk sowing the seeds of future credit quality problems for banks.', 'this concern has not increased in recent months.', 'nor has it diminished.', "despite their various and strenuous efforts to maintain recent profit performance, banks' earning rates are likely to remain under strong downward pressure in coming years.", 'eliminating excess capital and cutting into operating costs cannot provide continuous relief.', 'indeed, it seems unrealistic to think that average roes of over 15 per cent could continue in a world of 2 per cent inflation and a return on long bonds between 6 and 7 per cent.', 'one has to go back to the regulated, less competitive world of the early 1970s to find comparable margins between bank earnings and bond yields.', 'supervision of bank capital i referred earlier to banks managing their capital more actively.', "the rba's main supervision task this year has been extending the capital adequacy rules to cover the market risks in banks' trading books -- that is, the risks from fluctuations in interest rates, exchange rates, equity prices and commodity prices.", "the new guidelines become effective at the beginning of 1998. the novel feature of the market risk guidelines, which were developed by the basle committee on banking supervision and are being adopted internationally, is the reliance they allow to be placed on banks' own risk management systems.", 'banks have the option of using their internal models to calculate required capital, or of employing a standard model specified by the basle committee.', 'of course, internal models need to meet certain minimum standards -- both quantitative and qualitative -- before they will be accepted for supervisory purposes.', 'a bank whose systems are not up to scratch will have to use the standard model.', 'the rba must sign off on the adequacy of internal systems.', 'but the onus for effective day-to-day risk management will remain squarely with the boards and senior management of banks.', "as an aside, during the past year we introduced arrangements under which a bank's chief all executive, with the endorsement of the board, must attest to the rba that key risks have been identified, that systems have been designed to manage those risks, that the descriptions of those systems held by the rba are current and that the systems are working effectively.", 'we are already seeing important general benefits from these new arrangements.', 'they have resulted in more high-level attention to risk management systems and the system descriptions provided to us.', 'chief executives now need to see those manuals, which were previously often regarded as an administrative inconvenience for officers handling liaison with the rba.', 'this has added discipline and rigour to the whole risk management process.', 'eleven banks have applied to us for internal model status under the market risk rules, and they are all presently upgrading their existing risk measurement and management practices to meet the minimum requirements.', 'as well as to measurement methodology, they are giving attention to such features as the adequacy of separation of front- and back-office operations, procedures to ensure that traders deal only in products for which robust operational and legal arrangements are in place, the rigour of revaluation processes and procedures for stress testing and back testing.', 'we remain hopeful that, by the end of the year, all internal models will have reached a standard with which we can be comfortable, but there is a good deal of work still to be done in some cases.', 'another eleven banks plan to use the standard model for market risk, while the remainder have insufficient market risks to be affected by the new guidelines or are branches, covered by their home country supervisors.', 'our assessment remains that the new arrangements will not add materially to required capital for the banking system as a whole.', "however, the impact on individual capital ratios will vary, depending on the scope of each bank's trading activities.", 'for some there will be an increase.', 'for others, required capital may actually fall, as the benefits from substituting specific market risk charges for existing credit risk capital will outweigh the additional capital needed for general market risks.', "the next question about supervision of banks' capital is whether the present rules covering credit risk might be replaced by a more sophisticated methodology more in line with the market risk framework.", 'the current rules are relatively crude, in the sense that capital ratios are applied against very broad categories of credit exposure without any firm basis in the actual likelihood of loss.', 'in the way that potential losses from a portfolio of traded instruments can be estimated using historical data on daily price movements, potential losses from a portfolio of loans can, in principle, be estimated from an examination of default histories.', 'supervisors would add a mark-up for safety to these estimates, as they have in the case of market risk.', 'lack of reliable data on defaults and credit losses has been a major obstacle to this approach.', 'but banks are working to remedy this, and are making progress toward putting the management of credit risk onto a more objective/scientific basis.', 'modelling techniques can be applied more easily to some components of a loan portfolio -- such as high-volume, standard housing and credit card receivables -- than to others.', 'for this reason, an incremental approach to recognising models for credit risk supervision is likely to emerge.', '- 4 - there is probably quite a way to go before credit risk is generally as amenable to modelling as market risk is.', 'and since credit risk remains potentially the greatest threat to the soundness of banks and banking systems, supervisors are likely to be conservative about changes to the present rules, with all their imperfections.', 'implications of new government policies there is clearly a lot of market-driven change "in the pipeline" for banks.', "the government's policy decisions following the financial system inquiry will further alter the environment for banks and others in coming years.", 'those policy changes, announced by the treasurer early this month, have many dimensions.', 'i would like to talk about just two of those -- effects on competition in banking and on the payments system.', 'there is no doubt that the proposed policy changes will increase competition, by widening the range of potential players in both deposit-taking and in retail payments.', '(there will be less change as far as lending is concerned; apart from the need to conform with the consumer protection provisions of the uniform credit laws, there are already few regulatory impediments to the entry of new lenders -- as the recent history of home lending shows clearly enough.)', 'the new rules should add to competition in deposit-taking in several ways.', 'first, creating a single licensing regime for all deposit-taking institutions (dtis) should help to level the proverbial playing field among credit unions, building societies and banks.', 'a single depositor protection system -- based on depositors having prior claim over the assets of a troubled institution -- will be a key element in this.', 'the actual impact of the new regime on the competitive standing of the various dti groups will, of course, depend on the effectiveness of the smaller institutions in promoting their new status.', 'under the single licensing regime banks will still constitute a particular category among deposit-takers, but distinguished primarily by their size.', 'only institutions with at least $50 million in tier 1 capital, and having a settlement account with the rba, will be able to use the label "bank".', 'the single regulatory regime will, in principle, allow smaller dtis to grow into this status more readily than they can now.', 'under new policy, mutual organisations will be able to have a banking licence, or to own a bank -- subject, of course, to satisfying prudential qualifications.', 'previously, it was possible for mutuals to be associated only with non-bank dtis.', 'it will also be open for banks to be established under non-operating holding company structures.', 'until now, with limited exceptions, a bank itself has had to be the holding company of a financial group.', 'no doubt some groups will, for one reason or another, see commercial advantage from reorganising an existing operation under a holding company, or in establishing a new bank under such a structure.', 'it seems likely that groups with bancassurance or allfinanz aspirations will go this way.', 'for some financial groups, the possibility in future of having more than one banking authority (or licence), or a banking authority and a non-bank deposit-taking licence, will also be seen as helpful to their competitive position.', 'moreover, the government has foreshadowed that the new licensing agency -- the australian prudential regulation authority (apra) -- will have a more flexible attitude to the mixing of financial and non-financial activities in the one group.', 'but this does not mean "open slather".', 'the general presumption in favour of dispersed ownership of banks and other deposit-takers will remain -- with individual shareholdings above 15 per cent needing to pass a national interest test.', 'and there will be a "demonstrable congruity" test for non-financial activities to sit alongside a bank in a conglomerate.', 'the interpretation and administration of this test will be for the new agency, but the treasurer has referred to cases "where financial products can be logically bundled with a supply of non-financial goods and services", and has indicated that apra\'s assessment of applications will be guided by international trends.', 'one can readily imagine activities such as information-processing and communication of various kinds passing a congruence test.', 'there could well be others over time.', 'incidentally, the intention clearly is that licensed deposit-takers will still be distinct legal entities with dedicated capital, separate management systems and so on.', 'a non-financial company might be able to own a bank, but it could not be licensed in its own right as a bank or other deposit-taker.', 'one can only speculate about the exact effects of these reforms on the evolution of banking and finance in australia over coming years.', 'these effects will be intermingled with those of technological change, global pressures, the administration of merger policy, and so on.', 'but it seems clear enough that more flexibility in entry rules for new players, and more flexibility in corporate structures, will add to competition and make life a little tougher (at least) for the established deposit-takers.', 'this will be another force bearing down on margins and profitability.', 'one should not forget, of course, that these policy reforms will open up opportunities (such as for holding company structures) previously denied to existing players too.', 'and the eventual elimination of the non-callable deposit regime will remove another sort of unevenness in the playing field -- one which currently penalises authorised banks relative to the non-bank dtis and merchant banks.', 'let me turn now to the payments system where similar forces will be at work.', "from the rba's perspective there are three main changes in store.", 'one is that participants in the payments system, other than deposit-takers, could qualify for an exchange settlement account (esa) at the rba.', 'the treasurer\'s statement said: "while the immediate scope for greater access is likely to be limited, access will not be constrained to licensed banks or other deposit-taking institutions".', 'new opportunities might, consequently, be available to companies offering payment services based on credit facilities, such as credit cards.', 'with an esa, they would be able to offer final settlement of payment obligations to other institutions in their own right, rather than having to negotiate an agency arrangement with a bank.', 'while the details are yet to be worked out -- by the rba in this case -- two prerequisites for esa access will be: no reduction in the safety and stability of the payments system; and • • access only for institutions which provide, or propose to provide, extensive third party transactions (as opposed to companies making transactions on their own account).', 'again, we are not talking "free-for-all", but we are talking a markedly broader range of payments opportunities for non-traditional players.', 'a second change is that the rba will have regulatory power over widely-used stored-value instruments -- such as cards, internet tokens and even travellers cheques -- where their issuer is not a licensed deposit-taker.', 'this will be prudential regulation aimed at reducing systemic risks and preserving public confidence in the various forms of electronic cash.', '- 6 - the more general, and most significant, reform in payments policy is that the rba will be given formal, statutory responsibilities for the payments and settlements system, with powers to back them up.', 'its responsibilities will cover not only issues of stability and safety, but will extend to the efficiency and competitiveness of the system, including questions of fair access for new payments providers.', 'the rba will be required, for instance, to look into the fees and charges levied by the established players on newcomers wishing to join existing networks, or to use existing infrastructure.', 'to carry out these responsibilities, we will need to develop criteria for assessing the acceptability of membership and third party access provisions in the various payments clearing streams.', "we will also produce and publish benchmarks for judging the safety and efficiency of australia's payments system.", 'when the rtgs system commences for high-value payments in the first half of 1998, a major step will have been taken to reduce risk and improve safety in domestic payments.', 'we will be encouraging as many payments as practicable to move onto that system.', 'the next major frontier is to reduce the settlement risks of australian banks in their international transactions.', 'this will be, if anything, more challenging than domestic rtgs has been, but some progress is being made internationally.', 'i suspect that there is as much to be done to improve the efficiency of the australian payments system and the "fairness" of access arrangements to retail payments streams.', 'the accc has recently found wanting the basis on which smaller players may negotiate participation in the eftpos system.', "i should emphasise that it will be the rba's intention to adopt as light a regulatory touch as possible over the payments system.", 'there has, after all, been a good deal of recent progress in reforming that system without the bank having explicit powers.', 'we hope such progress will continue -- through the australian payments clearing association and other industry-based bodies.', 'only where payments arrangements fall short of our efficiency and safety benchmarks -- and there are no serious attempts by the industry to rectify that position reasonably quickly -- will we embark on the path of prescriptive regulation.', 'end piece it is a truism that change is always with us.', 'but i suspect that banks face more than their fair share of it in coming years.', 'i hope my remarks will be useful background for your speculation about the details of this change over the next couple of days.']	Graeme J. Thompson	Reserve Bank of Australia	Deputy Governor	Australia
https://www.bis.org/review/r971001f.pdf	Mr. Bäckström elucidates the problems Sweden went through in the early 1990s, and considers whether other countries might draw lessons from the Swedish experience (Central Bank Articles and Speeches, 29 Aug 87)	Talk given by the Governor of the Swedish Riskbank, Mr. Urban Bäckström, at the Jackson Hole symposium organised by the Federal Reserve Bank of Kansas City on 29/8/87.	1997-08-29 00:00:00	Mr. Bäckström elucidates the problems Sweden went through in the early 1990s, and considers whether other countries might draw lessons from the Swedish experience Talk given by the Governor of the Swedish Riskbank, Mr. Urban Bäckström, at the Jackson Hole symposium organised by the Federal Reserve Bank of Kansas City on 29/8/87. First a word of thanks to the Federal Reserve Bank of Kansas City for the invitation to discuss the financial problems Sweden went through in the early 1990s. I shall also try to draw some conclusions from our experiences that may be relevant for other countries. Before I came to Sveriges Riksbank I was State Secretary at the Ministry of Finance and involved among other things in the management of Sweden's financial crisis. While there had, of course, been a good many indications of mounting problems, I was personally made formally aware of the acute and severe financial crisis by a phone call. At the beginning of October 1991, I had been in the job just a few days when I got a call from the head of the Financial Supervisory Authority (banking supervision in Sweden is performed by this authority, not by the central bank). He wanted to inform the Government that a large Swedish bank had more than exhausted its equity capital and would have to go bankrupt if a reconstruction could not be arranged. While working at the Ministry of Finance on the initial problems in the banking sector we started to study historical and international records of financial crises. Irving Fisher's well-known paper in Econometrica, "The Debt-Deflation Theory of Great Depressions," from 1933 provided inspiration. We also came across a new volume, "The Risk of Economic Crisis", edited by Martin Feldstein and containing interesting contributions by, among others, Benjamin Friedman, Paul Krugman, Lawrence Summers and our chairman today, E. Gerald Corrigan. The conclusion from these sources was that a fall in asset prices, such as we had in Sweden, may create problems for private sector balance sheets, affect the supply of credit and result in payment system disturbances. Step by step this may affect spending decisions by households and firms, thereby impinging on general economic activity. A destabilised financial system can bring the economy into what Fisher termed "debt deflation", that is, a situation where the financial crisis may become very serious and protracted. Thus it was important both to avoid a widespread failure of Swedish banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis. But here first is a brief account of the Swedish crisis. The Swedish crisis - what happened? The economic problems in Sweden in the early 1990s should be seen in their historical context. For several reasons, economic growth in Sweden has been relatively weak ever since about 1970. Following the collapse of the Bretton Woods system the creation of a stable macroeconomic environment turned out to be difficult. Wage formation functioned badly, fiscal policy was unduly weak and this was gradually compounded by structural problems. Credit market deregulation in 1985, necessary in itself, meant that the monetary conditions became more expansionary. This coincided, moreover, with rising activity, relatively high inflation expectations, a tax system that favoured borrowing, and remaining exchange controls that restrained investment in foreign assets. In the absence of a more restrictive economic policy to parry all this, the freer credit market led to a rapidly growing stock of debt (see Fig.). In the course of only five years the GDP ratio for private sector debt moved up from 85 to 135 per cent. The credit boom coincided with rising share and real estate prices. During the second half of the 1980s real aggregate asset prices increased by a total of over 125 per cent. A speculative bubble had been generated. The expansion of credit was also associated with increased real economic demand. Private financial saving dropped by as much as 7 percentage points of GDP and turned negative. The economy became overheated and inflation accelerated. Sizeable current-account deficits, accompanied by large outflows of direct-investment and other long-term capital (once exchange control had been finally abandoned in the late 1980s), led to a growing stock of private sector short-term debt in foreign currency. Step by step the Swedish economy became increasingly vulnerable to shocks. During 1990 matters came to a head. Competitiveness had been eroded by the relatively high inflation in the late 1980s, resulting in an overvalued currency. This caused exports to weaken and meant that the fixed exchange rate policy began to be questioned, leading to periods with relatively high nominal interest rates. Moreover, the tax system was reformed in order to reduce its harmful economic effects, but this also contributed to higher post-tax interest rates. Asset prices began to fall and economic activity turned downwards. Between the summers of 1990 and 1993 GDP dropped by a total of 6 per cent. Aggregate unemployment shot up from 3 to 12 per cent of the labour force and the public sector deficit worsened to as much as 12 per cent of GDP. A tidal wave of bankruptcies was a heavy blow to the banking sector, which in this period had to make provisions for loan losses totalling the equivalent of 12 per cent of annual GDP. While this course of events stemmed, as I have indicated, from a variety of factors, it was no doubt the financial vulnerability that helped make it so dramatic. The Swedish economy was steadily approaching a situation that entailed both a banking and a currency crisis. Matters were most acute in the fall of 1992 in conjunction with the European currency unrest. The crisis in banking was triggered, not by a classic bank run but by a loss of international confidence and difficulties with international financing. In many respects the crisis in Sweden resembled what has happened in a number of other countries. By the summer of 1993 the economy was becoming more stable and the problems in banking receded. Fiscal and monetary policy contributed to this and so did a deliberate policy of handling problem banks. The private sector's financial balance underwent a dramatic change, moving from a deficit of about 8 per cent of GDP in 1990 to a financial surplus of over 11 per cent in 1993. This was a swing of almost 20 percentage points of GDP in the course of only three years. A good deal of the swing no doubt came from private sector adjustments to cope with insufficient solvency. Falling asset prices in conjunction with high debt levels lead to balance-sheet problems in the private sector. The automatic stabilisers in the government budget probably helped to lessen the contraction of GDP. This meant that business profits and household disposable income were sustained relatively well. But it also entailed a massive increase in the budget deficit and this in turn generated new problems. The government debt trend became unsustainable and economic policy's credibility was weakened. In the early stages of the crisis, monetary policy was directed to maintain the fixed exchange rate. This line had broad support among the general public as well as in the political system. The aim was to establish a low-inflation policy once and for all. But in spite of major efforts, both political and economic, the international currency unrest in November 1992 meant that the fixed exchange rate had to be abandoned. It was replaced by a flexible exchange rate and an explicit inflation target. This resulted in a considerable depreciation of Sweden's currency, but during 1993 the continued fall in international bond rates meant that Swedish interest rates also moved down to levels that were comparatively low. Together with the Riksbank's reduction of its instrumental rate, this gave the monetary conditions a stimulatory turn. It also helped to stabilise both the economy and the banking system. Lower market rates eased the fall in asset prices, lightened the burden of servicing private sector debt and mitigated the negative impact on the financial system. Rescuing the banking sector was necessary to avoid a collapse of the real economy. There is no evidence that a credit crunch developed, though anecdotal information did suggest that creditors became more restrictive. I shall be returning shortly and in more detail to how the banking problems were tackled. In 1994, the major budget problems and the expansionary monetary conditions rebounded. Inflation expectations began to move up in many parts of the economy and when interest rates increased worldwide in the spring of 1994, bond rates in Sweden rose much more than in other countries - from just under 7 per cent to over 12 per cent in a few months. This was accompanied by a further weakening of the exchange rate to levels that were appreciably below any reasonable assessment of the real equilibrium rate. The situation called, in other words, for an economic policy realignment -- for what we can call aftercare -- once the acute financial crisis had been checked. A major consolidation of government finance was launched, accompanied by a tightening of the monetary stance which demonstrated that the 2 per cent inflation target was to be taken seriously. In time, this course has enhanced economic policy's credibility and led to more permanent economic stabilisation. Management of the bank crisis To those of us who were working on the initial banking problems it was soon clear that the crisis in Swedish banking could become very serious. In spring 1992, preparations were therefore made to cope with a variety of conceivable situations. Later we found that our worst-case scenario was on the verge of happening. Looking back, one can see that in the course of the crisis the seven largest banks, with 90 per cent of the market, all suffered heavy losses. In these years their aggregate loan losses amounted to the equivalent of 12 per cent of Sweden's annual GDP. The stock of non-performing loans was much larger than the banking sector's total equity capital and five of the seven largest banks were obliged to obtain capital contributions from either the State or their owners. It was thus truly a matter of a systemic crisis. In connection with a serious financial crisis it is important first and foremost to maintain the banking system's liquidity. It is a matter of preventing large segments of the banking system from failing on account of acute financing problems. In September 1992, the Government and the Opposition jointly announced a general guarantee for the whole of the banking system. The Riksdag, Sweden's parliament, formally approved the guarantee that December. This broad political consensus was I believe of vital importance and made the prompt handling of the financial crisis possible. The bank guarantee provided protection from losses for all creditors except shareholders. The Government's mandate from Parliament was not restricted to a specific sum and its hands were also very free in other respects. This necessitated close cooperation with the political opposition in the actual management of the banking problems. The decision was of course troublesome and far-reaching. Besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard. The political system concluded that in the event of widespread failures in the banking system, the national economy would suffer major repercussions. The direct outlays in connection with the capital injection into the banking sector added up to just over 4 per cent of GDP. However, it is now calculated that most of this can be recovered. One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders. A separate authority was set up to administer the bank guarantee and manage the banks that landed in a crisis and faced problems with solvency, though the crucial decisions about the provision of support were ultimately a matter for the Government. A clear separation of roles was achieved between the political level and the authorities, as well as between different authorities. Naturally this did not preclude very close cooperation between the Ministry of Finance, the Bank Support Authority, the Financial Supervisory Authority and the Riksbank. It was up to the Riksbank to supply liquidity on a relatively large scale at normal interest and repayment terms, but not to solve problems of bank solvency. Collateral was not required for the loans to banks, neither intraday nor overnight. The banking system was free to obtain unlimited liquidity by drawing on its accounts with the central bank. The bank guarantee meant that the solvency of the Riksbank was not at risk. In order to offset the loss of foreign credit lines to Swedish banks, during the height of the crisis the Riksbank also lent large amounts in foreign currency. Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria. The banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable. Knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries. The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank's current income for a gradual write-down of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long-run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point. With the other method, an open account of all expected losses and writedowns is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended. The Swedish authorities opted for the second method: disclose expected loan losses and assign realistic values to real estate and other assets. This method was consistent with other basic principles for the bank support, such as the need to restore confidence. Looking back, it can be said that in general the level of valuation was realistic. Since the acute crisis had been triggered by difficulties in obtaining international finance, great pains were taken to give a transparent picture of how the crisis was being managed, so as to gain the confidence of Sweden's creditors. This applied both to the account of the magnitude of the banking problems and to the content of the bank guarantee. Various informative projects were arranged for this purpose throughout the world. In Sweden, too, considerable efforts were made to legitimise the measures and their costs. The banking problems did arouse a lively debate in Swedish society, but the work could still be done in broad political consensus, which was a great advantage. The bank guarantee was terminated in 1996 and replaced with a deposit guarantee that is financed entirely by the banks. Conclusions The problems in the Swedish banking system at the beginning of this decade seem to have been more extensive than those which arose in Sweden in the early 1920s. The two periods also differ substantially in the management of the crisis. This may have had a bearing on the very different course of events in these two crises. In the early 1920s, the fall in GDP totalled 18 per cent and the price level dropped 30 per cent in the course of two years. In the 1990s the loss of GDP stopped at around 6 per cent and the price trend did not become really deflationary. Allow me now to summarise what I consider to be the most important lessons from Sweden's financial crisis: 1. Prevent the conditions for a financial crisis The primary conclusion from our experience of Sweden's financial crisis is that various steps should be taken to ensure that the conditions for a financial crisis do not arise. - Fundamentally it is a matter of conducting a credible economic policy focused on price stability. This provides the prerequisites for a monetary policy reaction to excessive increases in asset prices and credit stocks that would be liable to boost inflation and create the type of speculative climate that paves the way to a financial crisis. - Looking back, it can be said that if various indicators that commonly form the background to a financial crisis had been followed systematically, then incipient problems could have been detected early on. That in turn could have influenced the conduct of fiscal and monetary policy so that Sweden's financial crisis was contained or even prevented. In spite of the evident signs, few -- if any -- in the public discussion warned of what might happen. Martin Feldstein offers an interesting explanation in his introduction to "The Risk of Economic Crisis" from 1991. At that time, the industrialised world had not experienced an outright financial crisis since the 1930s. As a result, economists had devoted relatively little work to the analysis of this subject, being more concerned to understand the more normal economic world. This symposium is a positive sign that matters have changed in that respect. The conclusion drawn by the Riksbank is that various indicators must be followed systematically with the aim of detecting any signs of potential financial problems and systemic risks. - In Sweden's case the supervisory authority was not prepared for the new environment that emerged after credit market deregulation. This meant that during the 1980s the banks were able to grant loans on doubtful and sometimes even directly unsound grounds without any supervisory intervention. In addition, in many cases the loans were poorly documented. The lesson from this is that much must be required of a supervisor operating in an environment characterised by deregulated markets. 2. If a financial crisis does occur In a sense all major financial crises are unique and therefore difficult to prepare for and avoid. Once a crisis is about to develop there are some important lessons concerning its handling that can be learnt. - If an economy is hit by a financial crisis, the first important step is to maintain liquidity in the banking system and prevent the banking system from collapsing. For the management of Sweden's banking crisis the political consensus was of major importance for the payment system's credibility among the Swedish public as well as among the banking system's creditors throughout the world. The transparent approach to the banking problems and the various projects for spreading information no doubt had a positive effect, too. - The prompt and transparent handling of the banking sector problems is also important. The terms for recapitalisation should be such as to avoid moral hazard problems. - Automatic stabilisers in the government budget and stimulatory monetary conditions can help to mitigate the economy's depressive tendencies, but they also entail risks. Economic policy has to strike a fine balance so that inflation expectations do not rise, the exchange rate weakens and interest rates move up, which could do more harm than good. In this respect a small, open economy has less freedom of action than a larger economy. - It is important both to avoid a widespread failure of banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis. References Feldstein, M., (ed.), (1991), The Risk of Economic Crisis, NBER Conference Report, University of Chicago Press, Chicago and London. Fisher, I., (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, vol. 1 (October), pp. 337-357. Ingves, S. and Lind, G., (1996), The management of the bank crisis - in retrospect, Quarterly Review, No. I, pp. 5-18, Sveriges Riksbank.	['mr. bäckström elucidates the problems sweden went through in the early 1990s, and considers whether other countries might draw lessons from the swedish experience talk given by the governor of the swedish riskbank, mr. urban bäckström, at the jackson hole symposium organised by the federal reserve bank of kansas city on 29/8/87.', 'first a word of thanks to the federal reserve bank of kansas city for the invitation to discuss the financial problems sweden went through in the early 1990s.', 'i shall also try to draw some conclusions from our experiences that may be relevant for other countries.', "before i came to sveriges riksbank i was state secretary at the ministry of finance and involved among other things in the management of sweden's financial crisis.", 'while there had, of course, been a good many indications of mounting problems, i was personally made formally aware of the acute and severe financial crisis by a phone call.', 'at the beginning of october 1991, i had been in the job just a few days when i got a call from the head of the financial supervisory authority (banking supervision in sweden is performed by this authority, not by the central bank).', 'he wanted to inform the government that a large swedish bank had more than exhausted its equity capital and would have to go bankrupt if a reconstruction could not be arranged.', 'while working at the ministry of finance on the initial problems in the banking sector we started to study historical and international records of financial crises.', 'irving fisher\'s well-known paper in econometrica, "the debt-deflation theory of great depressions," from 1933 provided inspiration.', 'we also came across a new volume, "the risk of economic crisis", edited by martin feldstein and containing interesting contributions by, among others, benjamin friedman, paul krugman, lawrence summers and our chairman today, e. gerald corrigan.', 'the conclusion from these sources was that a fall in asset prices, such as we had in sweden, may create problems for private sector balance sheets, affect the supply of credit and result in payment system disturbances.', 'step by step this may affect spending decisions by households and firms, thereby impinging on general economic activity.', 'a destabilised financial system can bring the economy into what fisher termed "debt deflation", that is, a situation where the financial crisis may become very serious and protracted.', 'thus it was important both to avoid a widespread failure of swedish banks and to bring about a macroeconomic stabilisation.', 'the two are interdependent.', 'the collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis.', 'but here first is a brief account of the swedish crisis.', 'the swedish crisis - what happened?', 'the economic problems in sweden in the early 1990s should be seen in their historical context.', 'for several reasons, economic growth in sweden has been relatively weak ever since about 1970. following the collapse of the bretton woods system the creation of a stable macroeconomic environment turned out to be difficult.', 'wage formation functioned badly, fiscal policy was unduly weak and this was gradually compounded by structural problems.', 'credit market deregulation in 1985, necessary in itself, meant that the monetary conditions became more expansionary.', 'this coincided, moreover, with rising activity, relatively high inflation expectations, a tax system that favoured borrowing, and remaining exchange controls that restrained investment in foreign assets.', 'in the absence of a more restrictive economic policy to parry all this, the freer credit market led to a rapidly growing stock of debt (see fig.).', 'in the course of only five years the gdp ratio for private sector debt moved up from 85 to 135 per cent.', 'the credit boom coincided with rising share and real estate prices.', 'during the second half of the 1980s real aggregate asset prices increased by a total of over 125 per cent.', 'a speculative bubble had been generated.', 'the expansion of credit was also associated with increased real economic demand.', 'private financial saving dropped by as much as 7 percentage points of gdp and turned negative.', 'the economy became overheated and inflation accelerated.', 'sizeable current-account deficits, accompanied by large outflows of direct-investment and other long-term capital (once exchange control had been finally abandoned in the late 1980s), led to a growing stock of private sector short-term debt in foreign currency.', 'step by step the swedish economy became increasingly vulnerable to shocks.', 'during 1990 matters came to a head.', 'competitiveness had been eroded by the relatively high inflation in the late 1980s, resulting in an overvalued currency.', 'this caused exports to weaken and meant that the fixed exchange rate policy began to be questioned, leading to periods with relatively high nominal interest rates.', 'moreover, the tax system was reformed in order to reduce its harmful economic effects, but this also contributed to higher post-tax interest rates.', 'asset prices began to fall and economic activity turned downwards.', 'between the summers of 1990 and 1993 gdp dropped by a total of 6 per cent.', 'aggregate unemployment shot up from 3 to 12 per cent of the labour force and the public sector deficit worsened to as much as 12 per cent of gdp.', 'a tidal wave of bankruptcies was a heavy blow to the banking sector, which in this period had to make provisions for loan losses totalling the equivalent of 12 per cent of annual gdp.', 'while this course of events stemmed, as i have indicated, from a variety of factors, it was no doubt the financial vulnerability that helped make it so dramatic.', 'the swedish economy was steadily approaching a situation that entailed both a banking and a currency crisis.', 'matters were most acute in the fall of 1992 in conjunction with the european currency unrest.', 'the crisis in banking was triggered, not by a classic bank run but by a loss of international confidence and difficulties with international financing.', 'in many respects the crisis in sweden resembled what has happened in a number of other countries.', 'by the summer of 1993 the economy was becoming more stable and the problems in banking receded.', 'fiscal and monetary policy contributed to this and so did a deliberate policy of handling problem banks.', "the private sector's financial balance underwent a dramatic change, moving from a deficit of about 8 per cent of gdp in 1990 to a financial surplus of over 11 per cent in 1993. this was a swing of almost 20 percentage points of gdp in the course of only three years.", 'a good deal of the swing no doubt came from private sector adjustments to cope with insufficient solvency.', 'falling asset prices in conjunction with high debt levels lead to balance-sheet problems in the private sector.', 'the automatic stabilisers in the government budget probably helped to lessen the contraction of gdp.', 'this meant that business profits and household disposable income were sustained relatively well.', 'but it also entailed a massive increase in the budget deficit and this in turn generated new problems.', "the government debt trend became unsustainable and economic policy's credibility was weakened.", 'in the early stages of the crisis, monetary policy was directed to maintain the fixed exchange rate.', 'this line had broad support among the general public as well as in the political system.', 'the aim was to establish a low-inflation policy once and for all.', 'but in spite of major efforts, both political and economic, the international currency unrest in november 1992 meant that the fixed exchange rate had to be abandoned.', 'it was replaced by a flexible exchange rate and an explicit inflation target.', "this resulted in a considerable depreciation of sweden's currency, but during 1993 the continued fall in international bond rates meant that swedish interest rates also moved down to levels that were comparatively low.", "together with the riksbank's reduction of its instrumental rate, this gave the monetary conditions a stimulatory turn.", 'it also helped to stabilise both the economy and the banking system.', 'lower market rates eased the fall in asset prices, lightened the burden of servicing private sector debt and mitigated the negative impact on the financial system.', 'rescuing the banking sector was necessary to avoid a collapse of the real economy.', 'there is no evidence that a credit crunch developed, though anecdotal information did suggest that creditors became more restrictive.', 'i shall be returning shortly and in more detail to how the banking problems were tackled.', 'in 1994, the major budget problems and the expansionary monetary conditions rebounded.', 'inflation expectations began to move up in many parts of the economy and when interest rates increased worldwide in the spring of 1994, bond rates in sweden rose much more than in other countries - from just under 7 per cent to over 12 per cent in a few months.', 'this was accompanied by a further weakening of the exchange rate to levels that were appreciably below any reasonable assessment of the real equilibrium rate.', 'the situation called, in other words, for an economic policy realignment -- for what we can call aftercare -- once the acute financial crisis had been checked.', 'a major consolidation of government finance was launched, accompanied by a tightening of the monetary stance which demonstrated that the 2 per cent inflation target was to be taken seriously.', "in time, this course has enhanced economic policy's credibility and led to more permanent economic stabilisation.", 'management of the bank crisis to those of us who were working on the initial banking problems it was soon clear that the crisis in swedish banking could become very serious.', 'in spring 1992, preparations were therefore made to cope with a variety of conceivable situations.', 'later we found that our worst-case scenario was on the verge of happening.', 'looking back, one can see that in the course of the crisis the seven largest banks, with 90 per cent of the market, all suffered heavy losses.', "in these years their aggregate loan losses amounted to the equivalent of 12 per cent of sweden's annual gdp.", "the stock of non-performing loans was much larger than the banking sector's total equity capital and five of the seven largest banks were obliged to obtain capital contributions from either the state or their owners.", 'it was thus truly a matter of a systemic crisis.', "in connection with a serious financial crisis it is important first and foremost to maintain the banking system's liquidity.", 'it is a matter of preventing large segments of the banking system from failing on account of acute financing problems.', 'in september 1992, the government and the opposition jointly announced a general guarantee for the whole of the banking system.', "the riksdag, sweden's parliament, formally approved the guarantee that december.", 'this broad political consensus was i believe of vital importance and made the prompt handling of the financial crisis possible.', 'the bank guarantee provided protection from losses for all creditors except shareholders.', "the government's mandate from parliament was not restricted to a specific sum and its hands were also very free in other respects.", 'this necessitated close cooperation with the political opposition in the actual management of the banking problems.', 'the decision was of course troublesome and far-reaching.', 'besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard.', 'the political system concluded that in the event of widespread failures in the banking system, the national economy would suffer major repercussions.', 'the direct outlays in connection with the capital injection into the banking sector added up to just over 4 per cent of gdp.', 'however, it is now calculated that most of this can be recovered.', 'one way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.', 'a separate authority was set up to administer the bank guarantee and manage the banks that landed in a crisis and faced problems with solvency, though the crucial decisions about the provision of support were ultimately a matter for the government.', 'a clear separation of roles was achieved between the political level and the authorities, as well as between different authorities.', 'naturally this did not preclude very close cooperation between the ministry of finance, the bank support authority, the financial supervisory authority and the riksbank.', 'it was up to the riksbank to supply liquidity on a relatively large scale at normal interest and repayment terms, but not to solve problems of bank solvency.', 'collateral was not required for the loans to banks, neither intraday nor overnight.', 'the banking system was free to obtain unlimited liquidity by drawing on its accounts with the central bank.', 'the bank guarantee meant that the solvency of the riksbank was not at risk.', 'in order to offset the loss of foreign credit lines to swedish banks, during the height of the crisis the riksbank also lent large amounts in foreign currency.', 'banks applying for support had their assets valued by the bank support authority, using uniform criteria.', 'the banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable.', 'knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries.', 'the swedish bank support authority had to choose between two alternative strategies.', "the first method involves deferring the reporting of losses for as long as is legally possible and using the bank's current income for a gradual write-down of the loss making assets.", 'one advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long-run market values.', 'a serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise.', 'the handling of problems among savings and loan institution in the united states in the 1980s is a case in point.', 'with the other method, an open account of all expected losses and writedowns is presented at an early stage.', 'this clarifies the extent of the problems and the support that is required.', 'provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence.', 'it entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed.', 'this can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended.', 'the swedish authorities opted for the second method: disclose expected loan losses and assign realistic values to real estate and other assets.', 'this method was consistent with other basic principles for the bank support, such as the need to restore confidence.', 'looking back, it can be said that in general the level of valuation was realistic.', "since the acute crisis had been triggered by difficulties in obtaining international finance, great pains were taken to give a transparent picture of how the crisis was being managed, so as to gain the confidence of sweden's creditors.", 'this applied both to the account of the magnitude of the banking problems and to the content of the bank guarantee.', 'various informative projects were arranged for this purpose throughout the world.', 'in sweden, too, considerable efforts were made to legitimise the measures and their costs.', 'the banking problems did arouse a lively debate in swedish society, but the work could still be done in broad political consensus, which was a great advantage.', 'the bank guarantee was terminated in 1996 and replaced with a deposit guarantee that is financed entirely by the banks.', 'conclusions the problems in the swedish banking system at the beginning of this decade seem to have been more extensive than those which arose in sweden in the early 1920s.', 'the two periods also differ substantially in the management of the crisis.', 'this may have had a bearing on the very different course of events in these two crises.', 'in the early 1920s, the fall in gdp totalled 18 per cent and the price level dropped 30 per cent in the course of two years.', 'in the 1990s the loss of gdp stopped at around 6 per cent and the price trend did not become really deflationary.', "allow me now to summarise what i consider to be the most important lessons from sweden's financial crisis: 1. prevent the conditions for a financial crisis the primary conclusion from our experience of sweden's financial crisis is that various steps should be taken to ensure that the conditions for a financial crisis do not arise.", '- fundamentally it is a matter of conducting a credible economic policy focused on price stability.', 'this provides the prerequisites for a monetary policy reaction to excessive increases in asset prices and credit stocks that would be liable to boost inflation and create the type of speculative climate that paves the way to a financial crisis.', '- looking back, it can be said that if various indicators that commonly form the background to a financial crisis had been followed systematically, then incipient problems could have been detected early on.', "that in turn could have influenced the conduct of fiscal and monetary policy so that sweden's financial crisis was contained or even prevented.", 'in spite of the evident signs, few -- if any -- in the public discussion warned of what might happen.', 'martin feldstein offers an interesting explanation in his introduction to "the risk of economic crisis" from 1991. at that time, the industrialised world had not experienced an outright financial crisis since the 1930s.', 'as a result, economists had devoted relatively little work to the analysis of this subject, being more concerned to understand the more normal economic world.', 'this symposium is a positive sign that matters have changed in that respect.', 'the conclusion drawn by the riksbank is that various indicators must be followed systematically with the aim of detecting any signs of potential financial problems and systemic risks.', "- in sweden's case the supervisory authority was not prepared for the new environment that emerged after credit market deregulation.", 'this meant that during the 1980s the banks were able to grant loans on doubtful and sometimes even directly unsound grounds without any supervisory intervention.', 'in addition, in many cases the loans were poorly documented.', 'the lesson from this is that much must be required of a supervisor operating in an environment characterised by deregulated markets.', '2. if a financial crisis does occur in a sense all major financial crises are unique and therefore difficult to prepare for and avoid.', 'once a crisis is about to develop there are some important lessons concerning its handling that can be learnt.', '- if an economy is hit by a financial crisis, the first important step is to maintain liquidity in the banking system and prevent the banking system from collapsing.', "for the management of sweden's banking crisis the political consensus was of major importance for the payment system's credibility among the swedish public as well as among the banking system's creditors throughout the world.", 'the transparent approach to the banking problems and the various projects for spreading information no doubt had a positive effect, too.', '- the prompt and transparent handling of the banking sector problems is also important.', 'the terms for recapitalisation should be such as to avoid moral hazard problems.', "- automatic stabilisers in the government budget and stimulatory monetary conditions can help to mitigate the economy's depressive tendencies, but they also entail risks.", 'economic policy has to strike a fine balance so that inflation expectations do not rise, the exchange rate weakens and interest rates move up, which could do more harm than good.', 'in this respect a small, open economy has less freedom of action than a larger economy.', '- it is important both to avoid a widespread failure of banks and to bring about a macroeconomic stabilisation.', 'the two are interdependent.', 'the collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis.', 'references feldstein, m., (ed.', '), (1991), the risk of economic crisis, nber conference report, university of chicago press, chicago and london.', 'fisher, i., (1933), the debt-deflation theory of great depressions, econometrica, vol.', '337-357. ingves, s. and lind, g., (1996), the management of the bank crisis - in retrospect, quarterly review, no.']	Urban Bäckström	Sveriges Riksbank	Governor	Sweden
https://www.bis.org/review/r971001e.pdf	Mr. Kelley looks at the role of the Federal Reserve in the Payments System (Central Bank Articles and Speeches, 23 Sep 97)	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Bank Administration Institute's Symposium on Payments System Strategy, Washington, D.C. 23/9/97.	1997-09-23 00:00:00	Mr. Kelley looks at the role of the Federal Reserve in the Payments System Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Bank Administration Institute's Symposium on Payments System Strategy, Washington, D.C. 23/9/97. It is a pleasure to be here today to discuss the Federal Reserve's role in the evolving U.S. payments system, a role which is now under careful review. A great deal is going on in the payments industry and, of course, the Federal Reserve is squarely in the middle of the action. You are, too, and we all need to work together to shape the future of our payments systems to ensure that they are as strong as possible. Understanding where we have been and where we are today is an essential foundation for addressing where we wish to go in the future. Accordingly, I will briefly review the history of the role of the Federal Reserve in the payments system, share with you in some detail our ongoing review of that role, and outline some possible directions for the future. All individuals, businesses, and government entities in this country rely upon the smooth functioning of the payments system to purchase goods, pay for services, receive payments, and make investments. Today, all of us can be confident that the payments we initiate will be satisfactorily completed. Tomorrow, technology and regulatory changes will alter the face of the payments system. Interstate banking, which spread nearly nationwide this past June, consolidation in the banking industry, legislation that mandates that most government payments be made electronically by 1999, the opportunities provided by the Internet, and other technological developments, will also contribute to the continued evolution of payment options, payment choices, and payment needs. We, at the Federal Reserve, have been studying what our role in that evolution should be and how best to ensure that all users of payment services will continue to have confidence that their payments will be completed reliably and efficiently and that all banks will have access to payment services on a fair and equitable basis. Before I address the Federal Reserve's future role in the payments system, I would like to review how and why the Federal Reserve came to play its current role. In the 50 years following the Civil War, a series of severe financial crises swept the country, disrupting and undermining the national economy. During the financial panic of 1907 cash payments were largely suspended throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks. Otherwise solvent banks failed. The 1907 crisis and the lessons of failing to ensure a stable national economy were still fresh in the minds of Congress when they created the Federal Reserve System. Thus, when Congress passed the Federal Reserve Act in 1913, it directed the Federal Reserve to provide an elastic currency -- that is, a supply of currency in the quantities demanded by the public -- and gave it the authority to establish a nationwide check collection system. In 1917, Congress amended the Federal Reserve Act to prohibit banks from charging the Federal Reserve Banks presentment fees. These Congressional actions launched the Federal Reserve as an active participant in the payments system. Initially, the Reserve Banks fulfilled their role by providing check collection services and permitting member banks to issue transfer drafts to make payments anywhere in the country, which were paid in immediately available funds by any Reserve Bank. Gradually, as needs were identified and as technologies developed, the Reserve Banks added new payments services, beginning with the Fedwire funds transfer system in 1918, the book-entry securities service in 1968, and, finally, the automated clearing house (ACH) in the early 1970s. For much of the time, the Reserve Banks provided payment services to member banks without charge other than required reserves, and non-member banks had access to these services only through member banks. Everything changed in 1980, when Congress enacted the Monetary Control Act (MCA). A primary purpose of the MCA was to promote an efficient payments system by encouraging competition between the Federal Reserve and private-sector providers of payment services. The Act requires the Federal Reserve Banks to charge fees for their payment services, which must, over the long run, be set to recover all direct and indirect costs of providing the services. In addition, the MCA requires the Federal Reserve Banks to recover imputed costs, such as taxes and the cost of capital, and imputed profits that would have been earned if the services were provided by a private firm. Importantly, the MCA also extended reserve requirements to nonmember banks and granted all banks equal access to the Fed's payment services. Congress further expanded the role of the Federal Reserve in the payments system in 1987 when it enacted the Expedited Funds Availability Act (EFAA). For the first time, this act gave the Fed the authority to regulate check payments that were not processed by the Federal Reserve Banks. Thus, the EFAA significantly broadened the System's ability to ensure that the nation's check collection system is efficient and accessible. It also limited the time that a bank may hold funds before making them available to customers for withdrawal and directed the Federal Reserve to improve the process used to return unpaid checks to banks of first deposit. Thus, Congress has directed the Federal Reserve to ensure that the payments system in this country is efficient and effective, that it supports the economic needs of its citizens, and that it is available to all banks so that they can provide for the payment needs of their customers -- the end users of the payments system. To achieve these goals, Congress cast the Federal Reserve in the often difficult position of providing payment services, thereby competing with some of the institutions it regulates, and regulating the payments system in which it is an active participant. We are very mindful of these sometimes conflicting responsibilities and take great pains to ensure that each responsibility is addressed fairly and equitably. As service providers, the Federal Reserve Banks strive to operate in an efficient and cost-effective way. The Reserve Banks continually upgrade their computer and telecommunications systems so that increasing proportions of funds, book-entry, and ACH transactions can be processed without human intervention and, therefore, more accurately, rapidly, and cost effectively. Striving to serve their customers, the Reserve Banks offer a variety of products to meet the differing business requirements of large, mid-sized, and small institutions with widely divergent processing capabilities. For example, banks may obtain payment services from the Federal Reserve Banks using personal computers connected via switched, dial-in communications links or they may connect their mainframe computers to those in the Federal Reserve via dedicated high-speed telecommunications lines. Similarly, banks -- typically the larger ones -- may select check deposit products that require little sorting by the Reserve Banks, and they pay relatively low fees. Smaller banks may deposit checks in ways that meet their relatively greater sorting needs, thereby incurring higher fees, and many banks use a mix of these products. Importantly, because the Reserve Banks must compete for customers, they must provide services that meet or exceed the quality of other providers and must ensure that internal operations are efficient. As a regulator, the Federal Reserve has taken steps to improve the efficiency and effectiveness of the payments system, often with the full awareness that it was moving contrary to its own narrow competitive interests as a service provider. The Expedited Funds Availability Act of 1987, which was implemented through Regulation CC, included provisions designed to speed the processing of dishonored checks. In developing procedures to implement those provisions, the Federal Reserve, working with the banking industry, created a means to process returned checks on high speed equipment, which shortened return times by reducing the number of banks that might handle dishonored checks. More recently, in 1994, the Board modified Regulation CC to implement the same-day settlement rule, which broadened banks' ability to present checks to collecting banks directly and receive same-day funds in settlement. Direct presentments reduced the role of intermediaries, including the Reserve Banks, but it improved the efficiency of the payments system. As expected, the volume of checks collected through Reserve Banks has declined. This summarizes the history of our involvement in payments to date, and the situation on the surface looks quite stable. Why, then, is the Federal Reserve undertaking a fundamental review of its role? There are several reasons. First, as I have noted, the banking industry is in the midst of significant change. These changes are primarily evolutionary -- driven by advances in technology, by industry consolidation, and by regulations that now permit interstate branch banking. They do, however, provide the opportunity for revolutionary responses that may, with time, dramatically alter the face of the payments system. We need to understand and help to beneficially shape these forces. Second, from time to time, and certainly in a period of change such as this one, it is appropriate for any organization to reassess its mission and how it fulfills that mission. As you know, the United States remains far more dependent on paper checks for making payments than any other industrialized country, even though electronic transactions appear to be more efficient and less costly. As you also know, the Federal Reserve is the only institution that presents checks to all depository institutions nationwide. We suspect that industry consolidation and electronic technology may change the impact of our nationwide reach, but exactly how and when that might happen, and what would be appropriate responses, are not clear. Careful self-scrutiny is clearly timely. Finally, there are significant differences of opinion in the industry, and our society more generally, as to the appropriate payments role of the Federal Reserve. As a public service entity, the Federal Reserve should address these concerns. In light of all this, in October 1996, Chairman Greenspan asked me to serve on a committee that is led by Vice Chair Rivlin to examine the Federal Reserve's role in the payments system. The committee has been at work all year, and we expect to complete our task shortly. Let me now outline what we have done, how we have gone about it, and where it is leading us. To begin the study, the committee reviewed the general environment in which payments services are offered. The committee analyzed the economic factors influencing the supply of and demand for wholesale services -- that is, for the large-value and securities transfers that support the interbank market -- and retail services, primarily small dollar payments. We studied current trends in the financial services industry, including the development of new and emerging payment services, and our role in those markets. And, we examined how the Federal Reserve's participation in the payments system affects our ability to implement monetary policy decisions and to regulate and supervise banks. Based on its internal review, the committee decided to focus its study on the Federal Reserve Banks' retail payment services -- check and ACH. The committee excluded the wholesale systems because (1) these systems are efficient and effective now, (2) they are an important vehicle for controlling systemic risk, requiring very close monitoring, (3) they are an integral part in implementing monetary policy decisions, (4) they play an important role in providing everyday liquidity to financial markets, and (5) they provide certainty to payments system participants in times of financial stress. It is worth noting that most central banks in major economies, like the Federal Reserve, provide large-value funds transfer services to banks and many also provide some form of securities settlement and safekeeping services. This is not to imply that we are complacently satisfied with all aspects of our country's wholesale payment arrangements, but rather that we do not feel that a review of the Federal Reserve's role in them is needed at this time. The committee felt that it was critically important to this study that we draw on the insights and expertise of the banking industry and other payments system participants. We wanted to understand fully the dynamics of the payments system and the changes that the industry envisions over the next five to ten years, as well as the reasoning behind the varying views about the Federal Reserve's payments activities. Thus, the committee developed a series of hypothetical scenarios for Federal Reserve participation in the retail payments system that we discussed with industry representatives in a series of forums that were conducted last May and June. Some of you may have attended one of those forums. In total, we held ten national and fifty-two regional forums. Attendees represented a diverse group of payments system participants, including representatives from large and small banks, private payments system providers, corporations, trade associations, academicians, consultants, and emerging payments system service providers. In total, over 500 representatives from 473 organizations participated. To obtain the thoughts of these payments system participants, the Committee developed five hypothetical scenarios for the Federal Reserve's future role in the check and ACH payment services. These scenarios were not developed specifically as policy options but rather were intended solely to stimulate discussion. Because many of you are familiar with these scenarios, I will review them only briefly. In two scenarios the Federal Reserve would withdraw from participation in the check and ACH markets and in the remaining three scenarios, the Federal Reserve would continue to provide those services. In the first withdrawal scenario, the Federal Reserve would announce its intention to liquidate its check and ACH services, although we would take steps to provide for a smooth transition for our customers. In the second, the Federal Reserve envisioned selling its check and ACH services to a private-sector entity that would retain no privileged ties to the Federal Reserve. The three scenarios under which the Federal Reserve would continue to provide retail payment services to banks varied considerably. These scenarios envisioned future roles in which the Federal Reserve would (1) merely ensure that all banks had access to our existing check and ACH services, which many saw as a de facto exit strategy, (2) use our operational presence to stimulate development of more cost-effective and efficient payment methods, or (3) take aggressive steps to expedite the movement to an electronic-based retail payments system. To stimulate discussion about each scenario and its effect on the provision of retail payments, several key questions were introduced. For example, we asked what would happen to the prices and availability of retail payments in times of relative economic stability and in times of financial stress, such as in the Texas banking crisis. Another question asked was what participants thought would be the best way to transform our largely paper-based system to a more electronic one. What have we heard? As you would guess, there are various perspectives on the fundamental question of the appropriate role for the Federal Reserve in the payments system. Some believe that it is inappropriate for the Federal Reserve to provide payment services and that the private sector could provide essentially the same services at a lower cost and perhaps greater efficiency. Many others believe that, by providing payment services, the Federal Reserve ensures that all payments system participants will be able to access competitively priced payment services. While some believe that it is inappropriate for the Federal Reserve to regulate the industry in which it competes, others believe that by providing payment services, the Federal Reserve gains operational experience that makes it a better regulator. More specifically, participants had differing views on various aspects of these issues and the consequences of each scenario. Many were concerned that, if the Federal Reserve withdrew from these services, it would result in short-term service disruptions with few long-term benefits. Many indicated that prices for retail services would rise, and smaller banks and remotely located banks were concerned that they would have difficulty obtaining check and ACH services. Concern was expressed that without an operational presence, the Federal Reserve would have to regulate the retail payments system more extensively to ensure that all banks had access to the services. While not unanimous, there was strong support from institutions of all sizes for continued Federal Reserve provision of retail payment services. Some stated that because check payments would continue to dominate the U.S. payments system for the foreseeable future, the Federal Reserve should maintain its check services while consumers adapt to the use of electronic payments mechanisms. Others indicated that by establishing a more aggressive operational presence in the check and ACH services, the Federal Reserve could undertake initiatives to promote efficiency in general, and to encourage the use of electronics to collect checks in particular. Some indicated that private-sector service providers would prefer to invest in developing new markets and devising new technologies rather than in expanding their capacity to collect paper checks. They also indicated that they face significant resource demands to address other operational issues, such as the federal government's initiative to deliver almost all payments electronically by 1999 and preparation for the year 2000. No matter what their view about the Federal Reserve's continued presence in the retail payments market, virtually all participants believed that the Federal Reserve could play an important role in educating consumers about the benefits of electronic payments. While the committee has not reached detailed final conclusions, it is clear that the Federal Reserve can best ensure the safety and effectiveness of the nation's payments system by continuing to provide its existing retail payment services for checks and ACH, and we will so recommend. We agree with a recurring theme at the forums that there would likely be significant disruptions in the payments system if the Federal Reserve withdrew, with little net societal benefit. Currently, the banking industry is trying to grapple with a variety of technological issues, an effort that is requiring a great deal of resources. Banks are adopting the latest technological innovations to provide their customers with new and improved services and preparing to be century date change compliant. By continuing to provide payment services, the Federal Reserve would enable banks and service providers to continue to focus on these future oriented efforts. This would be far more productive, for example, than attempting to restructure an efficient, but dated, paper-based check collection system. But, as yet, the Committee has not decided on its specific recommendations for Federal Reserve involvement in retail payment services. Many issues identified and needing resolution are still "open." They include considering whether the Federal Reserve should assume a very aggressive operational and regulatory posture to convert all payments to electronics and whether we should launch an intensive public education campaign to inform consumers of the benefits of electronic transactions. We are also considering suggestions that we establish a regulatory regime that encourages electronic payments and discourages paper, that the Federal Reserve take the lead in establishing standards for electronic payments, and that we work toward a revised legal structure more suitable to an electronic environment. Operationally, the Federal Reserve might offer banks new products that take advantage of the latest technology and assist in their efforts to make their customers more comfortable with electronics. Also the Federal Reserve could conceivably open its secure communications to banks that want to offer their own electronic products. To summarize, wholesale payments are being made, at least for now, in a relatively settled regime. But, as we have been discussing, there is great activity in the retail arena. Indeed, many growing and innovative retail payments, such as credit card, debit card, smart card, and Internet payments, do not flow through the Federal Reserve at all, although some do settle using Federal Reserve services. All payments methods will continue to evolve, and the Federal Reserve's role will also evolve as we will continue to work to fulfill our mandate to foster a reliable, efficient, and accessible system. As we assess the options to achieve these goals, we pledge to carefully consider the industry's views concerning future Federal Reserve participation in the payments system and to work in close collaboration with the private sector every step of the way. _____________________________	["mr. kelley looks at the role of the federal reserve in the payments system remarks by mr. edward w. kelley, jr., a member of the board of governors of the us federal reserve system, before the bank administration institute's symposium on payments system strategy, washington, d.c. 23/9/97.", "it is a pleasure to be here today to discuss the federal reserve's role in the evolving u.s. payments system, a role which is now under careful review.", 'a great deal is going on in the payments industry and, of course, the federal reserve is squarely in the middle of the action.', 'you are, too, and we all need to work together to shape the future of our payments systems to ensure that they are as strong as possible.', 'understanding where we have been and where we are today is an essential foundation for addressing where we wish to go in the future.', 'accordingly, i will briefly review the history of the role of the federal reserve in the payments system, share with you in some detail our ongoing review of that role, and outline some possible directions for the future.', 'all individuals, businesses, and government entities in this country rely upon the smooth functioning of the payments system to purchase goods, pay for services, receive payments, and make investments.', 'today, all of us can be confident that the payments we initiate will be satisfactorily completed.', 'tomorrow, technology and regulatory changes will alter the face of the payments system.', 'interstate banking, which spread nearly nationwide this past june, consolidation in the banking industry, legislation that mandates that most government payments be made electronically by 1999, the opportunities provided by the internet, and other technological developments, will also contribute to the continued evolution of payment options, payment choices, and payment needs.', 'we, at the federal reserve, have been studying what our role in that evolution should be and how best to ensure that all users of payment services will continue to have confidence that their payments will be completed reliably and efficiently and that all banks will have access to payment services on a fair and equitable basis.', "before i address the federal reserve's future role in the payments system, i would like to review how and why the federal reserve came to play its current role.", 'in the 50 years following the civil war, a series of severe financial crises swept the country, disrupting and undermining the national economy.', 'during the financial panic of 1907 cash payments were largely suspended throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks.', 'otherwise solvent banks failed.', 'the 1907 crisis and the lessons of failing to ensure a stable national economy were still fresh in the minds of congress when they created the federal reserve system.', 'thus, when congress passed the federal reserve act in 1913, it directed the federal reserve to provide an elastic currency -- that is, a supply of currency in the quantities demanded by the public -- and gave it the authority to establish a nationwide check collection system.', 'in 1917, congress amended the federal reserve act to prohibit banks from charging the federal reserve banks presentment fees.', 'these congressional actions launched the federal reserve as an active participant in the payments system.', 'initially, the reserve banks fulfilled their role by providing check collection services and permitting member banks to issue transfer drafts to make payments anywhere in the country, which were paid in immediately available funds by any reserve bank.', 'gradually, as needs were identified and as technologies developed, the reserve banks added new payments services, beginning with the fedwire funds transfer system in 1918, the book-entry securities service in 1968, and, finally, the automated clearing house (ach) in the early 1970s.', 'for much of the time, the reserve banks provided payment services to member banks without charge other than required reserves, and non-member banks had access to these services only through member banks.', 'everything changed in 1980, when congress enacted the monetary control act (mca).', 'a primary purpose of the mca was to promote an efficient payments system by encouraging competition between the federal reserve and private-sector providers of payment services.', 'the act requires the federal reserve banks to charge fees for their payment services, which must, over the long run, be set to recover all direct and indirect costs of providing the services.', 'in addition, the mca requires the federal reserve banks to recover imputed costs, such as taxes and the cost of capital, and imputed profits that would have been earned if the services were provided by a private firm.', "importantly, the mca also extended reserve requirements to nonmember banks and granted all banks equal access to the fed's payment services.", 'congress further expanded the role of the federal reserve in the payments system in 1987 when it enacted the expedited funds availability act (efaa).', 'for the first time, this act gave the fed the authority to regulate check payments that were not processed by the federal reserve banks.', "thus, the efaa significantly broadened the system's ability to ensure that the nation's check collection system is efficient and accessible.", 'it also limited the time that a bank may hold funds before making them available to customers for withdrawal and directed the federal reserve to improve the process used to return unpaid checks to banks of first deposit.', 'thus, congress has directed the federal reserve to ensure that the payments system in this country is efficient and effective, that it supports the economic needs of its citizens, and that it is available to all banks so that they can provide for the payment needs of their customers -- the end users of the payments system.', 'to achieve these goals, congress cast the federal reserve in the often difficult position of providing payment services, thereby competing with some of the institutions it regulates, and regulating the payments system in which it is an active participant.', 'we are very mindful of these sometimes conflicting responsibilities and take great pains to ensure that each responsibility is addressed fairly and equitably.', 'as service providers, the federal reserve banks strive to operate in an efficient and cost-effective way.', 'the reserve banks continually upgrade their computer and telecommunications systems so that increasing proportions of funds, book-entry, and ach transactions can be processed without human intervention and, therefore, more accurately, rapidly, and cost effectively.', 'striving to serve their customers, the reserve banks offer a variety of products to meet the differing business requirements of large, mid-sized, and small institutions with widely divergent processing capabilities.', 'for example, banks may obtain payment services from the federal reserve banks using personal computers connected via switched, dial-in communications links or they may connect their mainframe computers to those in the federal reserve via dedicated high-speed telecommunications lines.', 'similarly, banks -- typically the larger ones -- may select check deposit products that require little sorting by the reserve banks, and they pay relatively low fees.', 'smaller banks may deposit checks in ways that meet their relatively greater sorting needs, thereby incurring higher fees, and many banks use a mix of these products.', 'importantly, because the reserve banks must compete for customers, they must provide services that meet or exceed the quality of other providers and must ensure that internal operations are efficient.', 'as a regulator, the federal reserve has taken steps to improve the efficiency and effectiveness of the payments system, often with the full awareness that it was moving contrary to its own narrow competitive interests as a service provider.', 'the expedited funds availability act of 1987, which was implemented through regulation cc, included provisions designed to speed the processing of dishonored checks.', 'in developing procedures to implement those provisions, the federal reserve, working with the banking industry, created a means to process returned checks on high speed equipment, which shortened return times by reducing the number of banks that might handle dishonored checks.', "more recently, in 1994, the board modified regulation cc to implement the same-day settlement rule, which broadened banks' ability to present checks to collecting banks directly and receive same-day funds in settlement.", 'direct presentments reduced the role of intermediaries, including the reserve banks, but it improved the efficiency of the payments system.', 'as expected, the volume of checks collected through reserve banks has declined.', 'this summarizes the history of our involvement in payments to date, and the situation on the surface looks quite stable.', 'why, then, is the federal reserve undertaking a fundamental review of its role?', 'there are several reasons.', 'first, as i have noted, the banking industry is in the midst of significant change.', 'these changes are primarily evolutionary -- driven by advances in technology, by industry consolidation, and by regulations that now permit interstate branch banking.', 'they do, however, provide the opportunity for revolutionary responses that may, with time, dramatically alter the face of the payments system.', 'we need to understand and help to beneficially shape these forces.', 'second, from time to time, and certainly in a period of change such as this one, it is appropriate for any organization to reassess its mission and how it fulfills that mission.', 'as you know, the united states remains far more dependent on paper checks for making payments than any other industrialized country, even though electronic transactions appear to be more efficient and less costly.', 'as you also know, the federal reserve is the only institution that presents checks to all depository institutions nationwide.', 'we suspect that industry consolidation and electronic technology may change the impact of our nationwide reach, but exactly how and when that might happen, and what would be appropriate responses, are not clear.', 'careful self-scrutiny is clearly timely.', 'finally, there are significant differences of opinion in the industry, and our society more generally, as to the appropriate payments role of the federal reserve.', 'as a public service entity, the federal reserve should address these concerns.', "in light of all this, in october 1996, chairman greenspan asked me to serve on a committee that is led by vice chair rivlin to examine the federal reserve's role in the payments system.", 'the committee has been at work all year, and we expect to complete our task shortly.', 'let me now outline what we have done, how we have gone about it, and where it is leading us.', 'to begin the study, the committee reviewed the general environment in which payments services are offered.', 'the committee analyzed the economic factors influencing the supply of and demand for wholesale services -- that is, for the large-value and securities transfers that support the interbank market -- and retail services, primarily small dollar payments.', 'we studied current trends in the financial services industry, including the development of new and emerging payment services, and our role in those markets.', "and, we examined how the federal reserve's participation in the payments system affects our ability to implement monetary policy decisions and to regulate and supervise banks.", "based on its internal review, the committee decided to focus its study on the federal reserve banks' retail payment services -- check and ach.", 'the committee excluded the wholesale systems because (1) these systems are efficient and effective now, (2) they are an important vehicle for controlling systemic risk, requiring very close monitoring, (3) they are an integral part in implementing monetary policy decisions, (4) they play an important role in providing everyday liquidity to financial markets, and (5) they provide certainty to payments system participants in times of financial stress.', 'it is worth noting that most central banks in major economies, like the federal reserve, provide large-value funds transfer services to banks and many also provide some form of securities settlement and safekeeping services.', "this is not to imply that we are complacently satisfied with all aspects of our country's wholesale payment arrangements, but rather that we do not feel that a review of the federal reserve's role in them is needed at this time.", 'the committee felt that it was critically important to this study that we draw on the insights and expertise of the banking industry and other payments system participants.', "we wanted to understand fully the dynamics of the payments system and the changes that the industry envisions over the next five to ten years, as well as the reasoning behind the varying views about the federal reserve's payments activities.", 'thus, the committee developed a series of hypothetical scenarios for federal reserve participation in the retail payments system that we discussed with industry representatives in a series of forums that were conducted last may and june.', 'some of you may have attended one of those forums.', 'in total, we held ten national and fifty-two regional forums.', 'attendees represented a diverse group of payments system participants, including representatives from large and small banks, private payments system providers, corporations, trade associations, academicians, consultants, and emerging payments system service providers.', 'in total, over 500 representatives from 473 organizations participated.', "to obtain the thoughts of these payments system participants, the committee developed five hypothetical scenarios for the federal reserve's future role in the check and ach payment services.", 'these scenarios were not developed specifically as policy options but rather were intended solely to stimulate discussion.', 'because many of you are familiar with these scenarios, i will review them only briefly.', 'in two scenarios the federal reserve would withdraw from participation in the check and ach markets and in the remaining three scenarios, the federal reserve would continue to provide those services.', 'in the first withdrawal scenario, the federal reserve would announce its intention to liquidate its check and ach services, although we would take steps to provide for a smooth transition for our customers.', 'in the second, the federal reserve envisioned selling its check and ach services to a private-sector entity that would retain no privileged ties to the federal reserve.', 'the three scenarios under which the federal reserve would continue to provide retail payment services to banks varied considerably.', 'these scenarios envisioned future roles in which the federal reserve would (1) merely ensure that all banks had access to our existing check and ach services, which many saw as a de facto exit strategy, (2) use our operational presence to stimulate development of more cost-effective and efficient payment methods, or (3) take aggressive steps to expedite the movement to an electronic-based retail payments system.', 'to stimulate discussion about each scenario and its effect on the provision of retail payments, several key questions were introduced.', 'for example, we asked what would happen to the prices and availability of retail payments in times of relative economic stability and in times of financial stress, such as in the texas banking crisis.', 'another question asked was what participants thought would be the best way to transform our largely paper-based system to a more electronic one.', 'what have we heard?', 'as you would guess, there are various perspectives on the fundamental question of the appropriate role for the federal reserve in the payments system.', 'some believe that it is inappropriate for the federal reserve to provide payment services and that the private sector could provide essentially the same services at a lower cost and perhaps greater efficiency.', 'many others believe that, by providing payment services, the federal reserve ensures that all payments system participants will be able to access competitively priced payment services.', 'while some believe that it is inappropriate for the federal reserve to regulate the industry in which it competes, others believe that by providing payment services, the federal reserve gains operational experience that makes it a better regulator.', 'more specifically, participants had differing views on various aspects of these issues and the consequences of each scenario.', 'many were concerned that, if the federal reserve withdrew from these services, it would result in short-term service disruptions with few long-term benefits.', 'many indicated that prices for retail services would rise, and smaller banks and remotely located banks were concerned that they would have difficulty obtaining check and ach services.', 'concern was expressed that without an operational presence, the federal reserve would have to regulate the retail payments system more extensively to ensure that all banks had access to the services.', 'while not unanimous, there was strong support from institutions of all sizes for continued federal reserve provision of retail payment services.', 'some stated that because check payments would continue to dominate the u.s. payments system for the foreseeable future, the federal reserve should maintain its check services while consumers adapt to the use of electronic payments mechanisms.', 'others indicated that by establishing a more aggressive operational presence in the check and ach services, the federal reserve could undertake initiatives to promote efficiency in general, and to encourage the use of electronics to collect checks in particular.', 'some indicated that private-sector service providers would prefer to invest in developing new markets and devising new technologies rather than in expanding their capacity to collect paper checks.', "they also indicated that they face significant resource demands to address other operational issues, such as the federal government's initiative to deliver almost all payments electronically by 1999 and preparation for the year 2000. no matter what their view about the federal reserve's continued presence in the retail payments market, virtually all participants believed that the federal reserve could play an important role in educating consumers about the benefits of electronic payments.", "while the committee has not reached detailed final conclusions, it is clear that the federal reserve can best ensure the safety and effectiveness of the nation's payments system by continuing to provide its existing retail payment services for checks and ach, and we will so recommend.", 'we agree with a recurring theme at the forums that there would likely be significant disruptions in the payments system if the federal reserve withdrew, with little net societal benefit.', 'currently, the banking industry is trying to grapple with a variety of technological issues, an effort that is requiring a great deal of resources.', 'banks are adopting the latest technological innovations to provide their customers with new and improved services and preparing to be century date change compliant.', 'by continuing to provide payment services, the federal reserve would enable banks and service providers to continue to focus on these future oriented efforts.', 'this would be far more productive, for example, than attempting to restructure an efficient, but dated, paper-based check collection system.', 'but, as yet, the committee has not decided on its specific recommendations for federal reserve involvement in retail payment services.', 'many issues identified and needing resolution are still "open."', 'they include considering whether the federal reserve should assume a very aggressive operational and regulatory posture to convert all payments to electronics and whether we should launch an intensive public education campaign to inform consumers of the benefits of electronic transactions.', 'we are also considering suggestions that we establish a regulatory regime that encourages electronic payments and discourages paper, that the federal reserve take the lead in establishing standards for electronic payments, and that we work toward a revised legal structure more suitable to an electronic environment.', 'operationally, the federal reserve might offer banks new products that take advantage of the latest technology and assist in their efforts to make their customers more comfortable with electronics.', 'also the federal reserve could conceivably open its secure communications to banks that want to offer their own electronic products.', 'to summarize, wholesale payments are being made, at least for now, in a relatively settled regime.', 'but, as we have been discussing, there is great activity in the retail arena.', 'indeed, many growing and innovative retail payments, such as credit card, debit card, smart card, and internet payments, do not flow through the federal reserve at all, although some do settle using federal reserve services.', "all payments methods will continue to evolve, and the federal reserve's role will also evolve as we will continue to work to fulfill our mandate to foster a reliable, efficient, and accessible system.", "as we assess the options to achieve these goals, we pledge to carefully consider the industry's views concerning future federal reserve participation in the payments system and to work in close collaboration with the private sector every step of the way."]	Edward W Kelley, Jr	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r971001d.pdf	Ms. Phillips discusses derivatives and risk management in the context of banking supervision	Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the U.S. Federal Reserve System at the Derivatives	1997-09-30 22:00:00	Ms. Phillips discusses derivatives and risk management in the context of banking supervision Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the U.S. Federal Reserve System at the Derivatives & Risk Management Symposium of the Fordham University School of Law, New York, on 19/9/97. Thank you for inviting me to speak in this symposium on derivatives and risk management, sponsored by the Institute on Law and Financial Services. These two topics have attracted wide attention among the public, market participants, and government over the past several years, and will probably continue to do so for many years. Clearly, financial engineering and improvements in risk management have helped the financial industry offer products to their clients to better control various business risks. At the same time, financial institutions also benefit from these innovations in that they can better manage the risks associated with increasingly complex financial instruments and the growing volume of financial transactions. As you know, risk management is a process for identifying, measuring, reporting, and controlling risks. While the term has been recently popularized in the financial press, the root concepts of risk management are not new to the financial industry. Indeed, by taking risk, or acting as an intermediary in transferring risk, the financial industry fulfils a role that has been and continues to be vital for economic growth. It is fair to say, however, that the process of risk management is becoming increasingly quantitative. Turning to derivatives, this is also not a recent innovation. Derivative markets, such as those for futures contracts, have existed for decades, indeed even centuries for some kinds of price risks. The trends in financial engineering that we have been seeing in recent years are really the fruits of technological progress: Reduced costs of product innovation and increased feasibility of applying financial theories that require intensive computational power. Along with the technological progress that has made it possible, financial engineering has profoundly changed the structure of many leading banks. These processes continue to reverberate throughout the industry. Banks engineer new products to shift business risks to others that had been borne routinely in the past. The reverse side of the coin is that market participants can assume risks through alternatives to the traditional lending and investing avenues. For example, credit derivatives, which are in a nascent stage of development, may someday lead to banks being able to trade credit risk associated with commercial bank loans as easily as they can alter the risk profile of their bond portfolios. Prior to these innovations, institutions could be generally compartmentalized into market segments that did not directly compete with one another. Government regulation mirrored and reinforced this segmentation. With financial innovation came new levels of competition, which then caused pressure for government to change the rules of play. As a result, the legal strictures preventing banks from engaging in certain businesses are being loosened. Banks are increasingly in direct competition with securities firms and insurance companies. New technology and financial innovation have clearly affected the way in which many firms manage their business. They have also put stress on many aspects of traditional legal, regulatory, and accounting frameworks. Over the past decade bank supervisors have learned some important lessons in this regard. These lessons propel our efforts to adapt supervisory and regulatory regimes to better accommodate the changes under way in the financial services sector -- to move to a new supervisory paradigm. Today, I would like to briefly summarize some of these lessons, illustrate how they are shaping the evolution of bank supervision, and some thoughts of how they may affect international supervision, as well. Lessons Learned by Bank Supervisors Perhaps the most basic lesson we have learned from our experience in supervising trading and derivatives activities is that the underlying risk of a financial instrument is more important than what an instrument is called. Although two instruments that differ in name only may have entirely different treatment under existing (and outmoded) legal and regulatory frameworks, the market, credit, liquidity, operational, and reputational risks embodied in them can be identical. To be sure, financial engineering can create derivative instruments that combine risks in complex ways. But, upon analysis, traditional cash instruments that appear simple may have greater risk than the complex instruments that are labelled "derivative." Indeed, placing financial instruments in pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management -- often with unfortunate results. The structured note phenomenon of 1993 and 1994 is an important example. Many institutions shunned "derivatives" in favor of these seemingly low-risk securities issued by federal agencies, only to find out later that these instruments had significant price volatility from embedded options. The reaction of many was to label structured notes as derivatives as well, rather than understanding that it was the underlying risk characteristics that had been poorly managed. In its supervisory role, the Federal Reserve is increasingly emphasizing the need for managing the risks of banking and de-emphasizing a focus on specific instruments. For example, in 1993 we issued examiner guidance on trading and dealer activities. This guidance covered a large spectrum of financial instruments, including derivatives. The risk management principles under examination applied whether or not the institution used derivatives. We addressed structured notes in similar fashion in 1995 with guidance on the risk management of bank investment and end-user activities. More recently, the Federal Reserve issued examiner guidance on the risks relating to banks' management of secondary credit market activities, including securitization activities, the extension of various types of off-balance-sheet credit enhancements, and the use of credit derivatives. The guidance stresses the importance of internal capital allocation schemes and risk management systems that accurately reflect the economic substance of transactions. A second lesson that has been reinforced over the past several years is that risk must be measured and managed comprehensively. That is, the focus should be on the dynamics of the portfolio rather than on specific instruments, which can ignore the interplay among various instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. Past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. However, technology and financial innovation are enabling banks to put theories and conceptual techniques into practice to manage the market and credit risks involved in trading, investment, and lending activities. Most dealer banks now routinely employ value-at-risk (VaR) measures to manage the market risks of their trading portfolios and significant strides are being made in the quantitative measurement and management of credit risk. The move to a portfolio-based approach to managing risk has influenced bank supervisory efforts in several other ways. All three of the U.S. banking agencies now take a more risk-focused approach to supervision. This is simply allocating more supervisory resources to a bank's activities that pose greater risk. For example, bank examiners no longer exhaustively review all of a bank's activities. Instead, the examination approach is now to identify and review the sources of risk within a bank's various lines of business. The need to measure risk on a portfolio basis has also begun to be reflected more explicitly in our capital guidelines and our reporting requirements. Beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal VaR measures. This approach allows banks to make use of empirical correlations among risk factors when computing the VaR. A third lesson that our experience with derivatives and other financial innovations has driven home is the critical importance of firms' internal processes for controlling risk. This, of course, is the most obvious lesson from several spectacular losses that the press has put under the rubric of "derivatives debacles." Supervisors, both here and abroad, are focusing more on reviewing the adequacy of internal controls and management processes, such as enforced risk limits. These are the key to gaining maximum benefit from financial innovation, while at the same time avoiding missteps. The final lesson that I will highlight is the need for supervisory and regulatory polices that are more "incentive-compatible" in the sense that they • foster sound risk management within the institution rather than narrow adherence to rules and regulations; • minimize burden by using internal risk measurement systems; and • are reinforced by market forces and the performance incentives of bank owners and managers. Too often financial engineering is targeted at regulatory arbitrage -- that is, exploiting loopholes in narrowly focused regulatory policies that are based on old, traditional instruments or business lines. Also, potential new products may not be introduced because their regulatory treatment is viewed as too burdensome or uncertain. This situation demonstrates all too clearly the differing reaction times of public and private entities. Regulatory policies and standards often take a long time to change whereas, in the private sector, market forces can quickly remedy outmoded standards. The resulting distortions of resources that arise when supervisory standards are slow to change is an unfortunate, albeit predictable, outcome. Policymakers can reduce this potential for distortion by structuring policies to be more "incentive-compatible." This involves harnessing market forces and market discipline to achieve supervisory objectives. Increasingly, supervisors are trying to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. The use of internal VaR models for calculating capital charges for trading activities is an important step in this direction. Risk-focused supervision emphasizing sound practices and internal controls is another. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. This approach is currently being studied and tested by a group of U.S. banks organized by the New York Clearing House. What will be the eventual outcome of incorporating the lessons learned into banking supervision? I see two themes in the evolution in the supervision of financial institutions: First is providing strong regulatory incentives for banks to exercise • prudence in taking and managing risk, and to develop ever better systems and processes for risk management. I believe the best evidence of this thinking is illustrated by the recent moves to align regulatory capital requirements for market risk with individual institutions' systems for allocating economic capital based on their own internal models. Supervisory oversight then concentrates on the performance of each institution's risk management process rather than devising a regulatory capital scheme that may not fit every institution, and inevitably have loopholes or inconsistencies that can be exploited. • Second, greater reliance will be placed -- particularly for nonbank business lines -- on the discipline the market can exert on individual participants. The latter element to our supervisory approach depends on market participants acting in their own self interest when dealing with counterparties. That involves understanding the risks of engaging in business and properly pricing transactions. Reliable financial information is an essential ingredient to efficient market discipline. Such information would clearly convey the risk profile of the institution it represents. In its absence, markets are more susceptible to distortions caused by rumors, misinformation, or failures to disclose. Many believe the dearth of information on risk profiles reflects the market's reliance on the federal safety net. Such information would be available if participants were not, to a large extent, indemnified from loss. It is this desire to see market discipline taking a greater role in regulating the affairs of banking organizations and others that has motivated the Federal Reserve Board to voice its opinions about accounting standards that are being developed by the Financial Accounting Standards Board (FASB). As in regulation, an important consideration to setting accounting standards should be the benefits of a particular standard outweighing its cost. The Federal Reserve's opinion is that the accounting for derivatives (and other financial instruments for that matter) should be consistent with the approach to risk management the firm takes in its business. This consistency can yield cost savings by reducing the need for two sets of books: one for financial reporting and another that supports internal management decisions. Moreover, it avoids the possibility of regulatory reports diverging from financial reporting, thereby helping to ensure that supervisory information and capital requirements appropriately reflect the institution's economic risks. Globalization of these Lessons and Future Prospects The challenges of supervision in a rapidly changing financial and technological environment are compounded by global integration of the marketplace. To the extent that regulation in one country is deemed too restrictive, firms can avoid it by simply booking business in another country. The ease with which firms can circumvent national borders and regulatory jurisdictions is a challenge of one dimension. If circumvention results in unsafe or unsound banking practices, it is a problem of another dimension. The problem may end up back in the United States after all. It is for these reasons that the Federal Reserve and the other U.S. banking agencies have been advocating that international agreements on banking supervision have a risk focus. For example, the Basle Committee on Supervision (under the Bank for International Settlements) recently agreed to embrace a portfolio-based, risk-sensitive approach to setting capital requirements for market risk. Instead, supervisors will be building upon the processes banks use to measure trading risks. This should substantially reduce regulatory burden and make standards more compatible with industry practice. In addition, the Basle Committee has agreed to common frameworks for gaining information on the derivatives activities of supervised institutions. A major task before us is to work with emerging-market countries to strengthen and unify banking supervision. Greater consistency should reduce the risk of systemic problems arising from a financial disruption in any particular market. While most of these efforts have focused on market risk, I think it is fair to point out that the major exposure for most banks is credit risk. Looking to the future, will the risk-based capital approach for credit risk ever evolve into an internal models approach? The answer is probably yes; however, with credit-risk modeling in such an early stage of development, it is premature to predict just when credit modeling and the supporting data will develop to the point that they can be relied upon as effective management tools. I am, however, encouraged by progress in modeling credit risk. The risk-based capital accord has worked well in the past and remains useful today. It was an excellent vehicle for bringing about a convergence in bank capital standards worldwide. But it does illustrate the problems of a standardized scheme. For example, banks have an incentive to securitize low-risk assets to avoid regulatory capital charges that unregulated competitors need not meet. Alternatively, market participants can get a false sense of security about a bank's condition if the risk-based capital ratios understate the true risks of the bank's portfolios. Recognizing these shortcomings, we regulators need to continually review and revise our standards, as we have proposed in connection with certain securitizations of assets. Conclusion Some of you in the audience may be surprised that my remarks on derivatives end with a discussion of risk-based capital. This, to me, illustrates the unexpected effects of financial innovation. A decade ago, few would have predicted that techniques for controlling trading risks might point the way for measuring risks in lending and allocating capital -- but that's the very nature of innovation. Those who identify new ways to apply lessons learned in one area to other activities are the ones most likely to succeed. Taking risk is unavoidable in banking, indeed bankers must do so to survive. The key is to identify, manage, and control the risks that are inherent in the business. The intelligent use of derivatives is one way to accomplish that. One should focus not on derivatives in and of themselves, but on their role and effect on a bank's overall portfolio.	['ms. phillips discusses derivatives and risk management in the context of banking supervision remarks by governor susan m. phillips, a member of the board of governors of the u.s. federal reserve system at the derivatives & risk management symposium of the fordham university school of law, new york, on 19/9/97.', 'thank you for inviting me to speak in this symposium on derivatives and risk management, sponsored by the institute on law and financial services.', 'these two topics have attracted wide attention among the public, market participants, and government over the past several years, and will probably continue to do so for many years.', 'clearly, financial engineering and improvements in risk management have helped the financial industry offer products to their clients to better control various business risks.', 'at the same time, financial institutions also benefit from these innovations in that they can better manage the risks associated with increasingly complex financial instruments and the growing volume of financial transactions.', 'as you know, risk management is a process for identifying, measuring, reporting, and controlling risks.', 'while the term has been recently popularized in the financial press, the root concepts of risk management are not new to the financial industry.', 'indeed, by taking risk, or acting as an intermediary in transferring risk, the financial industry fulfils a role that has been and continues to be vital for economic growth.', 'it is fair to say, however, that the process of risk management is becoming increasingly quantitative.', 'turning to derivatives, this is also not a recent innovation.', 'derivative markets, such as those for futures contracts, have existed for decades, indeed even centuries for some kinds of price risks.', 'the trends in financial engineering that we have been seeing in recent years are really the fruits of technological progress: reduced costs of product innovation and increased feasibility of applying financial theories that require intensive computational power.', 'along with the technological progress that has made it possible, financial engineering has profoundly changed the structure of many leading banks.', 'these processes continue to reverberate throughout the industry.', 'banks engineer new products to shift business risks to others that had been borne routinely in the past.', 'the reverse side of the coin is that market participants can assume risks through alternatives to the traditional lending and investing avenues.', 'for example, credit derivatives, which are in a nascent stage of development, may someday lead to banks being able to trade credit risk associated with commercial bank loans as easily as they can alter the risk profile of their bond portfolios.', 'prior to these innovations, institutions could be generally compartmentalized into market segments that did not directly compete with one another.', 'government regulation mirrored and reinforced this segmentation.', 'with financial innovation came new levels of competition, which then caused pressure for government to change the rules of play.', 'as a result, the legal strictures preventing banks from engaging in certain businesses are being loosened.', 'banks are increasingly in direct competition with securities firms and insurance companies.', 'new technology and financial innovation have clearly affected the way in which many firms manage their business.', 'they have also put stress on many aspects of traditional legal, regulatory, and accounting frameworks.', 'over the past decade bank supervisors have learned some important lessons in this regard.', 'these lessons propel our efforts to adapt supervisory and regulatory regimes to better accommodate the changes under way in the financial services sector -- to move to a new supervisory paradigm.', 'today, i would like to briefly summarize some of these lessons, illustrate how they are shaping the evolution of bank supervision, and some thoughts of how they may affect international supervision, as well.', 'lessons learned by bank supervisors perhaps the most basic lesson we have learned from our experience in supervising trading and derivatives activities is that the underlying risk of a financial instrument is more important than what an instrument is called.', 'although two instruments that differ in name only may have entirely different treatment under existing (and outmoded) legal and regulatory frameworks, the market, credit, liquidity, operational, and reputational risks embodied in them can be identical.', 'to be sure, financial engineering can create derivative instruments that combine risks in complex ways.', 'but, upon analysis, traditional cash instruments that appear simple may have greater risk than the complex instruments that are labelled "derivative."', 'indeed, placing financial instruments in pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management -- often with unfortunate results.', 'the structured note phenomenon of 1993 and 1994 is an important example.', 'many institutions shunned "derivatives" in favor of these seemingly low-risk securities issued by federal agencies, only to find out later that these instruments had significant price volatility from embedded options.', 'the reaction of many was to label structured notes as derivatives as well, rather than understanding that it was the underlying risk characteristics that had been poorly managed.', 'in its supervisory role, the federal reserve is increasingly emphasizing the need for managing the risks of banking and de-emphasizing a focus on specific instruments.', 'for example, in 1993 we issued examiner guidance on trading and dealer activities.', 'this guidance covered a large spectrum of financial instruments, including derivatives.', 'the risk management principles under examination applied whether or not the institution used derivatives.', 'we addressed structured notes in similar fashion in 1995 with guidance on the risk management of bank investment and end-user activities.', "more recently, the federal reserve issued examiner guidance on the risks relating to banks' management of secondary credit market activities, including securitization activities, the extension of various types of off-balance-sheet credit enhancements, and the use of credit derivatives.", 'the guidance stresses the importance of internal capital allocation schemes and risk management systems that accurately reflect the economic substance of transactions.', 'a second lesson that has been reinforced over the past several years is that risk must be measured and managed comprehensively.', 'that is, the focus should be on the dynamics of the portfolio rather than on specific instruments, which can ignore the interplay among various instruments.', 'although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy.', 'past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios.', 'however, technology and financial innovation are enabling banks to put theories and conceptual techniques into practice to manage the market and credit risks involved in trading, investment, and lending activities.', 'most dealer banks now routinely employ value-at-risk (var) measures to manage the market risks of their trading portfolios and significant strides are being made in the quantitative measurement and management of credit risk.', 'the move to a portfolio-based approach to managing risk has influenced bank supervisory efforts in several other ways.', 'all three of the u.s. banking agencies now take a more risk-focused approach to supervision.', "this is simply allocating more supervisory resources to a bank's activities that pose greater risk.", "for example, bank examiners no longer exhaustively review all of a bank's activities.", "instead, the examination approach is now to identify and review the sources of risk within a bank's various lines of business.", 'the need to measure risk on a portfolio basis has also begun to be reflected more explicitly in our capital guidelines and our reporting requirements.', 'beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal var measures.', 'this approach allows banks to make use of empirical correlations among risk factors when computing the var.', "a third lesson that our experience with derivatives and other financial innovations has driven home is the critical importance of firms' internal processes for controlling risk.", 'this, of course, is the most obvious lesson from several spectacular losses that the press has put under the rubric of "derivatives debacles."', 'supervisors, both here and abroad, are focusing more on reviewing the adequacy of internal controls and management processes, such as enforced risk limits.', 'these are the key to gaining maximum benefit from financial innovation, while at the same time avoiding missteps.', 'the final lesson that i will highlight is the need for supervisory and regulatory polices that are more "incentive-compatible" in the sense that they • foster sound risk management within the institution rather than narrow adherence to rules and regulations; • minimize burden by using internal risk measurement systems; and • are reinforced by market forces and the performance incentives of bank owners and managers.', 'too often financial engineering is targeted at regulatory arbitrage -- that is, exploiting loopholes in narrowly focused regulatory policies that are based on old, traditional instruments or business lines.', 'also, potential new products may not be introduced because their regulatory treatment is viewed as too burdensome or uncertain.', 'this situation demonstrates all too clearly the differing reaction times of public and private entities.', 'regulatory policies and standards often take a long time to change whereas, in the private sector, market forces can quickly remedy outmoded standards.', 'the resulting distortions of resources that arise when supervisory standards are slow to change is an unfortunate, albeit predictable, outcome.', 'policymakers can reduce this potential for distortion by structuring policies to be more "incentive-compatible."', 'this involves harnessing market forces and market discipline to achieve supervisory objectives.', 'increasingly, supervisors are trying to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation.', 'the use of internal var models for calculating capital charges for trading activities is an important step in this direction.', 'risk-focused supervision emphasizing sound practices and internal controls is another.', 'a significant effort that could increase supervisory reliance on market discipline in the future is the federal reserve\'s so-called "pre-commitment" approach to determining capital for market risk.', 'it seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management.', 'this approach is currently being studied and tested by a group of u.s. banks organized by the new york clearing house.', 'what will be the eventual outcome of incorporating the lessons learned into banking supervision?', 'i see two themes in the evolution in the supervision of financial institutions: first is providing strong regulatory incentives for banks to exercise • prudence in taking and managing risk, and to develop ever better systems and processes for risk management.', "i believe the best evidence of this thinking is illustrated by the recent moves to align regulatory capital requirements for market risk with individual institutions' systems for allocating economic capital based on their own internal models.", "supervisory oversight then concentrates on the performance of each institution's risk management process rather than devising a regulatory capital scheme that may not fit every institution, and inevitably have loopholes or inconsistencies that can be exploited.", '• second, greater reliance will be placed -- particularly for nonbank business lines -- on the discipline the market can exert on individual participants.', 'the latter element to our supervisory approach depends on market participants acting in their own self interest when dealing with counterparties.', 'that involves understanding the risks of engaging in business and properly pricing transactions.', 'reliable financial information is an essential ingredient to efficient market discipline.', 'such information would clearly convey the risk profile of the institution it represents.', 'in its absence, markets are more susceptible to distortions caused by rumors, misinformation, or failures to disclose.', "many believe the dearth of information on risk profiles reflects the market's reliance on the federal safety net.", 'such information would be available if participants were not, to a large extent, indemnified from loss.', 'it is this desire to see market discipline taking a greater role in regulating the affairs of banking organizations and others that has motivated the federal reserve board to voice its opinions about accounting standards that are being developed by the financial accounting standards board (fasb).', 'as in regulation, an important consideration to setting accounting standards should be the benefits of a particular standard outweighing its cost.', "the federal reserve's opinion is that the accounting for derivatives (and other financial instruments for that matter) should be consistent with the approach to risk management the firm takes in its business.", 'this consistency can yield cost savings by reducing the need for two sets of books: one for financial reporting and another that supports internal management decisions.', "moreover, it avoids the possibility of regulatory reports diverging from financial reporting, thereby helping to ensure that supervisory information and capital requirements appropriately reflect the institution's economic risks.", 'globalization of these lessons and future prospects the challenges of supervision in a rapidly changing financial and technological environment are compounded by global integration of the marketplace.', 'to the extent that regulation in one country is deemed too restrictive, firms can avoid it by simply booking business in another country.', 'the ease with which firms can circumvent national borders and regulatory jurisdictions is a challenge of one dimension.', 'if circumvention results in unsafe or unsound banking practices, it is a problem of another dimension.', 'the problem may end up back in the united states after all.', 'it is for these reasons that the federal reserve and the other u.s. banking agencies have been advocating that international agreements on banking supervision have a risk focus.', 'for example, the basle committee on supervision (under the bank for international settlements) recently agreed to embrace a portfolio-based, risk-sensitive approach to setting capital requirements for market risk.', 'instead, supervisors will be building upon the processes banks use to measure trading risks.', 'this should substantially reduce regulatory burden and make standards more compatible with industry practice.', 'in addition, the basle committee has agreed to common frameworks for gaining information on the derivatives activities of supervised institutions.', 'a major task before us is to work with emerging-market countries to strengthen and unify banking supervision.', 'greater consistency should reduce the risk of systemic problems arising from a financial disruption in any particular market.', 'while most of these efforts have focused on market risk, i think it is fair to point out that the major exposure for most banks is credit risk.', 'looking to the future, will the risk-based capital approach for credit risk ever evolve into an internal models approach?', 'the answer is probably yes; however, with credit-risk modeling in such an early stage of development, it is premature to predict just when credit modeling and the supporting data will develop to the point that they can be relied upon as effective management tools.', 'i am, however, encouraged by progress in modeling credit risk.', 'the risk-based capital accord has worked well in the past and remains useful today.', 'it was an excellent vehicle for bringing about a convergence in bank capital standards worldwide.', 'but it does illustrate the problems of a standardized scheme.', 'for example, banks have an incentive to securitize low-risk assets to avoid regulatory capital charges that unregulated competitors need not meet.', "alternatively, market participants can get a false sense of security about a bank's condition if the risk-based capital ratios understate the true risks of the bank's portfolios.", 'recognizing these shortcomings, we regulators need to continually review and revise our standards, as we have proposed in connection with certain securitizations of assets.', 'conclusion some of you in the audience may be surprised that my remarks on derivatives end with a discussion of risk-based capital.', 'this, to me, illustrates the unexpected effects of financial innovation.', "a decade ago, few would have predicted that techniques for controlling trading risks might point the way for measuring risks in lending and allocating capital -- but that's the very nature of innovation.", 'those who identify new ways to apply lessons learned in one area to other activities are the ones most likely to succeed.', 'taking risk is unavoidable in banking, indeed bankers must do so to survive.', 'the key is to identify, manage, and control the risks that are inherent in the business.', 'the intelligent use of derivatives is one way to accomplish that.', "one should focus not on derivatives in and of themselves, but on their role and effect on a bank's overall portfolio."]	Susan M Phillips	Board of Governors of the US Federal Reserve System	Governor	US
https://www.bis.org/review/r971001c.pdf	Mr. McDonough considers the challenge presented by the Year 2000 problem (Central Bank Articles and Speeches, 21 Sep 97)	Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough before the Annual Membership Meeting of the Institute of International Finance in Hong Kong on 21/9/97.	1997-09-21 00:00:00	Mr. McDonough considers the challenge presented by the Year 2000 problem Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough before the Annual Membership Meeting of the Institute of International Finance in Hong Kong on 21/9/97. I am pleased to be able to share my thoughts with you today on an issue that is sure to challenge every one of our organizations for the next several years -- the Year 2000 and how the century date change poses a very significant risk for financial markets. As I look at the membership of the Institute of International Finance gathered here in Hong Kong, I cannot help but be impressed as to how truly global financial markets have become. Realizing that this meeting is being hosted here in Hong Kong, with the People's Republic of China as the host country, further underscores how rapidly the world is changing and how interdependent we are. As a central banker, I worry a lot about events that could disrupt financial markets. Many of the events that I worry about are hypothetical. In those cases, a large part of my job is to convince others that the hypothetical event in question is sufficiently possible that it is in the industry's best interest to work together to try to avoid the event and related problems. Today, I am sure that I do not have to convince you about the inevitability of the approaching century date change. It is a certainty. What remains for me to do is to help put the dimension of the Year 2000 issue in perspective and suggest some of the actions that are necessary now if we are to avoid potentially serious problems down the road. As recently as the early 1990s, few banks and other financial institutions paid much attention to the Year 2000 problems. After all, using two digits in programs to represent the year made sense for decades. Many institutions didn't recognize the problem at all; others speculated that changes in technology would somehow appear and solve the problem. Now, however, delays have come back to haunt those institutions that acted passively, or not at all, in marshalling the resources needed to manage the problem. Financial institutions depend on the proper sequencing of events and calculations based on dates, but the logic built into applications to sequence events and perform calculations will not work properly when we hit 2000. As a result, Year 2000 issues pervade every business area of all financial and non-financial institutions. As if that were not enough, the problem is not just limited to the business lines and the applications upon which businesses rely. Operating systems and the equipment on which business applications run also are reliant on microchip-embedded logic affected by two-digit year representations. Unlike business applications where the dates usually are visible, potential problems in operating systems and equipment usually are invisible or embedded in programs. That means that banks and other institutions must rely on vendors, rather than their in-house technical staff, to identify and fix the problems. Similarly, mechanical devices used in security systems, elevators, and heating and cooling equipment controlled by microchips can be affected and may even cease to run. Making sure that all of our business applications work together properly will be a formidable challenge, both internally and across the financial services industries. For a variety of business and economic reasons, different approaches to correcting Year 2000 problems will be taken by different organizations. Even within organizations, corrective approaches may well vary for different business applications. Because the changes necessary to fix applications to make them Year 2000-compliant will be completed at different times, testing and re-testing will be needed to assure that information flows properly. Continual testing, however, will consume a very significant amount of resources, usually drawn from business line areas. Consultants estimate that testing alone will absorb as much as 70 percent of Year 2000 project resources at some institutions. The Year 2000 issue stretches well beyond the doors of financial services companies. Your customers and counterparties also must cope. How well they handle this complex and costly technical challenge could affect their business prospects and even their viability. Consequently, over the next couple of years, underwriting standards should specially consider how customers are addressing the issue, and credit officers should monitor the progress of customers who rely on technology on a regular basis. In my Bank's and the Basle Supervisors' work with the industry to meet the Year 2000 challenge, a number of issues have arisen that are worth calling to your attention. Probably the most significant issue is the relationship that banks have with third-party vendors and service providers. Not infrequently, we have found that banks have assumed either that vendors will make their products and services Year 2000-compliant, or have sought only general assurances from the vendors, which have been accepted at face value. Either approach puts a bank at significant risk. In addition, we uncovered instances when products represented by vendors as compliant simply were not. More significantly, we found that even if a vendor has made appropriate modifications and tested a product, there can be no guarantee that it will work properly in a bank's unique operating environment or in concert with related applications. It is now quite clear that every product must be tested and certified as compliant by the user, and testing must be repeated upon the release of new compliant applications, environmental software, and hardware. Remote operations and foreign activities pose special challenges for Year 2000 programs. Efforts to develop or use off-the-shelf applications or to put in place a general plan of action can fail to take into account activities that are unique to a particular business or location. Making certain that inventories are complete for complex organizational structures and geographically dispersed banks is proving to be a very difficult task. Obtaining and retaining the staff resources capable of dealing with Year 2000 issues will be another increasingly difficult problem. There is a limited pool of skilled technical staff to make needed changes, and demands on this pool are growing as the time draws closer. In the short run, the ability to add to this pool significantly through training is limited. Qualified outside consultants already are heavily committed and will become even more scarce over time. Obtaining equipment on which to conduct tests also often requires significant lead time. All of this suggests that controlling the cost of Year 2000 projects will be a problem for many institutions as resource prices are bid up. Already, we have seen many institutions increase their Year 2000 budgets several times, and by significant amounts, as they develop their detailed plans. Security also is likely to be of increasing concern as we move forward. As time pressures mount, there is a risk that shortcuts will be taken. The checking of credentials for new staff or outside contractors or consultants may be rushed and less rigorous. Date-dependent security applications may be turned off to facilitate testing. In an industry like ours, with so much interconnectivity, any compromise of security simply cannot be tolerated. Every financial institution needs its own comprehensive project plan to address the Year 2000 problem. In the United States, bank supervisors have suggested an approach that includes a number of phases. A technical paper prepared by the Basle Committee on Banking Supervision and released by the G-10 Governors on September 8th discusses a very similar approach. In both cases, the basic approach includes the following components: • setting the Year 2000 project as a strategic objective to be managed at the highest level; • making sure that staff at all levels recognize the importance of the project as a business issue, not just a technical one; • identifying all applications, operating systems and equipment affected by the Year 2000 problem, and developing appropriate plans and schedules that can be monitored at the highest level within the organization; • determining what needs to be done and making the necessary changes; • testing each system to be sure that it works, not only as an independent application, but in concert with related systems within the institution, and with those of correspondents and customers; and, lastly, • putting Year 2000-compliant applications into production. The Basle Supervisors' paper does a good job of laying out the full scope of the challenge, and I commend it to your attention. The paper should serve as a strong wake-up call. There still is time to address the problem, but now there is urgency in making the difficult choices. In the mere two years that are left, the challenge will be to minimize business and systemic impacts as much as possible. By now, all major financial institutions should have identified what needs to be done and be in, or near, the final stages of developing detailed plans. Work on changing all applications identified as high business priorities also should be well under way. In the United States, most large institutions plan to have their major applications available for external testing around the middle of 1998, with an expectation that testing with other major institutions would largely be completed by year-end 1998. This schedule allows all of 1999 for end-to-end testing on an industry-wide basis. But even with two years to spare, it is safe to say that no organization will be able to cope successfully with the Year 2000 challenge unless both its management and staff realistically measure its scope and commit to its solution. Bluntly stated, if your own management and staff, or your correspondents and customers, take any of the following positions, your organization may be at risk: -- the Year 2000 is not an issue for our organization. • Denial It is. • -- our organization can handle the Year No resource problems 2000 with its existing resources and within current information technology budgets. Very unlikely. • -- our outside vendors and service Vendors will address the issue providers won't let us down. Trust is not a substitute for testing. • Covered by contract -- our lawyers have determined that we are appropriately protected by our legal agreements. The lawyers may get rich, but will you be in business? • Testing is not a problem -- our organization has good testing and acceptance procedures and we test all the time. Previous internal testing standards probably won't do the job this time. • -- our Obtaining adequate resources will not be an issue organization has a great technical staff and we can always hire additional resources if it becomes necessary. Good luck. As a bank supervisor, the Federal Reserve Bank of New York will do whatever it can to encourage banks to set up and adhere to programs that deal with Year 2000 problems. Our examiners will focus on how well individual banks are doing and will highlight for senior management and directors those instances when progress may be lagging. This oversight will include not only U.S. banks, but also the U.S. branches and agencies of foreign banks. However, the motivation and determination to cope with the Year 2000 problem must come from within banking organizations rather than from supervisory oversight. Getting the Year 2000 issue right is critical for every organization. Failure to get it right will affect the integrity of the payments system and the performance of the domestic, and maybe even the global, economy. The Federal Reserve is working hard to make certain that our systems will be ready and fully tested. And I am pleased by the high level of central bank coordination on this issue, as the recent release of the Basle Supervisors' technical paper demonstrates. All of us need to make sure we are paying sufficient attention and applying appropriate resources to the Year 2000 issue. Only in that way will we be able to insure that the millennium changeover is an occasion for joy and optimism.	['mr. mcdonough considers the challenge presented by the year 2000 problem remarks by the president of the federal reserve bank of new york, mr. william j. mcdonough before the annual membership meeting of the institute of international finance in hong kong on 21/9/97.', 'i am pleased to be able to share my thoughts with you today on an issue that is sure to challenge every one of our organizations for the next several years -- the year 2000 and how the century date change poses a very significant risk for financial markets.', 'as i look at the membership of the institute of international finance gathered here in hong kong, i cannot help but be impressed as to how truly global financial markets have become.', "realizing that this meeting is being hosted here in hong kong, with the people's republic of china as the host country, further underscores how rapidly the world is changing and how interdependent we are.", 'as a central banker, i worry a lot about events that could disrupt financial markets.', 'many of the events that i worry about are hypothetical.', "in those cases, a large part of my job is to convince others that the hypothetical event in question is sufficiently possible that it is in the industry's best interest to work together to try to avoid the event and related problems.", 'today, i am sure that i do not have to convince you about the inevitability of the approaching century date change.', 'it is a certainty.', 'what remains for me to do is to help put the dimension of the year 2000 issue in perspective and suggest some of the actions that are necessary now if we are to avoid potentially serious problems down the road.', 'as recently as the early 1990s, few banks and other financial institutions paid much attention to the year 2000 problems.', 'after all, using two digits in programs to represent the year made sense for decades.', "many institutions didn't recognize the problem at all; others speculated that changes in technology would somehow appear and solve the problem.", 'now, however, delays have come back to haunt those institutions that acted passively, or not at all, in marshalling the resources needed to manage the problem.', 'financial institutions depend on the proper sequencing of events and calculations based on dates, but the logic built into applications to sequence events and perform calculations will not work properly when we hit 2000. as a result, year 2000 issues pervade every business area of all financial and non-financial institutions.', 'as if that were not enough, the problem is not just limited to the business lines and the applications upon which businesses rely.', 'operating systems and the equipment on which business applications run also are reliant on microchip-embedded logic affected by two-digit year representations.', 'unlike business applications where the dates usually are visible, potential problems in operating systems and equipment usually are invisible or embedded in programs.', 'that means that banks and other institutions must rely on vendors, rather than their in-house technical staff, to identify and fix the problems.', 'similarly, mechanical devices used in security systems, elevators, and heating and cooling equipment controlled by microchips can be affected and may even cease to run.', 'making sure that all of our business applications work together properly will be a formidable challenge, both internally and across the financial services industries.', 'for a variety of business and economic reasons, different approaches to correcting year 2000 problems will be taken by different organizations.', 'even within organizations, corrective approaches may well vary for different business applications.', 'because the changes necessary to fix applications to make them year 2000-compliant will be completed at different times, testing and re-testing will be needed to assure that information flows properly.', 'continual testing, however, will consume a very significant amount of resources, usually drawn from business line areas.', 'consultants estimate that testing alone will absorb as much as 70 percent of year 2000 project resources at some institutions.', 'the year 2000 issue stretches well beyond the doors of financial services companies.', 'your customers and counterparties also must cope.', 'how well they handle this complex and costly technical challenge could affect their business prospects and even their viability.', 'consequently, over the next couple of years, underwriting standards should specially consider how customers are addressing the issue, and credit officers should monitor the progress of customers who rely on technology on a regular basis.', "in my bank's and the basle supervisors' work with the industry to meet the year 2000 challenge, a number of issues have arisen that are worth calling to your attention.", 'probably the most significant issue is the relationship that banks have with third-party vendors and service providers.', 'not infrequently, we have found that banks have assumed either that vendors will make their products and services year 2000-compliant, or have sought only general assurances from the vendors, which have been accepted at face value.', 'either approach puts a bank at significant risk.', 'in addition, we uncovered instances when products represented by vendors as compliant simply were not.', "more significantly, we found that even if a vendor has made appropriate modifications and tested a product, there can be no guarantee that it will work properly in a bank's unique operating environment or in concert with related applications.", 'it is now quite clear that every product must be tested and certified as compliant by the user, and testing must be repeated upon the release of new compliant applications, environmental software, and hardware.', 'remote operations and foreign activities pose special challenges for year 2000 programs.', 'efforts to develop or use off-the-shelf applications or to put in place a general plan of action can fail to take into account activities that are unique to a particular business or location.', 'making certain that inventories are complete for complex organizational structures and geographically dispersed banks is proving to be a very difficult task.', 'obtaining and retaining the staff resources capable of dealing with year 2000 issues will be another increasingly difficult problem.', 'there is a limited pool of skilled technical staff to make needed changes, and demands on this pool are growing as the time draws closer.', 'in the short run, the ability to add to this pool significantly through training is limited.', 'qualified outside consultants already are heavily committed and will become even more scarce over time.', 'obtaining equipment on which to conduct tests also often requires significant lead time.', 'all of this suggests that controlling the cost of year 2000 projects will be a problem for many institutions as resource prices are bid up.', 'already, we have seen many institutions increase their year 2000 budgets several times, and by significant amounts, as they develop their detailed plans.', 'security also is likely to be of increasing concern as we move forward.', 'as time pressures mount, there is a risk that shortcuts will be taken.', 'the checking of credentials for new staff or outside contractors or consultants may be rushed and less rigorous.', 'date-dependent security applications may be turned off to facilitate testing.', 'in an industry like ours, with so much interconnectivity, any compromise of security simply cannot be tolerated.', 'every financial institution needs its own comprehensive project plan to address the year 2000 problem.', 'in the united states, bank supervisors have suggested an approach that includes a number of phases.', 'a technical paper prepared by the basle committee on banking supervision and released by the g-10 governors on september 8th discusses a very similar approach.', 'in both cases, the basic approach includes the following components: • setting the year 2000 project as a strategic objective to be managed at the highest level; • making sure that staff at all levels recognize the importance of the project as a business issue, not just a technical one; • identifying all applications, operating systems and equipment affected by the year 2000 problem, and developing appropriate plans and schedules that can be monitored at the highest level within the organization; • determining what needs to be done and making the necessary changes; • testing each system to be sure that it works, not only as an independent application, but in concert with related systems within the institution, and with those of correspondents and customers; and, lastly, • putting year 2000-compliant applications into production.', "the basle supervisors' paper does a good job of laying out the full scope of the challenge, and i commend it to your attention.", 'the paper should serve as a strong wake-up call.', 'there still is time to address the problem, but now there is urgency in making the difficult choices.', 'in the mere two years that are left, the challenge will be to minimize business and systemic impacts as much as possible.', 'by now, all major financial institutions should have identified what needs to be done and be in, or near, the final stages of developing detailed plans.', 'work on changing all applications identified as high business priorities also should be well under way.', 'in the united states, most large institutions plan to have their major applications available for external testing around the middle of 1998, with an expectation that testing with other major institutions would largely be completed by year-end 1998. this schedule allows all of 1999 for end-to-end testing on an industry-wide basis.', 'but even with two years to spare, it is safe to say that no organization will be able to cope successfully with the year 2000 challenge unless both its management and staff realistically measure its scope and commit to its solution.', 'bluntly stated, if your own management and staff, or your correspondents and customers, take any of the following positions, your organization may be at risk: -- the year 2000 is not an issue for our organization.', '• denial it is.', '• -- our organization can handle the year no resource problems 2000 with its existing resources and within current information technology budgets.', "• -- our outside vendors and service vendors will address the issue providers won't let us down.", 'trust is not a substitute for testing.', '• covered by contract -- our lawyers have determined that we are appropriately protected by our legal agreements.', 'the lawyers may get rich, but will you be in business?', '• testing is not a problem -- our organization has good testing and acceptance procedures and we test all the time.', "previous internal testing standards probably won't do the job this time.", '• -- our obtaining adequate resources will not be an issue organization has a great technical staff and we can always hire additional resources if it becomes necessary.', 'as a bank supervisor, the federal reserve bank of new york will do whatever it can to encourage banks to set up and adhere to programs that deal with year 2000 problems.', 'our examiners will focus on how well individual banks are doing and will highlight for senior management and directors those instances when progress may be lagging.', 'this oversight will include not only u.s. banks, but also the u.s. branches and agencies of foreign banks.', 'however, the motivation and determination to cope with the year 2000 problem must come from within banking organizations rather than from supervisory oversight.', 'getting the year 2000 issue right is critical for every organization.', 'failure to get it right will affect the integrity of the payments system and the performance of the domestic, and maybe even the global, economy.', 'the federal reserve is working hard to make certain that our systems will be ready and fully tested.', "and i am pleased by the high level of central bank coordination on this issue, as the recent release of the basle supervisors' technical paper demonstrates.", 'all of us need to make sure we are paying sufficient attention and applying appropriate resources to the year 2000 issue.', 'only in that way will we be able to insure that the millennium changeover is an occasion for joy and optimism.']	William J McDonough	Federal Reserve Bank of New York	President	US
https://www.bis.org/review/r971001b.pdf	Mr. Wellink discusses different forms of economic policy co-ordination in EMU (Central Bank Articles and Speeches, 10 Sep 97)	Speech by the President of the Netherlands Bank, Dr. A.H.E.M. Wellink, on the occasion of the European Summer Institute Conference entitled "The German Economy and the European Union" held in Berlin on 10/9/97.	1997-09-10 00:00:00	Mr. Wellink discusses different forms of economic policy co-ordination in EMU Speech by the President of the Netherlands Bank, Dr. A.H.E.M. Wellink, on the occasion of the European Summer Institute Conference entitled 'The German Economy and the European Union' held in Berlin on 10/9/97. Introduction After these warm words of welcome, I have the honour to kick off this conference on the German economy and the European Union. The subject of my speech is the implications of Economic and Monetary Union (EMU), and in particular the requirements which EMU imposes on economic policy co-ordination. This topic is not new. The importance of economic policy coordination in a monetary union was already spelled out in 1970 in the Werner Report, which can be considered as the prelude to the first concrete attempt to design an economic and monetary union in Europe. Indeed, the Werner Committee advocated the establishment of a European economic government. History repeats itself, it seems, since the issue of co-ordination has been put anew on the agenda by the European Council, meeting in Amsterdam on 16 and 17 June of this year. I will take the opportunity to express my views on economic policy co-ordination in stage three of EMU. Economic policy co-ordination is a very broad concept and therefore sometimes the cause of much confusion. In the eyes of some people, the mere exchange of views on economic policies can be considered policy co-ordination. To others, co-ordination is equivalent to harmonisation of policies and relinquishing some sovereignty to the supranational level. A scholar in European integration will argue differently. In his opinion, policy co-ordination implies that policy makers take into account the repercussions of their actions on others, but remain responsible. In my view, economic policy co-ordination can be compared with an orchestra: it is difficult enough for a musician to learn how to play an instrument, let alone to play in an orchestra. My speech is structured as follows. I will discuss four different forms of economic policy co-ordination in EMU which all require different intensities of co-ordination: i) fiscal policy co-ordination among EU member countries, ii) the mix of fiscal and monetary policy, iii) the implementation of exchange rate policies, and iv) the co-ordination of labour market policies. The implementation of exchange rate policy in EMU is perhaps the odd one out. In contrast to the other three forms of co-ordination, there is only one single policy, that is the exchange rate policy of the euro area as a whole. But different institutions are responsible for making it work. Before discussing these different forms of policy co-ordination, however, I will provide an intellectual framework for the discussion by briefly outlining the limitations of economic policy-making as such. In other words, one cannot discuss how to play a symphony before knowing how to play the instruments. How to play an instrument? Traditionally, economists distinguish between - at least - two instruments of economic policy-making: fiscal and monetary policy-making. As far as fiscal policy is concerned, three main functions can be distinguished. First, the allocation function or the provision of public goods. Second, the redistribution function, or the adjustment of income and wealth to what society considers a 'fair' distribution. Third, the stabilisation function, or the use of fiscal policies to stabilise the business cycle. When discussing policy co-ordination in the context of EMU, the focus is on the latter function of fiscal policy, which does not imply that there is no role for the other functions. In the literature, the restrictions of the stabilisation function have come to the fore. As we have learnt from the experiences in the 1970s, fine-tuning has its difficulties, because of the time lag between the decision of measures and its effects, and - even more important - because of the lack of detailed information necessary for this kind of policy. Apart from the fine-tuning problem, there is the potential problem of time inconsistency, since a government may be tempted to pursue an inconsistent policy for the sake of short-term gains, for example in the run-up to elections. Under these circumstances, it is tempting to increase expenditure or reduce taxes. In other words, playing - 2 - the fiscal violin is not a piece of cake. Indeed, it takes good musicians years to learn to master the vibrato of this instrument. Pursuing monetary policy for the sake of short-term stabilisation is even more complicated than in the case of fiscal policies. Although monetary policy-making is not so much hampered by the lack of detailed and recent information, the time lag problem is even severe than in the field of fiscal policies, especially because in monetary policies time lags may differ substantially from case to case. The time lag problem is linked with the fact that the transmission process of monetary policy in the real economy is very complicated, and in many cases not fully understood. The famous black box monetary economists talk about. Finally, the problem of time inconsistency applies to monetary policy as well. Monetary authorities may be tempted to create unexpected inflation to stimulate the economy in the short run. Eventually, economic agents will revise their expectations and the result will not be a higher growth rate, but a higher rate of inflation instead. Hence, playing the monetary piano is perhaps even more difficult than playing the fiscal violin. Fiscal policy co-ordination Against this background, let's turn to discussing economic policy co-ordination in the context of EMU, starting with the co-ordination of fiscal policies. As I have already argued, playing the fiscal violin is very difficult. By definition, it is even more difficult to prevent fifteen EU fiscal violinists to play out of tune. Do my critical observations rule out any co-ordination, at any time? No, under certain special circumstances, fiscal policy co-ordination can be welfare-improving. This assertion is based on a conventional game-theoretical model: fiscal policy-makers maximise independently of each other - a welfare function in which the spillovers of their actions to other players are neglected. The joint welfare of the economies involved increases if fiscal policies are subsequently co-ordinated and policy makers take into account the consequences of their actions on the other players of the game. However, given the caveats mentioned, we have to conclude that the scope for active fiscal policy-making is limited. Only in very specific circumstances, the Ecofin Council should consider the possibility of fiscal policy co-ordination. For instance, when there is a risk of overheating or a common recession, or when the euro area is faced with a persistent balance-of-payments deficit. The basis for the co-ordination of fiscal policies is the multilateral surveillance procedure provided for in Article 103 of the EC Treaty. In my view, it is possible to elaborate the so-called broad guidelines of the economic policies of the Member States, which the Ecofin Council adopts in conformity with Article 103, and include fiscal policy co-ordination. So far, these broad guidelines have been very broad indeed. In the future, they should address individual countries more specifically. When a Member State does not comply with the broad guidelines, specific policy recommendations can, and should, be given to the Member State concerned. When appropriate, these recommendations should be published. The multilateral surveillance laid down in Article 103 allows for this. Indeed, this procedure provides sufficient additional scope for fiscal policy co-ordination that has not yet been applied to the extent possible. It should be emphasised that this kind of fiscal policy co-ordination should fit within the limits set by the pact for stability and growth. This pact requires Member States to strive for a budgetary position which is on average in balance or in surplus. It prevents unduly lax fiscal policies and, if they might occur, provides an effective instrument for putting an end to an excessive deficit. In other words, the stability pact prevents spillovers from lax fiscal policies to the interest rate level of the euro area as a whole and to the single monetary policy of the ECB in particular. The policy mix Let's suppose we have more or less managed to get the fiscal violins to play in tune. Now we want to introduce the monetary piano. We have two possibilities there. The easy option is to instruct the monetary piano player to play always the same notes. Whatever happens. This is equivalent to economic policy co-ordination in an environment of fixed exchange rates. In the case of - 3 - fixed exchange rates, there is no room for monetary fine-tuning, since monetary policies are determined by exchange rate policies. By definition, the burden of adjustment falls on budgetary policies. Let me illustrate this by giving the example of my own country. Monetary conditions in the Netherlands are currently relatively easy, taking into consideration credit expansion, the business cycle, asset prices and the inflation rate. Since Dutch monetary policy is first and foremost directed towards maintaining the guilder-Deutsche Mark peg, other policies should be geared to preventing the economy from overheating. I would hope in particular that the fiscal authorities decide to reduce the budget deficit further, which currently stands at about 2% of GDP, and thereby approach balanced budget within the next four years, that is during the next term of government. Denmark will achieve a budget surplus this year already. The second option is to give our monetary piano player the opportunity to tune in to the fiscal violins. One of my all-time favourites is Tschaikovsky's violin concerto. A splendid combination of piano and violin, but one of the most difficult concertos to play, I am told. Indeed, this is equivalent to economic policy co-ordination in an environment of flexible exchange rates. In the case of flexible exchange rates, the desired policy mix can be obtained either by adjustment on the fiscal, or on the monetary side. Compared to the fixed exchange rate case, this is a much more complicated situation. And this is the situation which will apply in EMU. Although it is, theoretically speaking, possible to share the burden of adjustment between both fiscal and monetary policies, in the case of EMU it was decided that monetary policies should be first and foremost aimed at achieving price stability. In addition, the European Central Bank is obliged to support the general economic policies of the Community, but this task is clearly of secondary nature, since it is stated in the EC Treaty that the ECB shall do so 'without prejudice to the objective of price stability'. In practice, therefore, the burden of adjustment will fall on budgetary policies. In my view, this was a correct decision, since for the reasons stated earlier, monetary policy should not be geared to short-term goals, like stabilising the business cycle. Nevertheless, it cannot be denied that monetary and fiscal policy are interdependent. This notion is clearly reflected in the Treaty. For instance, the excessive deficit procedure explicitly aims at preventing spillovers from lax fiscal policies to the single monetary policy of the ECB. The interdependence of monetary and fiscal policies makes a policy dialogue between ECB and Ecofin Council highly desirable. This dialogue should take place in a co-operative atmosphere, respecting different responsibilities and restrictions, of which the independence of the ECB is the most important one. The EC Treaty already offers several routes for this dialogue. The President of the Ecofin Council is entitled to participate in the meetings of the Governing Council of the ECB. Although he has no right to vote, he is allowed to submit motions for deliberation to the Governing Council. A second channel for this policy dialogue is the participation of the President of the ECB in the meetings of the Finance Ministers when the latter discuss issues of relevance to the ECB. Moreover, I expect that the President of the ECB will also take part in the informal sessions of the Ecofin Council. The Dutch model of policy dialogue between the central bank and the Minister of Finance might serve as an example for the co-ordination of the policy mix in the third stage of EMU. The current Dutch Bank Act allows the Minister of Finance to give directions to the central bank, a possibility which has never been used and will be cancelled in the new Bank Act, to become effective in 1998. In other words, the Dutch central bank is de facto fully independent. Nevertheless, there is an intensive dialogue between the Bank and the Ministry of Finance. The President of the Netherlands Bank and the Minister of Finance hold regular, bi-weekly luncheon sessions to discuss informally - topics of relevance for both the central bank and the Ministry of Finance. Moreover, top-level officials of both institutions meet regularly and there are also good day-to-day working relationships between employees of both the central bank and the ministry. In a way, this model of informal policy dialogue has increased the independent position of the Dutch central bank. Indeed, the frankness and openness of the discussions have increased the mutual respect and understanding. - 4 - Exchange rate policy Now let me turn to the exchange rate policy of the euro area. The odd one out, as I mentioned in my introductory remarks. Unlike fiscal policy co-ordination or co-ordination of the policy mix, there is only one single exchange rate policy. However, different institutions have their responsibilities in this area. One can compare it with a piano played by two people: but each should play the same tones at the same time. Therefore, I consider it important to discuss this issue as well. The exchange rate policy more or less constitutes a common responsibility of the Ecofin Council and the ECB. Article 109, paragraph 2 of the Treaty stipulates that the Ecofin Council, acting by a qualified majority either on a recommendation from the Commission after consulting the ECB or on a recommendation from the ECB, may formulate general orientations for the exchange rate policy of the euro area. The latter shall be without prejudice to the primary objective of the ECB to maintain price stability. I firmly believe that the Ecofin should exercise due care in making use of its competence to formulate general orientations. A German saying applies here: In der Beschränkung zeigt sich erst der Meister. The reason for this reservedness, in my opinion, is that the exchange rate of a currency is the consequence of monetary and economic policies. In other words, if monetary policy is directed towards price stability, the public finances of a country are sound, and economic policies are aimed at an efficient functioning of markets, the exchange rate of a currency will not be an issue. However, under exceptional circumstances major misalignments of the nominal exchange rate might occur. In this case, the Ecofin Council might consider the formulation of general orientations for the exchange rate policy. If they are formulated, general orientations should, in my view, not only be directed at the ECB. As exchange rate developments are the result of the full set of economic policies which have been pursued, general orientations should also involve a thorough discussion on fiscal as well as other economic policies. Misalignments may also be the result of policy actions outside the euro area. Hence, the implementation of general orientations should also involve a dialogue with non-EU policy makers. Article 109, paragraph 4 of the Treaty explicitly provides for this possibility: the Ecofin Council shall decide on the position of the Community at the international level as regards issues of particular relevance to EMU and decide on its representation in international meetings. The Treaty stipulates that the general orientations should be without prejudice to the primary objective of the ESCB to maintain price stability. In my view, it is always up to the ECB to decide how to act if the Ecofin Council has formulated general orientations. This is the only justified interpretation taking into consideration the Treaty provisions on central bank independence and the objective of the ESCB. In the exceptional case of a formal exchange rate mechanism involving non-EU countries, the Treaty stipulates that the Council is obliged to take a decision after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability. Eventually, the Ecofin Council may impose an exchange rate arrangement on the System. However, it is my reading of the Treaty that the ECB should pursue its primary objective - maintaining price stability - even under these circumstances. In other words, the ECB is allowed to suspend exchange market interventions or to trigger realignment discussions, if the exchange rate arrangement conflicts with its primary objective. This was agreed upon in the context of the exchange rate arrangement between the euro area and the 'pre-ins', the ERM-II. Co-ordination of labour market policies A last form of economic policy co-ordination has been given much attention in the Treaty of Amsterdam, the co-ordination of labour market policies. The amended Treaty contains a new chapter on employment. Moreover, the European Council has adopted a Resolution on growth and employment. It has been rightly decided not to come to a harmonisation of national labour market policies. The structure and functioning of labour markets in the EU differ from one country to another and require a decentralised approach. Co-ordination of labour market policies ensures a continuous - 5 - dialogue and exchange of information on policies embarked upon by the Member States. Indeed, policy co-ordination may lead to peer pressure, reinforcing labour market reforms. The latter are of crucial importance for the functioning of EMU. As it will no longer be possible to alter the nominal exchange rate if a country is faced with persistent and structural imbalances, other adjustment mechanisms have to be fostered. Do we need a conductor. or the 'gouvernement économique': antinode or dialogue? I can already hear you argue that it is easy to facilitate economic policy co-ordination by hiring a conductor for our orchestra. Indeed, it has been suggested that economic policy co-ordination should be supported by the establishment of a formal Stability Council or 'gouvernement économique'. This economic government would consist of the Ministers of Finance of the participating Member States only. Unfortunately for the proponents of such an institution, there is no Treaty base for its establishment. In my view, however, there is no reason to complain: we already have our Leonard Bernstein. All in all, the Treaty offers a well-balanced framework for policy co-ordination. The Ecofin Council is the centre piece for this policy co-ordination. The Ministers of Finance of the 'outs' are full members of the Ecofin Council and are allowed to participate in the discussions in the Council on policy co-ordination matters. Their participation makes sense, because economic developments in non-participating countries will have a major impact on developments in the euro zone. However, as they are still outside the euro area, they are not allowed to vote in some cases. Nonetheless, the Treaty does not rule out ad hoc, informal meetings for participating countries only. Such meeting could be very useful. But instead of labelling these gatherings as meetings of the Stability Council, I would consider them as meetings of an informal Stability Forum. This would enable members of the euro zone to informally prepare decisions on issues to be decided by the 'ins', such as the conversion rates of the 'second wave' of participants, or the imposition of sanctions on participating Member States with an excessive deficit. Finally, I would like to emphasise that a Stability Council of participating Member States can only be of a temporary nature, as in the end all EU member countries are to join EMU. Final Remarks To summarise my views, the existing institutional framework laid down in the Treaty is sufficient for this purpose. The multilateral surveillance procedure, laid down in Article 103 of the Treaty, provides an adequate, but at present not fully used, framework for fiscal policy co-ordination. The policy dialogue between ECB and Council of Ministers has also been provided for in the Treaty, for example by the presence of the ECB president and the Ecofin chairman at each other's meetings. Moreover, the Treaty of Amsterdam has introduced the possibility of co-ordination of labour market policies. Finally, the Treaty also provides for an intensive dialogue between ECB and Ecofin Council on the exchange rate policy of the euro area, without prejudice to the former's primary objective to maintain price stability. In this context, it is our current challenge to work out effective ways to give form and shape to economic policy co-ordination. The 'M' of EMU requires an 'E' with real substance. We should, however, not cause E and M to conflict by establishing a formal Stability Council. This would also give rise to the impression of a kind of elite group of 'ins', which we should avoid. Wouldn't it be rather strange to have a British style Members-only club from which the British (for the time being?) are excluded? Economic policy co-ordination is indeed a difficult subject. It should evade both the Scylla of a lack of co-ordination, and the Charibdis of too much of it. A lack of co-ordination would lead to a sub-optimal economic performance. However, too much of a good thing isn't good either: - 6 - overregulation must be avoided, and the wrong kind of co-ordination could even be dangerous. Or, to return to our orchestra, we can't just sit back and let our musicians play as they see fit. Judging the quality of the music by waiting for the reaction of the audience, is not a good approach. If we are hooted for our performance, it will be too late.	['mr. wellink discusses different forms of economic policy co-ordination in emu speech by the president of the netherlands bank, dr. a.h.e.m.', "wellink, on the occasion of the european summer institute conference entitled 'the german economy and the european union' held in berlin on 10/9/97.", 'introduction after these warm words of welcome, i have the honour to kick off this conference on the german economy and the european union.', 'the subject of my speech is the implications of economic and monetary union (emu), and in particular the requirements which emu imposes on economic policy co-ordination.', 'this topic is not new.', 'the importance of economic policy coordination in a monetary union was already spelled out in 1970 in the werner report, which can be considered as the prelude to the first concrete attempt to design an economic and monetary union in europe.', 'indeed, the werner committee advocated the establishment of a european economic government.', 'history repeats itself, it seems, since the issue of co-ordination has been put anew on the agenda by the european council, meeting in amsterdam on 16 and 17 june of this year.', 'i will take the opportunity to express my views on economic policy co-ordination in stage three of emu.', 'economic policy co-ordination is a very broad concept and therefore sometimes the cause of much confusion.', 'in the eyes of some people, the mere exchange of views on economic policies can be considered policy co-ordination.', 'to others, co-ordination is equivalent to harmonisation of policies and relinquishing some sovereignty to the supranational level.', 'a scholar in european integration will argue differently.', 'in his opinion, policy co-ordination implies that policy makers take into account the repercussions of their actions on others, but remain responsible.', 'in my view, economic policy co-ordination can be compared with an orchestra: it is difficult enough for a musician to learn how to play an instrument, let alone to play in an orchestra.', 'my speech is structured as follows.', 'i will discuss four different forms of economic policy co-ordination in emu which all require different intensities of co-ordination: i) fiscal policy co-ordination among eu member countries, ii) the mix of fiscal and monetary policy, iii) the implementation of exchange rate policies, and iv) the co-ordination of labour market policies.', 'the implementation of exchange rate policy in emu is perhaps the odd one out.', 'in contrast to the other three forms of co-ordination, there is only one single policy, that is the exchange rate policy of the euro area as a whole.', 'but different institutions are responsible for making it work.', 'before discussing these different forms of policy co-ordination, however, i will provide an intellectual framework for the discussion by briefly outlining the limitations of economic policy-making as such.', 'in other words, one cannot discuss how to play a symphony before knowing how to play the instruments.', 'how to play an instrument?', 'traditionally, economists distinguish between - at least - two instruments of economic policy-making: fiscal and monetary policy-making.', 'as far as fiscal policy is concerned, three main functions can be distinguished.', 'first, the allocation function or the provision of public goods.', "second, the redistribution function, or the adjustment of income and wealth to what society considers a 'fair' distribution.", 'third, the stabilisation function, or the use of fiscal policies to stabilise the business cycle.', 'when discussing policy co-ordination in the context of emu, the focus is on the latter function of fiscal policy, which does not imply that there is no role for the other functions.', 'in the literature, the restrictions of the stabilisation function have come to the fore.', 'as we have learnt from the experiences in the 1970s, fine-tuning has its difficulties, because of the time lag between the decision of measures and its effects, and - even more important - because of the lack of detailed information necessary for this kind of policy.', 'apart from the fine-tuning problem, there is the potential problem of time inconsistency, since a government may be tempted to pursue an inconsistent policy for the sake of short-term gains, for example in the run-up to elections.', 'under these circumstances, it is tempting to increase expenditure or reduce taxes.', 'in other words, playing - 2 - the fiscal violin is not a piece of cake.', 'indeed, it takes good musicians years to learn to master the vibrato of this instrument.', 'pursuing monetary policy for the sake of short-term stabilisation is even more complicated than in the case of fiscal policies.', 'although monetary policy-making is not so much hampered by the lack of detailed and recent information, the time lag problem is even severe than in the field of fiscal policies, especially because in monetary policies time lags may differ substantially from case to case.', 'the time lag problem is linked with the fact that the transmission process of monetary policy in the real economy is very complicated, and in many cases not fully understood.', 'the famous black box monetary economists talk about.', 'finally, the problem of time inconsistency applies to monetary policy as well.', 'monetary authorities may be tempted to create unexpected inflation to stimulate the economy in the short run.', 'eventually, economic agents will revise their expectations and the result will not be a higher growth rate, but a higher rate of inflation instead.', 'hence, playing the monetary piano is perhaps even more difficult than playing the fiscal violin.', "fiscal policy co-ordination against this background, let's turn to discussing economic policy co-ordination in the context of emu, starting with the co-ordination of fiscal policies.", 'as i have already argued, playing the fiscal violin is very difficult.', 'by definition, it is even more difficult to prevent fifteen eu fiscal violinists to play out of tune.', 'do my critical observations rule out any co-ordination, at any time?', 'no, under certain special circumstances, fiscal policy co-ordination can be welfare-improving.', 'this assertion is based on a conventional game-theoretical model: fiscal policy-makers maximise independently of each other - a welfare function in which the spillovers of their actions to other players are neglected.', 'the joint welfare of the economies involved increases if fiscal policies are subsequently co-ordinated and policy makers take into account the consequences of their actions on the other players of the game.', 'however, given the caveats mentioned, we have to conclude that the scope for active fiscal policy-making is limited.', 'only in very specific circumstances, the ecofin council should consider the possibility of fiscal policy co-ordination.', 'for instance, when there is a risk of overheating or a common recession, or when the euro area is faced with a persistent balance-of-payments deficit.', 'the basis for the co-ordination of fiscal policies is the multilateral surveillance procedure provided for in article 103 of the ec treaty.', 'in my view, it is possible to elaborate the so-called broad guidelines of the economic policies of the member states, which the ecofin council adopts in conformity with article 103, and include fiscal policy co-ordination.', 'so far, these broad guidelines have been very broad indeed.', 'in the future, they should address individual countries more specifically.', 'when a member state does not comply with the broad guidelines, specific policy recommendations can, and should, be given to the member state concerned.', 'when appropriate, these recommendations should be published.', 'the multilateral surveillance laid down in article 103 allows for this.', 'indeed, this procedure provides sufficient additional scope for fiscal policy co-ordination that has not yet been applied to the extent possible.', 'it should be emphasised that this kind of fiscal policy co-ordination should fit within the limits set by the pact for stability and growth.', 'this pact requires member states to strive for a budgetary position which is on average in balance or in surplus.', 'it prevents unduly lax fiscal policies and, if they might occur, provides an effective instrument for putting an end to an excessive deficit.', 'in other words, the stability pact prevents spillovers from lax fiscal policies to the interest rate level of the euro area as a whole and to the single monetary policy of the ecb in particular.', "the policy mix let's suppose we have more or less managed to get the fiscal violins to play in tune.", 'now we want to introduce the monetary piano.', 'we have two possibilities there.', 'the easy option is to instruct the monetary piano player to play always the same notes.', 'this is equivalent to economic policy co-ordination in an environment of fixed exchange rates.', 'in the case of - 3 - fixed exchange rates, there is no room for monetary fine-tuning, since monetary policies are determined by exchange rate policies.', 'by definition, the burden of adjustment falls on budgetary policies.', 'let me illustrate this by giving the example of my own country.', 'monetary conditions in the netherlands are currently relatively easy, taking into consideration credit expansion, the business cycle, asset prices and the inflation rate.', 'since dutch monetary policy is first and foremost directed towards maintaining the guilder-deutsche mark peg, other policies should be geared to preventing the economy from overheating.', 'i would hope in particular that the fiscal authorities decide to reduce the budget deficit further, which currently stands at about 2% of gdp, and thereby approach balanced budget within the next four years, that is during the next term of government.', 'denmark will achieve a budget surplus this year already.', 'the second option is to give our monetary piano player the opportunity to tune in to the fiscal violins.', "one of my all-time favourites is tschaikovsky's violin concerto.", 'a splendid combination of piano and violin, but one of the most difficult concertos to play, i am told.', 'indeed, this is equivalent to economic policy co-ordination in an environment of flexible exchange rates.', 'in the case of flexible exchange rates, the desired policy mix can be obtained either by adjustment on the fiscal, or on the monetary side.', 'compared to the fixed exchange rate case, this is a much more complicated situation.', 'and this is the situation which will apply in emu.', 'although it is, theoretically speaking, possible to share the burden of adjustment between both fiscal and monetary policies, in the case of emu it was decided that monetary policies should be first and foremost aimed at achieving price stability.', "in addition, the european central bank is obliged to support the general economic policies of the community, but this task is clearly of secondary nature, since it is stated in the ec treaty that the ecb shall do so 'without prejudice to the objective of price stability'.", 'in practice, therefore, the burden of adjustment will fall on budgetary policies.', 'in my view, this was a correct decision, since for the reasons stated earlier, monetary policy should not be geared to short-term goals, like stabilising the business cycle.', 'nevertheless, it cannot be denied that monetary and fiscal policy are interdependent.', 'this notion is clearly reflected in the treaty.', 'for instance, the excessive deficit procedure explicitly aims at preventing spillovers from lax fiscal policies to the single monetary policy of the ecb.', 'the interdependence of monetary and fiscal policies makes a policy dialogue between ecb and ecofin council highly desirable.', 'this dialogue should take place in a co-operative atmosphere, respecting different responsibilities and restrictions, of which the independence of the ecb is the most important one.', 'the ec treaty already offers several routes for this dialogue.', 'the president of the ecofin council is entitled to participate in the meetings of the governing council of the ecb.', 'although he has no right to vote, he is allowed to submit motions for deliberation to the governing council.', 'a second channel for this policy dialogue is the participation of the president of the ecb in the meetings of the finance ministers when the latter discuss issues of relevance to the ecb.', 'moreover, i expect that the president of the ecb will also take part in the informal sessions of the ecofin council.', 'the dutch model of policy dialogue between the central bank and the minister of finance might serve as an example for the co-ordination of the policy mix in the third stage of emu.', 'the current dutch bank act allows the minister of finance to give directions to the central bank, a possibility which has never been used and will be cancelled in the new bank act, to become effective in 1998. in other words, the dutch central bank is de facto fully independent.', 'nevertheless, there is an intensive dialogue between the bank and the ministry of finance.', 'the president of the netherlands bank and the minister of finance hold regular, bi-weekly luncheon sessions to discuss informally - topics of relevance for both the central bank and the ministry of finance.', 'moreover, top-level officials of both institutions meet regularly and there are also good day-to-day working relationships between employees of both the central bank and the ministry.', 'in a way, this model of informal policy dialogue has increased the independent position of the dutch central bank.', 'indeed, the frankness and openness of the discussions have increased the mutual respect and understanding.', '- 4 - exchange rate policy now let me turn to the exchange rate policy of the euro area.', 'the odd one out, as i mentioned in my introductory remarks.', 'unlike fiscal policy co-ordination or co-ordination of the policy mix, there is only one single exchange rate policy.', 'however, different institutions have their responsibilities in this area.', 'one can compare it with a piano played by two people: but each should play the same tones at the same time.', 'therefore, i consider it important to discuss this issue as well.', 'the exchange rate policy more or less constitutes a common responsibility of the ecofin council and the ecb.', 'article 109, paragraph 2 of the treaty stipulates that the ecofin council, acting by a qualified majority either on a recommendation from the commission after consulting the ecb or on a recommendation from the ecb, may formulate general orientations for the exchange rate policy of the euro area.', 'the latter shall be without prejudice to the primary objective of the ecb to maintain price stability.', 'i firmly believe that the ecofin should exercise due care in making use of its competence to formulate general orientations.', 'a german saying applies here: in der beschränkung zeigt sich erst der meister.', 'the reason for this reservedness, in my opinion, is that the exchange rate of a currency is the consequence of monetary and economic policies.', 'in other words, if monetary policy is directed towards price stability, the public finances of a country are sound, and economic policies are aimed at an efficient functioning of markets, the exchange rate of a currency will not be an issue.', 'however, under exceptional circumstances major misalignments of the nominal exchange rate might occur.', 'in this case, the ecofin council might consider the formulation of general orientations for the exchange rate policy.', 'if they are formulated, general orientations should, in my view, not only be directed at the ecb.', 'as exchange rate developments are the result of the full set of economic policies which have been pursued, general orientations should also involve a thorough discussion on fiscal as well as other economic policies.', 'misalignments may also be the result of policy actions outside the euro area.', 'hence, the implementation of general orientations should also involve a dialogue with non-eu policy makers.', 'article 109, paragraph 4 of the treaty explicitly provides for this possibility: the ecofin council shall decide on the position of the community at the international level as regards issues of particular relevance to emu and decide on its representation in international meetings.', 'the treaty stipulates that the general orientations should be without prejudice to the primary objective of the escb to maintain price stability.', 'in my view, it is always up to the ecb to decide how to act if the ecofin council has formulated general orientations.', 'this is the only justified interpretation taking into consideration the treaty provisions on central bank independence and the objective of the escb.', 'in the exceptional case of a formal exchange rate mechanism involving non-eu countries, the treaty stipulates that the council is obliged to take a decision after consulting the ecb in an endeavour to reach a consensus consistent with the objective of price stability.', 'eventually, the ecofin council may impose an exchange rate arrangement on the system.', 'however, it is my reading of the treaty that the ecb should pursue its primary objective - maintaining price stability - even under these circumstances.', 'in other words, the ecb is allowed to suspend exchange market interventions or to trigger realignment discussions, if the exchange rate arrangement conflicts with its primary objective.', "this was agreed upon in the context of the exchange rate arrangement between the euro area and the 'pre-ins', the erm-ii.", 'co-ordination of labour market policies a last form of economic policy co-ordination has been given much attention in the treaty of amsterdam, the co-ordination of labour market policies.', 'the amended treaty contains a new chapter on employment.', 'moreover, the european council has adopted a resolution on growth and employment.', 'it has been rightly decided not to come to a harmonisation of national labour market policies.', 'the structure and functioning of labour markets in the eu differ from one country to another and require a decentralised approach.', 'co-ordination of labour market policies ensures a continuous - 5 - dialogue and exchange of information on policies embarked upon by the member states.', 'indeed, policy co-ordination may lead to peer pressure, reinforcing labour market reforms.', 'the latter are of crucial importance for the functioning of emu.', 'as it will no longer be possible to alter the nominal exchange rate if a country is faced with persistent and structural imbalances, other adjustment mechanisms have to be fostered.', 'do we need a conductor.', "or the 'gouvernement économique': antinode or dialogue?", 'i can already hear you argue that it is easy to facilitate economic policy co-ordination by hiring a conductor for our orchestra.', "indeed, it has been suggested that economic policy co-ordination should be supported by the establishment of a formal stability council or 'gouvernement économique'.", 'this economic government would consist of the ministers of finance of the participating member states only.', 'unfortunately for the proponents of such an institution, there is no treaty base for its establishment.', 'in my view, however, there is no reason to complain: we already have our leonard bernstein.', 'all in all, the treaty offers a well-balanced framework for policy co-ordination.', 'the ecofin council is the centre piece for this policy co-ordination.', "the ministers of finance of the 'outs' are full members of the ecofin council and are allowed to participate in the discussions in the council on policy co-ordination matters.", 'their participation makes sense, because economic developments in non-participating countries will have a major impact on developments in the euro zone.', 'however, as they are still outside the euro area, they are not allowed to vote in some cases.', 'nonetheless, the treaty does not rule out ad hoc, informal meetings for participating countries only.', 'such meeting could be very useful.', 'but instead of labelling these gatherings as meetings of the stability council, i would consider them as meetings of an informal stability forum.', "this would enable members of the euro zone to informally prepare decisions on issues to be decided by the 'ins', such as the conversion rates of the 'second wave' of participants, or the imposition of sanctions on participating member states with an excessive deficit.", 'finally, i would like to emphasise that a stability council of participating member states can only be of a temporary nature, as in the end all eu member countries are to join emu.', 'final remarks to summarise my views, the existing institutional framework laid down in the treaty is sufficient for this purpose.', 'the multilateral surveillance procedure, laid down in article 103 of the treaty, provides an adequate, but at present not fully used, framework for fiscal policy co-ordination.', "the policy dialogue between ecb and council of ministers has also been provided for in the treaty, for example by the presence of the ecb president and the ecofin chairman at each other's meetings.", 'moreover, the treaty of amsterdam has introduced the possibility of co-ordination of labour market policies.', "finally, the treaty also provides for an intensive dialogue between ecb and ecofin council on the exchange rate policy of the euro area, without prejudice to the former's primary objective to maintain price stability.", 'in this context, it is our current challenge to work out effective ways to give form and shape to economic policy co-ordination.', "the 'm' of emu requires an 'e' with real substance.", 'we should, however, not cause e and m to conflict by establishing a formal stability council.', "this would also give rise to the impression of a kind of elite group of 'ins', which we should avoid.", "wouldn't it be rather strange to have a british style members-only club from which the british (for the time being?)", 'economic policy co-ordination is indeed a difficult subject.', 'it should evade both the scylla of a lack of co-ordination, and the charibdis of too much of it.', 'a lack of co-ordination would lead to a sub-optimal economic performance.', "however, too much of a good thing isn't good either: - 6 - overregulation must be avoided, and the wrong kind of co-ordination could even be dangerous.", "or, to return to our orchestra, we can't just sit back and let our musicians play as they see fit.", 'judging the quality of the music by waiting for the reaction of the audience, is not a good approach.', 'if we are hooted for our performance, it will be too late.']	Nout Wellink	De Nederlandsche Bank	President	Netherlands
https://www.bis.org/review/r971001a.pdf	Bank of Japan's September review of monetary and economic trends in Japan (Central Bank Articles and Speeches, 22 Sep 97)	BANK OF JAPAN, MONTHLY ECONOMIC REVIEW, 22/9/97.	1997-09-22 00:00:00	Bank of Japan's September review of monetary and economic trends in Japan BANK OF JAPAN, MONTHLY ECONOMIC REVIEW, 22/9/97. The consumption tax hike continues to have an impact on Japan's economy. Production has stayed virtually unchanged. The moderate economic recovery in Japan has not been undermined, however, given the continued improvement in income and expenditure which is centered on the business sector. With respect to final demand, public-sector investment has been on a decreasing trend, and housing investment has recently declined significantly. On the other hand, the increasing trend in net exports has continued, and business fixed investment has been rising steadily, particularly in machinery investment, against the background of the recovery in corporate profits. Meanwhile, economic indicators for personal consumption have recently been lackluster on the whole, reflecting the continued influence of the consumption tax hike. However, labor market conditions and income formation have been improving, albeit moderately. In these circumstances, industrial production has stayed virtually unchanged. Prices have remained stable on the whole, and the growth of monetary aggregates has continued at around 3.0 per cent year to year. With regard to personal consumption, outlays for travel have continued to increase moderately. With respect to goods, however, sales of passenger cars, electrical appliances, as well as sales at department stores and supermarkets have been below the previous year's level since April, reflecting the continued effects of the consumption tax hike. Among leading indicators of business fixed investment, machinery orders have been increasing steadily, although at a somewhat slower pace compared to the sharp rise in the second half of 1996. The increase in construction floor area has recently been weak, but it is basically following a moderate recovery trend. With respect to housing investment, housing starts in terms of the seasonally-adjusted annual rate have continued to decline following the surge in demand in the second half of 1996 ahead of the consumption tax hike. Housing starts had stayed at around 1.5 million since spring 1997, but declined to 1.34 million in June and to 1.24 million in July, the lowest level recorded since September 1985. Regarding public-sector investment, the amount of public works contracted peaked as orders included in the supplementary budget for fiscal 1996 were concluded, and the amount has followed a decreasing trend, reflecting the restrained budget for fiscal 1997. Against the background of steady overseas demand and the yen's depreciation to date, real exports have stayed firm since July after having increased significantly in the second quarter. Real imports, on the other hand, have been stagnant on average. As a result, the real trade surplus has been increasing with some fluctuations. The nominal current-account surplus has also been expanding significantly since April 1997, partly reflecting the decline in crude oil prices since early 1997. After recording high growth during the second half of 1996 and the first quarter 1997, industrial production in the second quarter remained virtually unchanged as the decline in demand following the surge ahead of the consumption tax hike was offset by factors such as the substantial increase in exports and the rebuilding of inventories. Production in the third quarter is expected to remain mostly unchanged from the second quarter. This is because a minor production cutback is expected in the transportation machinery industry where inventories have accumulated, while production will continue a steady increase in the electrical machinery industry. Inventories are at appropriate levels on the whole, except for the transportation machinery industry. - 2 - With respect to labor market conditions, the unemployment rate remains at a high level, and the increase in overtime working hours has slowed somewhat, reflecting developments in production. However, year-to-year growth in nominal wages and employment has been moderate but steady, reflecting the increase in corporate profits. Thus, labor market conditions and income formation continue to improve moderately on the whole. Prices remained stable on the whole, excluding the effect of the consumption tax hike. Domestic wholesale prices (adjusted for seasonal electricity rates) have remained virtually unchanged. This is because overall domestic supply and demand conditions have improved moderately, except for some construction goods, while import prices have declined. The year-to-year declines in corporate service prices are narrowing steadily on the whole, partly owing to the improvement in supply and demand conditions, particularly for real estate rents and information services, although leasing charges continue to decline. Consumer prices (nationwide, excluding perishables) overall are stable, marginally above the previous year's level, mainly because the year-to-year declines in goods prices have narrowed. The growth in monetary aggregates, measured in terms of the year-to-year growth of M2 + CDs average outstanding, has continued at around 3 per cent. Regarding money market rates, the overnight call rate (uncollateralized) has moved at a level slightly below the official discount rate. The 3-month CD rate has stayed at around 0.55 per cent. Meanwhile, the long-term government bond yield has been declining since the end of May as the market confirmed the moderate pace of the economic recovery, and reached below 2.0 per cent in early September. Recently, it has moved at a record low level of around 1.95 per cent. With respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since September 1995. The long-term prime lending rate was lowered by 0.2 percentage points each in June, July and September and has again reached the record low level of 2.5 per cent. In these circumstances, short- and long-term contracted interest rates for new loans and discounts (up to July) have moved at record low levels. On the stock exchange, the Nikkei 225 stock average moved at around ¥20,000 21,000 between May and July 1997, but later declined, partly reflecting the fall in U.S. stock prices. It fell below ¥18,000 in early September, and has recently been moving at around ¥18,000. In the foreign exchange market, the yen appreciated to ¥110 to the U.S. dollar in the first half of June. However, the yen later reversed its course and depreciated, with some fluctuations, and has recently moved at around ¥120. Meanwhile, the yen had also been appreciating against the Deutsche Mark since May, but recently depreciated somewhat to ¥67 - 69.	["bank of japan's september review of monetary and economic trends in japan bank of japan, monthly economic review, 22/9/97.", "the consumption tax hike continues to have an impact on japan's economy.", 'production has stayed virtually unchanged.', 'the moderate economic recovery in japan has not been undermined, however, given the continued improvement in income and expenditure which is centered on the business sector.', 'with respect to final demand, public-sector investment has been on a decreasing trend, and housing investment has recently declined significantly.', 'on the other hand, the increasing trend in net exports has continued, and business fixed investment has been rising steadily, particularly in machinery investment, against the background of the recovery in corporate profits.', 'meanwhile, economic indicators for personal consumption have recently been lackluster on the whole, reflecting the continued influence of the consumption tax hike.', 'however, labor market conditions and income formation have been improving, albeit moderately.', 'in these circumstances, industrial production has stayed virtually unchanged.', 'prices have remained stable on the whole, and the growth of monetary aggregates has continued at around 3.0 per cent year to year.', 'with regard to personal consumption, outlays for travel have continued to increase moderately.', "with respect to goods, however, sales of passenger cars, electrical appliances, as well as sales at department stores and supermarkets have been below the previous year's level since april, reflecting the continued effects of the consumption tax hike.", 'among leading indicators of business fixed investment, machinery orders have been increasing steadily, although at a somewhat slower pace compared to the sharp rise in the second half of 1996. the increase in construction floor area has recently been weak, but it is basically following a moderate recovery trend.', 'with respect to housing investment, housing starts in terms of the seasonally-adjusted annual rate have continued to decline following the surge in demand in the second half of 1996 ahead of the consumption tax hike.', "housing starts had stayed at around 1.5 million since spring 1997, but declined to 1.34 million in june and to 1.24 million in july, the lowest level recorded since september 1985. regarding public-sector investment, the amount of public works contracted peaked as orders included in the supplementary budget for fiscal 1996 were concluded, and the amount has followed a decreasing trend, reflecting the restrained budget for fiscal 1997. against the background of steady overseas demand and the yen's depreciation to date, real exports have stayed firm since july after having increased significantly in the second quarter.", 'real imports, on the other hand, have been stagnant on average.', 'as a result, the real trade surplus has been increasing with some fluctuations.', 'the nominal current-account surplus has also been expanding significantly since april 1997, partly reflecting the decline in crude oil prices since early 1997. after recording high growth during the second half of 1996 and the first quarter 1997, industrial production in the second quarter remained virtually unchanged as the decline in demand following the surge ahead of the consumption tax hike was offset by factors such as the substantial increase in exports and the rebuilding of inventories.', 'production in the third quarter is expected to remain mostly unchanged from the second quarter.', 'this is because a minor production cutback is expected in the transportation machinery industry where inventories have accumulated, while production will continue a steady increase in the electrical machinery industry.', 'inventories are at appropriate levels on the whole, except for the transportation machinery industry.', '- 2 - with respect to labor market conditions, the unemployment rate remains at a high level, and the increase in overtime working hours has slowed somewhat, reflecting developments in production.', 'however, year-to-year growth in nominal wages and employment has been moderate but steady, reflecting the increase in corporate profits.', 'thus, labor market conditions and income formation continue to improve moderately on the whole.', 'prices remained stable on the whole, excluding the effect of the consumption tax hike.', 'domestic wholesale prices (adjusted for seasonal electricity rates) have remained virtually unchanged.', 'this is because overall domestic supply and demand conditions have improved moderately, except for some construction goods, while import prices have declined.', 'the year-to-year declines in corporate service prices are narrowing steadily on the whole, partly owing to the improvement in supply and demand conditions, particularly for real estate rents and information services, although leasing charges continue to decline.', "consumer prices (nationwide, excluding perishables) overall are stable, marginally above the previous year's level, mainly because the year-to-year declines in goods prices have narrowed.", 'the growth in monetary aggregates, measured in terms of the year-to-year growth of m2 + cds average outstanding, has continued at around 3 per cent.', 'regarding money market rates, the overnight call rate (uncollateralized) has moved at a level slightly below the official discount rate.', 'the 3-month cd rate has stayed at around 0.55 per cent.', 'meanwhile, the long-term government bond yield has been declining since the end of may as the market confirmed the moderate pace of the economic recovery, and reached below 2.0 per cent in early september.', 'recently, it has moved at a record low level of around 1.95 per cent.', 'with respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since september 1995. the long-term prime lending rate was lowered by 0.2 percentage points each in june, july and september and has again reached the record low level of 2.5 per cent.', 'in these circumstances, short- and long-term contracted interest rates for new loans and discounts (up to july) have moved at record low levels.', 'on the stock exchange, the nikkei 225 stock average moved at around ¥20,000 21,000 between may and july 1997, but later declined, partly reflecting the fall in u.s. stock prices.', 'it fell below ¥18,000 in early september, and has recently been moving at around ¥18,000.', 'in the foreign exchange market, the yen appreciated to ¥110 to the u.s. dollar in the first half of june.', 'however, the yen later reversed its course and depreciated, with some fluctuations, and has recently moved at around ¥120.', 'meanwhile, the yen had also been appreciating against the deutsche mark since may, but recently depreciated somewhat to ¥67 - 69.']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r970925e.pdf	Mr. Meyer considers the economic outlook and challenges facing monetary policy (Central Bank Articles and Speeches, 17 Sep 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the 1998 Global Economic and Investment Outlook Conference, Carnegie Mellon University, Pittsburgh, Pennsylvania on 17/9/97.	1997-09-17 00:00:00	Mr. Meyer considers the economic outlook and challenges facing monetary policy Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the 1998 Global Economic and Investment Outlook Conference, Carnegie Mellon University, Pittsburgh, Pennsylvania on 17/9/97. Recent economic performance has been hailed on Wall Street as "paradise found" and the "best of times." And, on Main Street, there is ample survey evidence suggesting that consumers are feeling very upbeat about the prospects for the economy. I call the remarkable combination of healthy growth, low unemployment, low inflation, a soaring stock market, and declining federal budget deficit the "good news" economy. But there are challenges even in the "good news" economy and I want to focus on three of them this afternoon. The first challenge is to avoid complacency and appreciate the policy challenges that remain. The second is to explain how we have been able to achieve such favorable performance, given that it is better than almost anyone predicted and better than historical regularities suggested was even possible. And the third challenge is to assess the risks in the current environment and determine how monetary policy should be positioned to keep the good news coming. Two themes will become evident as I address these challenges. First, there are limits -limits on what policy can accomplish and limits on what the economy can achieve. Second, in assessing the current environment and its implications for monetary policy, uncertainties require us to balance historical regularities and newer possibilities. Expansions, to an important degree, have common properties, what I shall refer to as regularities. Both forecasters and policymakers rely on these. Forecasters make predictions about future developments based on regularities. The same regularities allow policymakers to act pre-emptively -changing policy today in anticipation of developments tomorrow. Yet each expansion has its own signature that reflects the specific set of transitory influences and longer-lasting structural changes in play at the time. The current episode features the following players. Cyclical regularities clearly in evidence include accelerator effects, changing tolerances for risk, and cyclical swings in the unemployment rate and in profits. Two other regularities that I especially want to focus on today are the Phillips Curve and the trend growth in output. The latter regularities define limits - limits to the sustainable level of output, at any moment, and, once that level of capacity is reached, to the growth of output over time. If these limits are exceeded, as typically happens during a cyclical expansion, the economy eventually overheats, inflation increases, and the expansion is undermined as policy is forced to rein in demand. Transitory influences, clearly among the stars of the current episode, feature a coincidence of favorable supply shocks that have restrained inflation. Finally, structural adjustments, in this episode, hint at a decline in NAIRU and/or an increase in trend growth. The central question in interpreting the recent experience is whether the old limits on economic performance are no longer binding, having been replaced by new possibilities, or are just being temporarily overruled by transitory influences. Before moving to the substance of my talk, let me remind you that my remarks on the outlook and monetary policy, today and always, are my views. I do not speak for the FOMC. Near-Term prospects in the Good News Economy Before addressing the challenges and developing these themes, let me briefly review the surprisingly favorable features of recent economic performance and comment on the near-term outlook. For this audience, I can summarize recent performance in a single sentence. We have been recently blessed with relatively strong cyclical growth, the lowest unemployment rate in 24 years, the lowest - 2 - inflation in 31 years, an impressive investment boom, soaring equity prices and a 5-year decline in the federal budget deficit that may take the deficit to below 1⁄2% of GDP in fiscal 1997. But this conference is about the next chapter in this story. And the key in the near term may be crosscurrents that appear likely to both moderate output growth and keep inflation relatively well contained. In the case of output growth, the crosscurrents are the continued strength in demand and the expected slowing in inventory investment. In the second quarter, the economy slowed to an upward revised 3.6% rate, from a 4.9% rate in the first quarter, a much more modest slowing than originally reported and widely anticipated during the quarter. This, by the way, has been a recurring pattern in the expansion -- every time I thought the economy had or was about to slow to trend, it has surprised with its continued strength. The fundamentals continue to look very positive. In particular, households as a group are wealthy and optimistic, businesses are profitable and confronted with dramatic technological opportunities, and financial conditions remain supportive. There appear to be few imbalances that are a threat to continued expansion. As a result, demand is expected to remain strong in the second half of the year, paced by a rebound in consumer spending and complemented by continued strength in business fixed investment. Forecasters know, however, that the composition or mix of output in one quarter -specifically the mix between final demand and inventory investment -- often provides an important hint of what is to come. While I interpret the strength of inventory investment in the first half -- including the upward revised rate of about $78 billion in the second quarter -- as largely voluntary, principally reflecting a response to the strength in past and prospective sales, the flow rate of accumulation in the second quarter is almost certainly unsustainable. That is, stocks may be in equilibrium, but the flow rate will have to slow to keep them there. The resulting slowdown in inventory investment is likely, therefore, to be a significant drag on production in the second half of this year, offsetting, at least in part, the expected rebound in final demand. On the inflation side, there are also important crosscurrents at work. I have been concerned about two considerations that suggest that inflation may well rise over time: the possibility that the economy is operating today beyond its sustainable capacity and the likelihood that the transitory factors that have, on balance, been restraining inflation will diminish in importance over time. However, three other influences that, in my view, have gradually become more significant considerations, are likely to moderate the tendency for inflation to rise in the near term. First, lower-than-expected overall and core inflation and continued modest pace of wage change over this year will encourage more restrained increases in wages and prices over the coming year. Lower inflation leads to lower inflation expectations, reinforcing the prospect for low inflation ahead. In this case, inertia is our friend and the result is a virtuous wage-price spiral, at least for a while. Second, some of the transitory factors, especially the appreciation of the dollar and resulting decline in import prices, appear to have longer legs and are likely to contribute more toward restraint on inflation in coming quarters than earlier appeared likely. Third, the upward adjustment to profits in the July NIPA revisions suggests there is more of a profit cushion that could delay the pass-through of higher compensation to price increases. While these crosscurrents suggest moderation in both output growth and inflation, crosscurrents don't necessarily balance. With respect to output growth, the crosscurrents do point toward slower growth in the second half compared to the first half, but is important whether the slower growth turns out to be near trend, holding utilization rates constant, or above trend, pushing utilization rates still higher. At the very least, the slowdown in inventory investment is likely to be accommodated with minimal disturbance to the continued expansion. But there is a risk that growth will continue to be above trend, pushing utilization rates up, from already high levels. - 3 - With respect to inflation, the netting of the crosscurrents suggests a modest increase in inflation in 1998, albeit from a steadily downward-revised and very low rate in 1997. I will pay very close attention to the source of any rebound in inflation, specifically the degree to which it reflects simply the dissipation of some of the favorable supply shocks that have contributed to the very low inflation this year and the degree to which it reflects the more persistent effect of high utilization rates. As a result, I will be focusing more on core than overall inflation rates and paying particularly close attention to labor costs, given that labor markets appear tighter than product markets and therefore more likely to be the source of any increase in inflation pressures. Still, any increase in inflation would begin from a lower base and may be more modest than previously appeared likely. The bottom line is that past performance, in several important dimensions, has been extraordinary and that prospects look favorable for continued expansion and relatively low inflation. Still, monetary policy must be alert to the potential of a developing upward trend in inflation in an economy that may already be operating beyond its sustainable capacity and possibly still growing at an above-trend rate. And, as always, there are challenges, even in the good news economy. Limits on What Monetary Policy Can Do The first challenge is to avoid becoming complacent. Even as there are good reasons for celebrating recent economic performance, there are good reasons for avoiding complacency. Specifically, there are dimensions of economic performance which are less stellar, such as the slow average growth rate in GDP in the 1990s, a continuation of the effects of the productivity slowdown that began in the early 1970s. There are, in addition, obvious longer-run problems that deserve to be confronted today, such as those related to the aging of the population and resulting pressures on entitlement programs. And there remain lingering social strains associated with a gradual increase in income inequality, interacting with the low average growth rate in productivity to produce a long period of relatively stagnant real income for the median income family. This less rosy perspective on the current state of the economy was suggested by several members of Congress during the recent oversight hearings on monetary policy. I think the point is an important one and I agree that we should not let the recent favorable performance of inflation, unemployment and equity prices distract our attention from the importance of confronting a slow average rate of increase in living standards and lingering social problems that both reflect and are exacerbated by a widening in income inequality. However, other than through its pursuit of its legislative mandates of price stability and maximum sustainable employment, monetary policy cannot make a major contribution to the resolution of these problems. Monetary policy, in particular cannot remedy increases in income inequality, raise the trend rate of increase in living standards, or combat inadequate opportunities for upward mobility out of poverty. It is, as always, important that we carry out our traditional responsibilities well, accommodating the maximum sustainable growth and achieving the maximum sustainable level of employment. But we cannot do more. Regularities The second challenge is to explain why performance has been so favorable, at least in terms of inflation and unemployment. Before exploring explanations of the puzzle, I want to focus on common features of cyclical expansions. In doing so, I will focus on cyclical expansions that have not been dominated by dramatic external shocks, such as the two episodes that were marked by steeply rising world oil prices -- first in the early 1970s and again in the late 1970s and early 1980s. While even these expansions share many of the patterns I emphasize later, their endings are dominated by the effects of the powerful supply shocks and policy responses to the shocks. Expansions, by definition, begin with considerable economic slack, inherited from the previous recession. The economy typically makes a rapid transition from declining output (the definition of recession) to above-trend growth. In a loose way, trend growth refers to the growth in the economy's productive capacity. When growth is above trend, production is expanding faster than the economy's - 4 - productive capacity and, as a result, resource utilization rates rise. Rising capacity utilization rates and falling unemployment rates are thus a typical feature of an expansion period. The natural dynamic of an expansion is for above-trend growth to continue until demand overtakes capacity, despite the best efforts of policy to avoid cyclical excesses. The end of the story is particularly important. Expansions do not die of old age or lethargy, a spontaneous weakening of aggregate demand, but rather of an accumulation of imbalances, specifically with demand outstripping the limits of sustainable level of input utilization and growth of output. The resulting rise in inflation becomes a threat to the continued expansion. Preventive medicine is therefore the best course of treatment. In this story, NAIRU sets a limit to how far the economy can expand before overheating sets in and inflation rises, and the Phillips Curve traces out an important part of the dynamics of inflation, how fast it responds to excess demand. Of course, the Phillips Curve framework has always been much easier to describe than to implement, given uncertainties about the estimates of NAIRU, given the fact that empirical regularities between inflation and unemployment always left much of the variation in inflation unexplained, and given the importance of supply shocks with significant, though transitory, effects on the inflation-unemployment nexus. Nevertheless, the regularity in the cyclical sensitivity of inflation, as embedded in the Phillips Curve, has proved to be an important guide to both forecasters and monetary policymakers in the past. Transitory Influences The consensus estimates of NAIRU as this expansion began -- about 6% -- did not prepare us for the recent surprisingly favorable performance. It is possible that the Phillips Curve and NAIRU is simply the wrong analytical framework, but I doubt it and am not aware of another model of inflation dynamics that is ready to take its place. So my response is to update my estimate of NAIRU and add other explanations consistent with this framework, but not to abandon this concept. One possible explanation is that one or more transitory factors, for the moment, are yielding a more favorable than usual outcome. A coincidence of favorable supply shocks is clearly, in my judgment, an important part of the answer to the puzzle. I won't talk at length about these factors, as I have done so in previous talks. I would just note that these favorable supply shocks include an appreciation of the dollar and consequent decline in import prices; a slowing in the rate of increase in benefit costs, concentrated in a slowdown in costs for health care insurance; a faster rate of decline in computer prices than earlier, reflecting the quicker pace of innovation; and more recently, a decline in oil prices and a slower rate of increase in food prices. A Cyclical Anomaly Let me include in my list of explanations for the current favorable economic performance an intriguing cyclical anomaly. One regularity of past expansions has been the close relationship between two widely used measures of resource utilization -- the capacity utilization and unemployment rates. They have traditionally moved together over a cycle and tended to mirror one another. In this case, it did not matter which one was used as a proxy for excess demand; and the unemployment rate could be used interchangeably as a measure of labor market demand pressures and overall economy-wide demand pressures. In the current episode, however, these two measures are sending different signals. The unemployment rate is flashing a warning of a very tight labor market. The capacity utilization rate, in contrast, suggests a reasonably balanced configuration of production and capacity in the product market, at least in the manufacturing sector. Why has this divergence developed and what are its implications for the relationship between inflation and unemployment? The divergence mirrors one of the other defining features of this expansion -- the boom in business fixed investment. The result is a high level of net investment, a more rapid rate of increase in the capital stock and hence in industrial capacity. - 5 - The resulting absence of excess demand in the product market is, in my view, an important factor explaining the frequently reported absence of pricing leverage by firms. Nothing gives a firm pricing leverage like excess demand. In addition, the resulting inability of firms to pass on higher costs in higher prices likely has altered the way firms operate in the labor market, making them more reluctant to bid aggressively for workers, contributing to a slower rate of increase in wages than we would otherwise have expected at prevailing labor utilization rates. It is possible that the gap that has opened between the unemployment and capacity utilization rates may be a factor that has, in effect, lowered NAIRU in this expansion. This explanation has potential, but there is no historical precedent and it is, therefore, difficult to judge its importance. Possibilities The most intriguing explanations for the recent favorable performance are structural changes, which may have relaxed the capacity constraints that are the core of the cyclical regularities story, or made these constraints more flexible than in the past, or tempered the ability and/or willingness of firms to respond to excess demand by raising wages and prices. I refer to these collectively as "possibilities," as they suggest an optimistic period of improved economic performance, contrasting with both the pessimism of the previously perceived limits in the cyclical regularities story or the grudging "for the moment" concession of explanations relying on transitory influences. There are two possibilities that have been widely discussed: that the economy can now sustain a lower unemployment rate without rising inflation (i.e., that NAIRU has declined) and that, once capacity has been reached, the economy is now capable of faster growth, compared to the estimates of trend growth reported earlier. A lot of the discussion about this episode focuses on sorting out the relative importance of the two possibilities -specifically, whether the recent favorable performance is due more to labor market structural change, as reflected in a lower NAIRU, or to product market structural change, as reflected in a higher rate of growth in productivity. Has there been a decline in NAIRU? Time varying parameter estimates of the Phillips Curve and the more casual eye both suggest a decline in NAIRU. Robert Gordon's work, for example, suggests a decline in NAIRU, from 6% in the decade prior to 1994, to about 51⁄2% by the end of 1995, with NAIRU stabilizing at this level since that time. One possible explanation for the more moderate rate of increase in compensation per hour than would have been expected from historical experience is an increase in worker insecurity as a consequence of the rapid pace of technological change and/or the rapid pace of restructuring and downsizing. As a result, workers may have been willing to trade off some real wages for increased security, resulting in a more modest increase in compensation per hour than otherwise would have been expected. The result is a slower rate of increase in compensation at any given level of unemployment, equivalent to a decline in NAIRU. Another possible explanation is the divergence between the unemployment and capacity utilization rates in this expansion that I discussed earlier. Although a decline in NAIRU is a story of relaxed limits, the worker insecurity explanation is not itself an optimistic story. Some workers, to be sure, gain, by opportunities for employment that otherwise would have been denied. But a broader group of workers suffer a slower increase in living standards, relative to what otherwise would have been "possible." Has there been an increase in trend productivity? Another possibility is that the trend rate of increase in productivity -- and hence the economy's sustainable rate of growth in GDP -- has recently increased. There is some confusion in many discussions of productivity growth about the implications of measurement bias. It is widely accepted that there is a downward bias in measured - 6 - productivity growth, the mirror image of the upward bias in measured inflation. But it is also widely accepted that a similar bias has been present over the entire postwar period. The measurement issue is relevant to explaining the inflation-unemployment experience in the current episode only if the bias has recently become more serious. An increase in measurement bias could be under way, perhaps related to an acceleration in technical change, but it will be a long time before we are able to establish this with a reasonable degree of certainty. Note also that if the measurement bias has increased, this would imply that both actual and potential output growth are higher than reported, with no obvious implication for the gap between actual and potential output, and hence for inflation pressures. Sources of higher productivity growth, all of which should show up in measured productivity, include a return on years of corporate restructuring and the increase in capital per worker associated with the current investment boom, much of which is linked to technological change, specifically the information revolution. There are a couple of reasons why this is an attractive explanation. No other explanation has the ability to explain as many features of the current experience as an increase in trend productivity. Technological change, according to this view, has resulted in new profit opportunities which in turn have resulted in an investment boom (heavily concentrated in high technology equipment), increased corporate earnings, and a soaring stock market. In addition, this explanation is consistent with many anecdotes from businesses about efficiency gains as new technology is put into place. There are, however, some problems with this story as the principal explanation for the favorable inflation performance. First, a productivity explanation would resonate better if the puzzle were why higher wage change was not being passed on in higher prices. But the greater puzzle is the slow pace of increase in compensation per hour at prevailing unemployment rates. This is more clearly the case after the downward revision in compensation in the July NIPA revisions, bringing that measure of compensation per hour more in line with the Employment Cost Index. Given the rate of increase in compensation, an unchanged trend growth in productivity of 1.1%, for example, seems quite consistent with recent price performance. Although not without some serious shortcomings, the published productivity data provide little encouragement to the view that there has been a significant improvement in underlying productivity growth. The growth in measured productivity over this expansion has, in fact, been disappointing. Over 1994 and 1995, in particular, measured productivity was nearly flat. Although it has accelerated over the last two years, this is consistent with another cyclical regularity, the tendency for productivity to accelerate with economic activity. And the rate of growth over the last year, even with the sharp upward revision in the second quarter, is 1.2%, just above the 1.1% average rate of increase over the period from the early 1970s up to the beginning of this expansion. Still, there are other pieces of data and interpretations of the published data that provide some support to a more optimistic assessment. For example, the acceleration in productivity to a 1.2% rate over the last year, at a time when the unemployment rate was dropping to a level that would suggest less productive workers were being drawn on, leaves open the possibility that the productivity trend has quickened. Perhaps the strongest case for an increase in the productivity trend comes from the higher rate of growth over the past two years if productivity is measured from the income side of the national accounts. Balancing regularities and possibilities In my testimony at the Congressional oversight hearings, I presented a range of estimates for NAIRU and trend growth from the CBO, Council of Economic Advisers, DRI, Macroeconomic Advisers and Professor Robert Gordon. The range for NAIRU was 5.4% to 5.9% and for trend growth, 2.1%-2.3%. Since my testimony, both DRI and Macroeconomic Advisers have revised down their estimates of NAIRU-DRI from 5.8% to 5.6% and Macroeconomic Advisers from 5.8% to 5.4%. The range of estimates is now therefore more tightly concentrated around 51⁄2%. I presented these estimates in - 7 - my testimony to emphasize the continuing importance the profession attaches to NAIRU, the central tendency of current NAIRU estimates, and the absence of significant upward adjustments to estimates of trend growth. In short, some updating in the regularities may be appropriate, especially in the case of NAIRU, but continued attention to their message of limits remains critical for disciplined policy. We should remain open minded and alert to the possibility of structural change, but cautious about reaching the conclusion that the regularities that have been so important in the past no longer set limits that policy must respect. The challenge for monetary policy Some day we shall look back on this episode with historical perspective and perhaps -and only perhaps -- have a better ability to sort out what contributed to the favorable outcome and the extent to which the prevailing coexistence of low unemployment and stable low inflation proved permanent or transitory. Monetary policy, however, is made in real time. The appropriate stance of monetary policy should reflect both the increased uncertainty surrounding the failure of historical regularities to predict the better-than-expected outcome in terms of inflation and unemployment and the best judgement about regularities as we update our estimates of NAIRU and trend growth in response to current data. At one extreme, the uncertainty about the source of the recent performance might be viewed as so great that the best course for monetary policy is a reactive posture, waiting for clear signs that inflation is rising and only tightening in response to such evidence. I agree that the current uncertainty encourages caution, but not to the point of paralysis. A prudent approach would continue to lean against the cyclical winds by adjusting policy in response to persistent increases in utilization rates as well as in response to changes in underlying inflation. Summing Up We should always have problems like today's, struggling to explain unexpectedly good performance. And it is important to keep in perspective any questions about how tight labor markets might be or whether near-term growth might remain above trend. The economy is very healthy and the prospects continue to be bright. But as we celebrate the exceptional present, we should not forget the lessons of the past. There are limits. They may not be the old limits that disciplined policy in the past. But even if the limits are new, they must be respected. Overheating is a natural product of expansions that overtax these limits. Recessions typically follow overheating. Good policy must therefore balance regularities and possibilities.	['mr. meyer considers the economic outlook and challenges facing monetary policy remarks by mr. laurence h. meyer, a member of the board of governors of the us federal reserve system, before the 1998 global economic and investment outlook conference, carnegie mellon university, pittsburgh, pennsylvania on 17/9/97.', 'recent economic performance has been hailed on wall street as "paradise found" and the "best of times."', 'and, on main street, there is ample survey evidence suggesting that consumers are feeling very upbeat about the prospects for the economy.', 'i call the remarkable combination of healthy growth, low unemployment, low inflation, a soaring stock market, and declining federal budget deficit the "good news" economy.', 'but there are challenges even in the "good news" economy and i want to focus on three of them this afternoon.', 'the first challenge is to avoid complacency and appreciate the policy challenges that remain.', 'the second is to explain how we have been able to achieve such favorable performance, given that it is better than almost anyone predicted and better than historical regularities suggested was even possible.', 'and the third challenge is to assess the risks in the current environment and determine how monetary policy should be positioned to keep the good news coming.', 'two themes will become evident as i address these challenges.', 'first, there are limits -limits on what policy can accomplish and limits on what the economy can achieve.', 'second, in assessing the current environment and its implications for monetary policy, uncertainties require us to balance historical regularities and newer possibilities.', 'expansions, to an important degree, have common properties, what i shall refer to as regularities.', 'both forecasters and policymakers rely on these.', 'forecasters make predictions about future developments based on regularities.', 'the same regularities allow policymakers to act pre-emptively -changing policy today in anticipation of developments tomorrow.', 'yet each expansion has its own signature that reflects the specific set of transitory influences and longer-lasting structural changes in play at the time.', 'the current episode features the following players.', 'cyclical regularities clearly in evidence include accelerator effects, changing tolerances for risk, and cyclical swings in the unemployment rate and in profits.', 'two other regularities that i especially want to focus on today are the phillips curve and the trend growth in output.', 'the latter regularities define limits - limits to the sustainable level of output, at any moment, and, once that level of capacity is reached, to the growth of output over time.', 'if these limits are exceeded, as typically happens during a cyclical expansion, the economy eventually overheats, inflation increases, and the expansion is undermined as policy is forced to rein in demand.', 'transitory influences, clearly among the stars of the current episode, feature a coincidence of favorable supply shocks that have restrained inflation.', 'finally, structural adjustments, in this episode, hint at a decline in nairu and/or an increase in trend growth.', 'the central question in interpreting the recent experience is whether the old limits on economic performance are no longer binding, having been replaced by new possibilities, or are just being temporarily overruled by transitory influences.', 'before moving to the substance of my talk, let me remind you that my remarks on the outlook and monetary policy, today and always, are my views.', 'i do not speak for the fomc.', 'near-term prospects in the good news economy before addressing the challenges and developing these themes, let me briefly review the surprisingly favorable features of recent economic performance and comment on the near-term outlook.', 'for this audience, i can summarize recent performance in a single sentence.', 'we have been recently blessed with relatively strong cyclical growth, the lowest unemployment rate in 24 years, the lowest - 2 - inflation in 31 years, an impressive investment boom, soaring equity prices and a 5-year decline in the federal budget deficit that may take the deficit to below 1⁄2% of gdp in fiscal 1997. but this conference is about the next chapter in this story.', 'and the key in the near term may be crosscurrents that appear likely to both moderate output growth and keep inflation relatively well contained.', 'in the case of output growth, the crosscurrents are the continued strength in demand and the expected slowing in inventory investment.', 'in the second quarter, the economy slowed to an upward revised 3.6% rate, from a 4.9% rate in the first quarter, a much more modest slowing than originally reported and widely anticipated during the quarter.', 'this, by the way, has been a recurring pattern in the expansion -- every time i thought the economy had or was about to slow to trend, it has surprised with its continued strength.', 'the fundamentals continue to look very positive.', 'in particular, households as a group are wealthy and optimistic, businesses are profitable and confronted with dramatic technological opportunities, and financial conditions remain supportive.', 'there appear to be few imbalances that are a threat to continued expansion.', 'as a result, demand is expected to remain strong in the second half of the year, paced by a rebound in consumer spending and complemented by continued strength in business fixed investment.', 'forecasters know, however, that the composition or mix of output in one quarter -specifically the mix between final demand and inventory investment -- often provides an important hint of what is to come.', 'while i interpret the strength of inventory investment in the first half -- including the upward revised rate of about $78 billion in the second quarter -- as largely voluntary, principally reflecting a response to the strength in past and prospective sales, the flow rate of accumulation in the second quarter is almost certainly unsustainable.', 'that is, stocks may be in equilibrium, but the flow rate will have to slow to keep them there.', 'the resulting slowdown in inventory investment is likely, therefore, to be a significant drag on production in the second half of this year, offsetting, at least in part, the expected rebound in final demand.', 'on the inflation side, there are also important crosscurrents at work.', 'i have been concerned about two considerations that suggest that inflation may well rise over time: the possibility that the economy is operating today beyond its sustainable capacity and the likelihood that the transitory factors that have, on balance, been restraining inflation will diminish in importance over time.', 'however, three other influences that, in my view, have gradually become more significant considerations, are likely to moderate the tendency for inflation to rise in the near term.', 'first, lower-than-expected overall and core inflation and continued modest pace of wage change over this year will encourage more restrained increases in wages and prices over the coming year.', 'lower inflation leads to lower inflation expectations, reinforcing the prospect for low inflation ahead.', 'in this case, inertia is our friend and the result is a virtuous wage-price spiral, at least for a while.', 'second, some of the transitory factors, especially the appreciation of the dollar and resulting decline in import prices, appear to have longer legs and are likely to contribute more toward restraint on inflation in coming quarters than earlier appeared likely.', 'third, the upward adjustment to profits in the july nipa revisions suggests there is more of a profit cushion that could delay the pass-through of higher compensation to price increases.', "while these crosscurrents suggest moderation in both output growth and inflation, crosscurrents don't necessarily balance.", 'with respect to output growth, the crosscurrents do point toward slower growth in the second half compared to the first half, but is important whether the slower growth turns out to be near trend, holding utilization rates constant, or above trend, pushing utilization rates still higher.', 'at the very least, the slowdown in inventory investment is likely to be accommodated with minimal disturbance to the continued expansion.', 'but there is a risk that growth will continue to be above trend, pushing utilization rates up, from already high levels.', '- 3 - with respect to inflation, the netting of the crosscurrents suggests a modest increase in inflation in 1998, albeit from a steadily downward-revised and very low rate in 1997. i will pay very close attention to the source of any rebound in inflation, specifically the degree to which it reflects simply the dissipation of some of the favorable supply shocks that have contributed to the very low inflation this year and the degree to which it reflects the more persistent effect of high utilization rates.', 'as a result, i will be focusing more on core than overall inflation rates and paying particularly close attention to labor costs, given that labor markets appear tighter than product markets and therefore more likely to be the source of any increase in inflation pressures.', 'still, any increase in inflation would begin from a lower base and may be more modest than previously appeared likely.', 'the bottom line is that past performance, in several important dimensions, has been extraordinary and that prospects look favorable for continued expansion and relatively low inflation.', 'still, monetary policy must be alert to the potential of a developing upward trend in inflation in an economy that may already be operating beyond its sustainable capacity and possibly still growing at an above-trend rate.', 'and, as always, there are challenges, even in the good news economy.', 'limits on what monetary policy can do the first challenge is to avoid becoming complacent.', 'even as there are good reasons for celebrating recent economic performance, there are good reasons for avoiding complacency.', 'specifically, there are dimensions of economic performance which are less stellar, such as the slow average growth rate in gdp in the 1990s, a continuation of the effects of the productivity slowdown that began in the early 1970s.', 'there are, in addition, obvious longer-run problems that deserve to be confronted today, such as those related to the aging of the population and resulting pressures on entitlement programs.', 'and there remain lingering social strains associated with a gradual increase in income inequality, interacting with the low average growth rate in productivity to produce a long period of relatively stagnant real income for the median income family.', 'this less rosy perspective on the current state of the economy was suggested by several members of congress during the recent oversight hearings on monetary policy.', 'i think the point is an important one and i agree that we should not let the recent favorable performance of inflation, unemployment and equity prices distract our attention from the importance of confronting a slow average rate of increase in living standards and lingering social problems that both reflect and are exacerbated by a widening in income inequality.', 'however, other than through its pursuit of its legislative mandates of price stability and maximum sustainable employment, monetary policy cannot make a major contribution to the resolution of these problems.', 'monetary policy, in particular cannot remedy increases in income inequality, raise the trend rate of increase in living standards, or combat inadequate opportunities for upward mobility out of poverty.', 'it is, as always, important that we carry out our traditional responsibilities well, accommodating the maximum sustainable growth and achieving the maximum sustainable level of employment.', 'but we cannot do more.', 'regularities the second challenge is to explain why performance has been so favorable, at least in terms of inflation and unemployment.', 'before exploring explanations of the puzzle, i want to focus on common features of cyclical expansions.', 'in doing so, i will focus on cyclical expansions that have not been dominated by dramatic external shocks, such as the two episodes that were marked by steeply rising world oil prices -- first in the early 1970s and again in the late 1970s and early 1980s.', 'while even these expansions share many of the patterns i emphasize later, their endings are dominated by the effects of the powerful supply shocks and policy responses to the shocks.', 'expansions, by definition, begin with considerable economic slack, inherited from the previous recession.', 'the economy typically makes a rapid transition from declining output (the definition of recession) to above-trend growth.', "in a loose way, trend growth refers to the growth in the economy's productive capacity.", "when growth is above trend, production is expanding faster than the economy's - 4 - productive capacity and, as a result, resource utilization rates rise.", 'rising capacity utilization rates and falling unemployment rates are thus a typical feature of an expansion period.', 'the natural dynamic of an expansion is for above-trend growth to continue until demand overtakes capacity, despite the best efforts of policy to avoid cyclical excesses.', 'the end of the story is particularly important.', 'expansions do not die of old age or lethargy, a spontaneous weakening of aggregate demand, but rather of an accumulation of imbalances, specifically with demand outstripping the limits of sustainable level of input utilization and growth of output.', 'the resulting rise in inflation becomes a threat to the continued expansion.', 'preventive medicine is therefore the best course of treatment.', 'in this story, nairu sets a limit to how far the economy can expand before overheating sets in and inflation rises, and the phillips curve traces out an important part of the dynamics of inflation, how fast it responds to excess demand.', 'of course, the phillips curve framework has always been much easier to describe than to implement, given uncertainties about the estimates of nairu, given the fact that empirical regularities between inflation and unemployment always left much of the variation in inflation unexplained, and given the importance of supply shocks with significant, though transitory, effects on the inflation-unemployment nexus.', 'nevertheless, the regularity in the cyclical sensitivity of inflation, as embedded in the phillips curve, has proved to be an important guide to both forecasters and monetary policymakers in the past.', 'transitory influences the consensus estimates of nairu as this expansion began -- about 6% -- did not prepare us for the recent surprisingly favorable performance.', 'it is possible that the phillips curve and nairu is simply the wrong analytical framework, but i doubt it and am not aware of another model of inflation dynamics that is ready to take its place.', 'so my response is to update my estimate of nairu and add other explanations consistent with this framework, but not to abandon this concept.', 'one possible explanation is that one or more transitory factors, for the moment, are yielding a more favorable than usual outcome.', 'a coincidence of favorable supply shocks is clearly, in my judgment, an important part of the answer to the puzzle.', "i won't talk at length about these factors, as i have done so in previous talks.", 'i would just note that these favorable supply shocks include an appreciation of the dollar and consequent decline in import prices; a slowing in the rate of increase in benefit costs, concentrated in a slowdown in costs for health care insurance; a faster rate of decline in computer prices than earlier, reflecting the quicker pace of innovation; and more recently, a decline in oil prices and a slower rate of increase in food prices.', 'a cyclical anomaly let me include in my list of explanations for the current favorable economic performance an intriguing cyclical anomaly.', 'one regularity of past expansions has been the close relationship between two widely used measures of resource utilization -- the capacity utilization and unemployment rates.', 'they have traditionally moved together over a cycle and tended to mirror one another.', 'in this case, it did not matter which one was used as a proxy for excess demand; and the unemployment rate could be used interchangeably as a measure of labor market demand pressures and overall economy-wide demand pressures.', 'in the current episode, however, these two measures are sending different signals.', 'the unemployment rate is flashing a warning of a very tight labor market.', 'the capacity utilization rate, in contrast, suggests a reasonably balanced configuration of production and capacity in the product market, at least in the manufacturing sector.', 'why has this divergence developed and what are its implications for the relationship between inflation and unemployment?', 'the divergence mirrors one of the other defining features of this expansion -- the boom in business fixed investment.', 'the result is a high level of net investment, a more rapid rate of increase in the capital stock and hence in industrial capacity.', '- 5 - the resulting absence of excess demand in the product market is, in my view, an important factor explaining the frequently reported absence of pricing leverage by firms.', 'nothing gives a firm pricing leverage like excess demand.', 'in addition, the resulting inability of firms to pass on higher costs in higher prices likely has altered the way firms operate in the labor market, making them more reluctant to bid aggressively for workers, contributing to a slower rate of increase in wages than we would otherwise have expected at prevailing labor utilization rates.', 'it is possible that the gap that has opened between the unemployment and capacity utilization rates may be a factor that has, in effect, lowered nairu in this expansion.', 'this explanation has potential, but there is no historical precedent and it is, therefore, difficult to judge its importance.', 'possibilities the most intriguing explanations for the recent favorable performance are structural changes, which may have relaxed the capacity constraints that are the core of the cyclical regularities story, or made these constraints more flexible than in the past, or tempered the ability and/or willingness of firms to respond to excess demand by raising wages and prices.', 'i refer to these collectively as "possibilities," as they suggest an optimistic period of improved economic performance, contrasting with both the pessimism of the previously perceived limits in the cyclical regularities story or the grudging "for the moment" concession of explanations relying on transitory influences.', 'there are two possibilities that have been widely discussed: that the economy can now sustain a lower unemployment rate without rising inflation (i.e., that nairu has declined) and that, once capacity has been reached, the economy is now capable of faster growth, compared to the estimates of trend growth reported earlier.', 'a lot of the discussion about this episode focuses on sorting out the relative importance of the two possibilities -specifically, whether the recent favorable performance is due more to labor market structural change, as reflected in a lower nairu, or to product market structural change, as reflected in a higher rate of growth in productivity.', 'has there been a decline in nairu?', 'time varying parameter estimates of the phillips curve and the more casual eye both suggest a decline in nairu.', "robert gordon's work, for example, suggests a decline in nairu, from 6% in the decade prior to 1994, to about 51⁄2% by the end of 1995, with nairu stabilizing at this level since that time.", 'one possible explanation for the more moderate rate of increase in compensation per hour than would have been expected from historical experience is an increase in worker insecurity as a consequence of the rapid pace of technological change and/or the rapid pace of restructuring and downsizing.', 'as a result, workers may have been willing to trade off some real wages for increased security, resulting in a more modest increase in compensation per hour than otherwise would have been expected.', 'the result is a slower rate of increase in compensation at any given level of unemployment, equivalent to a decline in nairu.', 'another possible explanation is the divergence between the unemployment and capacity utilization rates in this expansion that i discussed earlier.', 'although a decline in nairu is a story of relaxed limits, the worker insecurity explanation is not itself an optimistic story.', 'some workers, to be sure, gain, by opportunities for employment that otherwise would have been denied.', 'but a broader group of workers suffer a slower increase in living standards, relative to what otherwise would have been "possible."', 'has there been an increase in trend productivity?', "another possibility is that the trend rate of increase in productivity -- and hence the economy's sustainable rate of growth in gdp -- has recently increased.", 'there is some confusion in many discussions of productivity growth about the implications of measurement bias.', 'it is widely accepted that there is a downward bias in measured - 6 - productivity growth, the mirror image of the upward bias in measured inflation.', 'but it is also widely accepted that a similar bias has been present over the entire postwar period.', 'the measurement issue is relevant to explaining the inflation-unemployment experience in the current episode only if the bias has recently become more serious.', 'an increase in measurement bias could be under way, perhaps related to an acceleration in technical change, but it will be a long time before we are able to establish this with a reasonable degree of certainty.', 'note also that if the measurement bias has increased, this would imply that both actual and potential output growth are higher than reported, with no obvious implication for the gap between actual and potential output, and hence for inflation pressures.', 'sources of higher productivity growth, all of which should show up in measured productivity, include a return on years of corporate restructuring and the increase in capital per worker associated with the current investment boom, much of which is linked to technological change, specifically the information revolution.', 'there are a couple of reasons why this is an attractive explanation.', 'no other explanation has the ability to explain as many features of the current experience as an increase in trend productivity.', 'technological change, according to this view, has resulted in new profit opportunities which in turn have resulted in an investment boom (heavily concentrated in high technology equipment), increased corporate earnings, and a soaring stock market.', 'in addition, this explanation is consistent with many anecdotes from businesses about efficiency gains as new technology is put into place.', 'there are, however, some problems with this story as the principal explanation for the favorable inflation performance.', 'first, a productivity explanation would resonate better if the puzzle were why higher wage change was not being passed on in higher prices.', 'but the greater puzzle is the slow pace of increase in compensation per hour at prevailing unemployment rates.', 'this is more clearly the case after the downward revision in compensation in the july nipa revisions, bringing that measure of compensation per hour more in line with the employment cost index.', 'given the rate of increase in compensation, an unchanged trend growth in productivity of 1.1%, for example, seems quite consistent with recent price performance.', 'although not without some serious shortcomings, the published productivity data provide little encouragement to the view that there has been a significant improvement in underlying productivity growth.', 'the growth in measured productivity over this expansion has, in fact, been disappointing.', 'over 1994 and 1995, in particular, measured productivity was nearly flat.', 'although it has accelerated over the last two years, this is consistent with another cyclical regularity, the tendency for productivity to accelerate with economic activity.', 'and the rate of growth over the last year, even with the sharp upward revision in the second quarter, is 1.2%, just above the 1.1% average rate of increase over the period from the early 1970s up to the beginning of this expansion.', 'still, there are other pieces of data and interpretations of the published data that provide some support to a more optimistic assessment.', 'for example, the acceleration in productivity to a 1.2% rate over the last year, at a time when the unemployment rate was dropping to a level that would suggest less productive workers were being drawn on, leaves open the possibility that the productivity trend has quickened.', 'perhaps the strongest case for an increase in the productivity trend comes from the higher rate of growth over the past two years if productivity is measured from the income side of the national accounts.', 'balancing regularities and possibilities in my testimony at the congressional oversight hearings, i presented a range of estimates for nairu and trend growth from the cbo, council of economic advisers, dri, macroeconomic advisers and professor robert gordon.', 'the range for nairu was 5.4% to 5.9% and for trend growth, 2.1%-2.3%.', 'since my testimony, both dri and macroeconomic advisers have revised down their estimates of nairu-dri from 5.8% to 5.6% and macroeconomic advisers from 5.8% to 5.4%.', 'the range of estimates is now therefore more tightly concentrated around 51⁄2%.', 'i presented these estimates in - 7 - my testimony to emphasize the continuing importance the profession attaches to nairu, the central tendency of current nairu estimates, and the absence of significant upward adjustments to estimates of trend growth.', 'in short, some updating in the regularities may be appropriate, especially in the case of nairu, but continued attention to their message of limits remains critical for disciplined policy.', 'we should remain open minded and alert to the possibility of structural change, but cautious about reaching the conclusion that the regularities that have been so important in the past no longer set limits that policy must respect.', 'the challenge for monetary policy some day we shall look back on this episode with historical perspective and perhaps -and only perhaps -- have a better ability to sort out what contributed to the favorable outcome and the extent to which the prevailing coexistence of low unemployment and stable low inflation proved permanent or transitory.', 'monetary policy, however, is made in real time.', 'the appropriate stance of monetary policy should reflect both the increased uncertainty surrounding the failure of historical regularities to predict the better-than-expected outcome in terms of inflation and unemployment and the best judgement about regularities as we update our estimates of nairu and trend growth in response to current data.', 'at one extreme, the uncertainty about the source of the recent performance might be viewed as so great that the best course for monetary policy is a reactive posture, waiting for clear signs that inflation is rising and only tightening in response to such evidence.', 'i agree that the current uncertainty encourages caution, but not to the point of paralysis.', 'a prudent approach would continue to lean against the cyclical winds by adjusting policy in response to persistent increases in utilization rates as well as in response to changes in underlying inflation.', "summing up we should always have problems like today's, struggling to explain unexpectedly good performance.", 'and it is important to keep in perspective any questions about how tight labor markets might be or whether near-term growth might remain above trend.', 'the economy is very healthy and the prospects continue to be bright.', 'but as we celebrate the exceptional present, we should not forget the lessons of the past.', 'they may not be the old limits that disciplined policy in the past.', 'but even if the limits are new, they must be respected.', 'overheating is a natural product of expansions that overtax these limits.', 'recessions typically follow overheating.', 'good policy must therefore balance regularities and possibilities.']	Laurence H Meyer	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r970925d.pdf	Mr. Thiessen looks at the recent economic record in Canada and the challenges ahead for monetary policy (Central Bank Articles and Speeches, 16 Sep 97)	Notes for remarks by Mr. Gordon Thiessen, Governor of the Bank of Canada, to the New England-Canadian Business Council in Boston, USA, on 16/9/97.	1997-09-16 00:00:00	Mr. Thiessen looks at the recent economic record in Canada and the challenges ahead for monetary policy Notes for remarks by Mr. Gordon Thiessen, Governor of the Bank of Canada, to the New England-Canadian Business Council in Boston, USA, on 16/9/97. It has been a little over two years since my last public speech to an audience in the United States. During this time, a lot has happened in terms of economic developments in our two countries. One thing that continues to impress me is the remarkable performance of the U.S. economy, which has achieved six years of steady economic expansion, with high rates of job creation and low inflation. As a neighbour and major trading partner, Canada has certainly benefited from the strong U.S. economy. But I think that what is happening in the United States is relevant to Canada in other ways. First, it offers a yardstick that we Canadians often use to judge the performance of our own economy. Second, as the unused capacity in the Canadian economy is gradually absorbed, monetary policy in Canada will be facing challenges similar to those that the Federal Reserve has had to confront in trying to steer the U.S. economy on a path of durable, non-inflationary expansion. The recent U.S. experience in this area is, therefore, particularly interesting for us. Today, I would like to discuss the recent economic record in Canada and the challenges ahead for monetary policy. In doing so, I will emphasize the Bank of Canada's continued commitment to explicit targets for keeping inflation low. Along with their other benefits, these targets help anchor market expectations about future movements in the exchange rate. The role of the exchange rate in the operation of Canadian monetary policy is another topic I will discuss today. The recent economic record in Canada Let us first take a quick look at how the Canadian economy has performed in the recent past, in comparative terms. In terms of economic growth and job creation, there is no doubt that Canada has not done as well as the United States in the 1990s. And even though, in my view, there are good explanations for this, the fact remains that Canada has some catching up to do in this regard. Why has the growth in output and employment been more modest in Canada than in the United States in recent years? I believe that the reasons lie in the major transformation that the Canadian economy has been going through since the beginning of this decade. This transformation has been in response both to the universal forces of globalization and technological change, and to the need to unwind the domestic excesses and imbalances that had built up in the 1970s and the 1980s. Let me remind you that, through that period, high actual and expected inflation had led to escalating production costs, speculative activity, and the accumulation of debt by households, by businesses, and by Canadian governments. Our foreign indebtedness was also rising rapidly, as were the risk premiums in our interest rates, leaving us in a very vulnerable position indeed. By the late 1980s, the situation had become untenable. Canada had to adjust. Of course, the United States also had to cope with many of these changes. Why has the restructuring been more intense and disruptive in Canada? In my view, the most important reasons are that the distortions arising from high inflation were more severe in Canada and that the adjustments to globalization and technological change were slow in coming. As a result, Canada had to do more and do it faster. The short-run disruptions associated with the economic restructuring have been significant. Plant closings, cutbacks in major government programs, and layoffs in both the private and public sectors caused a great deal of uncertainty among Canadian households. And it did not help that interest rates rose sharply in 1994 and early 1995 as investor nervousness about Canada's fiscal and political situation increased in the wake of turbulence in global financial markets. All of this left Canadians anxious about the future and cautious about spending, which acted as a drag on output and employment. But there have also been some particularly encouraging results from the restructuring. Canada has made rather dramatic economic adjustments in recent years, and as a result has emerged with a much sounder economic foundation. Inflation has averaged just under 2 per cent during the past five and a half years -- well below that in the United States. With the benefit of low inflation and low interest rates, Canadian businesses have been investing in new technology and streamlining their operations to become more efficient, productive, and internationally competitive. Canadian governments have taken steps to reduce their deficits and to move towards less vulnerable debt positions. And, with our success in exporting and these improved fiscal positions, the persistent large shortfall in the current account of our international balance of payments has narrowed markedly. These improvements in Canada's economic fundamentals have not been lost on financial markets. They are the reason why risk premiums demanded by investors on Canadian dollar assets have declined sharply over the past two years. They are also the reason why the markets today see a potential for upward movement in the Canadian dollar over time, thus allowing interest rates on maturities up to 30 years to remain below comparable U.S. rates. This is a view of the Canadian dollar that we at the Bank of Canada share. These low Canadian interest rates represent a substantial stimulus to domestic spending. Because of the lags involved, it has taken households and businesses some time to respond. But now we have strong evidence, particularly from the interest-rate-sensitive sectors of the economy, that the consumer is back. And businesses continue to increase their capital spending. Moreover, the latest surveys of consumer and business confidence point to continued expansion in domestic spending in coming months. What is particularly heartening is that total employment growth has picked up recently, despite the cutbacks in the public sector, and that the number of full-time jobs has increased significantly. Altogether, it seems to me that the Canadian economy has the potential for a long period of sustained growth in output and employment, with rising productivity and improving living standards. The challenge ahead What does monetary policy need to do to help realize this potential? With the economy gathering momentum, the challenge for monetary policy in the period ahead will be to encourage monetary conditions that preserve Canada's good inflation performance, because low inflation is a prerequisite for a durable economic expansion. Experience has taught us that monetary stimulus which pushes too hard on the economy's capacity limits for too long inevitably leads to rising inflation and painful boom and bust economic cycles of the kind we suffered in Canada from the 1970s to the early 1990s. Concern about inflation risks at this stage may seem misplaced. But monetary policy actions have their full effects on the economy with relatively long lags. So what we must be concerned with is not the current rate of inflation but rather what may happen in 1998 and beyond. To maintain a low and stable rate of inflation in the period ahead, we must conduct monetary policy in a forward-looking, pre-emptive manner. This means that we should be ready to take action early to ensure that, as slack is absorbed, the pace of economic activity converges smoothly with the path implied by potential output -- that is, the economy's capacity to produce on a sustained basis. It is our view that the Canadian economy should indeed absorb the existing unused capacity over the course of the next couple of years. Thus, there will be a need to move to less-stimulative monetary conditions in the period ahead. Taking timely, measured steps in that direction is the recipe for avoiding the more substantial, and potentially more disruptive, tightening that would be required later if monetary policy actions were unduly delayed. As the Canadian economy approaches full capacity, we will have to contend with the considerable uncertainty that surrounds the estimation of potential output. The recent experience in the United States, where despite a high level of resource utilization there has been no sign yet of generalized inflationary pressures, raises the possibility that past relationships have been altered by structural changes at both the national and international levels. It is possible that technological innovations have increased the flexibility and efficiency of production processes. Heightened global competition and low inflation worldwide may have led to a reduction of inflation expectations and to a change in price- and wage-setting behaviour. Monetary policy must somehow find a way to take all of these factors into consideration in order to avoid systematic misjudgements on potential output and the risk of inflation. I believe that Canada's inflation-control target provides a useful framework within which to do that. Let me explain. Our target, set jointly with the Government of Canada, calls for inflation to be held within a range of 1 to 3 per cent. One attraction of an explicit inflation-control target is that it allows a ready assessment of macroeconomic performance by looking at the trend of the inflation rate relative to the target range. If it looks as though the trend of inflation will push through the top of the target range, this implies that demand in the economy has been unsustainably strong. Conversely, if it appears that the trend of inflation is about to fall through the bottom of the range, this suggests weak demand and a persistent margin of unused capacity. Moreover, if we somehow continually misjudge the economy's capacity to produce, we will in all likelihood witness an unexpected trend in the inflation rate. For example, if the rate is persistently lower than would have been expected in the past at the current levels of aggregate demand, and it is tending to press the bottom of the target range, chances are that the economy has more room to absorb higher levels of demand than previously thought. Thus, the targets provide a check on systematic errors in estimating potential output. However, if monetary policy is going to take account of such signals, the central bank had better make sure that its inflation-control strategy is a credible one. Why? Because only if it is widely accepted that the central bank will keep inflation under control, will businesses and individuals not respond immediately to signs of strong demand pressures by seeking to raise prices and wages. The recent U.S. experience attests to this. Indeed, strong credibility has been a key factor that has enabled the Fed to take account of the possible changes in economic structure that I mentioned earlier and to steer the U.S. economy successfully towards levels of aggregate demand and employment that in the past would have been thought incompatible with maintaining low inflation. It is by conducting monetary policy prudently during the economic upswing that we at the Bank of Canada will have the credibility needed when our economy begins to operate at levels that test its potential to produce. The role of the exchange rate I would now like to take a moment to underscore the important role that the exchange rate plays in the conduct of Canadian monetary policy and to explain what I meant earlier when I used the term "monetary conditions". In a medium-sized, open economy, like Canada's, a good deal of the impact of monetary policy actions is channelled through the exchange rate. But because financial markets do not always respond to events in completely predictable ways, we do not know exactly how interest rates and the exchange rate will move and interact. That is why we at the Bank have found it useful to construct an index of monetary conditions to help us keep track of the combined effect of these two variables on aggregate demand in Canada. To understand how we use monetary conditions in practice, let us look at the recent situation where cyclical differences have meant that the Canadian economy has been weaker than the U.S. economy. In these circumstances, the need for accommodative monetary conditions in Canada required the Bank of Canada to take action to lower interest rates. But the magnitude and timing of those interest rate reductions depended, to an important degree, on the exchange rate response. With the Canadian dollar roughly stable between late 1995 and late 1996, the easing in monetary conditions could take place through measured declines in interest rates. The strengthening Canadian dollar through the latter part of 1996 accelerated the decline in interest rates, as the Bank of Canada sought to maintain the degree of monetary ease achieved in the autumn of 1996. With the economy gathering momentum since then, persistent weakness in the Canadian dollar through June 1997 prompted a small increase in interest rates in order to offset an undesired further easing in monetary conditions. I might add that, since cyclical differences have required interest rates in Canada to be below those in the United States, there has been -- rightly -- a strong market perception that the relative weakness of the Canadian dollar is temporary and that a future appreciation will compensate investors for the lower yields on Canadian dollar assets. But experience has taught us that this process of exchange rate/interest rate interaction works well only if there are no concerns in the markets about Canadian economic policies. As we found out in 1994-95, when there were concerns about fiscal policy, a decline in the value of the Canadian dollar can generate a loss of confidence and expectations of further depreciation of the currency, not of subsequent appreciation. The upshot of all this is that, with a floating currency, market participants need a consistent and credible policy framework to help anchor their expectations about future movements in the exchange rate. Such a framework rests, above all, on a firm undertaking by the authorities to preserve the domestic purchasing value of the currency. I believe that our inflation-control targets, by giving a clear, precise view of this commitment, provide a strong underpinning for the external value of the Canadian dollar. What is my main message to you today? Canada is in better shape now than it has been for many years to face the economic challenges of the future and to reap the benefits of changing technology and an increasingly integrated world economy. But, for this scenario to unfold, there will have to be continued commitment by the authorities to prudent, credible economic policies. As far as monetary policy goes, this means a pledge to maintain Canada's good inflation performance. That is a pledge I can give without reservation.	['mr. thiessen looks at the recent economic record in canada and the challenges ahead for monetary policy notes for remarks by mr. gordon thiessen, governor of the bank of canada, to the new england-canadian business council in boston, usa, on 16/9/97.', 'it has been a little over two years since my last public speech to an audience in the united states.', 'during this time, a lot has happened in terms of economic developments in our two countries.', 'one thing that continues to impress me is the remarkable performance of the u.s. economy, which has achieved six years of steady economic expansion, with high rates of job creation and low inflation.', 'as a neighbour and major trading partner, canada has certainly benefited from the strong u.s. economy.', 'but i think that what is happening in the united states is relevant to canada in other ways.', 'first, it offers a yardstick that we canadians often use to judge the performance of our own economy.', 'second, as the unused capacity in the canadian economy is gradually absorbed, monetary policy in canada will be facing challenges similar to those that the federal reserve has had to confront in trying to steer the u.s. economy on a path of durable, non-inflationary expansion.', 'the recent u.s. experience in this area is, therefore, particularly interesting for us.', 'today, i would like to discuss the recent economic record in canada and the challenges ahead for monetary policy.', "in doing so, i will emphasize the bank of canada's continued commitment to explicit targets for keeping inflation low.", 'along with their other benefits, these targets help anchor market expectations about future movements in the exchange rate.', 'the role of the exchange rate in the operation of canadian monetary policy is another topic i will discuss today.', 'the recent economic record in canada let us first take a quick look at how the canadian economy has performed in the recent past, in comparative terms.', 'in terms of economic growth and job creation, there is no doubt that canada has not done as well as the united states in the 1990s.', 'and even though, in my view, there are good explanations for this, the fact remains that canada has some catching up to do in this regard.', 'why has the growth in output and employment been more modest in canada than in the united states in recent years?', 'i believe that the reasons lie in the major transformation that the canadian economy has been going through since the beginning of this decade.', 'this transformation has been in response both to the universal forces of globalization and technological change, and to the need to unwind the domestic excesses and imbalances that had built up in the 1970s and the 1980s.', 'let me remind you that, through that period, high actual and expected inflation had led to escalating production costs, speculative activity, and the accumulation of debt by households, by businesses, and by canadian governments.', 'our foreign indebtedness was also rising rapidly, as were the risk premiums in our interest rates, leaving us in a very vulnerable position indeed.', 'by the late 1980s, the situation had become untenable.', 'canada had to adjust.', 'of course, the united states also had to cope with many of these changes.', 'why has the restructuring been more intense and disruptive in canada?', 'in my view, the most important reasons are that the distortions arising from high inflation were more severe in canada and that the adjustments to globalization and technological change were slow in coming.', 'as a result, canada had to do more and do it faster.', 'the short-run disruptions associated with the economic restructuring have been significant.', 'plant closings, cutbacks in major government programs, and layoffs in both the private and public sectors caused a great deal of uncertainty among canadian households.', "and it did not help that interest rates rose sharply in 1994 and early 1995 as investor nervousness about canada's fiscal and political situation increased in the wake of turbulence in global financial markets.", 'all of this left canadians anxious about the future and cautious about spending, which acted as a drag on output and employment.', 'but there have also been some particularly encouraging results from the restructuring.', 'canada has made rather dramatic economic adjustments in recent years, and as a result has emerged with a much sounder economic foundation.', 'inflation has averaged just under 2 per cent during the past five and a half years -- well below that in the united states.', 'with the benefit of low inflation and low interest rates, canadian businesses have been investing in new technology and streamlining their operations to become more efficient, productive, and internationally competitive.', 'canadian governments have taken steps to reduce their deficits and to move towards less vulnerable debt positions.', 'and, with our success in exporting and these improved fiscal positions, the persistent large shortfall in the current account of our international balance of payments has narrowed markedly.', "these improvements in canada's economic fundamentals have not been lost on financial markets.", 'they are the reason why risk premiums demanded by investors on canadian dollar assets have declined sharply over the past two years.', 'they are also the reason why the markets today see a potential for upward movement in the canadian dollar over time, thus allowing interest rates on maturities up to 30 years to remain below comparable u.s. rates.', 'this is a view of the canadian dollar that we at the bank of canada share.', 'these low canadian interest rates represent a substantial stimulus to domestic spending.', 'because of the lags involved, it has taken households and businesses some time to respond.', 'but now we have strong evidence, particularly from the interest-rate-sensitive sectors of the economy, that the consumer is back.', 'and businesses continue to increase their capital spending.', 'moreover, the latest surveys of consumer and business confidence point to continued expansion in domestic spending in coming months.', 'what is particularly heartening is that total employment growth has picked up recently, despite the cutbacks in the public sector, and that the number of full-time jobs has increased significantly.', 'altogether, it seems to me that the canadian economy has the potential for a long period of sustained growth in output and employment, with rising productivity and improving living standards.', 'the challenge ahead what does monetary policy need to do to help realize this potential?', "with the economy gathering momentum, the challenge for monetary policy in the period ahead will be to encourage monetary conditions that preserve canada's good inflation performance, because low inflation is a prerequisite for a durable economic expansion.", "experience has taught us that monetary stimulus which pushes too hard on the economy's capacity limits for too long inevitably leads to rising inflation and painful boom and bust economic cycles of the kind we suffered in canada from the 1970s to the early 1990s.", 'concern about inflation risks at this stage may seem misplaced.', 'but monetary policy actions have their full effects on the economy with relatively long lags.', 'so what we must be concerned with is not the current rate of inflation but rather what may happen in 1998 and beyond.', 'to maintain a low and stable rate of inflation in the period ahead, we must conduct monetary policy in a forward-looking, pre-emptive manner.', "this means that we should be ready to take action early to ensure that, as slack is absorbed, the pace of economic activity converges smoothly with the path implied by potential output -- that is, the economy's capacity to produce on a sustained basis.", 'it is our view that the canadian economy should indeed absorb the existing unused capacity over the course of the next couple of years.', 'thus, there will be a need to move to less-stimulative monetary conditions in the period ahead.', 'taking timely, measured steps in that direction is the recipe for avoiding the more substantial, and potentially more disruptive, tightening that would be required later if monetary policy actions were unduly delayed.', 'as the canadian economy approaches full capacity, we will have to contend with the considerable uncertainty that surrounds the estimation of potential output.', 'the recent experience in the united states, where despite a high level of resource utilization there has been no sign yet of generalized inflationary pressures, raises the possibility that past relationships have been altered by structural changes at both the national and international levels.', 'it is possible that technological innovations have increased the flexibility and efficiency of production processes.', 'heightened global competition and low inflation worldwide may have led to a reduction of inflation expectations and to a change in price- and wage-setting behaviour.', 'monetary policy must somehow find a way to take all of these factors into consideration in order to avoid systematic misjudgements on potential output and the risk of inflation.', "i believe that canada's inflation-control target provides a useful framework within which to do that.", 'our target, set jointly with the government of canada, calls for inflation to be held within a range of 1 to 3 per cent.', 'one attraction of an explicit inflation-control target is that it allows a ready assessment of macroeconomic performance by looking at the trend of the inflation rate relative to the target range.', 'if it looks as though the trend of inflation will push through the top of the target range, this implies that demand in the economy has been unsustainably strong.', 'conversely, if it appears that the trend of inflation is about to fall through the bottom of the range, this suggests weak demand and a persistent margin of unused capacity.', "moreover, if we somehow continually misjudge the economy's capacity to produce, we will in all likelihood witness an unexpected trend in the inflation rate.", 'for example, if the rate is persistently lower than would have been expected in the past at the current levels of aggregate demand, and it is tending to press the bottom of the target range, chances are that the economy has more room to absorb higher levels of demand than previously thought.', 'thus, the targets provide a check on systematic errors in estimating potential output.', 'however, if monetary policy is going to take account of such signals, the central bank had better make sure that its inflation-control strategy is a credible one.', 'because only if it is widely accepted that the central bank will keep inflation under control, will businesses and individuals not respond immediately to signs of strong demand pressures by seeking to raise prices and wages.', 'the recent u.s. experience attests to this.', 'indeed, strong credibility has been a key factor that has enabled the fed to take account of the possible changes in economic structure that i mentioned earlier and to steer the u.s. economy successfully towards levels of aggregate demand and employment that in the past would have been thought incompatible with maintaining low inflation.', 'it is by conducting monetary policy prudently during the economic upswing that we at the bank of canada will have the credibility needed when our economy begins to operate at levels that test its potential to produce.', 'the role of the exchange rate i would now like to take a moment to underscore the important role that the exchange rate plays in the conduct of canadian monetary policy and to explain what i meant earlier when i used the term "monetary conditions".', "in a medium-sized, open economy, like canada's, a good deal of the impact of monetary policy actions is channelled through the exchange rate.", 'but because financial markets do not always respond to events in completely predictable ways, we do not know exactly how interest rates and the exchange rate will move and interact.', 'that is why we at the bank have found it useful to construct an index of monetary conditions to help us keep track of the combined effect of these two variables on aggregate demand in canada.', 'to understand how we use monetary conditions in practice, let us look at the recent situation where cyclical differences have meant that the canadian economy has been weaker than the u.s. economy.', 'in these circumstances, the need for accommodative monetary conditions in canada required the bank of canada to take action to lower interest rates.', 'but the magnitude and timing of those interest rate reductions depended, to an important degree, on the exchange rate response.', 'with the canadian dollar roughly stable between late 1995 and late 1996, the easing in monetary conditions could take place through measured declines in interest rates.', 'the strengthening canadian dollar through the latter part of 1996 accelerated the decline in interest rates, as the bank of canada sought to maintain the degree of monetary ease achieved in the autumn of 1996. with the economy gathering momentum since then, persistent weakness in the canadian dollar through june 1997 prompted a small increase in interest rates in order to offset an undesired further easing in monetary conditions.', 'i might add that, since cyclical differences have required interest rates in canada to be below those in the united states, there has been -- rightly -- a strong market perception that the relative weakness of the canadian dollar is temporary and that a future appreciation will compensate investors for the lower yields on canadian dollar assets.', 'but experience has taught us that this process of exchange rate/interest rate interaction works well only if there are no concerns in the markets about canadian economic policies.', 'as we found out in 1994-95, when there were concerns about fiscal policy, a decline in the value of the canadian dollar can generate a loss of confidence and expectations of further depreciation of the currency, not of subsequent appreciation.', 'the upshot of all this is that, with a floating currency, market participants need a consistent and credible policy framework to help anchor their expectations about future movements in the exchange rate.', 'such a framework rests, above all, on a firm undertaking by the authorities to preserve the domestic purchasing value of the currency.', 'i believe that our inflation-control targets, by giving a clear, precise view of this commitment, provide a strong underpinning for the external value of the canadian dollar.', 'what is my main message to you today?', 'canada is in better shape now than it has been for many years to face the economic challenges of the future and to reap the benefits of changing technology and an increasingly integrated world economy.', 'but, for this scenario to unfold, there will have to be continued commitment by the authorities to prudent, credible economic policies.', "as far as monetary policy goes, this means a pledge to maintain canada's good inflation performance.", 'that is a pledge i can give without reservation.']	Gordon Thiessen	Bank of Canada	Governor	Canada
https://www.bis.org/review/r970925c.pdf	Mr. Brash looks at economic developments and their bearing on inflationary trends (Central Bank Articles and Speeches, 17 Sep 97)	Speaking notes of Mr. Donald Brash, Governor of the Reserve Bank of New Zealand, on the release of the September, 1997 Economic Projections in Wellington on 17/9/97.	1997-09-17 00:00:00	Mr. Brash looks at economic developments and their bearing on inflationary trends Speaking notes of Mr. Donald Brash, Governor of the Reserve Bank of New Zealand, on the release of the September, 1997 Economic Projections in Wellington on 17/9/97. Introduction Good morning, and welcome to this briefing on the Reserve Bank's September 1997 Economic Projections. You will recall that, in contrast to our June and December Monetary Policy Statements, which the Bank is obliged to produce by statute, the Economic Projections which we release each March and September are more in the nature of 'self-initiated' documents. Their primary purpose is to assist us in assessing economic developments that have a bearing on inflation trends, and thereby to assist us in forming judgements on how monetary policy should evolve. In publishing our Projections, we take the opportunity to inform financial markets and the public generally on what is driving our day-to-day policy decisions. Typically, you can expect to see in our Economic Projections more discussion of matters such as investment behaviour, labour market trends, the balance of payments and so on than is to be found in our Monetary Policy Statements, which concentrate more on assessments of past and future financial market conditions, and the stance of monetary policy. However, both documents require us to produce a comprehensive view of the future trends in the New Zealand economy, and to test our previously articulated views against the stream of emerging data and opinion. A key ingredient in that process is our new forecasting and policy system (FPS) -- the system of models we now utilise in developing our Projections. One important change which that new system of models has made possible was introduced with our June Monetary Policy Statement. Whereas we had previously projected inflation on the basis of an assumed track for interest rates and the exchange rate, in June we shifted to a structure that constrains our Projections of inflation to converge on the mid-part of the 0 to 3 percent inflation target, while allowing the track of monetary conditions to vary as necessary to produce that outcome. You can see that process at work again in these Projections . One point made in relation to FPS when it was first introduced bears repeating. While it is an important tool which helps shape our view of the economy and its likely future path, it is not a 'black box'. FPS provides a coherent framework for thinking about the economy, but considerable judgement is still required to arrive at a final projection. There are clearly a number of different paths through which the economy can evolve to essentially the same point. What is portrayed in this document is just one of those paths, but one that we feel is both realistic and sound as a base for our policy judgements. The real economy Shortly after our June Monetary Policy Statement was published, the release of March quarter GDP data seemed to suggest that the economy was significantly weaker than we had allowed for. Our subsequent analysis indicated that there were particular factors (notably that Easter, unusually, fell into the March quarter) which explained much of the small decline in GDP in that quarter. Since then, the emerging data have suggested that the economy is a little weaker than we had portrayed in June, but that it is also resuming a robust growth path. Whereas we were projecting an annualised growth rate through the first half of calendar 1997 of a little over 1 percent, the estimate incorporated in these Projections is closer to 0.5 percent. Having said that, data released since we completed the Projections are, if anything, suggestive of stronger rather than weaker outcomes for June quarter GDP. In any event, we remain of the view expressed in June that activity will pick up in the second half of the year. Over the year to March 1998, we expect the economy to expand by around 2.5 percent, accelerating further to 4.6 percent growth in the year to March 1999. The factors driving that expansion include a robust global economy, gradually increasing household expenditures, improved productivity, stronger exports (partly the result of a lower exchange rate), business investment and an expansionary fiscal policy -- both from increased government spending under the Coalition Agreement and from the tax cuts scheduled for July 1998. Easier monetary conditions since earlier this year are also supportive of stronger growth. It seems clear that, in the middle of this decade, the New Zealand economy became somewhat over-stretched in terms of its ability to support the pace of spending. It seems equally clear that the economy has entered a period in which there is some spare capacity. Given the current and imminent expansionary forces that I have described, the spare-capacity phase should be short-lived, but long enough to take the pressure off inflation, and long enough to make it unlikely that we will experience the kind of destructive crunch that has so often brought past cycles to a shuddering halt. In this sense, we are describing a growth profile that reflects the steadying influence of maintaining low inflation, which in turn should contribute to New Zealand's future growth potential. We expect continued job creation throughout the period to March 2000, continued growth in real disposable household income (averaging over 3 percent per annum through the projection period), continuing modest fiscal surpluses, further declines in the government's debt-to-GDP ratio, and an improvement in the current account deficit from nearly 6 percent of GDP to around 4 percent of GDP. Inflation As I mentioned earlier, our new Projections framework takes as given that inflation should converge on the mid-part of our target range, and derives the monetary conditions that are needed to achieve that outcome. In that sense there is no particular news in the fact that we expect underlying inflation to be close to the middle of the target over the projection period. But there are some aspects of the inflation track that require comment. In particular, we now expect inflation outcomes over the next two quarters to be rather higher than was the case in June. There are two principal sources of that upward revision. First, the last few months have seen a 6 or 7 percent depreciation of the trade-weighted exchange rate. The increased inflation now expected over the next two quarters is, in part, a direct consequence of that depreciation. Secondly, domestic inflation continues to be strongly influenced by the policy decisions of the Government. We now estimate that, over the next two quarters, policy-related increases in Housing New Zealand rentals and tertiary education fees could well exceed the materiality threshold which is applied in determining our measure of underlying inflation. In that event, underlying inflation would be slightly lower than the estimates given in these Projections. Policy Implications We now view an MCI level of 725 as being appropriate for the next quarter. This is 100 basis points lower than the desired MCI level which has applied for the last quarter, but roughly equivalent to actual monetary conditions over recent weeks. You will recall that a 100 point reduction in the MCI is equivalent to a 1 percentage point decline in 90 day bill rates, a 2 percent decline in the TWI, or some equivalent combination. You may also recall that the average MCI for the December 1996 quarter was 1000. The extent of easing over the past nine months has clearly been significant, although certainly off a high base. Our Projections point to further, but quite small, easings in the first two quarters of 1998 before emerging inflationary pressures lead us to expect monetary conditions to enter another tightening phase. However, as we make clear in our policy assessment section, whether those further easings eventuate in 1998 is very much dependent on how the economy develops over the next few months. Financial market participants eager to bring forward the small, and conditional, easings shown in these Projections clearly do so at their own risk! On the face of it, with inflation over the next two years, and especially over the next two quarters, being a little higher than we thought likely back in June, easing now by more than we foreshadowed in June may seem surprising. The explanation is straightforward, and relates to the lags inherent in the operation of monetary policy. While inflation is a little higher in the short term than we had previously expected, it is still well within our target range, and has been boosted by factors which should be essentially transitory, such as the impact of moving Housing NZ rentals to market. Of more relevance to the outlook in 18 months to two years' time is the margin of spare capacity in the economy. That now looks somewhat larger than it did previously, and warrants somewhat easier monetary conditions. Although activity will be accelerating through 1998, it is not until 1999 that the inflation pressures associated with strong growth begin to emerge. A gradual tightening of monetary conditions from mid-1998 fits with that profile. There are, of course, alternative paths for monetary policy that could deliver inflation within our target range. As was discussed in June, one alternative path would involve more aggressive easing now, followed by earlier and more aggressive tightening next year. Another path would involve holding conditions relatively flat at about current levels until the latter part of 1998 before beginning a somewhat gentler tightening beyond that date. Inevitably, there is rather more art than science in selecting the best of these alternatives. What we have chosen reflects the risks that we see around us at present, and also reflects the benefits we see in providing a relatively smooth path for monetary conditions over time. The mix of monetary conditions On numerous occasions over the past year or two, I have indicated that the particular mix of monetary conditions was unhelpful -- that the exchange rate was too high, putting excessive pressure on exporters, and that interest rates remained too low to discourage borrowing for housing purposes, or to encourage increased domestic savings. The past quarter has seen a substantial, and welcome, shift in the mix of monetary conditions in the direction we believed appropriate. The fall in the exchange rate will boost the incomes of exporters and those competing with imports, and will ultimately increase export volumes. The projected improvement in the current account balance reflects that. The increase in interest rates is also helpful, given the continuing pressures we have seen in the domestic or non-tradeables sector of the economy, and especially in real estate markets. There is no benefit to New Zealand in seeing real estate prices increase to a point where they become vulnerable to a sudden, and damaging, correction. (Anyone who has been observing events in South-East Asia over the past couple of months will be conscious of the enormous damage that can be inflicted in those circumstances. Our own experience post-1987 is also instructive in that regard.) The shift in the mix of conditions, while substantial, has occurred in a manner which is fully consistent with our inflation target, and fully consistent with our use of an MCI in assessing the overall stance of monetary policy. It is certainly the case that the sharp decline of the exchange rate will boost inflation to some degree in the short term. That is already apparent in our Projections. But even with that increase, projected inflation remains well within our target range. And the increase in interest rates that has accompanied the exchange rate fall will work in the opposite direction, dampening inflation in the longer-term. The MCI At the time when the exchange rate was declining, and interest rates were rising, we heard a good deal of criticism of our MCI. It was, it was claimed, too rigid; it was forcing up interest rates at a time when the economy was already in recession; it was based on a relationship between interest rates and the exchange rate which was no longer valid; and so on. As I made clear in my speech to the Counties Kiwifruit Growers Association on 22 August, I regard those criticisms as ill-founded. I think the MCI structure has performed admirably over the past three months. In making that assessment, I think it is important to reflect on just how volatile international exchange rates have been over that period. Any of the alternative monetary policy arrangements we could have adopted in place of the MCI would also have been subject to a good deal of stress. I certainly see no reason to change the MCI approach at this point. Likewise, the description I offered in June of how the Bank might react to deviations in actual market conditions from the central or 'desired' MCI track appears to us to have weathered the tests of the past quarter rather well. I see no reason to modify that description now, and our response to evolving market conditions over the next three months will be consistent with my comments of June.	['mr. brash looks at economic developments and their bearing on inflationary trends speaking notes of mr. donald brash, governor of the reserve bank of new zealand, on the release of the september, 1997 economic projections in wellington on 17/9/97.', "introduction good morning, and welcome to this briefing on the reserve bank's september 1997 economic projections.", "you will recall that, in contrast to our june and december monetary policy statements, which the bank is obliged to produce by statute, the economic projections which we release each march and september are more in the nature of 'self-initiated' documents.", 'their primary purpose is to assist us in assessing economic developments that have a bearing on inflation trends, and thereby to assist us in forming judgements on how monetary policy should evolve.', 'in publishing our projections, we take the opportunity to inform financial markets and the public generally on what is driving our day-to-day policy decisions.', 'typically, you can expect to see in our economic projections more discussion of matters such as investment behaviour, labour market trends, the balance of payments and so on than is to be found in our monetary policy statements, which concentrate more on assessments of past and future financial market conditions, and the stance of monetary policy.', 'however, both documents require us to produce a comprehensive view of the future trends in the new zealand economy, and to test our previously articulated views against the stream of emerging data and opinion.', 'a key ingredient in that process is our new forecasting and policy system (fps) -- the system of models we now utilise in developing our projections.', 'one important change which that new system of models has made possible was introduced with our june monetary policy statement.', 'whereas we had previously projected inflation on the basis of an assumed track for interest rates and the exchange rate, in june we shifted to a structure that constrains our projections of inflation to converge on the mid-part of the 0 to 3 percent inflation target, while allowing the track of monetary conditions to vary as necessary to produce that outcome.', 'you can see that process at work again in these projections .', 'one point made in relation to fps when it was first introduced bears repeating.', "while it is an important tool which helps shape our view of the economy and its likely future path, it is not a 'black box'.", 'fps provides a coherent framework for thinking about the economy, but considerable judgement is still required to arrive at a final projection.', 'there are clearly a number of different paths through which the economy can evolve to essentially the same point.', 'what is portrayed in this document is just one of those paths, but one that we feel is both realistic and sound as a base for our policy judgements.', 'the real economy shortly after our june monetary policy statement was published, the release of march quarter gdp data seemed to suggest that the economy was significantly weaker than we had allowed for.', 'our subsequent analysis indicated that there were particular factors (notably that easter, unusually, fell into the march quarter) which explained much of the small decline in gdp in that quarter.', 'since then, the emerging data have suggested that the economy is a little weaker than we had portrayed in june, but that it is also resuming a robust growth path.', 'whereas we were projecting an annualised growth rate through the first half of calendar 1997 of a little over 1 percent, the estimate incorporated in these projections is closer to 0.5 percent.', 'having said that, data released since we completed the projections are, if anything, suggestive of stronger rather than weaker outcomes for june quarter gdp.', 'in any event, we remain of the view expressed in june that activity will pick up in the second half of the year.', 'over the year to march 1998, we expect the economy to expand by around 2.5 percent, accelerating further to 4.6 percent growth in the year to march 1999. the factors driving that expansion include a robust global economy, gradually increasing household expenditures, improved productivity, stronger exports (partly the result of a lower exchange rate), business investment and an expansionary fiscal policy -- both from increased government spending under the coalition agreement and from the tax cuts scheduled for july 1998. easier monetary conditions since earlier this year are also supportive of stronger growth.', 'it seems clear that, in the middle of this decade, the new zealand economy became somewhat over-stretched in terms of its ability to support the pace of spending.', 'it seems equally clear that the economy has entered a period in which there is some spare capacity.', 'given the current and imminent expansionary forces that i have described, the spare-capacity phase should be short-lived, but long enough to take the pressure off inflation, and long enough to make it unlikely that we will experience the kind of destructive crunch that has so often brought past cycles to a shuddering halt.', "in this sense, we are describing a growth profile that reflects the steadying influence of maintaining low inflation, which in turn should contribute to new zealand's future growth potential.", "we expect continued job creation throughout the period to march 2000, continued growth in real disposable household income (averaging over 3 percent per annum through the projection period), continuing modest fiscal surpluses, further declines in the government's debt-to-gdp ratio, and an improvement in the current account deficit from nearly 6 percent of gdp to around 4 percent of gdp.", 'inflation as i mentioned earlier, our new projections framework takes as given that inflation should converge on the mid-part of our target range, and derives the monetary conditions that are needed to achieve that outcome.', 'in that sense there is no particular news in the fact that we expect underlying inflation to be close to the middle of the target over the projection period.', 'but there are some aspects of the inflation track that require comment.', 'in particular, we now expect inflation outcomes over the next two quarters to be rather higher than was the case in june.', 'there are two principal sources of that upward revision.', 'first, the last few months have seen a 6 or 7 percent depreciation of the trade-weighted exchange rate.', 'the increased inflation now expected over the next two quarters is, in part, a direct consequence of that depreciation.', 'secondly, domestic inflation continues to be strongly influenced by the policy decisions of the government.', 'we now estimate that, over the next two quarters, policy-related increases in housing new zealand rentals and tertiary education fees could well exceed the materiality threshold which is applied in determining our measure of underlying inflation.', 'in that event, underlying inflation would be slightly lower than the estimates given in these projections.', 'policy implications we now view an mci level of 725 as being appropriate for the next quarter.', 'this is 100 basis points lower than the desired mci level which has applied for the last quarter, but roughly equivalent to actual monetary conditions over recent weeks.', 'you will recall that a 100 point reduction in the mci is equivalent to a 1 percentage point decline in 90 day bill rates, a 2 percent decline in the twi, or some equivalent combination.', 'you may also recall that the average mci for the december 1996 quarter was 1000. the extent of easing over the past nine months has clearly been significant, although certainly off a high base.', 'our projections point to further, but quite small, easings in the first two quarters of 1998 before emerging inflationary pressures lead us to expect monetary conditions to enter another tightening phase.', 'however, as we make clear in our policy assessment section, whether those further easings eventuate in 1998 is very much dependent on how the economy develops over the next few months.', 'financial market participants eager to bring forward the small, and conditional, easings shown in these projections clearly do so at their own risk!', 'on the face of it, with inflation over the next two years, and especially over the next two quarters, being a little higher than we thought likely back in june, easing now by more than we foreshadowed in june may seem surprising.', 'the explanation is straightforward, and relates to the lags inherent in the operation of monetary policy.', 'while inflation is a little higher in the short term than we had previously expected, it is still well within our target range, and has been boosted by factors which should be essentially transitory, such as the impact of moving housing nz rentals to market.', "of more relevance to the outlook in 18 months to two years' time is the margin of spare capacity in the economy.", 'that now looks somewhat larger than it did previously, and warrants somewhat easier monetary conditions.', 'although activity will be accelerating through 1998, it is not until 1999 that the inflation pressures associated with strong growth begin to emerge.', 'a gradual tightening of monetary conditions from mid-1998 fits with that profile.', 'there are, of course, alternative paths for monetary policy that could deliver inflation within our target range.', 'as was discussed in june, one alternative path would involve more aggressive easing now, followed by earlier and more aggressive tightening next year.', 'another path would involve holding conditions relatively flat at about current levels until the latter part of 1998 before beginning a somewhat gentler tightening beyond that date.', 'inevitably, there is rather more art than science in selecting the best of these alternatives.', 'what we have chosen reflects the risks that we see around us at present, and also reflects the benefits we see in providing a relatively smooth path for monetary conditions over time.', 'the mix of monetary conditions on numerous occasions over the past year or two, i have indicated that the particular mix of monetary conditions was unhelpful -- that the exchange rate was too high, putting excessive pressure on exporters, and that interest rates remained too low to discourage borrowing for housing purposes, or to encourage increased domestic savings.', 'the past quarter has seen a substantial, and welcome, shift in the mix of monetary conditions in the direction we believed appropriate.', 'the fall in the exchange rate will boost the incomes of exporters and those competing with imports, and will ultimately increase export volumes.', 'the projected improvement in the current account balance reflects that.', 'the increase in interest rates is also helpful, given the continuing pressures we have seen in the domestic or non-tradeables sector of the economy, and especially in real estate markets.', 'there is no benefit to new zealand in seeing real estate prices increase to a point where they become vulnerable to a sudden, and damaging, correction.', '(anyone who has been observing events in south-east asia over the past couple of months will be conscious of the enormous damage that can be inflicted in those circumstances.', 'our own experience post-1987 is also instructive in that regard.)', 'the shift in the mix of conditions, while substantial, has occurred in a manner which is fully consistent with our inflation target, and fully consistent with our use of an mci in assessing the overall stance of monetary policy.', 'it is certainly the case that the sharp decline of the exchange rate will boost inflation to some degree in the short term.', 'that is already apparent in our projections.', 'but even with that increase, projected inflation remains well within our target range.', 'and the increase in interest rates that has accompanied the exchange rate fall will work in the opposite direction, dampening inflation in the longer-term.', 'the mci at the time when the exchange rate was declining, and interest rates were rising, we heard a good deal of criticism of our mci.', 'it was, it was claimed, too rigid; it was forcing up interest rates at a time when the economy was already in recession; it was based on a relationship between interest rates and the exchange rate which was no longer valid; and so on.', 'as i made clear in my speech to the counties kiwifruit growers association on 22 august, i regard those criticisms as ill-founded.', 'i think the mci structure has performed admirably over the past three months.', 'in making that assessment, i think it is important to reflect on just how volatile international exchange rates have been over that period.', 'any of the alternative monetary policy arrangements we could have adopted in place of the mci would also have been subject to a good deal of stress.', 'i certainly see no reason to change the mci approach at this point.', "likewise, the description i offered in june of how the bank might react to deviations in actual market conditions from the central or 'desired' mci track appears to us to have weathered the tests of the past quarter rather well.", 'i see no reason to modify that description now, and our response to evolving market conditions over the next three months will be consistent with my comments of june.']	Donald T Brash	Reserve Bank of New Zealand	Governor	New Zealand
https://www.bis.org/review/r970925b.pdf	Mr. Greenspan comments on the importance of technological development and the value of education for economic growth in the United States (Central Bank Articles and Speeches, 12 Sep 97)	Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Building Dedication Ceremonies at the Kenan-Flagler Business School, University of North Carolina on 12/9/97.	1997-09-12 00:00:00	Mr. Greenspan comments on the importance of technological development and the value of education for economic growth in the United States Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Building Dedication Ceremonies at the Kenan-Flagler Business School, University of North Carolina on 12/9/97. I welcome the opportunity to join Dean Fulton, President Broad, President Emeritus Spangler, Chancellor Hooker, Hugh McColl, and the many other distinguished guests on the podium today. It isn't every day that we have the opportunity to dedicate a new building devoted to the research and training that our young people need for conducting business in a global setting. This new facility -- the McColl Bulding -- has been equipped with state-of-the-art information technology that will enhance the ability of the faculty and students of Kenan-Flagler to prepare for an exciting future in our global economy. The University has made this important commitment at a time when our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. One of the most central of these forces is the rapid acceleration of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, the fallout from rapidly changing technology is an environment in which the stock of plant and equipment with which most managers and workers interact is turning over increasingly rapidly, rendering a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, hopefully, explain why the value of education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value, especially the added value placed on products and services that customers find better tailored to their particular needs, delivered in shorter time frames, or improved in quality. This striving to unbundle the particular characteristics of goods and services in order to maximize their value to each individual inevitably results in the shift toward value created through the exploitation of ideas and concepts, rather than simply the utilization of physical resources and manual labor. Indeed, over the past century, by far the smallest part of the growth in America's real gross domestic product reflects increased physical product measured in bulk or weight. Most of our gains have been the result of new insights into how to rearrange physical reality to achieve ever-higher standards of living. We have dramatically reduced the physical bulk of our radios, for example, by substituting transistors for vacuum tubes. New architectural, engineering, and materials technologies have enabled the construction of buildings with the same space, but far less physical material, than was required 50 or 100 years ago. Most recently, mobile phones have been significantly downsized as they have been improved. The increasing importance of new insights has, of course, raised the value of information creation and transfer in boosting standards of living. Thus, it should be no surprise that new computer and telecommunications products have been accorded particularly high value by consumers and business and, hence, why companies that successfully innovate in this field exhibit particularly high stock market values. Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. The use, for example, of computer-assisted design instruments, machine tools, and inventory control systems has given our former, more rigid factory assembly lines greater flexibility. Businesses now can more quickly customize their production to changes in market conditions; design cycles are shorter, quality control has been improved, and costs are lower. Offices are now routinely outfitted with high-speed information-processing technology. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, the products more customized, and the markets more intensely competitive. Our nation's financial institutions, in turn, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will greatly depend on our capacity to develop and to apply new technology -- a quest that inevitably will entail some risk-taking. One lesson we have clearly learned is that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and ability to gain from that knowledge. Moreover, America's ability to remain in the forefront of new ideas and products has become ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. But, to be fully effective in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. Clearly our educational institutions will continue to play an important role in preparing workers. While we all are concerned about the performance of American elementary and secondary schools compared with those in other developed countries, there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. However, the notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. A great deal of innovation and development has been occurring in the business sector where firms are striving to stay on the cutting edge, in an environment where products and knowledge rapidly become obsolete. Education, as a result, is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits had better look forward to persistent hard work acquiring and maintaining the skills needed to cope with a dynamically evolving economy. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in both schools and in the workplace. Linkages between business and education should be encouraged at all levels of our education system. Your business school is an excellent example of how our educational institutions are building bridges to the private sector that will have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy. The growth of high-tech industry here in the Research Triangle, as well as in Silicon Valley and Boston -- all areas rich in educational and research institutions -- is no accident. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics indicate that the provision of formal education on the job has risen markedly in recent years. By 1995, 70 percent of workers in establishments with 50 or more employees had received some formal training during the twelve months preceding the survey. The incidence of training was relatively high across age groups and educational attainment. Most often this training was conducted in-house by company personnel, but larger firms also relied importantly on educational institutions. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. In the long run, better child-rearing and better basic education at the elementary and secondary school level are essential to providing the foundation for a lifetime of learning. But in the shorter run, we must also develop strategies to overcome the education deficiencies of all too many of our young people, and to renew the skills of workers who have not kept up with the changing demands of the workplace. The advent of the twenty-first century will certainly not bring an end to the challenges we are facing in a rapidly changing world. Americans will surely adjust to a frenetic pace of change, as we have in the past, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. As those frictions dissipate, however, I have no doubt that the economy will emerge healthier. And, if we are able to boost our investment in people, ideas, and processes as well as machines, the economy can operate more effectively as it adapts to change. This holds the potential to create an even greater payoff of a broadly based rise in living standards over the longer run. Your new Kenan-Flagler facility will enhance this University's ability to meet the challenge.	['mr. greenspan comments on the importance of technological development and the value of education for economic growth in the united states remarks by the chairman of the us federal reserve system, mr. alan greenspan, at the building dedication ceremonies at the kenan-flagler business school, university of north carolina on 12/9/97.', 'i welcome the opportunity to join dean fulton, president broad, president emeritus spangler, chancellor hooker, hugh mccoll, and the many other distinguished guests on the podium today.', "it isn't every day that we have the opportunity to dedicate a new building devoted to the research and training that our young people need for conducting business in a global setting.", 'this new facility -- the mccoll bulding -- has been equipped with state-of-the-art information technology that will enhance the ability of the faculty and students of kenan-flagler to prepare for an exciting future in our global economy.', "the university has made this important commitment at a time when our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead.", 'one of the most central of these forces is the rapid acceleration of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century.', 'in the short run, however, the fallout from rapidly changing technology is an environment in which the stock of plant and equipment with which most managers and workers interact is turning over increasingly rapidly, rendering a perception that human skills are becoming obsolete at a rate perhaps unprecedented in american history.', 'i shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, hopefully, explain why the value of education, especially to enhance advanced skills, is so vital to the future growth of our economy.', 'wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value.', 'assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value, especially the added value placed on products and services that customers find better tailored to their particular needs, delivered in shorter time frames, or improved in quality.', 'this striving to unbundle the particular characteristics of goods and services in order to maximize their value to each individual inevitably results in the shift toward value created through the exploitation of ideas and concepts, rather than simply the utilization of physical resources and manual labor.', "indeed, over the past century, by far the smallest part of the growth in america's real gross domestic product reflects increased physical product measured in bulk or weight.", 'most of our gains have been the result of new insights into how to rearrange physical reality to achieve ever-higher standards of living.', 'we have dramatically reduced the physical bulk of our radios, for example, by substituting transistors for vacuum tubes.', 'new architectural, engineering, and materials technologies have enabled the construction of buildings with the same space, but far less physical material, than was required 50 or 100 years ago.', 'most recently, mobile phones have been significantly downsized as they have been improved.', 'the increasing importance of new insights has, of course, raised the value of information creation and transfer in boosting standards of living.', 'thus, it should be no surprise that new computer and telecommunications products have been accorded particularly high value by consumers and business and, hence, why companies that successfully innovate in this field exhibit particularly high stock market values.', 'breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output.', 'these developments are affecting how we produce output and are demanding greater specialized knowledge.', 'the use, for example, of computer-assisted design instruments, machine tools, and inventory control systems has given our former, more rigid factory assembly lines greater flexibility.', 'businesses now can more quickly customize their production to changes in market conditions; design cycles are shorter, quality control has been improved, and costs are lower.', 'offices are now routinely outfitted with high-speed information-processing technology.', 'the accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks.', 'financial instruments have become increasingly diverse, the products more customized, and the markets more intensely competitive.', "our nation's financial institutions, in turn, are endeavoring to find more effective and efficient ways to deliver their services.", "in this environment, america's prospects for economic growth will greatly depend on our capacity to develop and to apply new technology -- a quest that inevitably will entail some risk-taking.", 'one lesson we have clearly learned is that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and ability to gain from that knowledge.', "moreover, america's ability to remain in the forefront of new ideas and products has become ever more difficult because of the rapid international diffusion of technology.", 'nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products.', 'but, to be fully effective in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring.', 'clearly our educational institutions will continue to play an important role in preparing workers.', 'while we all are concerned about the performance of american elementary and secondary schools compared with those in other developed countries, there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad.', "however, the notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged.", 'a great deal of innovation and development has been occurring in the business sector where firms are striving to stay on the cutting edge, in an environment where products and knowledge rapidly become obsolete.', 'education, as a result, is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits had better look forward to persistent hard work acquiring and maintaining the skills needed to cope with a dynamically evolving economy.', 'the recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in both schools and in the workplace.', 'linkages between business and education should be encouraged at all levels of our education system.', 'your business school is an excellent example of how our educational institutions are building bridges to the private sector that will have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy.', 'the growth of high-tech industry here in the research triangle, as well as in silicon valley and boston -- all areas rich in educational and research institutions -- is no accident.', 'in the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities.', 'some labor unions have done the same.', 'more broadly, recent surveys by the bureau of labor statistics indicate that the provision of formal education on the job has risen markedly in recent years.', 'by 1995, 70 percent of workers in establishments with 50 or more employees had received some formal training during the twelve months preceding the survey.', 'the incidence of training was relatively high across age groups and educational attainment.', 'most often this training was conducted in-house by company personnel, but larger firms also relied importantly on educational institutions.', 'at the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind.', 'in the long run, better child-rearing and better basic education at the elementary and secondary school level are essential to providing the foundation for a lifetime of learning.', 'but in the shorter run, we must also develop strategies to overcome the education deficiencies of all too many of our young people, and to renew the skills of workers who have not kept up with the changing demands of the workplace.', 'the advent of the twenty-first century will certainly not bring an end to the challenges we are facing in a rapidly changing world.', 'americans will surely adjust to a frenetic pace of change, as we have in the past, but we must recognize that adjustment is not automatic.', 'all shifts in the structure of the economy naturally create frictions and human stress, at least temporarily.', 'as those frictions dissipate, however, i have no doubt that the economy will emerge healthier.', 'and, if we are able to boost our investment in people, ideas, and processes as well as machines, the economy can operate more effectively as it adapts to change.', 'this holds the potential to create an even greater payoff of a broadly based rise in living standards over the longer run.', "your new kenan-flagler facility will enhance this university's ability to meet the challenge."]	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman	US
https://www.bis.org/review/r970925a.pdf	Mr. Meyer discusses the connection between policy makers and market participants in the United States (Central Bank Articles and Speeches, 12 Sep 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Fixed Income Summit of PSA, The Bond Market Trade Association held in Washington, D.C. on 12/9/97.	1997-09-12 00:00:00	Mr. Meyer discusses the connection between policy makers and market participants in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Fixed Income Summit of PSA, The Bond Market Trade Association held in Washington, D.C. on 12/9/97. Monetary Policy and the Bond Market: Complements or Substitutes? It is a pleasure to speak this afternoon at the Fixed Income Summit. To some analysts, a meeting of the heads of the top fifty government securities dealers would represent a concentration of influence over the U.S. economy that perhaps even surpasses that of the meeting I will attend on September 30. Indeed, some have argued that the activities of traders and investors in the bond market have become a major stabilizing force in the economy, even to the point of making the FOMC redundant. This premise suggests an interesting theme for my address this afternoon -- the connection, or maybe more appropriately the symbiosis, between policy makers and market participants. The Importance of Market Mechanisms The Federal Reserve has been most successful over the years when it has relied on market mechanisms to carry out its policy intent. Regulation Q, in its fixing of ceilings on deposit rates, distorted incentives and led to sudden and large swings in the pattern of intermediation. Selective credit controls, in retrospect, were a blunt instrument that was too unpredictable and extreme to use effectively. And the Board of Governors has found that reserve requirements, which represent a tax on depositories because our reserves do not bear interest, are best held steady at the lowest level consistent with the efficient implementation of policy. Instead, the Federal Reserve controls its balance sheet to influence a rate quoted by market participants any time that the reserve market is open -- the overnight federal funds rate. In truth, as you all know, movements in that rate have little direct significance, except to reserve managers and those relatively few others concerned with the overnight cost of funds. But how that rate gets transmitted along the term structure to yields on longer maturity instruments has broad significance that ultimately affects everyone in the economy. And that is where market participants come in. Policymakers' influence is focused on the current short rate. It is the job of traders and investors to read our intentions from the public record, form their own judgments as to the course of economic activity and inflation that are based on, in addition to monetary policy, current and prospective fiscal policies and demand and supply shocks, and translate all that into action as expressed in the prices of a bewildering array of debt, equity, and derivative instruments. Varieties of Errors While the market activities of traders and investors can importantly reinforce and strengthen the actions taken by the FOMC in the pursuit of its broad macroeconomic objectives, they cannot replace the FOMC. Sometimes, believe it or not, they turn out to complicate, rather than advance, the cause of monetary policy. Before I turn to the good the market does in complementing policy action, let me start by deflating the notion that an omniscient bond market always gets it right so as to render the FOMC redundant. Because many of the instruments in which you deal have long maturities, the judgments that have to be made to price them by necessity stretch well into the future. The scope for error can be large and the consequences costly. I think it is useful to separate the grounds for mistakes into two groups: market participants could be wrong about the economy, or wrong about policymakers' objectives. Two examples can make this distinction clearer. For one, we know, after the fact, that most analysts misjudged the full extent to which unusual restraint on credit was exerting a drag on spending from around 1989 to 1993. Essentially, both households and firms recoiled from the explosion of debt in the 1980s. They were burdened by high interest service and took steps to bring their balance sheets into a more sustainable configuration. Lenders, too, had their own imbalances, brought on importantly by the real estate bust. Among them, banks drew back from extending loans to a wide variety of borrowers, including businesses. In this environment, spreads of private over public rates widened in the market, and borrowers and lenders who went to depositories were confronted with far less favorable terms than they had grown accustomed to. While Chairman Greenspan and his fellow policymakers identified the credit crunch in a fairly timely fashion, it took some time to appreciate the full force of its power. By my reading, in the aggregate, market participants were slower on the uptake. Thus, the policy easings of 1991 and 1992 were greeted with some skepticism as market participants apparently interpreted those actions as reflecting a lessened concern about inflation on the part of the Federal Reserve, rather than the appropriate response to a softening in aggregate demand. The effect of those mis-assessments was to produce a stunning steepening of the yield curve. The spread between long and short-term rates is often viewed as one of the most reliable cyclical indicators and a widening as a measure of the increased stimulus of monetary policy. But I viewed the widening in this episode as evidence of the reduced effectiveness of monetary policy in an environment where actions by bond-market participants were preventing long-term interest rates from adjusting in response to the policy-induced decline in short-term rates. At its peak in mid-1992, the long-term Treasury bond yielded 475 basis points over the three-month bill rate, about three times the average for the prior three decades. True, as the full dimension of the effects of the credit crunch became apparent, yields fell from those heights. But in the interim, monetary policy's intentions were blunted by the market's misreading of the economy. This probably prolonged the need for ease and further accentuated the required easing of the federal funds rate. As another example, I have spent enough of my career projecting near-term economic trends to be familiar with a forecaster's favorite friend -- momentum. But momentum can easily be misjudged. It is easy to fall into the trap of presuming that what an economic actor did last is what that actor will do next. Thus, market prices tend to extrapolate that changes in monetary policy cluster in the same direction. This is a rule that works often enough, but, as a look back to 1994 and 1995 reminds us, not always. By mid-1994, the FOMC had substantially raised its intended federal funds rate, but market prices seemed to say that enough was not enough. The tightenings in May and August of that year, for example, were greeted by a roughly parallel shift up in money market futures rates, implying that the actions had not gotten the Federal Reserve any closer to the goal line -- instead, the goal line had been pushed back. And the Fed indeed did continue to tighten through early 1995. But by late 1994 and early 1995, the term structure spreads in financial markets remained very wide, implying an expectation of still significant further tightening. As a result, the restraint associated with the policy action was amplified. In retrospect, a tighter focus on fundamentals -- that policy was acting in a preemptive fashion to contain inflation, rather than an extrapolation of the sequence of recent policy actions -- would have helped to cap the rise in longer-term yields. The Benefits of Market Mechanisms While I have been speaking about all manner of misjudgments, I actually do have an economist's inherent confidence in market mechanisms. Market participants do, on average, get it right and are rewarded accordingly, to the benefit of economic efficiency. Indeed, the pattern of those rewards sharpens skills in trading and forecasting, ensuring that these benefits will continue to accrue. For that reason, policymakers are well advised to heed the message from markets that are expressed in prices. What I find most intriguing is the notion that markets can carry some, and, in the extreme view, all of the load for monetary policymakers. To push it to an extreme, it's as if the actions of the Federal Open Market Committee, of which I am a member, can be anticipated, augmented, and, perhaps, even replaced, by meetings of the Private Open Market Committee, of which you are members. There are two main advantages of these meetings of the Private Open Market Committee. First, members meet twenty-four hours a day, every business day of the year, so that the POMC can respond to every scrap of information on the economy, whether it be an official data release, a statement by an official, or a rumor about the future course of policy. Second, every participant can express the strength of his or her belief in a particular view by the amount of capital committed to the trade. Because of the inclusiveness of the market, a broad assortment of views about the workings of the economy can be reflected in prices. While the design of the FOMC fosters a similar diversity of views, virtually nonstop market trading allows prices to move before official policymakers can react. Of course, the FOMC delegates authority to the Chairman and, in this age of instantaneous communication, conference calls are always possible. But, practically, with a fixed calendar of FOMC meetings, a desire on our part for a systematic review of the situation to help our deliberations, and some inertia in decision making, markets will almost always be better positioned to react more quickly to news than the Federal Reserve. This speedy response, when right, puts in place stimulus or restraint sooner, perhaps lessening the need for us, ultimately, to move our policy instrument as much. In general, the more forward looking the bond market is with respect to future policy action, the shorter will be the lag from policy action to intended economic effect. In the absence of such a forward-looking response of long-term rates, short-term interest rates may have to move by more to achieve the same near-term impact on long-term interest rates and economic activity. Indeed, in those circumstances, the Federal Reserve would have to weigh carefully the effects on long rates of both the current and lagged levels of short rates so as to avoid the potential for an overshooting of short-term interest rates that would have adverse consequences for the economy. However, if long-term rates move swiftly in response to correctly anticipated policy, the required rise in short-term rates will be smaller and there will be less risk of overshooting. Thus, for the same reasons the Federal Reserve attempts to be pre-emptive in its monetary policy decisions, we would welcome pre-emptive pricing by market participants. But we must recognize that what markets are pricing is anticipated Federal Reserve action. If the prices are right, we will act to validate them. If the prices are wrong - built on the base of an incorrect view of the economy or Federal Reserve intentions -- we will prove them wrong and provide an anchor for the market to adjust to. It is also important to appreciate that the anticipatory contribution of the markets cannot be sustained unless the FOMC ratifies well-timed moves of the market. If the FOMC were to fail to do so, it would disconfirm the expectations on which the market move was based, making it less likely in the future that the market would play a constructive anticipatory role. Therefore, while forward-looking markets may change what we policy makers need to do, they will never eliminate the need for the FOMC to respond to changing economic developments. Some Lessons for Markets and Policymakers I hope that the important question that this discussion has been pointing to is obvious by now: How can we -- the Federal and the Private Open Market Committees -- operate to deliver the greatest good for the American economy while you respect your obligation to stakeholders to maximize their return? I think that there are two parts to the answer: We should work at arm's length but with full information. By arm's length, I mean that the information markets provide works best as an independent check on monetary policy decisions. If the FOMC were to tie mechanically our actions to market prices, then we would be placed in the sorry position of validating whatever whim that currently struck investors' fancy. If you were to take our reading of the economy as if from a sacred text, the unique sources of information and skills that you have refined would go untapped. It is far better that we should treat each other warily so as to keep each other sharp. By full information, I mean that the Federal Reserve should do its best to read signals from markets and to communicate to markets its policy intentions. The Domestic and Foreign Open Market Desks of the Federal Reserve Bank of New York are virtually in constant communication with market participants and routinely distill that information for their policy-making principals. My fellow governors and I routinely receive from our staff a translation of the term structure of Treasury yields into implied forward rates, volatility inferred from options prices, and paths for expected monetary policy action consistent with futures prices. Of late, the information we receive has included inferences drawn from quotes on the Treasury's inflation protected securities. In principle, such information should be helpful in interpreting all manner of economic behavior, including the pricing of financial instruments and wage setting. As yet, I must admit that, in the eight months since the first issue, the volume of trade and the apparent lack of interest in related contracts on the futures market has been somewhat disappointing. The Treasury's strong commitment to this product, reflected in the range of maturities that have and will be sold and the volume of securities sold, should do much to foster this market, as will the growing realization by market participants that indexed debt will represent an increasing share of the nation's debt obligations. But even after we have reliable quotes on a more complete indexed term structure, considerable analysis must still be done before we can cull readings of inflation expectations and inflation risk from market prices. As you well appreciate, the spread of the yield on a nominal instrument over its inflation-protected counterpart includes compensation for expected inflation, inflation uncertainty, and differential risk characteristics. Until we have a long enough history to be more certain of the relative contributions of each, we must watch, wait, and learn. Communication must flow two ways. Over the past few years, I am pleased to say, the FOMC has significantly enhanced the information it provides to the public. That list includes announcing actions -- and the reasons underlying them -- within the day that the decisions are made and providing complete transcripts of meetings with a five year lag. We continue to release a comprehensive record of policy discussions six to eight weeks after each meeting. We now report the daily size of reserve operations within minutes of their completion, and we have lifted the last veil covering the inner sanctum of policy: Rather than speaking in tongues about "slight" or "somewhat" changes in reserve pressures, the FOMC now announces the intended federal funds rate when it is changed. In one respect, the distance covered in that change was not all that great, in that for most of this decade, the Federal Reserve has been rather explicit in signaling through its choice of open market operations whenever the FOMC elected to alter its intended rate. But compared to the borrowed reserves operating period of the latter half of the previous decade, the change has been dramatic. Rather than rely on Fed watchers employed by primary dealers to read the tea leaves of our daily interventions, we inform everyone, openly, and take responsibility for the level of short-term interest rates. By my reading, this is one circumstance in which virtue has proved more than its own reward. Over the past 31⁄2 years, a financial innovation -- sweeps from retail deposits -- has complicated reserve operations. On average, depositories that have adopted sweeps have been able to reduce their effective reserve requirements by 80 to 90 percent. When aggregated over the entire banking system, the scale is staggering. By year-end, transactions deposits will probably have been reduced by nearly $1⁄4 trillion as the result of the cumulative effect of retail sweeps, which is big even by Washington standards. Going by a simple rule of thumb, required reserves will be lower by about one-tenth that total. This innovation has made the technical job of implementing monetary policy from day to day more difficult. Simply, reserve requirements are no longer necessarily the binding determinant of reserve demand for many banks. When reserve requirements are in excess of clearing balances, volatile movements in clearing balances will have a small effect on the reserves market. However, when desired clearing balances dictate short-run movements in the demand for reserves, the reserve market, and therefore the federal funds rate, may become a bit more volatile late in the trading day. However, to the credit of my colleagues charged with determining daily open market operations and of market participants who have adjusted operations to the new environment, that volatility has been quite muted. Still, if markets had only daily open market operations to discern the FOMC's intentions, the scope for misimpressions in this environment would be large. Because you can read press releases to learn our policy stance rather than the pattern of reserve additions or drains, there is much less chance for confusion. For pricing any instrument beyond overnight, market participants apparently find the intended federal funds rate to be more informative than the noisy effective federal funds rate. Nonetheless, it would be helpful to prevent a further increase in the volatility of the effective federal funds rate that might result from a further sweep-induced decline in required reserves. And a means is available to the Congress today to accomplish that end: The Federal Reserve should be permitted to pay interest on reserves. As it stands now, depositories resort to complicated means to evade our reserve requirements -- such as retail sweeps -because our reserves are sterile and to do less would put them at a competitive disadvantage in a market where profit margins are paper thin. By paying interest on reserves, the incentive to engage in sweeps would be sharply reduced and the practice would likely diminish over time, if not end entirely. As a result, bankers could devote their attention to more productive pursuits, and reserve markets would be easier to read. Conclusion I can assure you that I view financial markets as a national resource. To be sure, they do not light the way to proper policy making as perfectly as true believers may assert. But there is information to be gotten, and it has been my experience that policy makers do try to extract it. For our part, we will try to preserve those benefits. For your part, the Private Open Market Committee does public good -- even if it is the by-product of the pursuit of personal profits -- when it views policy making with a skeptical eye. After all, it is only the best of friends who have the courage to point out the most sensitive of faults.	['mr. meyer discusses the connection between policy makers and market participants in the united states remarks by mr. laurence h. meyer, a member of the board of governors of the us federal reserve system, before the fixed income summit of psa, the bond market trade association held in washington, d.c. on 12/9/97.', 'monetary policy and the bond market: complements or substitutes?', 'it is a pleasure to speak this afternoon at the fixed income summit.', 'to some analysts, a meeting of the heads of the top fifty government securities dealers would represent a concentration of influence over the u.s. economy that perhaps even surpasses that of the meeting i will attend on september 30. indeed, some have argued that the activities of traders and investors in the bond market have become a major stabilizing force in the economy, even to the point of making the fomc redundant.', 'this premise suggests an interesting theme for my address this afternoon -- the connection, or maybe more appropriately the symbiosis, between policy makers and market participants.', 'the importance of market mechanisms the federal reserve has been most successful over the years when it has relied on market mechanisms to carry out its policy intent.', 'regulation q, in its fixing of ceilings on deposit rates, distorted incentives and led to sudden and large swings in the pattern of intermediation.', 'selective credit controls, in retrospect, were a blunt instrument that was too unpredictable and extreme to use effectively.', 'and the board of governors has found that reserve requirements, which represent a tax on depositories because our reserves do not bear interest, are best held steady at the lowest level consistent with the efficient implementation of policy.', 'instead, the federal reserve controls its balance sheet to influence a rate quoted by market participants any time that the reserve market is open -- the overnight federal funds rate.', 'in truth, as you all know, movements in that rate have little direct significance, except to reserve managers and those relatively few others concerned with the overnight cost of funds.', 'but how that rate gets transmitted along the term structure to yields on longer maturity instruments has broad significance that ultimately affects everyone in the economy.', 'and that is where market participants come in.', "policymakers' influence is focused on the current short rate.", 'it is the job of traders and investors to read our intentions from the public record, form their own judgments as to the course of economic activity and inflation that are based on, in addition to monetary policy, current and prospective fiscal policies and demand and supply shocks, and translate all that into action as expressed in the prices of a bewildering array of debt, equity, and derivative instruments.', 'varieties of errors while the market activities of traders and investors can importantly reinforce and strengthen the actions taken by the fomc in the pursuit of its broad macroeconomic objectives, they cannot replace the fomc.', 'sometimes, believe it or not, they turn out to complicate, rather than advance, the cause of monetary policy.', 'before i turn to the good the market does in complementing policy action, let me start by deflating the notion that an omniscient bond market always gets it right so as to render the fomc redundant.', 'because many of the instruments in which you deal have long maturities, the judgments that have to be made to price them by necessity stretch well into the future.', 'the scope for error can be large and the consequences costly.', "i think it is useful to separate the grounds for mistakes into two groups: market participants could be wrong about the economy, or wrong about policymakers' objectives.", 'two examples can make this distinction clearer.', 'for one, we know, after the fact, that most analysts misjudged the full extent to which unusual restraint on credit was exerting a drag on spending from around 1989 to 1993. essentially, both households and firms recoiled from the explosion of debt in the 1980s.', 'they were burdened by high interest service and took steps to bring their balance sheets into a more sustainable configuration.', 'lenders, too, had their own imbalances, brought on importantly by the real estate bust.', 'among them, banks drew back from extending loans to a wide variety of borrowers, including businesses.', 'in this environment, spreads of private over public rates widened in the market, and borrowers and lenders who went to depositories were confronted with far less favorable terms than they had grown accustomed to.', 'while chairman greenspan and his fellow policymakers identified the credit crunch in a fairly timely fashion, it took some time to appreciate the full force of its power.', 'by my reading, in the aggregate, market participants were slower on the uptake.', 'thus, the policy easings of 1991 and 1992 were greeted with some skepticism as market participants apparently interpreted those actions as reflecting a lessened concern about inflation on the part of the federal reserve, rather than the appropriate response to a softening in aggregate demand.', 'the effect of those mis-assessments was to produce a stunning steepening of the yield curve.', 'the spread between long and short-term rates is often viewed as one of the most reliable cyclical indicators and a widening as a measure of the increased stimulus of monetary policy.', 'but i viewed the widening in this episode as evidence of the reduced effectiveness of monetary policy in an environment where actions by bond-market participants were preventing long-term interest rates from adjusting in response to the policy-induced decline in short-term rates.', 'at its peak in mid-1992, the long-term treasury bond yielded 475 basis points over the three-month bill rate, about three times the average for the prior three decades.', 'true, as the full dimension of the effects of the credit crunch became apparent, yields fell from those heights.', "but in the interim, monetary policy's intentions were blunted by the market's misreading of the economy.", 'this probably prolonged the need for ease and further accentuated the required easing of the federal funds rate.', "as another example, i have spent enough of my career projecting near-term economic trends to be familiar with a forecaster's favorite friend -- momentum.", 'but momentum can easily be misjudged.', 'it is easy to fall into the trap of presuming that what an economic actor did last is what that actor will do next.', 'thus, market prices tend to extrapolate that changes in monetary policy cluster in the same direction.', 'this is a rule that works often enough, but, as a look back to 1994 and 1995 reminds us, not always.', 'by mid-1994, the fomc had substantially raised its intended federal funds rate, but market prices seemed to say that enough was not enough.', 'the tightenings in may and august of that year, for example, were greeted by a roughly parallel shift up in money market futures rates, implying that the actions had not gotten the federal reserve any closer to the goal line -- instead, the goal line had been pushed back.', 'and the fed indeed did continue to tighten through early 1995. but by late 1994 and early 1995, the term structure spreads in financial markets remained very wide, implying an expectation of still significant further tightening.', 'as a result, the restraint associated with the policy action was amplified.', 'in retrospect, a tighter focus on fundamentals -- that policy was acting in a preemptive fashion to contain inflation, rather than an extrapolation of the sequence of recent policy actions -- would have helped to cap the rise in longer-term yields.', "the benefits of market mechanisms while i have been speaking about all manner of misjudgments, i actually do have an economist's inherent confidence in market mechanisms.", 'market participants do, on average, get it right and are rewarded accordingly, to the benefit of economic efficiency.', 'indeed, the pattern of those rewards sharpens skills in trading and forecasting, ensuring that these benefits will continue to accrue.', 'for that reason, policymakers are well advised to heed the message from markets that are expressed in prices.', 'what i find most intriguing is the notion that markets can carry some, and, in the extreme view, all of the load for monetary policymakers.', "to push it to an extreme, it's as if the actions of the federal open market committee, of which i am a member, can be anticipated, augmented, and, perhaps, even replaced, by meetings of the private open market committee, of which you are members.", 'there are two main advantages of these meetings of the private open market committee.', 'first, members meet twenty-four hours a day, every business day of the year, so that the pomc can respond to every scrap of information on the economy, whether it be an official data release, a statement by an official, or a rumor about the future course of policy.', 'second, every participant can express the strength of his or her belief in a particular view by the amount of capital committed to the trade.', 'because of the inclusiveness of the market, a broad assortment of views about the workings of the economy can be reflected in prices.', 'while the design of the fomc fosters a similar diversity of views, virtually nonstop market trading allows prices to move before official policymakers can react.', 'of course, the fomc delegates authority to the chairman and, in this age of instantaneous communication, conference calls are always possible.', 'but, practically, with a fixed calendar of fomc meetings, a desire on our part for a systematic review of the situation to help our deliberations, and some inertia in decision making, markets will almost always be better positioned to react more quickly to news than the federal reserve.', 'this speedy response, when right, puts in place stimulus or restraint sooner, perhaps lessening the need for us, ultimately, to move our policy instrument as much.', 'in general, the more forward looking the bond market is with respect to future policy action, the shorter will be the lag from policy action to intended economic effect.', 'in the absence of such a forward-looking response of long-term rates, short-term interest rates may have to move by more to achieve the same near-term impact on long-term interest rates and economic activity.', 'indeed, in those circumstances, the federal reserve would have to weigh carefully the effects on long rates of both the current and lagged levels of short rates so as to avoid the potential for an overshooting of short-term interest rates that would have adverse consequences for the economy.', 'however, if long-term rates move swiftly in response to correctly anticipated policy, the required rise in short-term rates will be smaller and there will be less risk of overshooting.', 'thus, for the same reasons the federal reserve attempts to be pre-emptive in its monetary policy decisions, we would welcome pre-emptive pricing by market participants.', 'but we must recognize that what markets are pricing is anticipated federal reserve action.', 'if the prices are right, we will act to validate them.', 'if the prices are wrong - built on the base of an incorrect view of the economy or federal reserve intentions -- we will prove them wrong and provide an anchor for the market to adjust to.', 'it is also important to appreciate that the anticipatory contribution of the markets cannot be sustained unless the fomc ratifies well-timed moves of the market.', 'if the fomc were to fail to do so, it would disconfirm the expectations on which the market move was based, making it less likely in the future that the market would play a constructive anticipatory role.', 'therefore, while forward-looking markets may change what we policy makers need to do, they will never eliminate the need for the fomc to respond to changing economic developments.', 'some lessons for markets and policymakers i hope that the important question that this discussion has been pointing to is obvious by now: how can we -- the federal and the private open market committees -- operate to deliver the greatest good for the american economy while you respect your obligation to stakeholders to maximize their return?', "i think that there are two parts to the answer: we should work at arm's length but with full information.", "by arm's length, i mean that the information markets provide works best as an independent check on monetary policy decisions.", "if the fomc were to tie mechanically our actions to market prices, then we would be placed in the sorry position of validating whatever whim that currently struck investors' fancy.", 'if you were to take our reading of the economy as if from a sacred text, the unique sources of information and skills that you have refined would go untapped.', 'it is far better that we should treat each other warily so as to keep each other sharp.', 'by full information, i mean that the federal reserve should do its best to read signals from markets and to communicate to markets its policy intentions.', 'the domestic and foreign open market desks of the federal reserve bank of new york are virtually in constant communication with market participants and routinely distill that information for their policy-making principals.', 'my fellow governors and i routinely receive from our staff a translation of the term structure of treasury yields into implied forward rates, volatility inferred from options prices, and paths for expected monetary policy action consistent with futures prices.', "of late, the information we receive has included inferences drawn from quotes on the treasury's inflation protected securities.", 'in principle, such information should be helpful in interpreting all manner of economic behavior, including the pricing of financial instruments and wage setting.', 'as yet, i must admit that, in the eight months since the first issue, the volume of trade and the apparent lack of interest in related contracts on the futures market has been somewhat disappointing.', "the treasury's strong commitment to this product, reflected in the range of maturities that have and will be sold and the volume of securities sold, should do much to foster this market, as will the growing realization by market participants that indexed debt will represent an increasing share of the nation's debt obligations.", 'but even after we have reliable quotes on a more complete indexed term structure, considerable analysis must still be done before we can cull readings of inflation expectations and inflation risk from market prices.', 'as you well appreciate, the spread of the yield on a nominal instrument over its inflation-protected counterpart includes compensation for expected inflation, inflation uncertainty, and differential risk characteristics.', 'until we have a long enough history to be more certain of the relative contributions of each, we must watch, wait, and learn.', 'communication must flow two ways.', 'over the past few years, i am pleased to say, the fomc has significantly enhanced the information it provides to the public.', 'that list includes announcing actions -- and the reasons underlying them -- within the day that the decisions are made and providing complete transcripts of meetings with a five year lag.', 'we continue to release a comprehensive record of policy discussions six to eight weeks after each meeting.', 'we now report the daily size of reserve operations within minutes of their completion, and we have lifted the last veil covering the inner sanctum of policy: rather than speaking in tongues about "slight" or "somewhat" changes in reserve pressures, the fomc now announces the intended federal funds rate when it is changed.', 'in one respect, the distance covered in that change was not all that great, in that for most of this decade, the federal reserve has been rather explicit in signaling through its choice of open market operations whenever the fomc elected to alter its intended rate.', 'but compared to the borrowed reserves operating period of the latter half of the previous decade, the change has been dramatic.', 'rather than rely on fed watchers employed by primary dealers to read the tea leaves of our daily interventions, we inform everyone, openly, and take responsibility for the level of short-term interest rates.', 'by my reading, this is one circumstance in which virtue has proved more than its own reward.', 'over the past 31⁄2 years, a financial innovation -- sweeps from retail deposits -- has complicated reserve operations.', 'on average, depositories that have adopted sweeps have been able to reduce their effective reserve requirements by 80 to 90 percent.', 'when aggregated over the entire banking system, the scale is staggering.', 'by year-end, transactions deposits will probably have been reduced by nearly $1⁄4 trillion as the result of the cumulative effect of retail sweeps, which is big even by washington standards.', 'going by a simple rule of thumb, required reserves will be lower by about one-tenth that total.', 'this innovation has made the technical job of implementing monetary policy from day to day more difficult.', 'simply, reserve requirements are no longer necessarily the binding determinant of reserve demand for many banks.', 'when reserve requirements are in excess of clearing balances, volatile movements in clearing balances will have a small effect on the reserves market.', 'however, when desired clearing balances dictate short-run movements in the demand for reserves, the reserve market, and therefore the federal funds rate, may become a bit more volatile late in the trading day.', 'however, to the credit of my colleagues charged with determining daily open market operations and of market participants who have adjusted operations to the new environment, that volatility has been quite muted.', "still, if markets had only daily open market operations to discern the fomc's intentions, the scope for misimpressions in this environment would be large.", 'because you can read press releases to learn our policy stance rather than the pattern of reserve additions or drains, there is much less chance for confusion.', 'for pricing any instrument beyond overnight, market participants apparently find the intended federal funds rate to be more informative than the noisy effective federal funds rate.', 'nonetheless, it would be helpful to prevent a further increase in the volatility of the effective federal funds rate that might result from a further sweep-induced decline in required reserves.', 'and a means is available to the congress today to accomplish that end: the federal reserve should be permitted to pay interest on reserves.', 'as it stands now, depositories resort to complicated means to evade our reserve requirements -- such as retail sweeps -because our reserves are sterile and to do less would put them at a competitive disadvantage in a market where profit margins are paper thin.', 'by paying interest on reserves, the incentive to engage in sweeps would be sharply reduced and the practice would likely diminish over time, if not end entirely.', 'as a result, bankers could devote their attention to more productive pursuits, and reserve markets would be easier to read.', 'conclusion i can assure you that i view financial markets as a national resource.', 'to be sure, they do not light the way to proper policy making as perfectly as true believers may assert.', 'but there is information to be gotten, and it has been my experience that policy makers do try to extract it.', 'for our part, we will try to preserve those benefits.', 'for your part, the private open market committee does public good -- even if it is the by-product of the pursuit of personal profits -- when it views policy making with a skeptical eye.', 'after all, it is only the best of friends who have the courage to point out the most sensitive of faults.']	Laurence H Meyer	Board of Governors of the US Federal Reserve System	member of the Board of Governors	US
https://www.bis.org/review/r970918b.pdf	Mr. Matsushita reports on a new framework of monetary policy under the new Bank of Japan Law (Central Bank Articles and Speeches, 27 Jun 97)	Speech given by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, to the Yomiuri International Economic Society in Tokyo on 27/6/97.	1997-06-27 00:00:00	Mr. Matsushita reports on a new framework of monetary policy under the new Bank of Japan Law Speech given by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, to the Yomiuri International Economic Society in Tokyo on 27/6/97. I. Introduction As you are all aware, the Diet passed the new Bank of Japan Law on June 11, which will come into effect on April 1, 1998. It has been the perennial wish of the Bank of Japan to revise the current Bank of Japan Law, which was legislated during World War II, to accommodate the significant changes that have occurred in the economic and financial environment and to make the Law able to withstand future changes in the environment. Revision of the Law was also indispensable for rebuilding the entire Japanese financial system so as to meet global standards. This revision built on the two principles of independence and transparency is thus a notable step in the 115 years of the Bank's history and also for reforming the financial system of Japan. The Bank of Japan Law holds great significance as one of the basic laws governing Japan's economic and financial activities. Looking back, this important revision was achieved in approximately one year from the start of discussions in spring 1996 owing to the support and efforts of many people, including Prime Minister Hashimoto, Finance Minister Mitsuzuka, and other government officials, members of parliament, and members of the Advisory Group on the Central Bank (an advisory panel to the Prime Minister) and the Financial System Research Council (an advisory committee to the Minister of Finance). Many words of encouragement as well as criticism were heard from the financial and business circles and the general public, including perhaps some of you who are here today. I would like to take this opportunity to express, on behalf of the Bank, our heartfelt gratitude to all. Naturally, the reform of the Bank of Japan is not consummated merely by the revision of the Law. We at the Bank of Japan believe it essential that we continue our efforts to conduct appropriate policy and operational management, cognizant of the responsibilities entrusted to us by the people. We are determined to promote, in line with the aim of the revision of the Law, wide-ranging reforms to further improve the transparency of policy management and the efficiency of the Bank's operational management. Today, I would first like to discuss recent monetary and economic conditions and the Bank's current monetary policy management. I will then explain the new framework of monetary policy under the new Law and how the Bank intends to manage monetary policy. II. Recent Monetary and Economic Conditions and Monetary Policy Management A. Recent economic and price developments and monetary policy management I would like to start with the recent domestic economic condition. Japan's economy is currently at a phase in which the downward pressures of fiscal tightening appear strongest, with personal consumption and housing investment declining in reaction to the stepped-up demand before the consumption tax rate was raised. However, in view of the firm developments in production and improvements in corporate profits and household income, the Bank judges that the economy continues to follow a moderate recovery trend. The results of the June Tankan-Short-term Economic Survey of Enterprises in Japan, which were released two days ago, for the most part confirmed this view. The question is whether the virtuous circle of demand, production, and income, which has been developing steadily, will keep its momentum and whether, as a result, the economy will gain further momentum for a self-sustained recovery despite the downward pressures of fiscal tightening. The key to this will be developments in business fixed investment and personal consumption, which, according to the Tankan results and other indicators, can be analyzed as follows. Firms' projections of revenues and profits and their plans for fixed investment indicate that recovery in business conditions will remain moderate for smaller firms, especially for those in the non-manufacturing sector. However, for firms as a whole, revenues and profits continue to be on an upward trend, especially for major firms, supported by increasing exports and buoyant demand for information technology-related goods and services. Fixed investment plans are also being revised upward. If this trend continues, the recovery in business conditions can be expected to spread to smaller firms. Employment and income are showing moderate but steady improvement, and bonus payments in summer 1997 are likely to enjoy a sizable rise. While personal consumption will inevitably be affected by the rise in the consumption tax rate and by the discontinuation of the special tax reduction, it is unlikely that the trend of recovery will be hampered considering the improvements in the income environment. Thus, the virtuous circle, generated by a recovery in private demand, is still at work. The Bank is, therefore, of the view that the current slowdown in demand will only be temporary and that it is likely that the economic recovery will continue. It is, however, necessary to continue to monitor closely consumer behavior and business activity. Prices remained virtually unchanged in April and May after the immediate effects of the rise in the consumption tax rate are discounted. The Bank will continue to monitor price developments closely, but expects prices to remain stable for some time, reflecting the recent appreciation of the yen and stabilized crude oil prices. In the management of current monetary policy, the Bank will continue to monitor economic developments closely, placing emphasis on further strengthening the foundations of the economic recovery. B. The thinking behind the Bank's easy stance of monetary policy I have heard various questions and criticisms with regard to the easy stance of monetary policy, which the Bank has continued with a view to strengthening the foundations of the economic recovery. Therefore, I would next like to share with you the thinking behind the current stance of monetary policy. First, there is the question of why the Bank has not changed its policy stance since 1995, when it lowered the official discount rate to 0.5 percent, despite a gradual recovery of the economy. Indeed, compared to 1995, concern about a deflationary spiral has subsided and economic activity has improved significantly. The purpose of the drastic monetary easing measures was to prevent an occurrence of a deflationary spiral, to strengthen the confidence of firms and households in the economic outlook, and to thereby place the Japanese economy on a path of self-sustained recovery. As you are aware, the Japanese economy is faced with the medium to long-term challenges of overcoming the after-effects of the bursting of the economic "bubble" and reforming its industrial structure. The economy has therefore had to achieve a recovery while addressing these weighty challenges. Further, since the latter half of 1996, measures for fiscal consolidation have been implemented, including a reducing of public-sector investment and a raising of the consumption tax rate. In order for the economy to attain noninflationary, sustainable growth under such circumstances, the forces of the self-sustained recovery achieved in the private sector need to be further strengthened. It is therefore the Bank's judgment that, at this point, it is necessary to monitor economic developments carefully bearing this in mind. Second, there has been criticism that, from the viewpoint of income distribution, the current low interest rates are putting the general public at a disadvantage. The Bank is fully aware of the difficult situation faced by those households which depend heavily on interest income. However, various types of income, whether it be wages, interest, or pensions, are distributed from the total output produced by economic activity. Therefore, without growth of the total output, sources of such income will not be generated. If the policy interest rate is raised before economic activity is sufficiently revitalized and, as a result, the economy is adversely affected, long-term interest rates may actually decline. It will then be difficult to say how the average level of short and long-term deposit interest rates will be affected. What I wish to emphasize is that in order for the overall level of interest rates to rise, there must have been the requisite improvement in the economic activity. Third, there have been concerns that low interest rates may encourage an outflow of domestic funds. In discussing this point, it must be remembered that the relationship between cross-border interest rate differentials and capital flows under the present floating exchange rate system differs from that under the fixed exchange rate system. Under the latter, there is no foreign exchange risk. Therefore, funds tend to flow to economies with higher interest rates. This is precisely why, under that system, strict regulation of capital flows was necessary. Under the floating exchange rate system, however, such capital flows do not necessarily occur. Even if one attempts to profit from a differential between domestic and overseas interest rates, the profit can be wiped out instantly with even a slight shift in the exchange rate. For example, if overseas interest rates rise, widening interest rate differentials, capital outflows may initially occur, causing the foreign currency to appreciate and the domestic currency to depreciate. After some time, however, expectations will emerge that the value of the foreign currency will start to decline. At that point, the benefits of investing in the foreign currency will have decreased significantly. Thus, when foreign exchange risk is taken into consideration, a situation in which the expected rate of return on foreign currency investment is substantially higher than that on domestic investment cannot be sustained. Under the floating exchange rate system, therefore, exchange rate fluctuations will apply the brakes to any one-sided capital flow. The long-term interest rate differential between Japan and the United States has been around 2 to 4 percent in recent years, and has widened in this time. It is true that during this time investment in foreign bonds has increased. Yet this has not depleted funds in Japan or caused domestic interest rates to remain at a high level. With global capital flows as active as they are today, the mechanism of the floating exchange rate system will function only more expeditiously. In other words, the speed of market adjustments has accelerated. What is critical in these circumstances is the occurrence of a capital flight, which may be triggered by a loss of market confidence in a country's economic policy management resulting from an inflation or recession in that country. In order to prevent this from occurring in Japan today, it is essential to strengthen the foundations of the economic recovery and to achieve noninflationary, sustainable growth. In this connection, some argue that the revision of the Foreign Exchange and Foreign Trade Control Law, together with the low interest rates, may accelerate capital outflow. The Bank intends to monitor carefully the effects of the revision on the markets. However, as I have just explained, the Bank believes that there is little possibility of a disruptive capital outflow occurring simply as a result of the interest rate differentials between Japan and abroad. Rather, a more serious problem to consider would be the emergence of a "transaction flight." Should market participants decide for certain reasons that overseas markets are more attractive and beneficial to the conducting of transactions, even financial and capital transactions between residents, which have conventionally been conducted in Japan-for example, securities transactions between domestic firms and households-may shift overseas. Although this will not induce an outflow of capital, transactions will be carried out abroad and the subsequent business opportunities will be transferred overseas. Should this trend continue, it might lead to a hollowing out of Japan's financial markets. This is why the "Big Bang" deregulation package must be implemented apace with the revision of the Foreign Exchange and Foreign Trade Control Law, to enhance the attractiveness of domestic financial markets and services. III. The New Framework of Monetary Policy under the New Bank of Japan Law To summarize what I have said so far, the Bank of Japan is managing monetary policy with a view to placing the Japanese economy on a path of noninflationary, sustainable growth. While this has always been the objective of monetary policy under the current Bank of Japan Law, it is stipulated more explicitly by the new which will come into effect Law, on April 1, 1998. Various revisions have also been incorporated in the new Law to ensure the achievement of this objective. I would, therefore, like to discuss the new framework of monetary policy under the new Bank of Japan Law and how we intend to make use of the new framework, firstly with regard to the objectives, secondly the instruments, and finally the management of monetary policy, including the decision-making procedures. A. Monetary Policy Objectives 1. Price stability I would first like to discuss the objectives of monetary policy. The new Bank of Japan Law stipulates that the objective of monetary policy is "to contribute to the sound development of the national economy through the pursuit of price stability." The sound development of the national economy is a common objective of all economic policies. As the objective of monetary policy is to contribute to the achievement of this ultimate objective through price stability, its direct objective will be to ensure price stability. Price stability, together with the stability of the financial system, is a precondition for money to smoothly perform its intrinsic functions. As the issuer and controller of money, maintenance of price stability is an inherent role of the central bank. It is, however, not easy to define price stability. There are diverse types of price indicators: for example, the Consumer Price Index, Wholesale Price Indexes, and the GDP deflator. Each of these has its limitation, such as the range of items covered or the timing of release. Further, many studies have been conducted more recently on the possibility that these indicators offer a substantially biased measurement of prices. Even with a perfectly reliable price indicator, there will still be disparate views regarding what specific percentage of price increases would be acceptable. Thus, it is difficult to define specifically what is meant by price stability. We at the Bank will continue to study this issue, including the interpretation of price indices. It becomes clearer, however, if the matter is considered from the viewpoint of the implications of price stability for economic activity. "Prices", sometimes referred to as "prices in general", are the average level of the prices of individual goods and services, and serve as a tool to measure the relative rise or fall in the price of individual goods and services. Therefore, if prices in general were to fluctuate significantly, firms and households would not be able to conduct efficient investment and consumption activity. For example, in an inflationary economy, even if the price of a firm's product rises, the firm will not be able to judge whether this will bring about increased earnings in the future, or whether it merely reflects a rise in prices in general with the price increase being offset by an increase in wages and cost of raw materials. In such an economy, firms will, in the long term, inevitably become cautious with their investments. Furthermore, when there are concerns about inflation, people will tend to curtail their spending. The same situation may arise in the case of a deflationary economy. One possible example was the Japanese economy in 1995, when there were concerns about a deflationary spiral. This line of thinking leads to the conclusion that ensuring price stability means maintaining a situation in which firms and households need not be concerned about a continuing rise or fall in prices in the future when planning their investment and consumption. 2. The relationship between price stability and the economy Having defined price stability, there may still be questions about the relationship between price stability and other important policy objectives or economic variables. For example, should we not care about the economy and economic growth as long as prices remain stable? What is the relationship between prices and foreign exchange rates or asset prices? First, with regard to the relationship between prices and the economy, it is true that in the short term, it seems as if higher economic growth could be realized if a certain level of price increase were allowed. However, it has recently been proved both theoretically and empirically that this effect will only be temporary. If such a process is repeated, the economy may well fall into an intractable situation of stagflation, in which the economy falls back into a recession but high inflation remains. This was the economic disease that plagued the industrialized countries of Europe and the United States from the mid-1970s to the early 1980s. In the light of that experience, there is a common understanding today that price stability is a precondition for sustainable economic growth. Second, how are foreign exchange rates and asset prices to be considered in the context of monetary policy management? They are important factors that require due attention. However, if their stability is made a direct objective of monetary policy, the stability of the domestic economy and of prices in general may be undermined. This is because land prices and exchange rates reflect certain factors which prices in general do not. Specifically, land prices incorporate changes in the productivity of land and in the expected rate of return. Exchange rates, in the long term, are adjusted by the market mechanism in accordance with the differentials between domestic and overseas inflation rates, or in other words, changes in the purchasing power parities. Any attempt to control such factors forcibly through macroeconomic policies will most likely cause distortions in other sectors of the economy. Needless to say, fluctuations in exchange rates and asset prices will affect the economy in various ways. It has been a valuable lesson of the bubble economy that significant fluctuations in asset prices may be a sign of some irregularities in economic activity or excessive expectations of economic entities. Therefore, while it would not be appropriate to attempt any rigid control of asset prices and exchange rates, the Bank will pay due attention to developments in them in managing monetary policy aimed at achieving the objective of price stability. B. Monetary policy instruments Let me next discuss the instruments of monetary policy under the new Bank of Japan Law. Economic textbooks often refer to (1) the official discount rate, (2) open market operations, and (3) reserve requirements as the three major monetary policy instruments. These are in fact the means with which the Bank of Japan implements monetary policy, and this will remain unchanged under the new Law. The revised Law, however, incorporates the following changes. First, the new Law explicitly stipulates that "guidelines for money market control through various measures such as buying and selling of bills or bonds"-that is, the Bank's basic policy for open market operations, or in other words, the Bank's policy for the guiding of money market rates-are to be decided by the Bank of Japan's Policy Board, while in the current Law, there is no explicit stipulation concerning such policy. Second, while the current Law stipulates that determination and altering of reserve requirements must be approved by the Minister of Finance, the new Law abolishes this approval system. With these changes, all three instruments of monetary policy-including official discount rate policy, which is already stipulated by the current Law as a matter for decision by the Policy Board--will be spelt out explicitly as matters to be decided by the Policy Board. Reserve requirements have been altered less frequently as the means of open market operations developed. I would therefore like to discuss in detail the historical background and the Bank's view of official discount rate changes and of the guiding of money market rates, with emphasis on how the Bank will utilize these two means of implementing monetary policy. 1. Relationship between official discount rate changes and the guiding of money market rates For many years, monetary policy was in most cases implemented in Japan by changing the official discount rate. This was because the financial markets were not sufficiently developed and, under these circumstances, deposit interest rates and lending rates were linked to the official discount rate. The situation changed gradually from the 1980s. The financial markets began to grow both in quality and quantity, with massive issuance of government securities and introduction of new financial instruments such as certificates of deposit (CDs) and commercial paper (CP). As a result, interest rates started to fluctuate freely reflecting the supply and demand conditions for funds, and accordingly, an environment was established in which the effects of monetary policy would permeate via market interest rates. In response to such changes in the financial markets, the Bank has devised various changes to its monetary policy management. For example, in the buying and selling of bills and bonds, the Bank abolished the system of conducting operations at the rate quoted by the Bank, and adopted a more transparent bidding system. The Bank also improved the efficiency of its market operations by shortening the lag between the announcement of operations and the settlement of funds. In 1991, the Bank abolished window guidance, a method in which the Bank gave direct guidance to financial institutions regarding the amount by which they increased their lendings, and provided for an environment in which the functions of interest rates could be used to influence the behavior of financial institutions. In addition, in 1994, deregulation of deposit interest rates was completed. This meant that the official discount rate no longer performed the role of directly bringing changes to deposit interest rates and lending rates, and instead, the significance of the guiding of money market rates increased. Consequently, on March 31, 1995, the Bank introduced a new system to utilize the guiding of money market rates as a means of monetary policy which is, by itself, as significant as the official discount rate. This is a system whereby the Bank publicly announces its policy for market operations after it has been approved by the Policy Board. The policy is stated with regard to the guiding level of overnight call money rates, the Bank's target rate in market operations. For example, the Bank might state that it "expects that the call money rate will remain on average slightly below the official discount rate." While this method of monetary policy implementation had already taken root in the United States, it was the first attempt for Japan back in March 1995. At the time of this first attempt, it so happened that Germany had lowered its official discount rate a day earlier, and it cannot be denied that the market could not quite understand and assimilate the Bank's policy intention. The Bank's use of the guiding of money market rates, however, has gradually gained understanding and has taken root in Japan as well. In fact, when the Bank encouraged a decline in the market rates on July 7, 1995, the policy intent permeated smoothly through the market without causing any confusion. The provision of the new Law stating that the policy for the guiding of money market rates be determined by the Policy Board reinforces the recent emphasis placed by the Bank on the market mechanism. What significance, then, will the official discount rate have in this age of marketization? Central banks overseas hold various views as to the relationship between official discount rate changes and the guiding of money market rates, and it is difficult to arrive at a single conclusion. However, examples overseas suggest that official discount rate changes continue to play an important role even in this age of economic and financial marketization and interest rate liberalization. Their function is to communicate plainly to everybody the changes in monetary policy. In order to maintain the efficacy of monetary policy amid the progress of marketization, it becomes even more necessary to win public understanding of and confidence in the central bank's economic outlook and the thinking behind its monetary policy management. In this regard, the easy-to-understand announcement effects of the official discount rate are valuable for monetary policy management based on the functioning of the market mechanism. I am sometimes asked which of the two would be employed first, the guiding of money market rates or official discount rate change. However, there is no fixed rule as to which should be implemented first. In some cases, the Bank may change the level it has set for the guiding of money market rates several times before changing the official discount rate, and in other cases, the Bank may first strongly indicate its policy intention by changing the official discount rate, and then guide the money market rates accordingly. For the reasons I have just explained, the Bank believes it necessary to make effective use of both official discount rate changes and the guiding of money market rates. C. Monetary policy management 1. Strengthening of the functions of the Policy Board I would now like to discuss monetary policy management, focusing on the decision-making process of monetary policy. The new Bank of Japan Law incorporates major revisions aimed at strengthening the functions of the Policy Board, the Bank of Japan's highest decision-making body. First, the composition of the Board is altered significantly. The current Policy Board consists of seven members: the Governor of the Bank of Japan, four appointed members, and two government members without voting rights, representing the Ministry of Finance and the Economic Planning Agency. The new Policy Board, however, will consist of nine members: the Governor and the two Deputy Governors of the Bank of Japan and six deliberative members. The main features of the changes are that, first, there will be no government members on the Board. Second, while the current appointed members must be selected from each of the four fields of city banking, regional banking, commerce and industry, and agriculture, the new deliberative members can be selected from among a much broader population, without any restriction on the fields they represent, so long as they are experts, including those on economy or finance. Third, in order to ensure interactive linkage between monetary policy decision-making and the Bank's business operations, the number of members from the management of the Bank is increased from one to three. A balance is to be struck, however, by appointing six deliberative members so that the three members from the management will not constitute the majority. Also, the powers of the Policy Board, which remained somewhat ambiguous under the current Law, are clarified. One example is the explicit stipulation of the three instruments of monetary policy as matters for decision by the Policy Board, which I discussed earlier. In addition to these revisions, we at the Bank will do our best to ensure that the Policy Board can fully function. For example, meetings of the executive are currently organized at the Bank of Japan pursuant to the Bank's by-laws. The meetings are attended by the Governor, the Deputy Governor, and the Executive Directors, and, as the executive body of the Bank, meets to discuss important matters related to the Bank's daily business operations and to deliberate on matters on which it needs to consult with the Policy Board. The meetings thus by no means represent decision-making opportunities. However, the holding of the meetings has invited criticism that the Bank perhaps has two decision-making processes. Under the new Law, therefore, the meetings will be abolished to prevent any misunderstanding regarding the procedures of monetary policy decision-making. As a result, meetings of the executive will not deliberate on monetary control issues before they are discussed by the Policy Board. The entire procedure related to monetary policy, from judging the economic and financial conditions to policy decision-making, will be concentrated at the Policy Board. 2. Holding of regular Policy Board meetings on monetary control matters With the powers of the Policy Board strengthened in this manner, the new Law provides for regular meetings of the Policy Board on monetary control matters as well as disclosure of summaries of discussions and transcripts (detailed records of discussions) of the meetings. The main aim of holding regular Policy Board meetings on monetary control matters is to ensure the stability of the financial markets. Currently, the Policy Board meets every Tuesday and Friday. However, the holding of ad hoc meetings means that there is the possibility that policy changes might be made at any time. That being the case, the markets inevitably become overly sensitive to various kinds of information, such as daily movements in economic indicators and individual statements by relevant people. In fact, on quite a few occasions, one piece of information has triggered speculation over monetary policy changes, leading to market disruption. It is indeed an intrinsic function of the financial markets to assimilate various kinds of information and to reflect them in the formation of interest rates. In order for this function to be played out in the most stable and efficient manner, however, it is important that undue speculation and market disruption be avoided. This will also be conducive to improving the efficacy of monetary policy. The new system of holding regular Board meetings on monetary control matters and of announcing the schedule of such meetings in advance has been devised based on such considerations. In determining the frequency of these regular meetings, due thought must be given to ensuring the timeliness of policy implementation as well as market stabilization. Although there is no need to preclude the possibility of ad hoc meetings, monetary policy decisions should in principle be made at the regular meetings in keeping with the purpose of the new system. If we look at the practices of other countries, the U.S. Federal Open Market Committee meets the least often at eight times a year, the Monetary Policy Committee of the Bank of England once a month, and the Central Bank Council of the German Bundesbank twice a month. The Bank will continue to study how best to run the Board meetings by considering such examples overseas and the aim of the new system. If I may add a word here, Policy Board meetings other than the regular meetings on monetary control matters will be held as necessary. Apart from determination of monetary policy, the Policy Board will also discuss and decide on a number of matters, such as issues related to the financial and payments systems as well as those related to the operational and organizational management of the Bank. The Policy Board currently meets twice weekly, and it is likely to meet frequently under the new Law as well. What is of special note in the new system is that, while Policy Board meetings will be held frequently, the opportunities to hold intensive discussions and decide on monetary control matters are specified. 3. Disclosure of summaries of discussions and transcripts of Policy Board meetings I would now like to explain the new disclosure system of summaries of discussions and transcripts of the regular Policy Board meetings on monetary control matters. One of the main principles underlying the revision of the Bank of Japan Law is improvement of the transparency of monetary policy. To this end, the new Law provides for the disclosure of the summaries of discussions and the transcripts of the regular Policy Board meetings on monetary control m	['mr. matsushita reports on a new framework of monetary policy under the new bank of japan law speech given by the governor of the bank of japan, mr. yasuo matsushita, to the yomiuri international economic society in tokyo on 27/6/97.', 'i. introduction as you are all aware, the diet passed the new bank of japan law on june 11, which will come into effect on april 1, 1998. it has been the perennial wish of the bank of japan to revise the current bank of japan law, which was legislated during world war ii, to accommodate the significant changes that have occurred in the economic and financial environment and to make the law able to withstand future changes in the environment.', 'revision of the law was also indispensable for rebuilding the entire japanese financial system so as to meet global standards.', "this revision built on the two principles of independence and transparency is thus a notable step in the 115 years of the bank's history and also for reforming the financial system of japan.", "the bank of japan law holds great significance as one of the basic laws governing japan's economic and financial activities.", 'looking back, this important revision was achieved in approximately one year from the start of discussions in spring 1996 owing to the support and efforts of many people, including prime minister hashimoto, finance minister mitsuzuka, and other government officials, members of parliament, and members of the advisory group on the central bank (an advisory panel to the prime minister) and the financial system research council (an advisory committee to the minister of finance).', 'many words of encouragement as well as criticism were heard from the financial and business circles and the general public, including perhaps some of you who are here today.', 'i would like to take this opportunity to express, on behalf of the bank, our heartfelt gratitude to all.', 'naturally, the reform of the bank of japan is not consummated merely by the revision of the law.', 'we at the bank of japan believe it essential that we continue our efforts to conduct appropriate policy and operational management, cognizant of the responsibilities entrusted to us by the people.', "we are determined to promote, in line with the aim of the revision of the law, wide-ranging reforms to further improve the transparency of policy management and the efficiency of the bank's operational management.", "today, i would first like to discuss recent monetary and economic conditions and the bank's current monetary policy management.", 'i will then explain the new framework of monetary policy under the new law and how the bank intends to manage monetary policy.', 'recent monetary and economic conditions and monetary policy management a. recent economic and price developments and monetary policy management i would like to start with the recent domestic economic condition.', "japan's economy is currently at a phase in which the downward pressures of fiscal tightening appear strongest, with personal consumption and housing investment declining in reaction to the stepped-up demand before the consumption tax rate was raised.", 'however, in view of the firm developments in production and improvements in corporate profits and household income, the bank judges that the economy continues to follow a moderate recovery trend.', 'the results of the june tankan-short-term economic survey of enterprises in japan, which were released two days ago, for the most part confirmed this view.', 'the question is whether the virtuous circle of demand, production, and income, which has been developing steadily, will keep its momentum and whether, as a result, the economy will gain further momentum for a self-sustained recovery despite the downward pressures of fiscal tightening.', 'the key to this will be developments in business fixed investment and personal consumption, which, according to the tankan results and other indicators, can be analyzed as follows.', "firms' projections of revenues and profits and their plans for fixed investment indicate that recovery in business conditions will remain moderate for smaller firms, especially for those in the non-manufacturing sector.", 'however, for firms as a whole, revenues and profits continue to be on an upward trend, especially for major firms, supported by increasing exports and buoyant demand for information technology-related goods and services.', 'fixed investment plans are also being revised upward.', 'if this trend continues, the recovery in business conditions can be expected to spread to smaller firms.', 'employment and income are showing moderate but steady improvement, and bonus payments in summer 1997 are likely to enjoy a sizable rise.', 'while personal consumption will inevitably be affected by the rise in the consumption tax rate and by the discontinuation of the special tax reduction, it is unlikely that the trend of recovery will be hampered considering the improvements in the income environment.', 'thus, the virtuous circle, generated by a recovery in private demand, is still at work.', 'the bank is, therefore, of the view that the current slowdown in demand will only be temporary and that it is likely that the economic recovery will continue.', 'it is, however, necessary to continue to monitor closely consumer behavior and business activity.', 'prices remained virtually unchanged in april and may after the immediate effects of the rise in the consumption tax rate are discounted.', 'the bank will continue to monitor price developments closely, but expects prices to remain stable for some time, reflecting the recent appreciation of the yen and stabilized crude oil prices.', 'in the management of current monetary policy, the bank will continue to monitor economic developments closely, placing emphasis on further strengthening the foundations of the economic recovery.', "b. the thinking behind the bank's easy stance of monetary policy i have heard various questions and criticisms with regard to the easy stance of monetary policy, which the bank has continued with a view to strengthening the foundations of the economic recovery.", 'therefore, i would next like to share with you the thinking behind the current stance of monetary policy.', 'first, there is the question of why the bank has not changed its policy stance since 1995, when it lowered the official discount rate to 0.5 percent, despite a gradual recovery of the economy.', 'indeed, compared to 1995, concern about a deflationary spiral has subsided and economic activity has improved significantly.', 'the purpose of the drastic monetary easing measures was to prevent an occurrence of a deflationary spiral, to strengthen the confidence of firms and households in the economic outlook, and to thereby place the japanese economy on a path of self-sustained recovery.', 'as you are aware, the japanese economy is faced with the medium to long-term challenges of overcoming the after-effects of the bursting of the economic "bubble" and reforming its industrial structure.', 'the economy has therefore had to achieve a recovery while addressing these weighty challenges.', 'further, since the latter half of 1996, measures for fiscal consolidation have been implemented, including a reducing of public-sector investment and a raising of the consumption tax rate.', 'in order for the economy to attain noninflationary, sustainable growth under such circumstances, the forces of the self-sustained recovery achieved in the private sector need to be further strengthened.', "it is therefore the bank's judgment that, at this point, it is necessary to monitor economic developments carefully bearing this in mind.", 'second, there has been criticism that, from the viewpoint of income distribution, the current low interest rates are putting the general public at a disadvantage.', 'the bank is fully aware of the difficult situation faced by those households which depend heavily on interest income.', 'however, various types of income, whether it be wages, interest, or pensions, are distributed from the total output produced by economic activity.', 'therefore, without growth of the total output, sources of such income will not be generated.', 'if the policy interest rate is raised before economic activity is sufficiently revitalized and, as a result, the economy is adversely affected, long-term interest rates may actually decline.', 'it will then be difficult to say how the average level of short and long-term deposit interest rates will be affected.', 'what i wish to emphasize is that in order for the overall level of interest rates to rise, there must have been the requisite improvement in the economic activity.', 'third, there have been concerns that low interest rates may encourage an outflow of domestic funds.', 'in discussing this point, it must be remembered that the relationship between cross-border interest rate differentials and capital flows under the present floating exchange rate system differs from that under the fixed exchange rate system.', 'under the latter, there is no foreign exchange risk.', 'therefore, funds tend to flow to economies with higher interest rates.', 'this is precisely why, under that system, strict regulation of capital flows was necessary.', 'under the floating exchange rate system, however, such capital flows do not necessarily occur.', 'even if one attempts to profit from a differential between domestic and overseas interest rates, the profit can be wiped out instantly with even a slight shift in the exchange rate.', 'for example, if overseas interest rates rise, widening interest rate differentials, capital outflows may initially occur, causing the foreign currency to appreciate and the domestic currency to depreciate.', 'after some time, however, expectations will emerge that the value of the foreign currency will start to decline.', 'at that point, the benefits of investing in the foreign currency will have decreased significantly.', 'thus, when foreign exchange risk is taken into consideration, a situation in which the expected rate of return on foreign currency investment is substantially higher than that on domestic investment cannot be sustained.', 'under the floating exchange rate system, therefore, exchange rate fluctuations will apply the brakes to any one-sided capital flow.', 'the long-term interest rate differential between japan and the united states has been around 2 to 4 percent in recent years, and has widened in this time.', 'it is true that during this time investment in foreign bonds has increased.', 'yet this has not depleted funds in japan or caused domestic interest rates to remain at a high level.', 'with global capital flows as active as they are today, the mechanism of the floating exchange rate system will function only more expeditiously.', 'in other words, the speed of market adjustments has accelerated.', "what is critical in these circumstances is the occurrence of a capital flight, which may be triggered by a loss of market confidence in a country's economic policy management resulting from an inflation or recession in that country.", 'in order to prevent this from occurring in japan today, it is essential to strengthen the foundations of the economic recovery and to achieve noninflationary, sustainable growth.', 'in this connection, some argue that the revision of the foreign exchange and foreign trade control law, together with the low interest rates, may accelerate capital outflow.', 'the bank intends to monitor carefully the effects of the revision on the markets.', 'however, as i have just explained, the bank believes that there is little possibility of a disruptive capital outflow occurring simply as a result of the interest rate differentials between japan and abroad.', 'rather, a more serious problem to consider would be the emergence of a "transaction flight."', 'should market participants decide for certain reasons that overseas markets are more attractive and beneficial to the conducting of transactions, even financial and capital transactions between residents, which have conventionally been conducted in japan-for example, securities transactions between domestic firms and households-may shift overseas.', 'although this will not induce an outflow of capital, transactions will be carried out abroad and the subsequent business opportunities will be transferred overseas.', "should this trend continue, it might lead to a hollowing out of japan's financial markets.", 'this is why the "big bang" deregulation package must be implemented apace with the revision of the foreign exchange and foreign trade control law, to enhance the attractiveness of domestic financial markets and services.', 'the new framework of monetary policy under the new bank of japan law to summarize what i have said so far, the bank of japan is managing monetary policy with a view to placing the japanese economy on a path of noninflationary, sustainable growth.', 'while this has always been the objective of monetary policy under the current bank of japan law, it is stipulated more explicitly by the new which will come into effect law, on april 1, 1998. various revisions have also been incorporated in the new law to ensure the achievement of this objective.', 'i would, therefore, like to discuss the new framework of monetary policy under the new bank of japan law and how we intend to make use of the new framework, firstly with regard to the objectives, secondly the instruments, and finally the management of monetary policy, including the decision-making procedures.', 'a. monetary policy objectives 1. price stability i would first like to discuss the objectives of monetary policy.', 'the new bank of japan law stipulates that the objective of monetary policy is "to contribute to the sound development of the national economy through the pursuit of price stability."', 'the sound development of the national economy is a common objective of all economic policies.', 'as the objective of monetary policy is to contribute to the achievement of this ultimate objective through price stability, its direct objective will be to ensure price stability.', 'price stability, together with the stability of the financial system, is a precondition for money to smoothly perform its intrinsic functions.', 'as the issuer and controller of money, maintenance of price stability is an inherent role of the central bank.', 'it is, however, not easy to define price stability.', 'there are diverse types of price indicators: for example, the consumer price index, wholesale price indexes, and the gdp deflator.', 'each of these has its limitation, such as the range of items covered or the timing of release.', 'further, many studies have been conducted more recently on the possibility that these indicators offer a substantially biased measurement of prices.', 'even with a perfectly reliable price indicator, there will still be disparate views regarding what specific percentage of price increases would be acceptable.', 'thus, it is difficult to define specifically what is meant by price stability.', 'we at the bank will continue to study this issue, including the interpretation of price indices.', 'it becomes clearer, however, if the matter is considered from the viewpoint of the implications of price stability for economic activity.', '"prices", sometimes referred to as "prices in general", are the average level of the prices of individual goods and services, and serve as a tool to measure the relative rise or fall in the price of individual goods and services.', 'therefore, if prices in general were to fluctuate significantly, firms and households would not be able to conduct efficient investment and consumption activity.', "for example, in an inflationary economy, even if the price of a firm's product rises, the firm will not be able to judge whether this will bring about increased earnings in the future, or whether it merely reflects a rise in prices in general with the price increase being offset by an increase in wages and cost of raw materials.", 'in such an economy, firms will, in the long term, inevitably become cautious with their investments.', 'furthermore, when there are concerns about inflation, people will tend to curtail their spending.', 'the same situation may arise in the case of a deflationary economy.', 'one possible example was the japanese economy in 1995, when there were concerns about a deflationary spiral.', 'this line of thinking leads to the conclusion that ensuring price stability means maintaining a situation in which firms and households need not be concerned about a continuing rise or fall in prices in the future when planning their investment and consumption.', '2. the relationship between price stability and the economy having defined price stability, there may still be questions about the relationship between price stability and other important policy objectives or economic variables.', 'for example, should we not care about the economy and economic growth as long as prices remain stable?', 'what is the relationship between prices and foreign exchange rates or asset prices?', 'first, with regard to the relationship between prices and the economy, it is true that in the short term, it seems as if higher economic growth could be realized if a certain level of price increase were allowed.', 'however, it has recently been proved both theoretically and empirically that this effect will only be temporary.', 'if such a process is repeated, the economy may well fall into an intractable situation of stagflation, in which the economy falls back into a recession but high inflation remains.', 'this was the economic disease that plagued the industrialized countries of europe and the united states from the mid-1970s to the early 1980s.', 'in the light of that experience, there is a common understanding today that price stability is a precondition for sustainable economic growth.', 'second, how are foreign exchange rates and asset prices to be considered in the context of monetary policy management?', 'they are important factors that require due attention.', 'however, if their stability is made a direct objective of monetary policy, the stability of the domestic economy and of prices in general may be undermined.', 'this is because land prices and exchange rates reflect certain factors which prices in general do not.', 'specifically, land prices incorporate changes in the productivity of land and in the expected rate of return.', 'exchange rates, in the long term, are adjusted by the market mechanism in accordance with the differentials between domestic and overseas inflation rates, or in other words, changes in the purchasing power parities.', 'any attempt to control such factors forcibly through macroeconomic policies will most likely cause distortions in other sectors of the economy.', 'needless to say, fluctuations in exchange rates and asset prices will affect the economy in various ways.', 'it has been a valuable lesson of the bubble economy that significant fluctuations in asset prices may be a sign of some irregularities in economic activity or excessive expectations of economic entities.', 'therefore, while it would not be appropriate to attempt any rigid control of asset prices and exchange rates, the bank will pay due attention to developments in them in managing monetary policy aimed at achieving the objective of price stability.', 'b. monetary policy instruments let me next discuss the instruments of monetary policy under the new bank of japan law.', 'economic textbooks often refer to (1) the official discount rate, (2) open market operations, and (3) reserve requirements as the three major monetary policy instruments.', 'these are in fact the means with which the bank of japan implements monetary policy, and this will remain unchanged under the new law.', 'the revised law, however, incorporates the following changes.', 'first, the new law explicitly stipulates that "guidelines for money market control through various measures such as buying and selling of bills or bonds"-that is, the bank\'s basic policy for open market operations, or in other words, the bank\'s policy for the guiding of money market rates-are to be decided by the bank of japan\'s policy board, while in the current law, there is no explicit stipulation concerning such policy.', 'second, while the current law stipulates that determination and altering of reserve requirements must be approved by the minister of finance, the new law abolishes this approval system.', 'with these changes, all three instruments of monetary policy-including official discount rate policy, which is already stipulated by the current law as a matter for decision by the policy board--will be spelt out explicitly as matters to be decided by the policy board.', 'reserve requirements have been altered less frequently as the means of open market operations developed.', "i would therefore like to discuss in detail the historical background and the bank's view of official discount rate changes and of the guiding of money market rates, with emphasis on how the bank will utilize these two means of implementing monetary policy.", '1. relationship between official discount rate changes and the guiding of money market rates for many years, monetary policy was in most cases implemented in japan by changing the official discount rate.', 'this was because the financial markets were not sufficiently developed and, under these circumstances, deposit interest rates and lending rates were linked to the official discount rate.', 'the situation changed gradually from the 1980s.', 'the financial markets began to grow both in quality and quantity, with massive issuance of government securities and introduction of new financial instruments such as certificates of deposit (cds) and commercial paper (cp).', 'as a result, interest rates started to fluctuate freely reflecting the supply and demand conditions for funds, and accordingly, an environment was established in which the effects of monetary policy would permeate via market interest rates.', 'in response to such changes in the financial markets, the bank has devised various changes to its monetary policy management.', 'for example, in the buying and selling of bills and bonds, the bank abolished the system of conducting operations at the rate quoted by the bank, and adopted a more transparent bidding system.', 'the bank also improved the efficiency of its market operations by shortening the lag between the announcement of operations and the settlement of funds.', 'in 1991, the bank abolished window guidance, a method in which the bank gave direct guidance to financial institutions regarding the amount by which they increased their lendings, and provided for an environment in which the functions of interest rates could be used to influence the behavior of financial institutions.', 'in addition, in 1994, deregulation of deposit interest rates was completed.', 'this meant that the official discount rate no longer performed the role of directly bringing changes to deposit interest rates and lending rates, and instead, the significance of the guiding of money market rates increased.', 'consequently, on march 31, 1995, the bank introduced a new system to utilize the guiding of money market rates as a means of monetary policy which is, by itself, as significant as the official discount rate.', 'this is a system whereby the bank publicly announces its policy for market operations after it has been approved by the policy board.', "the policy is stated with regard to the guiding level of overnight call money rates, the bank's target rate in market operations.", 'for example, the bank might state that it "expects that the call money rate will remain on average slightly below the official discount rate."', "while this method of monetary policy implementation had already taken root in the united states, it was the first attempt for japan back in march 1995. at the time of this first attempt, it so happened that germany had lowered its official discount rate a day earlier, and it cannot be denied that the market could not quite understand and assimilate the bank's policy intention.", "the bank's use of the guiding of money market rates, however, has gradually gained understanding and has taken root in japan as well.", 'in fact, when the bank encouraged a decline in the market rates on july 7, 1995, the policy intent permeated smoothly through the market without causing any confusion.', 'the provision of the new law stating that the policy for the guiding of money market rates be determined by the policy board reinforces the recent emphasis placed by the bank on the market mechanism.', 'what significance, then, will the official discount rate have in this age of marketization?', 'central banks overseas hold various views as to the relationship between official discount rate changes and the guiding of money market rates, and it is difficult to arrive at a single conclusion.', 'however, examples overseas suggest that official discount rate changes continue to play an important role even in this age of economic and financial marketization and interest rate liberalization.', 'their function is to communicate plainly to everybody the changes in monetary policy.', "in order to maintain the efficacy of monetary policy amid the progress of marketization, it becomes even more necessary to win public understanding of and confidence in the central bank's economic outlook and the thinking behind its monetary policy management.", 'in this regard, the easy-to-understand announcement effects of the official discount rate are valuable for monetary policy management based on the functioning of the market mechanism.', 'i am sometimes asked which of the two would be employed first, the guiding of money market rates or official discount rate change.', 'however, there is no fixed rule as to which should be implemented first.', 'in some cases, the bank may change the level it has set for the guiding of money market rates several times before changing the official discount rate, and in other cases, the bank may first strongly indicate its policy intention by changing the official discount rate, and then guide the money market rates accordingly.', 'for the reasons i have just explained, the bank believes it necessary to make effective use of both official discount rate changes and the guiding of money market rates.', 'c. monetary policy management 1. strengthening of the functions of the policy board i would now like to discuss monetary policy management, focusing on the decision-making process of monetary policy.', "the new bank of japan law incorporates major revisions aimed at strengthening the functions of the policy board, the bank of japan's highest decision-making body.", 'first, the composition of the board is altered significantly.', 'the current policy board consists of seven members: the governor of the bank of japan, four appointed members, and two government members without voting rights, representing the ministry of finance and the economic planning agency.', 'the new policy board, however, will consist of nine members: the governor and the two deputy governors of the bank of japan and six deliberative members.', 'the main features of the changes are that, first, there will be no government members on the board.', 'second, while the current appointed members must be selected from each of the four fields of city banking, regional banking, commerce and industry, and agriculture, the new deliberative members can be selected from among a much broader population, without any restriction on the fields they represent, so long as they are experts, including those on economy or finance.', "third, in order to ensure interactive linkage between monetary policy decision-making and the bank's business operations, the number of members from the management of the bank is increased from one to three.", 'a balance is to be struck, however, by appointing six deliberative members so that the three members from the management will not constitute the majority.', 'also, the powers of the policy board, which remained somewhat ambiguous under the current law, are clarified.', 'one example is the explicit stipulation of the three instruments of monetary policy as matters for decision by the policy board, which i discussed earlier.', 'in addition to these revisions, we at the bank will do our best to ensure that the policy board can fully function.', "for example, meetings of the executive are currently organized at the bank of japan pursuant to the bank's by-laws.", "the meetings are attended by the governor, the deputy governor, and the executive directors, and, as the executive body of the bank, meets to discuss important matters related to the bank's daily business operations and to deliberate on matters on which it needs to consult with the policy board.", 'the meetings thus by no means represent decision-making opportunities.', 'however, the holding of the meetings has invited criticism that the bank perhaps has two decision-making processes.', 'under the new law, therefore, the meetings will be abolished to prevent any misunderstanding regarding the procedures of monetary policy decision-making.', 'as a result, meetings of the executive will not deliberate on monetary control issues before they are discussed by the policy board.', 'the entire procedure related to monetary policy, from judging the economic and financial conditions to policy decision-making, will be concentrated at the policy board.', '2. holding of regular policy board meetings on monetary control matters with the powers of the policy board strengthened in this manner, the new law provides for regular meetings of the policy board on monetary control matters as well as disclosure of summaries of discussions and transcripts (detailed records of discussions) of the meetings.', 'the main aim of holding regular policy board meetings on monetary control matters is to ensure the stability of the financial markets.', 'currently, the policy board meets every tuesday and friday.', 'however, the holding of ad hoc meetings means that there is the possibility that policy changes might be made at any time.', 'that being the case, the markets inevitably become overly sensitive to various kinds of information, such as daily movements in economic indicators and individual statements by relevant people.', 'in fact, on quite a few occasions, one piece of information has triggered speculation over monetary policy changes, leading to market disruption.', 'it is indeed an intrinsic function of the financial markets to assimilate various kinds of information and to reflect them in the formation of interest rates.', 'in order for this function to be played out in the most stable and efficient manner, however, it is important that undue speculation and market disruption be avoided.', 'this will also be conducive to improving the efficacy of monetary policy.', 'the new system of holding regular board meetings on monetary control matters and of announcing the schedule of such meetings in advance has been devised based on such considerations.', 'in determining the frequency of these regular meetings, due thought must be given to ensuring the timeliness of policy implementation as well as market stabilization.', 'although there is no need to preclude the possibility of ad hoc meetings, monetary policy decisions should in principle be made at the regular meetings in keeping with the purpose of the new system.', 'if we look at the practices of other countries, the u.s. federal open market committee meets the least often at eight times a year, the monetary policy committee of the bank of england once a month, and the central bank council of the german bundesbank twice a month.', 'the bank will continue to study how best to run the board meetings by considering such examples overseas and the aim of the new system.', 'if i may add a word here, policy board meetings other than the regular meetings on monetary control matters will be held as necessary.', 'apart from determination of monetary policy, the policy board will also discuss and decide on a number of matters, such as issues related to the financial and payments systems as well as those related to the operational and organizational management of the bank.', 'the policy board currently meets twice weekly, and it is likely to meet frequently under the new law as well.', 'what is of special note in the new system is that, while policy board meetings will be held frequently, the opportunities to hold intensive discussions and decide on monetary control matters are specified.', '3. disclosure of summaries of discussions and transcripts of policy board meetings i would now like to explain the new disclosure system of summaries of discussions and transcripts of the regular policy board meetings on monetary control matters.', 'one of the main principles underlying the revision of the bank of japan law is improvement of the transparency of monetary policy.', 'to this end, the new law provides for the disclosure of the summaries of discussions and the transcripts of the regular policy board meetings on monetary control m']	Masaru Hayami	Bank of Japan	Governor	Japan
https://www.bis.org/review/r970918a.pdf	Bank of Japan's August review of monetary and economic trends in Japan (Central Bank Articles and Speeches, 26 Aug 97)	BANK OF JAPAN, MONTHLY ECONOMIC REVIEW, 26/8/97.	1997-08-26 00:00:00	Bank of Japan's August review of monetary and economic trends in Japan BANK OF JAPAN, MONTHLY ECONOMIC REVIEW, 26/8/97. Japan's economy continues on a moderate recovery trend. Production and income are showing firmness although the effects of the consumption tax hike remain. With respect to final demand, public-sector investment has been on a decreasing trend, and housing investment has declined. Meanwhile, net exports have recently been on an increasing trend, and business fixed investment has been rising steadily. Despite the continued influence of the consumption tax hike, the recovery trend of personal consumption does not seem to have been hindered given the improvement in labor market conditions and income formation. Industrial production has been firm. Meanwhile, prices have remained stable on the whole, and the growth of monetary aggregates has continued at around 3.0 per cent year to year. With regard to personal consumption, outlays for travel have continued to increase moderately. However, passenger-car sales marked the fourth month of consecutive decline year to year from April and sales of electrical appliances are also negative year to year. Sales at department stores and supermarkets continued to be below the previous year's level. These reflect some temporary factors, such as the typhoons which hit Japan in June and July, in addition to the continued reaction to the surge in demand ahead of the consumption tax hike. However, given that labor market conditions as well as income formation are improving steadily, albeit moderately, the recovery trend in personal consumption does not seem to have been hindered. Among leading indicators of business fixed investment, machinery orders have been increasing steadily, although at a somewhat slower pace compared to the sharp rise in the second half of 1996. The increase in the construction floor area has recently been weak, but it is following a moderate recovery trend. With respect to housing investment, housing starts in terms of the seasonally- adjusted annual rate reached a substantially high level in the fourth quarter 1996, partly reflecting the stepped-up demand ahead of the rise in the consumption tax rate. Later, they declined in reaction. Housing starts recorded around 1.5 million in spring 1997, but fell to 1.34 million in June, the lowest level recorded since January 1993. Regarding public-sector investment, the amount of public works contracted has recently picked up somewhat from the level recorded in early 1997 owing to orders included in the supplementary budget for fiscal 1996. However, public-sector investment has been following a declining trend on average, reflecting the restrained budget for fiscal 1997. Against the background of the steady overseas demand and the yen's depreciation to date, real exports stayed firm in July after having increased significantly in the second quarter reflecting some additional temporary factors. Real imports had been stagnant since April, but rose in July reflecting the rise in imports of foodstuffs and airplanes, in addition to the increasing trend of information-related goods. As a result, the real trade surplus stopped rising in July after the significant increase in the second quarter. The nominal current-account surplus showed a large expansion in the second quarter 1997, partly reflecting the decline in crude oil prices since early 1997. Industrial production in the second quarter has been firm and remained virtually unchanged after recording high growth during the second half of 1996 and the first quarter 1997. Despite the decline in demand following the surge ahead of the consumption tax hike, factors such as the substantial increase in exports and the rebuilding of inventories have supported production. Production is expected to increase slightly in July and August compared to the second quarter. Meanwhile, inventories are at appropriate levels on the whole, despite some accumulation in industries such as in automobiles. Labor market conditions have continued to improve on the whole. Although the unemployment rate remains at a high level, the growth in nominal wages has been increasing and the year-to-year employment growth has started to gather pace, albeit gradually, reflecting the increase in production and corporate profits. Prices remained stable on the whole, excluding the effect of the consumption tax hike. Although downward pressures remain, including that from the decline in import prices, as well as that from technological innovation in electrical machinery, domestic wholesale prices (adjusted for seasonal electricity rates) have remained virtually unchanged. This reflects the moderate improvement in overall domestic supply and demand conditions. The year-to-year declines in corporate service prices are narrowing steadily on the whole, partly owing to the improvement in supply and demand conditions, particularly for real estate rents and information services, although leasing charges continue to decline. Consumer prices (nationwide, excluding perishables) overall are marginally above the previous year's level mainly because the year-toyear declines in goods prices have narrowed. The growth in monetary aggregates, measured in terms of the year-to-year growth of M2 + CDs average outstanding, has been growing at around 3 per cent. Regarding money market rates, the overnight call rate (uncollateralized) has moved at a level slightly below the official discount rate. The 3-month CD rate has stayed at around 0.55 - 0.60 per cent. Meanwhile, the long-term government bond yield rose to 2.65 2.70 per cent in late May. Later, it started to decline as the market confirmed the moderate pace of the economic recovery, and reached a historically low level below 2.1 per cent in mid August. With respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since September 1995. The long-term prime lending rate was raised by 0.6 percentage points in May, and was then lowered by 0.2 percentage points both in June and July to 2.7 per cent. (The record low level is 2.5 per cent.) In these circumstances, short and long-term contracted interest rates on new loans and discounts (up to June) have moved at record low levels. On the stock exchange, the Nikkei 225 stock average moved at around ¥20,000 - 21,000 between May and July 1997, but later declined, reflecting such factors as the fall in U.S. stock prices. Recently, it has been moving at around ¥19,000. In the foreign exchange market, the yen appreciated to ¥110 to the U.S. dollar in the first half of June. The yen later depreciated slightly, and has recently stayed at around ¥115 - 120. Meanwhile, the yen has also been appreciating against the Deutsche Mark since May, and recently has moved at around ¥63 - 65.	["bank of japan's august review of monetary and economic trends in japan bank of japan, monthly economic review, 26/8/97.", "japan's economy continues on a moderate recovery trend.", 'production and income are showing firmness although the effects of the consumption tax hike remain.', 'with respect to final demand, public-sector investment has been on a decreasing trend, and housing investment has declined.', 'meanwhile, net exports have recently been on an increasing trend, and business fixed investment has been rising steadily.', 'despite the continued influence of the consumption tax hike, the recovery trend of personal consumption does not seem to have been hindered given the improvement in labor market conditions and income formation.', 'industrial production has been firm.', 'meanwhile, prices have remained stable on the whole, and the growth of monetary aggregates has continued at around 3.0 per cent year to year.', 'with regard to personal consumption, outlays for travel have continued to increase moderately.', 'however, passenger-car sales marked the fourth month of consecutive decline year to year from april and sales of electrical appliances are also negative year to year.', "sales at department stores and supermarkets continued to be below the previous year's level.", 'these reflect some temporary factors, such as the typhoons which hit japan in june and july, in addition to the continued reaction to the surge in demand ahead of the consumption tax hike.', 'however, given that labor market conditions as well as income formation are improving steadily, albeit moderately, the recovery trend in personal consumption does not seem to have been hindered.', 'among leading indicators of business fixed investment, machinery orders have been increasing steadily, although at a somewhat slower pace compared to the sharp rise in the second half of 1996. the increase in the construction floor area has recently been weak, but it is following a moderate recovery trend.', 'with respect to housing investment, housing starts in terms of the seasonally- adjusted annual rate reached a substantially high level in the fourth quarter 1996, partly reflecting the stepped-up demand ahead of the rise in the consumption tax rate.', 'later, they declined in reaction.', "housing starts recorded around 1.5 million in spring 1997, but fell to 1.34 million in june, the lowest level recorded since january 1993. regarding public-sector investment, the amount of public works contracted has recently picked up somewhat from the level recorded in early 1997 owing to orders included in the supplementary budget for fiscal 1996. however, public-sector investment has been following a declining trend on average, reflecting the restrained budget for fiscal 1997. against the background of the steady overseas demand and the yen's depreciation to date, real exports stayed firm in july after having increased significantly in the second quarter reflecting some additional temporary factors.", 'real imports had been stagnant since april, but rose in july reflecting the rise in imports of foodstuffs and airplanes, in addition to the increasing trend of information-related goods.', 'as a result, the real trade surplus stopped rising in july after the significant increase in the second quarter.', 'the nominal current-account surplus showed a large expansion in the second quarter 1997, partly reflecting the decline in crude oil prices since early 1997. industrial production in the second quarter has been firm and remained virtually unchanged after recording high growth during the second half of 1996 and the first quarter 1997. despite the decline in demand following the surge ahead of the consumption tax hike, factors such as the substantial increase in exports and the rebuilding of inventories have supported production.', 'production is expected to increase slightly in july and august compared to the second quarter.', 'meanwhile, inventories are at appropriate levels on the whole, despite some accumulation in industries such as in automobiles.', 'labor market conditions have continued to improve on the whole.', 'although the unemployment rate remains at a high level, the growth in nominal wages has been increasing and the year-to-year employment growth has started to gather pace, albeit gradually, reflecting the increase in production and corporate profits.', 'prices remained stable on the whole, excluding the effect of the consumption tax hike.', 'although downward pressures remain, including that from the decline in import prices, as well as that from technological innovation in electrical machinery, domestic wholesale prices (adjusted for seasonal electricity rates) have remained virtually unchanged.', 'this reflects the moderate improvement in overall domestic supply and demand conditions.', 'the year-to-year declines in corporate service prices are narrowing steadily on the whole, partly owing to the improvement in supply and demand conditions, particularly for real estate rents and information services, although leasing charges continue to decline.', "consumer prices (nationwide, excluding perishables) overall are marginally above the previous year's level mainly because the year-toyear declines in goods prices have narrowed.", 'the growth in monetary aggregates, measured in terms of the year-to-year growth of m2 + cds average outstanding, has been growing at around 3 per cent.', 'regarding money market rates, the overnight call rate (uncollateralized) has moved at a level slightly below the official discount rate.', 'the 3-month cd rate has stayed at around 0.55 - 0.60 per cent.', 'meanwhile, the long-term government bond yield rose to 2.65 2.70 per cent in late may.', 'later, it started to decline as the market confirmed the moderate pace of the economic recovery, and reached a historically low level below 2.1 per cent in mid august.', 'with respect to bank lending rates, the short-term prime lending rate has remained at a record low level of 1.625 per cent since september 1995. the long-term prime lending rate was raised by 0.6 percentage points in may, and was then lowered by 0.2 percentage points both in june and july to 2.7 per cent.', '(the record low level is 2.5 per cent.)', 'in these circumstances, short and long-term contracted interest rates on new loans and discounts (up to june) have moved at record low levels.', 'on the stock exchange, the nikkei 225 stock average moved at around ¥20,000 - 21,000 between may and july 1997, but later declined, reflecting such factors as the fall in u.s. stock prices.', 'recently, it has been moving at around ¥19,000.', 'in the foreign exchange market, the yen appreciated to ¥110 to the u.s. dollar in the first half of june.', 'the yen later depreciated slightly, and has recently stayed at around ¥115 - 120. meanwhile, the yen has also been appreciating against the deutsche mark since may, and recently has moved at around ¥63 - 65.']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r970916b.pdf	Mr. Crockett reviews the changing role of central banks (Central Bank Articles and Speeches, 11 Sep 97)	Speech by the General Manager of the Bank for International Settlements, Mr. Andrew Crockett, at the Money Macro and Finance Annual Conference held in Durham on 11/9/97.	1997-09-11 00:00:00	Speech by the General Mr. Crockett reviews the changing role of central banks Manager of the Bank for International Settlements, Mr. Andrew Crockett, at the Money Macro and Finance Annual Conference held in Durham on 11/9/97. The BIS Annual Report for 1996-97 observes, with characteristic understatement: "The last 25 years have been an eventful time for central banking". The period since the breakdown of the Bretton Woods system has, indeed, seen enormous changes in the economic and financial environment, and a major evolution in the objectives, indicators and instruments of central bank policy. My objective this afternoon will be to review these changes, and to identify some of the common factors that lie behind them. The changes in the environment have been of both a macro-economic and a structural character. Macro-economically, the move to floating exchange rates in the early 1970s was followed by a period of substandard economic performance. In the industrial world high inflation rates co-existed with disappointing growth. In the developing world, a borrowing spree was followed by a debt crisis. Not until the last few years have monetary authorities been successful in restoring a more satisfactory degree of price stability, and still the task is not complete. There have also been dramatic changes in financial structure. The process of liberalisation and innovation has led to a globalisation of finance and a quantum increase in intermediation. Coupled with an explosive growth in ever more complex financial instruments, this has presented new opportunities to financial intermediaries, but also created new sources of systemic risk. The changing environment has both influenced and been influenced by an evolution in the way central banks carry out their role of preserving monetary and financial stability. In the field of monetary stability, attempts to exploit the Phillips curve trade-off produced almost wholly negative results and led to a widespread consensus that the primary objective of monetary policy must be price stability. The intermediate targets of monetary policy objectives have also evolved, with the earlier emphasis on monetary aggregates giving way to exchange rate anchors in some countries and explicit or implicit inflation targets in others. At the level of tactics, market management techniques, which were formerly quite diverse, have tended to coalesce around the use of repurchase operations as a means of controlling very short-term interest rates. The other main function of central banks, that of preserving financial system stability, has acquired considerably more prominence as a result of financial liberalisation, which has led to the greatest spate of banking sector difficulties since the interwar period. The focus of central banks' approach to maintaining systemic stability has evolved from field-of-activity regulation to a greater stress on capital adequacy, and is still in the process of change. Meanwhile, a number of countries are rethinking the institutional structure of supervision, with some placing responsibility for day-to-day regulation with specialised supervisory agencies and assigning to the central bank the broad, though less well-defined responsibility for systemic stability. Throughout these changes, a constant feature has been central banks' search for effective means of implementing policy in an environment where economic agents can use new instruments and markets to arbitrage their way around restrictions and controls. The desire to avoid distorting incentives and exacerbating moral hazard has been a guiding principle in this search. The authorities have sought anchors for policy that are compatible with profit-seeking behaviour by private agents in an increasingly competitive market. It is this search that will be the underlying theme of this lecture. I will begin by noting some of the driving forces behind the changes that have taken place in the financial industry, and how they have manifested themselves. The key consequence for policy, I will argue, is that markets have become more thus increasing the scope for complete, arbitrage by private agents, and decreasing the scope for the monetary authorities to use direct controls to achieve policy objectives. In the next part of my remarks, I will review how approaches to monetary policy have evolved over the past 25 years, in respect of ultimate goals, intermediate targets and policy instruments. After this, I will consider how financial stability has grown as a policy concern, and how the way in which supervision is viewed has evolved. Finally, I will have a few words to say about the international monetary system. I. The Changing Financial Environment The driving forces behind the transformation in the financial environment that has occurred in the past twenty to thirty years have been innovation and liberalisation. Technological advances have dramatically lowered the cost of gathering and processing information, while new financial instruments have increased the range of transactions economic agents can undertake. Liberalisation has paved the way for the expansion and restructuring of the financial industry. It has been driven both by the ascendancy of the free market philosophy and by the difficulty of maintaining controls in the face of innovation. The combined effects of innovation and liberalisation have been dramatic. Geographical barriers have largely disappeared, leading to the emergence of an increasingly integrated global capital market with a sizable group of multinational financial intermediaries operating in all the major centres. Distinctions among different classes of financial intermediary have become blurred, with the relaxation of regulatory restraints, the growth of conglomerate structures, and the increasing ease with which institutions can transform the risk characteristics of their portfolios through the use of derivatives. Another significant development has been the securitisation of assets and the institutionalisation of savings. Together, these trends have greatly increased the volume of tradable financial assets, and the amount of transactions passing through financial markets and settled in clearing systems. The significance for central banks of these developments in the financial environment is that they have made markets more that is, they have greatly increased the ability of complete, market participants to exchange assets and income flows over time, space, and market instrument. Portfolio management is far less constrained than before by lack of access to liabilities or claims with desired pay-off characteristics. This has profound effects for central bank activity, both in the formulation and implementation of monetary policy, and in the preservation of financial stability. At the macro-economic level, markets can now discipline policies far more quickly and effectively than in the past. Bad policies, or indeed any policies that are unsustainable in the face of profit-maximising behaviour by private agents, will quickly have to be reversed. This means that the authorities always have to consider, in framing economic policies, whether they are credible and how the market will react to them. It is very hard, for example, to spring an inflationary "surprise" that has a positive effect on output; or to set an exchange rate objective that is inconsistent with the underlying stance of macro-economic policies. Concerning financial stability, more complete markets mean that competition squeezes out rents created by restricted franchises. Financial institutions have less of a cushion of protected profits and are therefore more vulnerable to losses caused by mismanagement or misfortune. This has inevitably increased the emphasis given to the role of the authorities as the ultimate guarantor of financial stability. At the same time, it has reduced the effectiveness of regulation that is not based on market incentives. Financial institutions have a broad menu of techniques that enable them to get around regulations that are intended to increase safety, but are burdensome to the institutions to which they apply. II. Monetary Policy (a) Objectives In the aftermath of the collapse of the Bretton Woods system (and for the United States for some time before that), monetary policy was designed to secure the best trade-off between output growth and inflation. The intellectual basis of policy was the Phillips curve. Eventually, however, the stagflation that marked the 1970s caused both the objective of policy and its implementation to be reassessed. Today, there is a widespread consensus among central bankers, and economists more generally, that price stability should be the overriding goal of monetary policy. The rational expectations literature, and the lessons of experience, suggest that there is no exploitable trade-off between output and inflation in anything other than the very short run. Moreover, inflation leads to distortions and uncertainties that impair economic performance. Worse, the short-run relationship between inflation and output growth seems to be asymmetric: the output sacrifice needed to get inflation down may be greater than the output gain when inflation is allowed to rise. Taken together, these considerations mean that the best service monetary policy can render for the real economy is to keep inflation credibly at low levels. In fact, policy has been remarkably successful in recent years in bringing inflation down in virtually all industrial countries. So much so, that a number of issues are now coming to the fore that were previously considered as of second-order importance. These questions include: how to avoid bias in the measurement of inflation; whether inflation should be zero or some low positive number; whether the authorities' objective should be expressed in terms of inflation or the price level; and how quickly one should return to the stated objective after a disturbance. It is hard to dispute that measurement bias in inflation should be corrected, if possible. That is easier said than done, however. Some biases can be relatively easily removed, such as that arising from infrequent re-weighting of the consumption basket. Others are more difficult to deal with, such as adjusting adequately for quality changes. And some are very difficult to correct, such as properly incorporating new goods and services. Still, with some heroic assumptions it should be possible to arrive at a serviceable estimate. The Boskin Commission in the United States has put the bias at just over 1%; in other countries, the bias is thought to be no more than half that. Concerning the desirable of (properly measured) inflation, there seems to be a level consensus that a low positive number (1-3%) is better than zero.1 The reasons for this are both a priori and empirical. When inflation averages zero over time, the price level must, by definition, be falling for a significant part of the time (and a significant number of individual prices will be falling, even if the general price level is flat). This creates two problems. Firstly, if wages and prices are sticky downward, it may require a higher level of unemployment to stabilise the overall inflation rate at zero than at some higher number.2 Secondly, since nominal interest rates cannot go below zero, it will become impossible to engineer negative (or even very low) real interest rates to help recovery from a recession. Such considerations have led most observers to favour a low but positive rate of inflation. Those who prefer zero tend to point to the distortionary effects of the tax system,3 or to the risk that any positive number can be revised up, as justifying the more ambitious target. It is the fear of slippage that also motivates the suggestion to express the price stability objective as a constant price (rather than a zero or constant rate of inflation). The idea is level that the impact of an inflationary (or deflationary) surprise in one period should be offset in the succeeding period by a policy aiming at reversing the initial shock. In this way, the price level would be constant through time, enhancing the credibility of monetary policy and facilitating the development of very long-term contracts. One obvious objection to the pursuit of a policy of literal price level stability, namely that it would require deliberate deflation following any inflationary disturbance, can be overcome by expressing the price objective in terms of a rising trend through time. Nevertheless, perhaps surprisingly, there is still little support in central banking circles for expressing the inflation objective in terms of the price level, rather than its first derivative. This may be because, if there is believed to be an optimal inflation objective, whether zero or a low positive number, it seems odd to adjust it as a result of past events. The last element of objective setting for central banks is how quickly they should seek to return to an inflation target once having been forced away from it. There seems to be an emerging inter consensus, reflected, alia, in statements by the Bank of England, that a period of 1-2 years is appropriate, this being the time it takes for a change in monetary policy to have the bulk of its effect in prices. To attempt a quicker restoration of price stability would risk overshooting, while to go more slowly would tend to undermine credibility. It should be noted, however, that this recommendation holds clearly only for minor departures from the objective. If the actual inflation rate is a long way away from the desired rate, there is no consensus on whether gradual or shock therapy is to be preferred. Much depends on the political circumstances, as well as on surrounding economic policies (e.g. fiscal policy) that affect credibility. (b) Anchors Just as difficult as setting the objective of monetary policy has been settling on the means for achieving it. A variety of approaches have been in vogue at various times in the past twenty or thirty years. has acquired a bad name because, at least in countries with Pure discretion nonindependent central banks, it is seen as a cloak for politically-motivated decisions. Such decisions have sometimes been a crude attempt to buy votes by easing of monetary policy before elections, the benefits of monetary relaxation coming relatively quickly and the costs of higher inflation emerging only later. More frequently, however, they have involved an attempt to use a presumed output/inflation trade-off to strengthen employment prospects; or an unwillingness to tighten monetary policy until evidence of inflationary pressures was already apparent in the data. Whatever the motivation, a fully discretionary policy has often lacked the strategic coherence to prevent inflation accelerating. became popular in a number of countries in the 1970s, on the Monetary targeting back of Milton Friedman's dictum that "inflation is always and everywhere a monetary phenomenon".4 The powerful intuitive appeal of the money-inflation link was undoubtedly helpful in mobilising support for a rigorous anti-inflation policy in the United States, United Kingdom and elsewhere in the late 1970s and early 1980s. Nevertheless, one of the key requirements for such a policy, namely a stable demand for some monetary aggregate, has not been adequately fulfilled in recent years (at least in most countries). One by one, central banks that had adopted monetary targets in the 1970s, dropped or downgraded them in the 1980s and 1990s. Nowadays only Germany and Switzerland place strong reliance on monetary aggregate targeting, and even they apply such policies with a significant measure of judgment. has a long history. The gold standard involved stabilising Exchange rate targeting the domestic price level in terms of gold, and the Bretton Woods system linked national currencies to the dollar. More recently, exchange rate anchors have been used effectively by a wide range of countries. Their value in restoring discipline and credibility is hard to doubt. But they have two major disadvantages that have become evident in recent years. Firstly, when capital markets are integrated, any country adopting a strict exchange rate peg subordinates its monetary policy to that of the anchor country. This works well when monetary policy requirements are in harmony; less well when there are divergences, as the United Kingdom discovered in 1992. Secondly, if a country adopting a currency peg fails to master domestic inflationary pressures, it may find that its balance of trade deteriorates and eventually reaches a point of unsustainability. The decision to adjust or abandon an unrealistic peg has proved to be one of the most difficult of economic policy decisions - in part because so much has typically gone into seeking to achieve credibility through adherence to the peg. In response to the perceived shortcomings of monetary and exchange rate targets, and of unconstrained discretion, attention has been given in recent years to inflation targeting and as a means of strengthening the likelihood that price stability objectives will central bank autonomy be met. At first sight it might seem tautological to use an inflation target to achieve an inflation objective. In fact, there is rather more to it, as the practice in the United Kingdom shows. The idea is that a public commitment to an inflation target, coupled with the maximum of transparency in describing the authorities' forecasts and decision-making process, enables a discretionary approach to be applied with less risk that monetary policy decisions will be biased toward leniency. If, in addition, the central bank is made fully independent to pursue a clearly-defined goal, political interference will be avoided. A growing list of countries have adopted the inflation targeting approach in recent years, including Canada, New Zealand, Australia, the United Kingdom, Sweden and Finland. The practical implementation of the approach has varied in a number of respects, including who sets the target (government or central bank); whether it is expressed as a range or a fixed point; the price index employed; the use of adjustment or "override" mechanisms, and so on. These differences, however, are less significant than the common principle on which targets are based. So far, targets have been rather successful, though the approach has yet to be tested under adverse conditions. (c) Tactics Just as there has been convergence in the goals and the strategy of monetary policy implementation, so too there has been in matters of tactics. Twenty or thirty years ago, a variety of operating tactics were used, including control of some measure of the monetary base; variations in reserve requirements; discretionary discount window intervention; open market operations, at a variety of maturities; direct lending controls; and moral suasion. Nowadays, direct controls on lending have been abandoned in virtually all countries. Reserve requirements have been reduced to very low levels, to avoid distorting patterns of intermediation, thus making control of the monetary base an imprecise instrument. Use of the discount window and bond market intervention have similarly fallen out of favour. Central banks now generally use very short-term reversible transactions ("repos" and "reverse repos") to inject or withdraw cash from the money market. The maturity of these transactions is typically either overnight or for a few days. Short-term money market operations enable central banks to maintain control over overnight interest rates. Longer-term interest rates are then influenced by expectations of how central banks are likely to adjust overnight rates in the face of economic developments. This, in turn, places a premium on credibility and effective signalling of policy intentions. The use of interest rates as the principal operating instrument does not mean, it should be stressed, that the volume of money and credit is considered unimportant as a determinant of inflationary trends. Rather, it reflects the view that "noise" in the demand for bank reserves is better accommodated by some short-term flexibility in the growth of liquidity than by fluctuations in overnight interest rates; and by the belief that judicious management of overnight interest rates will enable the authorities to achieve the desired degree of control over credit volumes in the medium term. At the same time, it is also part and parcel of the process that has led central banks to place relatively more weight on prices (interest rates, exchange rates) than on quantities in the formulation and implementation of policy. There are several reasons for this, ranging from the socio-political climate to structural economic factors such as the development of financial markets. II. Financial System Stability Besides the achievement of price stability through the appropriate use of monetary policy, the other major focus of central bank activity is the preservation of stability in the financial system. As first articulated by Bagehot, this involves a willingness to act as a lender-of-last-resort to the banking system, to counteract the possibility of a "run" developing on a solvent but illiquid institution, and to avoid the risk of a contagious spread of financial distress. Central banks have always had an important role in maintaining systemic stability, but it is only comparatively recently that economists generally have become aware of the analytic issues involved. Following the crisis of the 1930s, there was growing agreement, first in the United States and later elsewhere, that the stability of the financial system should be based on two pillars: firstly, explicit or implicit support to protect depositors at banking institutions; and secondly, a structure of regulation that would reduce the risk of banks getting into trouble in the first place. For the first twenty-five years or so of the post-war period, banking system stability attracted relatively little attention. Economic conditions were favourable, which limited the scope for troublesome bad-lending decisions. Just as important, restrictions on market access and regulation of permitted activities enhanced franchise values and provided protection against losses. Essentially, entry into banking was restricted, both by natural economies of scale and by regulatory restraints. Competition within the banking industry was limited by tolerating cartel-type practices and by rules, such as interest rate and credit expansion ceilings, that protected existing firms. Such practices greatly reduced the probability of bank failure. The value of the banking franchise made stockholders and managements unwilling to take risks with the continued viability of firms under their control. And if serious losses did occur, rescue by other firms was likely, either in order to acquire a valuable franchise, or as part of an implicit quid pro quo for the maintenance of their own favoured status. Two forces came to the fore in the 1970s and subsequently that made this regulatory approach unsustainable. One was the growing influence of the free market philosophy, and the accompanying dismantling of controls and restrictive practices. This affected the of willingness public authorities to limit competition in the name of stability. The other was the development of new financial instruments that enabled market participants to replicate virtually any kind of contract, regardless of regulatory restraints. This affected the ability of policy makers to influence financial activity through regulatory controls. Interest ceilings on demand deposits were circumvented by the development of NOW accounts; exchange controls spawned the development of Euro-currency accounts; and the growth of derivatives markets provided transactors with a multiplicity of ways of creating contracts with equivalent pay-off characteristics but different forms. The breakdown and eventual abandonment of direct controls required renewed attention to the issue of how to make the financial system resilient. The search was made more urgent by the fact that banks' capital strength had (predictably enough) weakened during the period when their protected franchise generated guaranteed profits. This weaker capital position was highlighted by a number of episodes in the 1970s and early 1980s, notably the Third World debt crisis that erupted in 1982. The vulnerability of banking systems in industrial countries that was revealed by the 1980s debt crisis led to a renewed focus on as a means of risk-based capital adequacy strengthening systemic resilience. Bank regulators had, of course, always had rules for capital holding by the institutions they supervised, but these were not harmonised across countries, and in many jurisdictions, they were in the form of crude capital/asset ratios. What was different about the regulatory approach developed in the 1980s is that it was founded on international agreement, and it focused on the concept of capital as a cushion against risk. The Basle Committee on Banking Supervision had been created in 1974, with the initial task of identifying which country's supervisors should be responsible for the activities and soundness of internationally active banks. In the mid-1980s the Committee turned its attention to the development of capital standards for such banks. When finally promulgated in 1988, these standards divided banks' assets into five risk categories, running from sovereign securities of industrial countries (with a zero risk weight) to ordinary commercial credits (with a 100% risk weight). Supervisors from G-10 countries agreed to see that internationally-active banks under their jurisdiction held capital at least equivalent to 8% of risk weighted assets. The Basle Capital Accord, which has subsequently been updated and amended, was a substantial step forward for bank regulation. It meant that required levels of capital were more closely related to the reasons for which banks hold capital, that is, to cover the risks in their portfolio. At a practical level, it led to a marked strengthening of major banks' capital ratios, which had become dangerously low. But although the Basle Capital Accord took regulatory practice a significant way towards the market, it did not take it the whole way. The limited number of risk categories obviously (and deliberately) did not capture the full spectrum of creditworthiness. And the "building block" approach to the calculation of risk did not allow for the risk-reducing (risk-enhancing) properties of diversification (concentration). Much recent thinking has focused on - using the incentive-compatible regulation market's own internal forces - as the most promising next step strengthening the financial system. It is banks' shareholders and management that have the strongest interest to measure risk accurately (at least if they expect to be around to bear the consequences of their actions). An internally generated measure of risk should be better than one derived from formulaic risk-weights generated by supervisors. There is, therefore, a strong case for supervisors to use the calculations developed by firms themselves, at least if they can be satisfied that the risk assessment model is adequately robust. This is the approach that the Basle Committee in fact followed when the capital accord was amended to include market risk in addition to credit risk. The difficulties of extending the approach to credit risk are considerable, since a loan portfolio does not have a market value whose variability can be tracked over a series of observations. Nevertheless, the concept is similar, and the best financial firms are now beginning to apply a similar methodology to the calculation of credit risk as they do to market risk. Does this mean that decisions relating to prudential capital requirements can be left to private institutions? Not quite. Although private institutions are, in principle, best placed to measure the riskiness of their own portfolio, they are not necessarily the best judge of how much capital they ought to hold. This is because when a public authority acts as a lender-of-last-resort, or ultimate guarantor of systemic stability, that authority is providing part of the "capital" that the banking system needs to safeguard stability. In the absence of regulatory rules, financial institutions would be tempted to economise on capital holding, reasoning that the authorities would either come to their assistance, or shoulder the consequences of systemic failure. So even if the task of measuring risk can be largely privatised, the task of deciding the appropriate level of capital holding may still require a public policy judgment. Important public policy decisions are also involved in dealing with financial institutions which, for whatever reason, find themselves with an inadequate capital. Low levels of capital can lead to the phenomenon of "gambling for resurrection" - banks pursuing risky strategies in the knowledge that shareholders will get the benefit of good outcomes, while bad outcomes will impose losses on third parties. Thus far, I have discussed financial stability in terms of the health of the institutions that go to make up the banking system. But there is another dimension that has received increasing attention from central bankers over the past 10-15 years. It concerns the market infrastructure that underpins financial transactions, and in particular the payment and settlement system. While this might seem an unexciting subject to economists, it is in fact of great practical importance. At a conservative estimate, more that $5 trillion per day passes through the settlement system, most of it representing large-value financial transactions cleared by a relative handful of major clearing banks. If one of these institutions became unable to meet its obligations in the clearing, the consequences could be dramatic. Because this is the case, it is worth taking a moment to understand the issues that arise. Broadly speaking, there are two sets of problems. Easiest to understand are the problems facing of payment and settlement systems - that is, those who trade in financial markets and then have users to use the systems to settle their deals. Almost every deal has two sides - one party pays, the other party delivers whatever is being bought. For these users, the difficulty arises where there is no mechanism to co-ordinate the two sides. The party paying is thus exposed to the risk that the counterparty fails to deliver, and vice versa. In other words, there is often no mechanism to ensure delivery-versus-payment. In securities markets this is by now a relatively familiar issue. More recently, the need to tackle the similar problem which arises when settling foreign exchange deals has come to be appreciated. In both cases the value of the deals being settled is so substantial that the resulting settlement risks can be of a size to cause systemic concern. The second set of problems concerns one particular category of system users - namely banks, who also typically the payment and settlement systems. Until quite recently, provide the standard form of settlement was end-of-day net settlement. That is to say, all the payments and receipts between banks were allowed to accumulate during the day, to be settled by a transfer of the smaller, net amount at the end of the day. Banks liked this arrangement because it meant they could hold smaller balances on their accounts at the central bank. But its systemic weakness was that it usually required participants in the clearing to grant unsecured, uncontrolled and unlimited credit to other participants during the period until final settlement occurs. It is quite common for the credit thereby extended to a single counterparty to exceed a bank's entire capital. Implicitly, the participants in the clearing are assuming that the central bank would be forced to come to the rescue if problems arose. Over the past few years, considerable effort has been devoted to alleviating these sources of systemic risk, and solutions are now being implemented. Solutions to protect users of the systems include introducing improved delivery versus payment mechanisms for securities markets and the possible introduction of some new form of multi-currency settlement arrangement for foreign exchange markets. Solutions to protect system providers include the introduction of tighter internal controls within traditional end-of-day settlement systems or, in an increasing number of cases, the replacement of such traditional systems by	['speech by the general mr. crockett reviews the changing role of central banks manager of the bank for international settlements, mr. andrew crockett, at the money macro and finance annual conference held in durham on 11/9/97.', 'the bis annual report for 1996-97 observes, with characteristic understatement: "the last 25 years have been an eventful time for central banking".', 'the period since the breakdown of the bretton woods system has, indeed, seen enormous changes in the economic and financial environment, and a major evolution in the objectives, indicators and instruments of central bank policy.', 'my objective this afternoon will be to review these changes, and to identify some of the common factors that lie behind them.', 'the changes in the environment have been of both a macro-economic and a structural character.', 'macro-economically, the move to floating exchange rates in the early 1970s was followed by a period of substandard economic performance.', 'in the industrial world high inflation rates co-existed with disappointing growth.', 'in the developing world, a borrowing spree was followed by a debt crisis.', 'not until the last few years have monetary authorities been successful in restoring a more satisfactory degree of price stability, and still the task is not complete.', 'there have also been dramatic changes in financial structure.', 'the process of liberalisation and innovation has led to a globalisation of finance and a quantum increase in intermediation.', 'coupled with an explosive growth in ever more complex financial instruments, this has presented new opportunities to financial intermediaries, but also created new sources of systemic risk.', 'the changing environment has both influenced and been influenced by an evolution in the way central banks carry out their role of preserving monetary and financial stability.', 'in the field of monetary stability, attempts to exploit the phillips curve trade-off produced almost wholly negative results and led to a widespread consensus that the primary objective of monetary policy must be price stability.', 'the intermediate targets of monetary policy objectives have also evolved, with the earlier emphasis on monetary aggregates giving way to exchange rate anchors in some countries and explicit or implicit inflation targets in others.', 'at the level of tactics, market management techniques, which were formerly quite diverse, have tended to coalesce around the use of repurchase operations as a means of controlling very short-term interest rates.', 'the other main function of central banks, that of preserving financial system stability, has acquired considerably more prominence as a result of financial liberalisation, which has led to the greatest spate of banking sector difficulties since the interwar period.', "the focus of central banks' approach to maintaining systemic stability has evolved from field-of-activity regulation to a greater stress on capital adequacy, and is still in the process of change.", 'meanwhile, a number of countries are rethinking the institutional structure of supervision, with some placing responsibility for day-to-day regulation with specialised supervisory agencies and assigning to the central bank the broad, though less well-defined responsibility for systemic stability.', "throughout these changes, a constant feature has been central banks' search for effective means of implementing policy in an environment where economic agents can use new instruments and markets to arbitrage their way around restrictions and controls.", 'the desire to avoid distorting incentives and exacerbating moral hazard has been a guiding principle in this search.', 'the authorities have sought anchors for policy that are compatible with profit-seeking behaviour by private agents in an increasingly competitive market.', 'it is this search that will be the underlying theme of this lecture.', 'i will begin by noting some of the driving forces behind the changes that have taken place in the financial industry, and how they have manifested themselves.', 'the key consequence for policy, i will argue, is that markets have become more thus increasing the scope for complete, arbitrage by private agents, and decreasing the scope for the monetary authorities to use direct controls to achieve policy objectives.', 'in the next part of my remarks, i will review how approaches to monetary policy have evolved over the past 25 years, in respect of ultimate goals, intermediate targets and policy instruments.', 'after this, i will consider how financial stability has grown as a policy concern, and how the way in which supervision is viewed has evolved.', 'finally, i will have a few words to say about the international monetary system.', 'i. the changing financial environment the driving forces behind the transformation in the financial environment that has occurred in the past twenty to thirty years have been innovation and liberalisation.', 'technological advances have dramatically lowered the cost of gathering and processing information, while new financial instruments have increased the range of transactions economic agents can undertake.', 'liberalisation has paved the way for the expansion and restructuring of the financial industry.', 'it has been driven both by the ascendancy of the free market philosophy and by the difficulty of maintaining controls in the face of innovation.', 'the combined effects of innovation and liberalisation have been dramatic.', 'geographical barriers have largely disappeared, leading to the emergence of an increasingly integrated global capital market with a sizable group of multinational financial intermediaries operating in all the major centres.', 'distinctions among different classes of financial intermediary have become blurred, with the relaxation of regulatory restraints, the growth of conglomerate structures, and the increasing ease with which institutions can transform the risk characteristics of their portfolios through the use of derivatives.', 'another significant development has been the securitisation of assets and the institutionalisation of savings.', 'together, these trends have greatly increased the volume of tradable financial assets, and the amount of transactions passing through financial markets and settled in clearing systems.', 'the significance for central banks of these developments in the financial environment is that they have made markets more that is, they have greatly increased the ability of complete, market participants to exchange assets and income flows over time, space, and market instrument.', 'portfolio management is far less constrained than before by lack of access to liabilities or claims with desired pay-off characteristics.', 'this has profound effects for central bank activity, both in the formulation and implementation of monetary policy, and in the preservation of financial stability.', 'at the macro-economic level, markets can now discipline policies far more quickly and effectively than in the past.', 'bad policies, or indeed any policies that are unsustainable in the face of profit-maximising behaviour by private agents, will quickly have to be reversed.', 'this means that the authorities always have to consider, in framing economic policies, whether they are credible and how the market will react to them.', 'it is very hard, for example, to spring an inflationary "surprise" that has a positive effect on output; or to set an exchange rate objective that is inconsistent with the underlying stance of macro-economic policies.', 'concerning financial stability, more complete markets mean that competition squeezes out rents created by restricted franchises.', 'financial institutions have less of a cushion of protected profits and are therefore more vulnerable to losses caused by mismanagement or misfortune.', 'this has inevitably increased the emphasis given to the role of the authorities as the ultimate guarantor of financial stability.', 'at the same time, it has reduced the effectiveness of regulation that is not based on market incentives.', 'financial institutions have a broad menu of techniques that enable them to get around regulations that are intended to increase safety, but are burdensome to the institutions to which they apply.', 'monetary policy (a) objectives in the aftermath of the collapse of the bretton woods system (and for the united states for some time before that), monetary policy was designed to secure the best trade-off between output growth and inflation.', 'the intellectual basis of policy was the phillips curve.', 'eventually, however, the stagflation that marked the 1970s caused both the objective of policy and its implementation to be reassessed.', 'today, there is a widespread consensus among central bankers, and economists more generally, that price stability should be the overriding goal of monetary policy.', 'the rational expectations literature, and the lessons of experience, suggest that there is no exploitable trade-off between output and inflation in anything other than the very short run.', 'moreover, inflation leads to distortions and uncertainties that impair economic performance.', 'worse, the short-run relationship between inflation and output growth seems to be asymmetric: the output sacrifice needed to get inflation down may be greater than the output gain when inflation is allowed to rise.', 'taken together, these considerations mean that the best service monetary policy can render for the real economy is to keep inflation credibly at low levels.', 'in fact, policy has been remarkably successful in recent years in bringing inflation down in virtually all industrial countries.', 'so much so, that a number of issues are now coming to the fore that were previously considered as of second-order importance.', "these questions include: how to avoid bias in the measurement of inflation; whether inflation should be zero or some low positive number; whether the authorities' objective should be expressed in terms of inflation or the price level; and how quickly one should return to the stated objective after a disturbance.", 'it is hard to dispute that measurement bias in inflation should be corrected, if possible.', 'that is easier said than done, however.', 'some biases can be relatively easily removed, such as that arising from infrequent re-weighting of the consumption basket.', 'others are more difficult to deal with, such as adjusting adequately for quality changes.', 'and some are very difficult to correct, such as properly incorporating new goods and services.', 'still, with some heroic assumptions it should be possible to arrive at a serviceable estimate.', 'the boskin commission in the united states has put the bias at just over 1%; in other countries, the bias is thought to be no more than half that.', 'concerning the desirable of (properly measured) inflation, there seems to be a level consensus that a low positive number (1-3%) is better than zero.1 the reasons for this are both a priori and empirical.', 'when inflation averages zero over time, the price level must, by definition, be falling for a significant part of the time (and a significant number of individual prices will be falling, even if the general price level is flat).', 'this creates two problems.', 'firstly, if wages and prices are sticky downward, it may require a higher level of unemployment to stabilise the overall inflation rate at zero than at some higher number.2 secondly, since nominal interest rates cannot go below zero, it will become impossible to engineer negative (or even very low) real interest rates to help recovery from a recession.', 'such considerations have led most observers to favour a low but positive rate of inflation.', 'those who prefer zero tend to point to the distortionary effects of the tax system,3 or to the risk that any positive number can be revised up, as justifying the more ambitious target.', 'it is the fear of slippage that also motivates the suggestion to express the price stability objective as a constant price (rather than a zero or constant rate of inflation).', 'the idea is level that the impact of an inflationary (or deflationary) surprise in one period should be offset in the succeeding period by a policy aiming at reversing the initial shock.', 'in this way, the price level would be constant through time, enhancing the credibility of monetary policy and facilitating the development of very long-term contracts.', 'one obvious objection to the pursuit of a policy of literal price level stability, namely that it would require deliberate deflation following any inflationary disturbance, can be overcome by expressing the price objective in terms of a rising trend through time.', 'nevertheless, perhaps surprisingly, there is still little support in central banking circles for expressing the inflation objective in terms of the price level, rather than its first derivative.', 'this may be because, if there is believed to be an optimal inflation objective, whether zero or a low positive number, it seems odd to adjust it as a result of past events.', 'the last element of objective setting for central banks is how quickly they should seek to return to an inflation target once having been forced away from it.', 'there seems to be an emerging inter consensus, reflected, alia, in statements by the bank of england, that a period of 1-2 years is appropriate, this being the time it takes for a change in monetary policy to have the bulk of its effect in prices.', 'to attempt a quicker restoration of price stability would risk overshooting, while to go more slowly would tend to undermine credibility.', 'it should be noted, however, that this recommendation holds clearly only for minor departures from the objective.', 'if the actual inflation rate is a long way away from the desired rate, there is no consensus on whether gradual or shock therapy is to be preferred.', 'much depends on the political circumstances, as well as on surrounding economic policies (e.g.', 'fiscal policy) that affect credibility.', '(b) anchors just as difficult as setting the objective of monetary policy has been settling on the means for achieving it.', 'a variety of approaches have been in vogue at various times in the past twenty or thirty years.', 'has acquired a bad name because, at least in countries with pure discretion nonindependent central banks, it is seen as a cloak for politically-motivated decisions.', 'such decisions have sometimes been a crude attempt to buy votes by easing of monetary policy before elections, the benefits of monetary relaxation coming relatively quickly and the costs of higher inflation emerging only later.', 'more frequently, however, they have involved an attempt to use a presumed output/inflation trade-off to strengthen employment prospects; or an unwillingness to tighten monetary policy until evidence of inflationary pressures was already apparent in the data.', 'whatever the motivation, a fully discretionary policy has often lacked the strategic coherence to prevent inflation accelerating.', 'became popular in a number of countries in the 1970s, on the monetary targeting back of milton friedman\'s dictum that "inflation is always and everywhere a monetary phenomenon".4 the powerful intuitive appeal of the money-inflation link was undoubtedly helpful in mobilising support for a rigorous anti-inflation policy in the united states, united kingdom and elsewhere in the late 1970s and early 1980s.', 'nevertheless, one of the key requirements for such a policy, namely a stable demand for some monetary aggregate, has not been adequately fulfilled in recent years (at least in most countries).', 'one by one, central banks that had adopted monetary targets in the 1970s, dropped or downgraded them in the 1980s and 1990s.', 'nowadays only germany and switzerland place strong reliance on monetary aggregate targeting, and even they apply such policies with a significant measure of judgment.', 'has a long history.', 'the gold standard involved stabilising exchange rate targeting the domestic price level in terms of gold, and the bretton woods system linked national currencies to the dollar.', 'more recently, exchange rate anchors have been used effectively by a wide range of countries.', 'their value in restoring discipline and credibility is hard to doubt.', 'but they have two major disadvantages that have become evident in recent years.', 'firstly, when capital markets are integrated, any country adopting a strict exchange rate peg subordinates its monetary policy to that of the anchor country.', 'this works well when monetary policy requirements are in harmony; less well when there are divergences, as the united kingdom discovered in 1992. secondly, if a country adopting a currency peg fails to master domestic inflationary pressures, it may find that its balance of trade deteriorates and eventually reaches a point of unsustainability.', 'the decision to adjust or abandon an unrealistic peg has proved to be one of the most difficult of economic policy decisions - in part because so much has typically gone into seeking to achieve credibility through adherence to the peg.', 'in response to the perceived shortcomings of monetary and exchange rate targets, and of unconstrained discretion, attention has been given in recent years to inflation targeting and as a means of strengthening the likelihood that price stability objectives will central bank autonomy be met.', 'at first sight it might seem tautological to use an inflation target to achieve an inflation objective.', 'in fact, there is rather more to it, as the practice in the united kingdom shows.', "the idea is that a public commitment to an inflation target, coupled with the maximum of transparency in describing the authorities' forecasts and decision-making process, enables a discretionary approach to be applied with less risk that monetary policy decisions will be biased toward leniency.", 'if, in addition, the central bank is made fully independent to pursue a clearly-defined goal, political interference will be avoided.', 'a growing list of countries have adopted the inflation targeting approach in recent years, including canada, new zealand, australia, the united kingdom, sweden and finland.', 'the practical implementation of the approach has varied in a number of respects, including who sets the target (government or central bank); whether it is expressed as a range or a fixed point; the price index employed; the use of adjustment or "override" mechanisms, and so on.', 'these differences, however, are less significant than the common principle on which targets are based.', 'so far, targets have been rather successful, though the approach has yet to be tested under adverse conditions.', '(c) tactics just as there has been convergence in the goals and the strategy of monetary policy implementation, so too there has been in matters of tactics.', 'twenty or thirty years ago, a variety of operating tactics were used, including control of some measure of the monetary base; variations in reserve requirements; discretionary discount window intervention; open market operations, at a variety of maturities; direct lending controls; and moral suasion.', 'nowadays, direct controls on lending have been abandoned in virtually all countries.', 'reserve requirements have been reduced to very low levels, to avoid distorting patterns of intermediation, thus making control of the monetary base an imprecise instrument.', 'use of the discount window and bond market intervention have similarly fallen out of favour.', 'central banks now generally use very short-term reversible transactions ("repos" and "reverse repos") to inject or withdraw cash from the money market.', 'the maturity of these transactions is typically either overnight or for a few days.', 'short-term money market operations enable central banks to maintain control over overnight interest rates.', 'longer-term interest rates are then influenced by expectations of how central banks are likely to adjust overnight rates in the face of economic developments.', 'this, in turn, places a premium on credibility and effective signalling of policy intentions.', 'the use of interest rates as the principal operating instrument does not mean, it should be stressed, that the volume of money and credit is considered unimportant as a determinant of inflationary trends.', 'rather, it reflects the view that "noise" in the demand for bank reserves is better accommodated by some short-term flexibility in the growth of liquidity than by fluctuations in overnight interest rates; and by the belief that judicious management of overnight interest rates will enable the authorities to achieve the desired degree of control over credit volumes in the medium term.', 'at the same time, it is also part and parcel of the process that has led central banks to place relatively more weight on prices (interest rates, exchange rates) than on quantities in the formulation and implementation of policy.', 'there are several reasons for this, ranging from the socio-political climate to structural economic factors such as the development of financial markets.', 'financial system stability besides the achievement of price stability through the appropriate use of monetary policy, the other major focus of central bank activity is the preservation of stability in the financial system.', 'as first articulated by bagehot, this involves a willingness to act as a lender-of-last-resort to the banking system, to counteract the possibility of a "run" developing on a solvent but illiquid institution, and to avoid the risk of a contagious spread of financial distress.', 'central banks have always had an important role in maintaining systemic stability, but it is only comparatively recently that economists generally have become aware of the analytic issues involved.', 'following the crisis of the 1930s, there was growing agreement, first in the united states and later elsewhere, that the stability of the financial system should be based on two pillars: firstly, explicit or implicit support to protect depositors at banking institutions; and secondly, a structure of regulation that would reduce the risk of banks getting into trouble in the first place.', 'for the first twenty-five years or so of the post-war period, banking system stability attracted relatively little attention.', 'economic conditions were favourable, which limited the scope for troublesome bad-lending decisions.', 'just as important, restrictions on market access and regulation of permitted activities enhanced franchise values and provided protection against losses.', 'essentially, entry into banking was restricted, both by natural economies of scale and by regulatory restraints.', 'competition within the banking industry was limited by tolerating cartel-type practices and by rules, such as interest rate and credit expansion ceilings, that protected existing firms.', 'such practices greatly reduced the probability of bank failure.', 'the value of the banking franchise made stockholders and managements unwilling to take risks with the continued viability of firms under their control.', 'and if serious losses did occur, rescue by other firms was likely, either in order to acquire a valuable franchise, or as part of an implicit quid pro quo for the maintenance of their own favoured status.', 'two forces came to the fore in the 1970s and subsequently that made this regulatory approach unsustainable.', 'one was the growing influence of the free market philosophy, and the accompanying dismantling of controls and restrictive practices.', 'this affected the of willingness public authorities to limit competition in the name of stability.', 'the other was the development of new financial instruments that enabled market participants to replicate virtually any kind of contract, regardless of regulatory restraints.', 'this affected the ability of policy makers to influence financial activity through regulatory controls.', 'interest ceilings on demand deposits were circumvented by the development of now accounts; exchange controls spawned the development of euro-currency accounts; and the growth of derivatives markets provided transactors with a multiplicity of ways of creating contracts with equivalent pay-off characteristics but different forms.', 'the breakdown and eventual abandonment of direct controls required renewed attention to the issue of how to make the financial system resilient.', "the search was made more urgent by the fact that banks' capital strength had (predictably enough) weakened during the period when their protected franchise generated guaranteed profits.", 'this weaker capital position was highlighted by a number of episodes in the 1970s and early 1980s, notably the third world debt crisis that erupted in 1982. the vulnerability of banking systems in industrial countries that was revealed by the 1980s debt crisis led to a renewed focus on as a means of risk-based capital adequacy strengthening systemic resilience.', 'bank regulators had, of course, always had rules for capital holding by the institutions they supervised, but these were not harmonised across countries, and in many jurisdictions, they were in the form of crude capital/asset ratios.', 'what was different about the regulatory approach developed in the 1980s is that it was founded on international agreement, and it focused on the concept of capital as a cushion against risk.', "the basle committee on banking supervision had been created in 1974, with the initial task of identifying which country's supervisors should be responsible for the activities and soundness of internationally active banks.", 'in the mid-1980s the committee turned its attention to the development of capital standards for such banks.', "when finally promulgated in 1988, these standards divided banks' assets into five risk categories, running from sovereign securities of industrial countries (with a zero risk weight) to ordinary commercial credits (with a 100% risk weight).", 'supervisors from g-10 countries agreed to see that internationally-active banks under their jurisdiction held capital at least equivalent to 8% of risk weighted assets.', 'the basle capital accord, which has subsequently been updated and amended, was a substantial step forward for bank regulation.', 'it meant that required levels of capital were more closely related to the reasons for which banks hold capital, that is, to cover the risks in their portfolio.', "at a practical level, it led to a marked strengthening of major banks' capital ratios, which had become dangerously low.", 'but although the basle capital accord took regulatory practice a significant way towards the market, it did not take it the whole way.', 'the limited number of risk categories obviously (and deliberately) did not capture the full spectrum of creditworthiness.', 'and the "building block" approach to the calculation of risk did not allow for the risk-reducing (risk-enhancing) properties of diversification (concentration).', "much recent thinking has focused on - using the incentive-compatible regulation market's own internal forces - as the most promising next step strengthening the financial system.", "it is banks' shareholders and management that have the strongest interest to measure risk accurately (at least if they expect to be around to bear the consequences of their actions).", 'an internally generated measure of risk should be better than one derived from formulaic risk-weights generated by supervisors.', 'there is, therefore, a strong case for supervisors to use the calculations developed by firms themselves, at least if they can be satisfied that the risk assessment model is adequately robust.', 'this is the approach that the basle committee in fact followed when the capital accord was amended to include market risk in addition to credit risk.', 'the difficulties of extending the approach to credit risk are considerable, since a loan portfolio does not have a market value whose variability can be tracked over a series of observations.', 'nevertheless, the concept is similar, and the best financial firms are now beginning to apply a similar methodology to the calculation of credit risk as they do to market risk.', 'does this mean that decisions relating to prudential capital requirements can be left to private institutions?', 'although private institutions are, in principle, best placed to measure the riskiness of their own portfolio, they are not necessarily the best judge of how much capital they ought to hold.', 'this is because when a public authority acts as a lender-of-last-resort, or ultimate guarantor of systemic stability, that authority is providing part of the "capital" that the banking system needs to safeguard stability.', 'in the absence of regulatory rules, financial institutions would be tempted to economise on capital holding, reasoning that the authorities would either come to their assistance, or shoulder the consequences of systemic failure.', 'so even if the task of measuring risk can be largely privatised, the task of deciding the appropriate level of capital holding may still require a public policy judgment.', 'important public policy decisions are also involved in dealing with financial institutions which, for whatever reason, find themselves with an inadequate capital.', 'low levels of capital can lead to the phenomenon of "gambling for resurrection" - banks pursuing risky strategies in the knowledge that shareholders will get the benefit of good outcomes, while bad outcomes will impose losses on third parties.', 'thus far, i have discussed financial stability in terms of the health of the institutions that go to make up the banking system.', 'but there is another dimension that has received increasing attention from central bankers over the past 10-15 years.', 'it concerns the market infrastructure that underpins financial transactions, and in particular the payment and settlement system.', 'while this might seem an unexciting subject to economists, it is in fact of great practical importance.', 'at a conservative estimate, more that $5 trillion per day passes through the settlement system, most of it representing large-value financial transactions cleared by a relative handful of major clearing banks.', 'if one of these institutions became unable to meet its obligations in the clearing, the consequences could be dramatic.', 'because this is the case, it is worth taking a moment to understand the issues that arise.', 'broadly speaking, there are two sets of problems.', 'easiest to understand are the problems facing of payment and settlement systems - that is, those who trade in financial markets and then have users to use the systems to settle their deals.', 'almost every deal has two sides - one party pays, the other party delivers whatever is being bought.', 'for these users, the difficulty arises where there is no mechanism to co-ordinate the two sides.', 'the party paying is thus exposed to the risk that the counterparty fails to deliver, and vice versa.', 'in other words, there is often no mechanism to ensure delivery-versus-payment.', 'in securities markets this is by now a relatively familiar issue.', 'more recently, the need to tackle the similar problem which arises when settling foreign exchange deals has come to be appreciated.', 'in both cases the value of the deals being settled is so substantial that the resulting settlement risks can be of a size to cause systemic concern.', 'the second set of problems concerns one particular category of system users - namely banks, who also typically the payment and settlement systems.', 'until quite recently, provide the standard form of settlement was end-of-day net settlement.', 'that is to say, all the payments and receipts between banks were allowed to accumulate during the day, to be settled by a transfer of the smaller, net amount at the end of the day.', 'banks liked this arrangement because it meant they could hold smaller balances on their accounts at the central bank.', 'but its systemic weakness was that it usually required participants in the clearing to grant unsecured, uncontrolled and unlimited credit to other participants during the period until final settlement occurs.', "it is quite common for the credit thereby extended to a single counterparty to exceed a bank's entire capital.", 'implicitly, the participants in the clearing are assuming that the central bank would be forced to come to the rescue if problems arose.', 'over the past few years, considerable effort has been devoted to alleviating these sources of systemic risk, and solutions are now being implemented.', 'solutions to protect users of the systems include introducing improved delivery versus payment mechanisms for securities markets and the possible introduction of some new form of multi-currency settlement arrangement for foreign exchange markets.', 'solutions to protect system providers include the introduction of tighter internal controls within traditional end-of-day settlement systems or, in an increasing number of cases, the replacement of such traditional systems by']	Andrew Crockett	Bank for International Settlements	General Manager	BIS
https://www.bis.org/review/r970916a.pdf	Mr. Grenville discusses the Reserve Bank of Australia and the business cycle (Central Bank Articles and Speeches, 5 Sep 97)	Talk by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the Melbourne Institute of Applied Economic and Social Research Conference on "Business Cycles: Policy and Analysis" held in Melbourne on 5/9/97.	1997-09-05 00:00:00	Mr. Grenville discusses the Reserve Bank of Australia and the business cycle* Talk by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the Melbourne Institute of Applied Economic and Social Research Conference on "Business Cycles: Policy and Analysis" held in Melbourne on 5/9/97. "Real output ... fluctuates around a rising trend." (Solow 1997, p. 230). This seemingly innocuous statement encompasses much of what practical, operational macro-economics is about: how to raise the trend; and how to reduce fluctuations around this trend. This talk focuses on what monetary policy might do to reduce fluctuations around the trend. The Governor spoke only a few weeks ago about what monetary policy might do for growth (Macfarlane 1997). In a nutshell, price stability will be generally helpful to long-term growth because it ensures resources are deployed more efficiently, but the main sources of growth are to be found in increases in labour inputs and productivity. What about monetary policy and the cycle? The starting point is that life would be more comfortable all around if the cyclical swings are not too big and if the bumps in various parts of the economy are not too coincident. It seems likely, too, that however convenient it is analytically to separate trend from fluctuations, there will be a link between the cycle and either the level of GDP or its trend growth rate. If the severity of the downturns is reduced and the economy operates with a smaller output gap, then the level of income over time is, on average, higher. As well, big swings (such as 1982 and 1990) risk hysteresis: the process of winding unemployment down again has proved to be slow and difficult. Is there anything to be said on the other side of the argument? You will recall the Schumpeterian argument that cycles have some cathartic, cleansing function. I have more faith in competition to ensure that the benefit of technology is introduced as quickly as it should be, and so I do not see a vital need for the Schumpeterian cleansing process. But, in any case, however successful policy may be, enough of a cycle seems likely to remain, in order to ensure the Schumpeterian process has the opportunity to take place.1 So let us take as given that it is desirable to have as little cycle as possible, and examine two aspects of this. First, the role of monetary policy in the cycle, and secondly, how the cycle may have changed over time to alter the way monetary policy impinges on the cycle. Characteristics of monetary policy A thumb-nail sketch of history serves as a reminder that the role of monetary policy in the cycle has been the subject of changing views over the years. • For the first couple of decades of this century, the gold standard was the undisputed centre-point of monetary policy, anchoring prices. Income smoothing was not an objective of monetary policy. The result -unsurprisingly -- was that price level stability was maintained (in the sense that there was a longer-term anchor which forced the price level back towards its starting point), but there was considerable variation (both in prices and in output) in the short term. The Depression forced a re-appraisal, but fiscal policy became the • instrument to smooth the fluctuations in output -- monetary policy was seen to be caught in the infamous liquidity trap. This idea has not entirely disappeared, and the notion of "pushing on a string" still has currency. • Somewhere in the ensuing decade or two, monetary policy emerged as a counter-cyclical co-player, on a par with fiscal policy. There was no particular, specialised difference between monetary policy and fiscal policy (at least in the eyes of most policy-makers) -- inflation control and cyclical smoothing were more or less the same task. Inevitably, in time, the attempt was made to squeeze more out of the Phillips curve trade-off than was available. • By the 1970s, a clear specialisation had developed (most precisely enunciated in the academic literature, but reflected also in operational monetary policy). The over-use of the Keynesian tools had unanchored price expectations, and the OPEC oil price shock contributed to the reassessment. Most central banks in industrial countries adopted a monetary target, specifically aimed at achieving price stability. • The high water of this monetarist view occurred around 1980. Over the next five years, it rapidly lost its pivotal role, because the key relationship in this view-of-the-world broke down -- the relationship between money and nominal income turned out to be unstable.2 With the breakdown of the anchor of a stable money demand function, practitioners were forced to look elsewhere. In our own case, it has taken us, eventually, to an inflation target. But others have put forward the view that monetary policy should only care about price stability, without any direct concern with output. The origins of this can be found in Friedman's monetarism (he was, of course, concerned above all with price stability). It seems only a minor elision to slip from monetarism to a single objective for monetary policy. But the point to note here is that the old monetary rules had an important element of income smoothing built into them -- when output slowed in the course of the cycle, money supply rules produced a more-or-less automatic easing of monetary policy, because the central relationship was between money and nominal income. As the stability of the monetary demand relationship broke down, it would have been logical enough to focus on the next link of the causal chain, and replace money by nominal income as the target. Curiously, however, the de facto inheritors of this stream of thought took price stability -- the long-term element of monetarism -- and made it a short-term target. In this view of the world, there was no role at all for monetary policy as a cyclical buffer. How was this justified? The arguments put forward were: • the classical dichotomy between prices and activity: money does not affect activity; • what might be called the "Tinbergen proposition": with one instrument, only one goal can be achieved; • political economy reasons -- usually associated with "time inconsistency" arguments; a simple, unambiguous commitment to price stability anchors price • expectations most effectively, and this benefit is worth the cost that might come from ignoring activity; • the lags in recognition and implementation of policy are so long that activity stabilisation is futile or even counter-productive. I have looked at these in some detail in an earlier paper (Grenville 1996), so I will be brief here. The classical dichotomy between prices and activity reminds central bankers of their long-term priorities, but even though the long-run Phillips curve may be vertical, the short-run curves are certainly not. The Tinbergen proposition is superficially attractive, but not much help in practical decision-making. Trade-offs between various objectives are common to policy-making (and just about every aspect of life), and these trade-offs have to be handled by a weighing of the conflicting objectives, not by ignoring one of them. The "political economy" aspects have been prominent in the academic literature, and some very neat models can be built to illustrate the issues of time inconsistency. The models usually involve the "monetary authorities" (no distinction is made between governments and central banks) making an ex ante commitment to price stability, but reneging on this to squeeze higher activity in the short term, in the form of an "inflation surprise" (Kydland and Prescott 1977). The simple versions of the arguments have never appealed much to central bankers who believe that their own reputation is at stake and who, because of this, are unlikely to exploit the short-term Phillips curve trade-off. To see central bankers as congenitally inclined to administer "inflation surprises" does not seem to capture their true character.3 If there is a problem here, it seems more likely to lie in the political interaction of policy-making between governments and central banks and it is best addressed by greater independence, not by imposing a single objective on the central bank. What about the role of a simple single price objective in anchoring price expectations? A decade or so ago, there was a realistic hope that the clear enunciation of a target for prices would stabilise price expectations. It would have to be said that the experience of the last decade would suggest that expectations are to a very large degree backward-looking. Central banks give prominence to their price stability objective in an attempt to influence price 3 Blinder (1997, p. 13) describes this as: "One place where academic economists have been barking loudly up the wrong tree". expectations in this way, and it seems sensible for them to do so. But it would be a mistake to think that there is a big dividend waiting to be reaped here. Whether the lags in recognition and implementation are so long as to make the operation of monetary policy perverse in relation to the business cycle is something that can be established only empirically. Like most empirical matters, there is room for considerable difference of opinion. While the lags seem to be (as Friedman promised) "long and variable", a policy which leans against the business cycle with a view to containing demand-driven inflation will generally affect activity beneficially rather than perversely.4 At the other end of the spectrum is the view that "central bank manipulation of financial variables has seemingly exaggerated, not smoothed, economic fluctuations" (Makin 1993, p. 12). One problem in this sort of assessment is that we do not know the counter-factual. What we do know, however, is that cycles are endemic to all economies. So the counter-factual is not straight-line growth. We know, too, that Australia's cycles are broadly the same as those in other similar countries. In a world where cycles are universal and endemic, it is easy to blame the authorities for the failure of the economy to proceed along a steady path, perfectly aligned with trend growth. As the upswing accelerates, policy is tightened: it is then blamed for being too slow to react. When the inevitable downturn comes, the firm policies that are in place at that time are pronounced "guilty by association". The appropriate counter-factual should specify an alternative policy regime, and compare the performance under this rule.5 One relevant issue here is: how strong are the "self-righting" forces which tend to take unemployment back towards its natural rate? If these are strong, the case for an activity component in policy-making is weaker. To put this more specifically, will the in-built stabilising forces operate more quickly than the lags in monetary policy? The important empirical issue here is the lags in policy, interacting with the uncertainty of forecasts. Most estimates of the lags suggest that a change in interest rates has its maximum effect on activity after about four to six quarters. This is often popularly interpreted to mean that nothing happens, after the monetary policy lever is pulled, for four or six quarters. Of course, this is quite wrong. Even with these estimates, there is a fair bit of action during the first year, and provided forecasts are sufficiently accurate, it is possible for policy to be effective over shorter lengths of time -- for instance, if it was desired to have an effect for the next year only, policy could be reversed some time during the year to achieve rough neutrality beyond the period of a year (Gruen, Romalis and Chandra 1997).6 4 For some econometric support of this view, see Dungey and Pagan (1997, pp. 31-34). 5 Makin's alternative is money-base targeting. The Bank has written extensively on money rules (the widest variety of tests appears in de Brouwer, Ng and Subbaraman (1993)). Makin's model is Switzerland (the only major central bank that has tried to implement a money-base rule) in the 1980s, but this hardly seems a supporting example. Switzerland still has business cycles and experienced inflation of nearly 7 per cent in the late 1980s. 6 I should record, very much in parentheses, my own biases that these lags are consistently over-estimated, and that when we find more subtle techniques of econometric testing, we will find that the lags are shorter. This is based on pure, intuitive observation, particularly of the 1994 experience, where the effect of monetary policy seemed to be quite quick. This is a reminder that there are, essentially, two problems with the econometric method used to establish lag lengths. The first is the implicit assumption that the lags are much the same length from episode to episode (occasionally there are tests for changing lag length, as in Gruen et al. (1997)), whereas it may be that the lag depends very much on the particular episode. Where actors in the economy quickly come to believe that the authorities are determined to slow a speeding economy, it may well be that the lags are quite short. The contrast here is between 1988 (long lags) and 1994 (short). The other problem is the classic one of separately identifying the policy reaction function and the effect of policy on the economy. Relatively early in the upswing, policy is tightened, but there is no discernible response because the upswing still has a good deal of Perhaps a more telling argument is that it is simply not sensible -- or even possible -- to ignore the cycle, unless a suitable "neutral" operating rule can be found for setting monetary policy. The monetary aggregates were, in this sense, a "neutral" rule. They could provide an operating rule for monetary policy which could be relied on to influence activity beneficially in the face of demand shocks: a monetary rule exercises some degree of counter-cyclical influence, without any overt discretionary action. But with the breakdown of the close relationship between money and nominal income, such a monetary rule is not a satisfactory "automatic pilot" for policy, and no similarly neutral rule suggests itself. One possible "neutral" monetary policy would be to leave real interest rates unchanged, but it is hard to see that, in practice, this would be sustainable in the face of an economy either running abnormally quickly or slowly -- there would be continuing questions about whether the real interest rate that had been chosen was neutral or was, in fact, skewed in one direction or the other. Also, such a rule would not tie down the rate of inflation -- for this you need a nominal rather than a real objective. Another possibility that can be rejected fairly quickly is the rule of thumb apparently sometimes offered in the face of medical uncertainty: "First do no harm". This may be sensible if medical malpractice suits threaten, but hardly seems a proper basis for economic policy, as it seems to be unduly biased towards inaction. Equally easy to dismiss are those who suggest that we should do something to control inflation, but say that the lags between policy and activity are so long and uncertain that we should never try to do anything to influence activity. The problem with this suggestion is that if the lags between policy and activity are long, uncertain and variable, then the lags between policy and inflation are longer and more uncertain still. In a world where demand shocks are common and policy operates on inflation largely via activity, it is hard to conceive of an anti-inflation policy which was somehow directed solely at inflation, in the belief that an attempt to direct it at activity will cause more problems than it solves.7 Given the long lags in policy, there would seem to be a prima facie case for the authorities moving not just pre-emptively, but by large amounts whenever they believe that the cycle is turning. Such a policy has been advocated by Goodhart (1992).8 Curiously, in the light of these arguments, policy in Australia and just about everywhere seems to do precisely the opposite -- it has the characteristic of "interest rate smoothing". Others in the Bank have written about this recently (see Lowe and Ellis (1997)), so I can cover this quite briefly. In short, the reasons seem to be: • uncertainty. Thirty years ago, Brainard established that, if policy-makers are uncertain about the effect of their policies, they should do less than they think would otherwise be optimal; if policy-makers erred by applying too much of the instrument against the • cycle, they would surely be severely blamed for it; on the other hand, dampening the cycle without entirely eliminating it is seen as an acceptable outcome. In this world, policy-makers are more likely to lean on the side of caution in exercising their instrument. In short, the arguments about the difficulties of influencing activity should make central bankers cautious and modest about their role as cyclical stabilisers, but do not excuse them from taking the cycle into account in setting policy, and doing what they can to lop peaks and fill troughs. With inflation down, a consensus among central banks seems to be emerging. Central banks still give very high priority to inflation control (they are, after all, the embodiment of Rogoff's anti-inflationary central banker), but they do not, generally, focus exclusively on price stability. The arguments are essentially empirical ones, with the focus on the question: "how fast can the economy grow while maintaining price stability?" You will note the Reserve Bank's rhetoric is precisely along these lines, with policy driven by common-sense and a strenuous effort to understand the cycle, rather than some doctrinal adherence to a simple rule. Has the cycle changed (and if so, how)? There is much talk, particularly in America, of a New Era in economics -- of rapid growth, no cycles and price stability. While something important and beneficial does seem to be happening in the United States, we need to separate out what is possible from the wishful thinking. We all hope that productivity is higher than before: this is possible and might add modestly to US long-term growth potential, which has in the past been put at around 2-21⁄2 per cent. We hope that, with price stability well established and various other changes in the economy (on which, more later), the amplitude of cycles might be lessened and policy may be more effective. We hope, also, that prices are well anchored by America's good record of low inflation. But the fundamental law of economics -- scarcity -- has not been repealed. The factors that are held to be responsible for the New Era -- "globalisation of production, changes in finance, the nature of employment, government policy, emerging markets, and information technology" (Weber 1997, p. 71) -- will all be helpful, but they raise the long-term sustainable growth rate only to the extent to which they raise productivity growth on an on-going basis. If the actual rate of growth exceeds the long-term potential, sooner or later pressure comes on resources and inflation will be the result. The same helpful factors may well apply in Australia: • if some kind of multiplier/accelerator process is the driving force of the cycle, we know that the type of investment has changed substantially over the years, with large fixed long-term investment becoming less important and short-term investments (such as computers) becoming more important. The old traditional driving force was the inventory cycle. Work done at the Bank (Flood and Lowe 1993) shows a clear change in the cyclical pattern. The average quarterly contribution of inventory investment to GDP(E) has fallen from close to 1 per cent in 1960/61-1971/72 to around a quarter of that in 1984/85-1995/96 (with smaller standard deviations as well). This confirms our intuitive observation of the prevalence of "just in time" inventory systems.9 What is clear, too, is that service industries (with much more limited stock-holding) have become very much more important; • as cyclical components of production become less dominant, the cycle may be attenuated. Manufacturing, construction and wholesale trade have been the production sectors most correlated with the overall cycle and these, together, have fallen from nearly 40 per cent of production in 1974/75 to just over 30 per cent in 1995/96. As the economy becomes more complex and varied, correlation between sectors diminishes: the tourism sector may be doing well when house construction is slow; • perhaps the most important on-going change to the cycle is the continuing integration of Australia with the international economy. Thirty years ago, 10 per cent of (real) GDP was exported; now it is almost 25 per cent. When domestic demand rises, there is much greater capacity than before for this to "spill" overseas, into imports. All this is for others to examine in more detail. The focus here is on just one aspect of the way the cycle might have changed over time -- that is, how the interaction between monetary policy and the cycle may have altered. First, has financial deregulation changed the interaction between monetary policy and the cycle? This was certainly expected to be one of the impacts of financial deregulation. The Campbell Inquiry talked about it.10 In the housing sector, for example, the upswing of the cycle suddenly came up against the restraints of quantitative controls, and this was enough to turn the cycle down. In the old, regulated world, firms and households were not able to borrow enough to smooth their expenditure over time (they were "liquidity constrained" -- see Blundell-Wignall and Bullock (1992)). It may well be that deregulation has removed these old constraints, but at the same time, it seems to have had some tendency to encourage or at least facilitate large or longer swings of the cycle. To put it crudely, financial deregulation provided more rope for the cycle to swing with greater amplitude. It would be easy to exaggerate the importance of this effect, because there were very large swings in the housing sector before deregulation, and asset-price booms and busts occurred even in the regulated world. We might hope, too, that some lessons have been learned from the asset boom of the late 1980s. The conclusion that can be drawn is that those who expected financial deregulation to smooth the cycle by itself have been disappointed. One specific aspect of deregulation -- the floating of the exchange rate -- has altered the transmission of monetary policy in a way which should have smoothed the cycle. One of the characteristics of the floating exchange rate is that its movement more or less mirrors the course of the cycle, with an appreciation of the exchange rate at those moments when the cycle is running fastest. Partly this reflects the impact of commodity prices on the exchange rate, but it also reflects the policy response of interest rates over the course of the cycle. The result is that demand is more readily "spilt" into imports during the expansionary phase of the cycle, so production is buffered. (This reinforces the effect of greater international integration, mentioned above.)11 Even this, however, does not ensure that the new world of the floating exchange rate makes the cycle smoother: it can be argued that in the old fixed-exchange-rate world, policy reacted earlier to stop the expansionary phase of the cycle, for fear of it spilling over into an unacceptable current account deficit. So, once again, financial deregulation has given the cycle, for better or worse, more room for manoeuvre. The old world of "stop/start" did not have much to recommend it, but nor did the world of the late 1980s, where an asset boom developed a big head of steam and inevitably was damaging when it came to an end. The floating exchange rate probably allows expansions to last longer, but does not ensure that they end gently. Graph 1: Graph 2: This history makes us look for a degree of caution in policy-making, aiming for longer, gentler phases in the cycle. There is nothing in the historical patterns of the cycle which suggests that they have a pendulum-like determinancy. On the contrary, the variation in length and amplitude (contrast, for example, 1986 with 1982 or 1990: see also Graph 2) would suggest that the shape of the cycle is not at all regular and pre-determined. While it may be possible to explain cycles in terms of "a stochastically disturbed difference equation of very low order" (Lucas 1977), the true causes seem less mechanical than this might imply, particularly if the implication is that cycles are unaffected by and unresponsive to policy. The hope is that the upswing which has been underway since 1991 can go for quite some time yet. This may well require it to travel at a sedate pace at certain stages during the expansion, and we have certainly witnessed this over the past two years or so. But this seems far preferable to an economy which is running clearly too fast and has to be brought to a sudden halt. While it is true that the economy might well have grown a bit faster over the past two years without this igniting inflationary pressures, the one factor that most economists agree on is that monetary policy cannot fine-tune the cycle. Let me develop this idea by looking in detail at the 1994 experience. The starting point here was an economy which began to grow too fast, with demand growing at 7 per cent in the year to the September quarter, and excessive wage demands. The Bank judged that this would produce inflationary pressures, and so raised interest rates three times in relatively quick succession in the second half of 1994. As far as we can tell, this was a necessary adjustment of policy, because the classic symptoms of excess demand emerged over the 1994/95 period with wages accelerating (to reach over 5 per cent by the middle of 1995, despite high unemployment, at around 9 per cent) and then, lagged behind this, inflation rising to 3.3 per cent. Given the fragile nature of price expectations and the importance of getting actual inflation back towards 21⁄2 per cent relatively quickly to reinforce the stability of price expectations, the response of policy, even with the benefit of hindsight, seems about right. (Graph 3) Graph 3: To round off this section, ensuring that you are not left with a false impression about the Bank's (limited) ability to tame the cycle, I present Graph 4. This might suggest that the Australian cycle (at least from the early 1980s until the mid 1990s) has followed the American cycle so closely that any other explanation seems superfluous. To put this point differently, the problem in explaining the cycle is not to find the causes of cyclical behaviour, but to decide -- in the face of a wide variety of "culprits" -- which one is, in fact, driving the cycle. In some ways this is like an Agatha Christie detective story, with all the characters equally and obviously suspect. Unlike an Agatha Christie novel, however, it is possible that they all did it, if not simultaneously and in concert, at least more or less coincidentally. The Bank's econometric research certainly gives a very important place to the United States in explaining the Australian cycle (see Gruen and Shuetrim (1994)) and we have looked at the puzzle of why the United States seems so much more important than its trade share would imply (see de Roos and Russell (1996), de Brouwer and Romalis (1996) and Debelle and Preston (1995)). But there is still an important role for monetary policy (Gruen and Shuetrim 1994, and Gruen, Romalis and Chandra 1997). The moral is: don't expect monetary policy to be able to eliminate the cycle, but don't ignore its ability to "top and tail" the fluctuations. Graph 4: The cycle and prices The Reserve Bank does expect that its activities will have some beneficial effect on the course of the cycle, but the main focus is on inflation. We accept that there will be some movement of inflation over the course of the cycle, but we want to make sure that inflation does not rise over time (now that price stability has been achieved). You can see this sense of priorities -- with medium-term price stability being the sine qua non, and our acceptance that inflation may vary a little over the course of the cycle -- in the specification of the inflation target as being an average "over the course of the cycle". This has caused quite a bit of misinterpretation about the specification. In talking to an audience such as this, I can take the time to set out quite specifically what we have in mind by "over the course of the cycle". We can go back a bit in history to illustrate the point here. In the 1950s and 1960s (see Graph 5), inflation moved about quite a bit -- from more or less zero to around 5 per cent per annum -- but people look back on this period as "price stability". Why is that so? The critical issue here is that even though inflation rose and fell over the course of the cycle, price expectations did not move -- even when inflation was running at 5 per cent, the community at large expected it would soon be back to its normal lower pace. Stabilising and maintaining price expectations is the key issue in thinking about the question of "over the course of the cycle". The Graph 5: Bank should not be so trigger happy that it tightens policy at every threat of a price rise (no matter how slight or temporary).There is a trade-off between output stabilisation and price stabilisation (see Debelle and Stevens (1995)), and an attempt to smooth the path of prices perfectly would make policy destabilising. We want to be on -- and stay on -- the short-term Phillips curve associated with 2-3 per cent price expectations. We would not be too fretted if actual inflation moves about a bit over the short term, provided price expectations do not change (i.e. we stay on this short-run curve). To put this in operational terms, if we have limited price stability credibility, we have to be more careful that inflation does not depart much from 21⁄2 per cent, or depart for too long. As credibility builds over time, monetary policy does not have to respond to every hint of inflation, knowing that the small fluctuations in inflation over the course of the cycle will not have any permanent effects. We would then, in effect, be back to the world of the 1950s and 1960s, at least as far as price expectations are concerned. In raising this issue of price movements over the course of the cycle, I should also record that the relationship between activity and prices probably has changed quite a bit over recent years. I have written about this in more detail (Grenville 1997 ), so I will not go into it in detail today. But summarising the argument, there are a number of factors which should make prices less sensitive to the course of the cycle: • the float of the exchange rate; • greater international integration; • greater competition, coming both from international integration and from domestic measures to enhance competition; better linkages between markets, largely via better transport and • communication. All this fits with the earlier discussion of "New Era economics". These factors help to prevent inflation being triggered by the expansionary phase of the cycle, and limit the propagation of inflation shocks. While we often think of price stability as being a medium-term and long-term problem, the obvious point is that the medium term is made up of a series of short terms -- if short-term hikes in inflation can be avoided, then the problem of maintaining price stability in the medium and long term has been solved. But Chairman Greenspan's warning, in February 1997, about too-ready acceptance of a "New Era" is still relevant: "But, regrettably, history is strewn with visions of such 'new eras' that, in the end, have proven to be a mirage. In short, history counsels caution." (Greenspan 1997). Price stability still requires good monetary policy supported by an anti-inflation consensus. Conclusion Economics has long been known as the dismal science, but in recent years mortality has become a pre-occupation. Judging by recent book titles, not only is the business cycle dead, but so too are inflation, economics, history and capitalism. Following Greenspan's lead, it would be wise to withhold judgment on the death of the cycle for the moment, or at least borrow Mark Twain's line and say that the reports are greatly exaggerated. Economies still seem vulnerable to alternating "over optimism ... (and) a contrary error of pessimism" as noted by Keynes. Periodic supply-side shocks still seem likely. And policy-m	['mr. grenville discusses the reserve bank of australia and the business cycle* talk by mr. stephen grenville, a deputy governor of the reserve bank of australia, to the melbourne institute of applied economic and social research conference on "business cycles: policy and analysis" held in melbourne on 5/9/97.', '"real output ... fluctuates around a rising trend."', '(solow 1997, p. 230).', 'this seemingly innocuous statement encompasses much of what practical, operational macro-economics is about: how to raise the trend; and how to reduce fluctuations around this trend.', 'this talk focuses on what monetary policy might do to reduce fluctuations around the trend.', 'the governor spoke only a few weeks ago about what monetary policy might do for growth (macfarlane 1997).', 'in a nutshell, price stability will be generally helpful to long-term growth because it ensures resources are deployed more efficiently, but the main sources of growth are to be found in increases in labour inputs and productivity.', 'what about monetary policy and the cycle?', 'the starting point is that life would be more comfortable all around if the cyclical swings are not too big and if the bumps in various parts of the economy are not too coincident.', 'it seems likely, too, that however convenient it is analytically to separate trend from fluctuations, there will be a link between the cycle and either the level of gdp or its trend growth rate.', 'if the severity of the downturns is reduced and the economy operates with a smaller output gap, then the level of income over time is, on average, higher.', 'as well, big swings (such as 1982 and 1990) risk hysteresis: the process of winding unemployment down again has proved to be slow and difficult.', 'is there anything to be said on the other side of the argument?', 'you will recall the schumpeterian argument that cycles have some cathartic, cleansing function.', 'i have more faith in competition to ensure that the benefit of technology is introduced as quickly as it should be, and so i do not see a vital need for the schumpeterian cleansing process.', 'but, in any case, however successful policy may be, enough of a cycle seems likely to remain, in order to ensure the schumpeterian process has the opportunity to take place.1 so let us take as given that it is desirable to have as little cycle as possible, and examine two aspects of this.', 'first, the role of monetary policy in the cycle, and secondly, how the cycle may have changed over time to alter the way monetary policy impinges on the cycle.', 'characteristics of monetary policy a thumb-nail sketch of history serves as a reminder that the role of monetary policy in the cycle has been the subject of changing views over the years.', '• for the first couple of decades of this century, the gold standard was the undisputed centre-point of monetary policy, anchoring prices.', 'income smoothing was not an objective of monetary policy.', 'the result -unsurprisingly -- was that price level stability was maintained (in the sense that there was a longer-term anchor which forced the price level back towards its starting point), but there was considerable variation (both in prices and in output) in the short term.', 'the depression forced a re-appraisal, but fiscal policy became the • instrument to smooth the fluctuations in output -- monetary policy was seen to be caught in the infamous liquidity trap.', 'this idea has not entirely disappeared, and the notion of "pushing on a string" still has currency.', '• somewhere in the ensuing decade or two, monetary policy emerged as a counter-cyclical co-player, on a par with fiscal policy.', 'there was no particular, specialised difference between monetary policy and fiscal policy (at least in the eyes of most policy-makers) -- inflation control and cyclical smoothing were more or less the same task.', 'inevitably, in time, the attempt was made to squeeze more out of the phillips curve trade-off than was available.', '• by the 1970s, a clear specialisation had developed (most precisely enunciated in the academic literature, but reflected also in operational monetary policy).', 'the over-use of the keynesian tools had unanchored price expectations, and the opec oil price shock contributed to the reassessment.', 'most central banks in industrial countries adopted a monetary target, specifically aimed at achieving price stability.', '• the high water of this monetarist view occurred around 1980. over the next five years, it rapidly lost its pivotal role, because the key relationship in this view-of-the-world broke down -- the relationship between money and nominal income turned out to be unstable.2 with the breakdown of the anchor of a stable money demand function, practitioners were forced to look elsewhere.', 'in our own case, it has taken us, eventually, to an inflation target.', 'but others have put forward the view that monetary policy should only care about price stability, without any direct concern with output.', "the origins of this can be found in friedman's monetarism (he was, of course, concerned above all with price stability).", 'it seems only a minor elision to slip from monetarism to a single objective for monetary policy.', 'but the point to note here is that the old monetary rules had an important element of income smoothing built into them -- when output slowed in the course of the cycle, money supply rules produced a more-or-less automatic easing of monetary policy, because the central relationship was between money and nominal income.', 'as the stability of the monetary demand relationship broke down, it would have been logical enough to focus on the next link of the causal chain, and replace money by nominal income as the target.', 'curiously, however, the de facto inheritors of this stream of thought took price stability -- the long-term element of monetarism -- and made it a short-term target.', 'in this view of the world, there was no role at all for monetary policy as a cyclical buffer.', 'how was this justified?', 'the arguments put forward were: • the classical dichotomy between prices and activity: money does not affect activity; • what might be called the "tinbergen proposition": with one instrument, only one goal can be achieved; • political economy reasons -- usually associated with "time inconsistency" arguments; a simple, unambiguous commitment to price stability anchors price • expectations most effectively, and this benefit is worth the cost that might come from ignoring activity; • the lags in recognition and implementation of policy are so long that activity stabilisation is futile or even counter-productive.', 'i have looked at these in some detail in an earlier paper (grenville 1996), so i will be brief here.', 'the classical dichotomy between prices and activity reminds central bankers of their long-term priorities, but even though the long-run phillips curve may be vertical, the short-run curves are certainly not.', 'the tinbergen proposition is superficially attractive, but not much help in practical decision-making.', 'trade-offs between various objectives are common to policy-making (and just about every aspect of life), and these trade-offs have to be handled by a weighing of the conflicting objectives, not by ignoring one of them.', 'the "political economy" aspects have been prominent in the academic literature, and some very neat models can be built to illustrate the issues of time inconsistency.', 'the models usually involve the "monetary authorities" (no distinction is made between governments and central banks) making an ex ante commitment to price stability, but reneging on this to squeeze higher activity in the short term, in the form of an "inflation surprise" (kydland and prescott 1977).', 'the simple versions of the arguments have never appealed much to central bankers who believe that their own reputation is at stake and who, because of this, are unlikely to exploit the short-term phillips curve trade-off.', 'to see central bankers as congenitally inclined to administer "inflation surprises" does not seem to capture their true character.3 if there is a problem here, it seems more likely to lie in the political interaction of policy-making between governments and central banks and it is best addressed by greater independence, not by imposing a single objective on the central bank.', 'what about the role of a simple single price objective in anchoring price expectations?', 'a decade or so ago, there was a realistic hope that the clear enunciation of a target for prices would stabilise price expectations.', 'it would have to be said that the experience of the last decade would suggest that expectations are to a very large degree backward-looking.', 'central banks give prominence to their price stability objective in an attempt to influence price 3 blinder (1997, p. 13) describes this as: "one place where academic economists have been barking loudly up the wrong tree".', 'expectations in this way, and it seems sensible for them to do so.', 'but it would be a mistake to think that there is a big dividend waiting to be reaped here.', 'whether the lags in recognition and implementation are so long as to make the operation of monetary policy perverse in relation to the business cycle is something that can be established only empirically.', 'like most empirical matters, there is room for considerable difference of opinion.', 'while the lags seem to be (as friedman promised) "long and variable", a policy which leans against the business cycle with a view to containing demand-driven inflation will generally affect activity beneficially rather than perversely.4 at the other end of the spectrum is the view that "central bank manipulation of financial variables has seemingly exaggerated, not smoothed, economic fluctuations" (makin 1993, p. 12).', 'one problem in this sort of assessment is that we do not know the counter-factual.', 'what we do know, however, is that cycles are endemic to all economies.', 'so the counter-factual is not straight-line growth.', "we know, too, that australia's cycles are broadly the same as those in other similar countries.", 'in a world where cycles are universal and endemic, it is easy to blame the authorities for the failure of the economy to proceed along a steady path, perfectly aligned with trend growth.', 'as the upswing accelerates, policy is tightened: it is then blamed for being too slow to react.', 'when the inevitable downturn comes, the firm policies that are in place at that time are pronounced "guilty by association".', 'the appropriate counter-factual should specify an alternative policy regime, and compare the performance under this rule.5 one relevant issue here is: how strong are the "self-righting" forces which tend to take unemployment back towards its natural rate?', 'if these are strong, the case for an activity component in policy-making is weaker.', 'to put this more specifically, will the in-built stabilising forces operate more quickly than the lags in monetary policy?', 'the important empirical issue here is the lags in policy, interacting with the uncertainty of forecasts.', 'most estimates of the lags suggest that a change in interest rates has its maximum effect on activity after about four to six quarters.', 'this is often popularly interpreted to mean that nothing happens, after the monetary policy lever is pulled, for four or six quarters.', 'of course, this is quite wrong.', 'even with these estimates, there is a fair bit of action during the first year, and provided forecasts are sufficiently accurate, it is possible for policy to be effective over shorter lengths of time -- for instance, if it was desired to have an effect for the next year only, policy could be reversed some time during the year to achieve rough neutrality beyond the period of a year (gruen, romalis and chandra 1997).6 4 for some econometric support of this view, see dungey and pagan (1997, pp.', "5 makin's alternative is money-base targeting.", 'the bank has written extensively on money rules (the widest variety of tests appears in de brouwer, ng and subbaraman (1993)).', "makin's model is switzerland (the only major central bank that has tried to implement a money-base rule) in the 1980s, but this hardly seems a supporting example.", 'switzerland still has business cycles and experienced inflation of nearly 7 per cent in the late 1980s.', '6 i should record, very much in parentheses, my own biases that these lags are consistently over-estimated, and that when we find more subtle techniques of econometric testing, we will find that the lags are shorter.', 'this is based on pure, intuitive observation, particularly of the 1994 experience, where the effect of monetary policy seemed to be quite quick.', 'this is a reminder that there are, essentially, two problems with the econometric method used to establish lag lengths.', 'the first is the implicit assumption that the lags are much the same length from episode to episode (occasionally there are tests for changing lag length, as in gruen et al.', '(1997)), whereas it may be that the lag depends very much on the particular episode.', 'where actors in the economy quickly come to believe that the authorities are determined to slow a speeding economy, it may well be that the lags are quite short.', 'the contrast here is between 1988 (long lags) and 1994 (short).', 'the other problem is the classic one of separately identifying the policy reaction function and the effect of policy on the economy.', 'relatively early in the upswing, policy is tightened, but there is no discernible response because the upswing still has a good deal of perhaps a more telling argument is that it is simply not sensible -- or even possible -- to ignore the cycle, unless a suitable "neutral" operating rule can be found for setting monetary policy.', 'the monetary aggregates were, in this sense, a "neutral" rule.', 'they could provide an operating rule for monetary policy which could be relied on to influence activity beneficially in the face of demand shocks: a monetary rule exercises some degree of counter-cyclical influence, without any overt discretionary action.', 'but with the breakdown of the close relationship between money and nominal income, such a monetary rule is not a satisfactory "automatic pilot" for policy, and no similarly neutral rule suggests itself.', 'one possible "neutral" monetary policy would be to leave real interest rates unchanged, but it is hard to see that, in practice, this would be sustainable in the face of an economy either running abnormally quickly or slowly -- there would be continuing questions about whether the real interest rate that had been chosen was neutral or was, in fact, skewed in one direction or the other.', 'also, such a rule would not tie down the rate of inflation -- for this you need a nominal rather than a real objective.', 'another possibility that can be rejected fairly quickly is the rule of thumb apparently sometimes offered in the face of medical uncertainty: "first do no harm".', 'this may be sensible if medical malpractice suits threaten, but hardly seems a proper basis for economic policy, as it seems to be unduly biased towards inaction.', 'equally easy to dismiss are those who suggest that we should do something to control inflation, but say that the lags between policy and activity are so long and uncertain that we should never try to do anything to influence activity.', 'the problem with this suggestion is that if the lags between policy and activity are long, uncertain and variable, then the lags between policy and inflation are longer and more uncertain still.', 'in a world where demand shocks are common and policy operates on inflation largely via activity, it is hard to conceive of an anti-inflation policy which was somehow directed solely at inflation, in the belief that an attempt to direct it at activity will cause more problems than it solves.7 given the long lags in policy, there would seem to be a prima facie case for the authorities moving not just pre-emptively, but by large amounts whenever they believe that the cycle is turning.', 'such a policy has been advocated by goodhart (1992).8 curiously, in the light of these arguments, policy in australia and just about everywhere seems to do precisely the opposite -- it has the characteristic of "interest rate smoothing".', 'others in the bank have written about this recently (see lowe and ellis (1997)), so i can cover this quite briefly.', 'in short, the reasons seem to be: • uncertainty.', 'thirty years ago, brainard established that, if policy-makers are uncertain about the effect of their policies, they should do less than they think would otherwise be optimal; if policy-makers erred by applying too much of the instrument against the • cycle, they would surely be severely blamed for it; on the other hand, dampening the cycle without entirely eliminating it is seen as an acceptable outcome.', 'in this world, policy-makers are more likely to lean on the side of caution in exercising their instrument.', 'in short, the arguments about the difficulties of influencing activity should make central bankers cautious and modest about their role as cyclical stabilisers, but do not excuse them from taking the cycle into account in setting policy, and doing what they can to lop peaks and fill troughs.', 'with inflation down, a consensus among central banks seems to be emerging.', "central banks still give very high priority to inflation control (they are, after all, the embodiment of rogoff's anti-inflationary central banker), but they do not, generally, focus exclusively on price stability.", 'the arguments are essentially empirical ones, with the focus on the question: "how fast can the economy grow while maintaining price stability?"', "you will note the reserve bank's rhetoric is precisely along these lines, with policy driven by common-sense and a strenuous effort to understand the cycle, rather than some doctrinal adherence to a simple rule.", 'has the cycle changed (and if so, how)?', 'there is much talk, particularly in america, of a new era in economics -- of rapid growth, no cycles and price stability.', 'while something important and beneficial does seem to be happening in the united states, we need to separate out what is possible from the wishful thinking.', 'we all hope that productivity is higher than before: this is possible and might add modestly to us long-term growth potential, which has in the past been put at around 2-21⁄2 per cent.', 'we hope that, with price stability well established and various other changes in the economy (on which, more later), the amplitude of cycles might be lessened and policy may be more effective.', "we hope, also, that prices are well anchored by america's good record of low inflation.", 'but the fundamental law of economics -- scarcity -- has not been repealed.', 'the factors that are held to be responsible for the new era -- "globalisation of production, changes in finance, the nature of employment, government policy, emerging markets, and information technology" (weber 1997, p. 71) -- will all be helpful, but they raise the long-term sustainable growth rate only to the extent to which they raise productivity growth on an on-going basis.', 'if the actual rate of growth exceeds the long-term potential, sooner or later pressure comes on resources and inflation will be the result.', 'the same helpful factors may well apply in australia: • if some kind of multiplier/accelerator process is the driving force of the cycle, we know that the type of investment has changed substantially over the years, with large fixed long-term investment becoming less important and short-term investments (such as computers) becoming more important.', 'the old traditional driving force was the inventory cycle.', 'work done at the bank (flood and lowe 1993) shows a clear change in the cyclical pattern.', 'the average quarterly contribution of inventory investment to gdp(e) has fallen from close to 1 per cent in 1960/61-1971/72 to around a quarter of that in 1984/85-1995/96 (with smaller standard deviations as well).', 'this confirms our intuitive observation of the prevalence of "just in time" inventory systems.9 what is clear, too, is that service industries (with much more limited stock-holding) have become very much more important; • as cyclical components of production become less dominant, the cycle may be attenuated.', 'manufacturing, construction and wholesale trade have been the production sectors most correlated with the overall cycle and these, together, have fallen from nearly 40 per cent of production in 1974/75 to just over 30 per cent in 1995/96.', 'as the economy becomes more complex and varied, correlation between sectors diminishes: the tourism sector may be doing well when house construction is slow; • perhaps the most important on-going change to the cycle is the continuing integration of australia with the international economy.', 'thirty years ago, 10 per cent of (real) gdp was exported; now it is almost 25 per cent.', 'when domestic demand rises, there is much greater capacity than before for this to "spill" overseas, into imports.', 'all this is for others to examine in more detail.', 'the focus here is on just one aspect of the way the cycle might have changed over time -- that is, how the interaction between monetary policy and the cycle may have altered.', 'first, has financial deregulation changed the interaction between monetary policy and the cycle?', 'this was certainly expected to be one of the impacts of financial deregulation.', 'the campbell inquiry talked about it.10 in the housing sector, for example, the upswing of the cycle suddenly came up against the restraints of quantitative controls, and this was enough to turn the cycle down.', 'in the old, regulated world, firms and households were not able to borrow enough to smooth their expenditure over time (they were "liquidity constrained" -- see blundell-wignall and bullock (1992)).', 'it may well be that deregulation has removed these old constraints, but at the same time, it seems to have had some tendency to encourage or at least facilitate large or longer swings of the cycle.', 'to put it crudely, financial deregulation provided more rope for the cycle to swing with greater amplitude.', 'it would be easy to exaggerate the importance of this effect, because there were very large swings in the housing sector before deregulation, and asset-price booms and busts occurred even in the regulated world.', 'we might hope, too, that some lessons have been learned from the asset boom of the late 1980s.', 'the conclusion that can be drawn is that those who expected financial deregulation to smooth the cycle by itself have been disappointed.', 'one specific aspect of deregulation -- the floating of the exchange rate -- has altered the transmission of monetary policy in a way which should have smoothed the cycle.', 'one of the characteristics of the floating exchange rate is that its movement more or less mirrors the course of the cycle, with an appreciation of the exchange rate at those moments when the cycle is running fastest.', 'partly this reflects the impact of commodity prices on the exchange rate, but it also reflects the policy response of interest rates over the course of the cycle.', 'the result is that demand is more readily "spilt" into imports during the expansionary phase of the cycle, so production is buffered.', '(this reinforces the effect of greater international integration, mentioned above.', ')11 even this, however, does not ensure that the new world of the floating exchange rate makes the cycle smoother: it can be argued that in the old fixed-exchange-rate world, policy reacted earlier to stop the expansionary phase of the cycle, for fear of it spilling over into an unacceptable current account deficit.', 'so, once again, financial deregulation has given the cycle, for better or worse, more room for manoeuvre.', 'the old world of "stop/start" did not have much to recommend it, but nor did the world of the late 1980s, where an asset boom developed a big head of steam and inevitably was damaging when it came to an end.', 'the floating exchange rate probably allows expansions to last longer, but does not ensure that they end gently.', 'graph 1: graph 2: this history makes us look for a degree of caution in policy-making, aiming for longer, gentler phases in the cycle.', 'there is nothing in the historical patterns of the cycle which suggests that they have a pendulum-like determinancy.', 'on the contrary, the variation in length and amplitude (contrast, for example, 1986 with 1982 or 1990: see also graph 2) would suggest that the shape of the cycle is not at all regular and pre-determined.', 'while it may be possible to explain cycles in terms of "a stochastically disturbed difference equation of very low order" (lucas 1977), the true causes seem less mechanical than this might imply, particularly if the implication is that cycles are unaffected by and unresponsive to policy.', 'the hope is that the upswing which has been underway since 1991 can go for quite some time yet.', 'this may well require it to travel at a sedate pace at certain stages during the expansion, and we have certainly witnessed this over the past two years or so.', 'but this seems far preferable to an economy which is running clearly too fast and has to be brought to a sudden halt.', 'while it is true that the economy might well have grown a bit faster over the past two years without this igniting inflationary pressures, the one factor that most economists agree on is that monetary policy cannot fine-tune the cycle.', 'let me develop this idea by looking in detail at the 1994 experience.', 'the starting point here was an economy which began to grow too fast, with demand growing at 7 per cent in the year to the september quarter, and excessive wage demands.', 'the bank judged that this would produce inflationary pressures, and so raised interest rates three times in relatively quick succession in the second half of 1994. as far as we can tell, this was a necessary adjustment of policy, because the classic symptoms of excess demand emerged over the 1994/95 period with wages accelerating (to reach over 5 per cent by the middle of 1995, despite high unemployment, at around 9 per cent) and then, lagged behind this, inflation rising to 3.3 per cent.', 'given the fragile nature of price expectations and the importance of getting actual inflation back towards 21⁄2 per cent relatively quickly to reinforce the stability of price expectations, the response of policy, even with the benefit of hindsight, seems about right.', "(graph 3) graph 3: to round off this section, ensuring that you are not left with a false impression about the bank's (limited) ability to tame the cycle, i present graph 4. this might suggest that the australian cycle (at least from the early 1980s until the mid 1990s) has followed the american cycle so closely that any other explanation seems superfluous.", 'to put this point differently, the problem in explaining the cycle is not to find the causes of cyclical behaviour, but to decide -- in the face of a wide variety of "culprits" -- which one is, in fact, driving the cycle.', 'in some ways this is like an agatha christie detective story, with all the characters equally and obviously suspect.', 'unlike an agatha christie novel, however, it is possible that they all did it, if not simultaneously and in concert, at least more or less coincidentally.', "the bank's econometric research certainly gives a very important place to the united states in explaining the australian cycle (see gruen and shuetrim (1994)) and we have looked at the puzzle of why the united states seems so much more important than its trade share would imply (see de roos and russell (1996), de brouwer and romalis (1996) and debelle and preston (1995)).", 'but there is still an important role for monetary policy (gruen and shuetrim 1994, and gruen, romalis and chandra 1997).', 'the moral is: don\'t expect monetary policy to be able to eliminate the cycle, but don\'t ignore its ability to "top and tail" the fluctuations.', 'graph 4: the cycle and prices the reserve bank does expect that its activities will have some beneficial effect on the course of the cycle, but the main focus is on inflation.', 'we accept that there will be some movement of inflation over the course of the cycle, but we want to make sure that inflation does not rise over time (now that price stability has been achieved).', 'you can see this sense of priorities -- with medium-term price stability being the sine qua non, and our acceptance that inflation may vary a little over the course of the cycle -- in the specification of the inflation target as being an average "over the course of the cycle".', 'this has caused quite a bit of misinterpretation about the specification.', 'in talking to an audience such as this, i can take the time to set out quite specifically what we have in mind by "over the course of the cycle".', 'we can go back a bit in history to illustrate the point here.', 'in the 1950s and 1960s (see graph 5), inflation moved about quite a bit -- from more or less zero to around 5 per cent per annum -- but people look back on this period as "price stability".', 'why is that so?', 'the critical issue here is that even though inflation rose and fell over the course of the cycle, price expectations did not move -- even when inflation was running at 5 per cent, the community at large expected it would soon be back to its normal lower pace.', 'stabilising and maintaining price expectations is the key issue in thinking about the question of "over the course of the cycle".', 'the graph 5: bank should not be so trigger happy that it tightens policy at every threat of a price rise (no matter how slight or temporary).there is a trade-off between output stabilisation and price stabilisation (see debelle and stevens (1995)), and an attempt to smooth the path of prices perfectly would make policy destabilising.', 'we want to be on -- and stay on -- the short-term phillips curve associated with 2-3 per cent price expectations.', 'we would not be too fretted if actual inflation moves about a bit over the short term, provided price expectations do not change (i.e.', 'we stay on this short-run curve).', 'to put this in operational terms, if we have limited price stability credibility, we have to be more careful that inflation does not depart much from 21⁄2 per cent, or depart for too long.', 'as credibility builds over time, monetary policy does not have to respond to every hint of inflation, knowing that the small fluctuations in inflation over the course of the cycle will not have any permanent effects.', 'we would then, in effect, be back to the world of the 1950s and 1960s, at least as far as price expectations are concerned.', 'in raising this issue of price movements over the course of the cycle, i should also record that the relationship between activity and prices probably has changed quite a bit over recent years.', 'i have written about this in more detail (grenville 1997 ), so i will not go into it in detail today.', 'but summarising the argument, there are a number of factors which should make prices less sensitive to the course of the cycle: • the float of the exchange rate; • greater international integration; • greater competition, coming both from international integration and from domestic measures to enhance competition; better linkages between markets, largely via better transport and • communication.', 'all this fits with the earlier discussion of "new era economics".', 'these factors help to prevent inflation being triggered by the expansionary phase of the cycle, and limit the propagation of inflation shocks.', 'while we often think of price stability as being a medium-term and long-term problem, the obvious point is that the medium term is made up of a series of short terms -- if short-term hikes in inflation can be avoided, then the problem of maintaining price stability in the medium and long term has been solved.', 'but chairman greenspan\'s warning, in february 1997, about too-ready acceptance of a "new era" is still relevant: "but, regrettably, history is strewn with visions of such \'new eras\' that, in the end, have proven to be a mirage.', 'in short, history counsels caution."', 'price stability still requires good monetary policy supported by an anti-inflation consensus.', 'conclusion economics has long been known as the dismal science, but in recent years mortality has become a pre-occupation.', 'judging by recent book titles, not only is the business cycle dead, but so too are inflation, economics, history and capitalism.', "following greenspan's lead, it would be wise to withhold judgment on the death of the cycle for the moment, or at least borrow mark twain's line and say that the reports are greatly exaggerated.", 'economies still seem vulnerable to alternating "over optimism ... (and) a contrary error of pessimism" as noted by keynes.', 'periodic supply-side shocks still seem likely.']	Stephen Grenville	Reserve Bank of Australia	Deputy Governor	Australia
https://www.bis.org/review/r970912b.pdf	Mr. Greenspan considers the recent history of the Federal Reserve System's policy process (Central Bank Articles and Speeches, 5 Sep 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University, Stanford, California on 5/9/97.	1997-09-05 00:00:00	Mr. Greenspan considers the recent history of the Federal Reserve System's policy process Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University, Stanford, California on 5/9/97. It is a pleasure to be at this conference marking the fifteenth anniversary of the Center for Economic Policy Research. The Center, by encouraging academic research into public policy and bringing that research to the attention of policymakers, is performing a most valuable role in our society. I am particularly pleased that Milton Friedman has taken time to join us. His views have had as much, if not more, impact on the way we think about monetary policy and many other important economic issues as those of any person in the last half of the twentieth century. Federal Reserve policy, over the years, has been subject to criticism, often with justification, from Professor Friedman and others. It has been argued, for example, that policy failed to anticipate the emerging inflation of the 1970s, and by fostering excessive monetary creation, contributed to the inflationary upsurge. Surely, it was maintained, some monetary policy rule, however imperfect, would have delivered far superior performance. Even if true in this case, though, policy rules might not always be preferable. Policy rules, at least in a general way, presume some understanding of how economic forces work. Moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly. Use of a rule presupposes that action x will, with a reasonably high probability, be followed over time by event y. Another premise behind many rule-based policy prescriptions, however, is that our knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. In this view, ad hoc or discretionary policy can cause uncertainty for private decision makers and be wrong for extended periods if there is no anchor to bring it back into line. In addition, discretionary policy is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't those of elected representatives supersede those of unelected officials? The monetary policy of the Federal Reserve has involved varying degrees of rule- and discretionary-based modes of operation over time. Recognizing the potential drawbacks of purely discretionary policy, the Federal Reserve frequently has sought to exploit past patterns and regularities to operate in a systematic way. But we have found that very often historical regularities have been disrupted by unanticipated change, especially in technologies. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Accordingly we are constantly evaluating how much we can infer from the past and how relationships might have changed. In an ever changing world, some element of discretion appears to be an unavoidable aspect of policymaking. Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy. Still, sensible policy does presuppose a conceptual framework, or implicit model, however incompletely specified, of how the economic system operates. Of necessity, we make judgments based importantly on historical regularities in behavior inferred from data relationships. These perceived regularities can be embodied in formal empirical models, often covering only a portion of the economic system. Generally, the regularities inform our interpretation of "experience" and tell us what to look for to determine whether history is in the process of repeating itself, and if not, why not. From such an examination, along with an assessment of past policy actions, we attempt to judge to what extent our current policies should deviate from our past patterns of behavior. When this Center was founded 15 years ago, the rules versus discretion debate focused on the appropriate policy role of the monetary aggregates, and this discussion was echoed in the Federal Reserve's policy process. In the late 1970s, the Federal Reserve's actions to deal with developing inflationary instabilities were shaped in part by the reality portrayed by Milton Friedman's analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs, followed on the heels of similar patterns of average money growth. The Federal Reserve, in response to such evaluations, acted aggressively under newly installed Chairman Paul Volcker. A considerable tightening of the average stance of policy -- based on intermediate M1 targets tied to reserve operating objectives -- eventually reversed the surge in inflation. The last fifteen years have been a period of consolidating the gains of the early 1980s and extending them to their logical end -- the achievement of price stability. We are not quite there yet, but we trust it is on the horizon. Although the ultimate goals of policy have remained the same over these past fifteen years, the techniques used in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation. Focusing on M1, and following operating procedures that imparted a considerable degree of automaticity to short-term interest rate movements, was extraordinarily useful in the early Volcker years. But after nationwide NOW accounts were introduced, the demand for M1 in the judgment of the Federal Open Market Committee became too interest-sensitive for that aggregate to be useful in implementing policy. Because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for M1 growth in its judgment no longer were reliable guides for outcomes in nominal spending and inflation. In response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending. As a consequence, by late 1982, M1 was de-emphasized and policy decisions per force became more discretionary. However, in recognition of the longer-run relationship of prices and M2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting our policy stance. As an indicator, M2 served us well for a number of years. But by the early 1990s, its usefulness was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors that led to a restructuring of business and household balance sheets. The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates. By 1993, this extraordinary velocity behavior had become so pronounced that the Federal Reserve was forced to begin disregarding the signals M2 was sending, at least for the time being. Data since mid-1994 do seem to show the re-emergence of a relationship of M2 with nominal income and short-term interest rates similar to that experienced during the three decades of the 1960s through the 1980s. As I indicated to the Congress recently, however, the period of predictable velocity is too brief to justify restoring M2 to its role of earlier years, though clearly persistent outsized changes would get our attention. Increasingly since 1982 we have been setting the funds rate directly in response to a wide variety of factors and forecasts. We recognize that, in fixing the short-term rate, we lose much of the information on the balance of money supply and demand that changing market rates afford, but for the moment we see no alternative. In the current state of our knowledge, money demand has become too difficult to predict. Although our operating target is a nominal short-term rate, we view its linkages to spending and prices as indirect and complex. For one, arguably, it is real, not nominal, rates that are more relevant to spending. For another, spending, prices and other economic variables respond to a whole host of financial variables. Hence, in judging the stance of policy we routinely look at the financial impulses coming from foreign exchange, bond, and equity markets, along with supply conditions in credit markets generally, including at financial intermediaries. Nonetheless, we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates. In current circumstances, however, determining which financial data should be aggregated to provide an appropriate empirical proxy for the money stock that tracks income and spending represents a severe challenge for monetary analysts. The absence of a monetary aggregate anchor, however, has not left policy completely adrift. From a longer-term perspective we have been guided by a firm commitment to contain any forces that would undermine economic expansion and efficiency by raising inflation, and we have kept our focus firmly on the ultimate goal of achieving price stability. Within that framework we have attempted not only to lean against the potential for an overheating economy, but also to cushion shortfalls in economic growth. And, recognizing the lags in the effects of policy, we have tried to move in anticipation of such disequilibria developing. But this is a very general framework and does not present clear guidance for day-to-day policy decisions. Thus, as the historic relationship between measured money supply and spending deteriorated, policymaking, seeing no alternative, turned more eclectic and discretionary. Nonetheless, we try to develop as best we can a stable conceptual framework, so policy actions are as regular and predictable as possible -- that is, governed by systematic behavior but open to evidence of structural macroeconomic changes that require policy to adapt. The application of such an approach is illustrated by a number of disparate events we have confronted since 1982 that were in some important respects outside our previous experience. In the early and mid-1980s, the FOMC faced most notably the sharp swings in fiscal policy, the unprecedented rise and fall of the dollar, and the associated shifts in international trade and capital flows. But I will concentrate on several events of the last decade where I personally participated in forming the judgments used in policy implementation. One such event was the stock market crash of October 1987 shortly after I arrived. Unlike many uncertain situations that have confronted monetary policy, there was little question that the appropriate central bank action was to ease policy significantly. We knew we would soon have to sop up the excess liquidity that we added to the system, but the timing and, I believe, the magnitude of our actions were among our easier decisions. Our concerns at that time reflected questions about how the financial markets and the economy would respond to the shock of a decline of more than one-fifth in stock prices in one day, and whether monetary policy alone could stabilize the system. By the early spring of 1988 it was evident that the economy had stabilized and we needed to begin reversing the easy stance of policy. Another development that confronted policy was the commercial property price bust of the late 1980s and early 1990s. Since a large volume of bank and thrift loans was tied to the real estate market and backed by real estate collateral, the fall in property prices impaired the capital of a large number of depositories. These institutions reacted by curtailing new lending -the unprecedented "credit crunch" of 1990 and 1991. Not unexpectedly, our policy response was to move toward significant ease. Our primary concern was the state of the credit markets and the economy, but we could also see that these broader issues were linked inextricably to the state of depository institutions' balance sheets and profitability. A satisfactory recovery from the recession of that period, in our judgment, required the active participation of a viable banking system. The extraordinary circumstances dictated a highly unusual path for monetary policy. The stance of policy eased substantially even after the economy began to recover from the 1990-91 recession, and a stimulative policy was deliberately maintained well into the early expansion period. By mid-1993, however, property prices stabilized and the credit crunch gradually began to dissipate. It was clear as the year moved toward a close that monetary policy, characterized by a real federal funds rate of virtually zero, was now far too easy in light of the strengthening economy on the horizon. Financial and economic conditions were returning to more traditional relationships, and policy had to shift from a situation-specific formulation to one based more closely on previous historical patterns. Although it was difficult at that time to discern any overt inflationary signals, the balance of risks, in our judgment, clearly dictated pre-emptive action. The 1994 to 1995 period was most instructive. It appears we were successful in moving pre-emptively to throttle down an impending unstable boom, which almost surely would have resulted in the current expansion coming to an earlier halt. Because this was the first change in the stance of policy after a prolonged period of unusual ease, we took special care to spell out our analysis and expectations for policy in an unusually explicit way to inform the markets well before we began to tighten. In addition, we began for the first time to issue explanatory statements as changes in the stance of policy were implemented. Even so, the idea of tightening to head off inflation before it was visible in the data was not universally applauded or perhaps understood. Financial markets reacted unusually strongly to our 1994 policy actions, often ratcheting up their expectations for further rate increases when we actually tightened, resulting in very large increases in longer-term interest rates. At the time, these reactions seemed to reflect the extent to which investment strategies had been counting on a persistence of low interest rates. This was a classic case in which we had to be careful not to allow market expectations of Federal Reserve actions to be major elements of policy determination. We are always concerned about assuming that short-term movements in market prices are reflections of changes in underlying supply and demand conditions when we may be observing nothing more than fluctuating expectations about our own policy actions. Most recently, the economy has demonstrated a remarkable confluence of robust growth, high resource utilization, and damped inflation. Once again we have been faced with analyzing and reacting to a situation in which incoming data have not readily conformed to historical experience. Specifically, the persistence of rising profit margins in the face of stable or falling inflation raises the question of what is happening to productivity. If data on profits and prices are even approximately accurate, total consolidated corporate unit costs have, of necessity, been materially contained. With labor costs constituting three-fourths of costs, unless growth in compensation per hour is falling, which seems most unlikely from other information, it is difficult to avoid the conclusion that output per hour has to be rising at a pace significantly in excess of the officially published annual growth rate of nonfarm productivity of one percent over recent quarters. The degree to which these data may be understated is underlined by backing out from the total what appears to be a reasonably accurate, or at least consistent, measure of productivity of corporate businesses. The level of nonfarm noncorporate productivity implied by this exercise has been falling continuously since 1973 despite reasonable earnings margins for proprietorships and partnerships. Presumably this reflects the significant upward bias in our measurement of service prices, which dominate our noncorporate sector. Nonetheless, the still open question is whether productivity growth is in the process of picking up. For it is the answer to this question that is material to the current debate between those who argue that the economy is entering a "new era" of greatly enhanced sustainable growth and unusually high levels of resource utilization, and those who do not. A central bank, while needing to be open to evidence of structural economic change, also needs to be cautious. Supplying excess liquidity to support growth that turns out to have been ephemeral would undermine the very good economic performance we have enjoyed. We raised the federal funds rate in March to help protect against this latter possibility, and with labor resources currently stretched tight, we need to remain on alert. Whatever its successes, the current monetary policy regime is far from ideal. Each episode has had to be treated as unique or nearly so. It may have been the best we could do at the moment. But we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions. Gold was such an anchor or rule, prior to World War I, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value. A fixed, or even adaptive, rule on the expansion of the monetary base would anchor the system, but it is hard to envision acceptance for that approach because it also limits economic policy discretion. Moreover, flows of U.S. currency abroad, which are variable and difficult to estimate, and bank reserves avoidance are subverting any relationship that might have existed between growth in the monetary base and U.S. economic performance. Another type of rule using readings on output and prices to help guide monetary policy, such as John Taylor's, has attracted widening interest in recent years in the financial markets, the academic community, and at central banks. Taylor-type rules or reaction functions have a number of attractive features. They assume that central banks can appropriately pay attention simultaneously to developments in both output and inflation, provided their reactions occur in the context of a longer-run goal of price stability and that they recognize that activity is limited by the economy's sustainable potential. As Taylor himself has pointed out, these types of formulations are at best "guideposts" to help central banks, not inflexible rules that eliminate discretion. One reason is that their formulation depends on the values of certain key variables -- most crucially the equilibrium real federal funds rate and the production potential of the economy. In practice these have been obtained by observation of past macroeconomic behavior -- either through informal inspection of the data, or more formally as embedded in models. In that sense, like all rules, as I noted earlier, they embody a forecast that the future will be like the past. Unfortunately, however, history is not an infallible guide to the future, and the levels of these two variables are currently under active debate. The mechanics of monetary policy that I have been addressing are merely means to an end. What are we endeavoring to achieve, and why? The goal of macroeconomic policy should be maximum sustainable growth over the long term, and evidence has continued to accumulate around the world that price stability is a necessary condition for the achievement of that goal. Beyond this very general statement, however, lie difficult issues of concept and measurement for policymakers and academicians to keep us occupied for the next fifteen years and more. Inflation impairs economic efficiency in part because people have difficulty separating movements in relative prices from movements in the general price level. But what prices matter? Certainly prices of goods and services now being produced -- our basic measure of inflation -- matter. But what about prices of claims on future goods and services, like equities, real estate or other earning assets? Is stability in the average level of these prices essential to the stability of the economy? Recent Japanese economic history only underlines the difficulty and importance of this question. The prices of final goods and services were stable in Japan in the mid-to-late 1980s, but soaring asset prices distorted resource allocation and ultimately undermined the performance of the macroeconomy. In the United States, evaluating the effects on the economy of shifts in balance sheets and variations in asset prices has been an integral part of the development of monetary policy. In recent years, for example, we have expended considerable effort to understand the implications of changes in household balance sheets in the form of high and rising consumer debt burdens and increases in market wealth from the run-up in the stock market. And the equity market itself has been the subject of analysis as we attempt to assess the implications for financial and economic stability of the extraordinary rise in equity prices -- a rise based apparently on continuing upward revisions in estimates of our corporations' already robust long-term earning prospects. But, unless they are moving together, prices of assets and of goods and services cannot both be an objective of a particular monetary policy, which, after all, has one effective instrument -- the short-term interest rate. We have chosen product prices as our primary focus on the grounds that stability in the average level of these prices is likely to be consistent with financial stability as well as maximum sustainable growth. History, however, is somewhat ambiguous on the issue of whether central banks can safely ignore asset markets, except as they affect product prices. Over the coming decades, moreover, what constitutes product price and, hence, price stability will itself become harder to measure. When industrial product was the centerpiece of the economy during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a period of years. I have already noted the problems in defining price and output and, hence, in measuring productivity over the past twenty years. The simple notion of price has turned decidedly complex. What is the price of a unit of software or of a medical procedure? How does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has been altered so radically? The pace of change and the shifting to harder-to-measure types of output are more likely to quicken than to slow down. Indeed, how will we measure inflation in the future when our data -- using current techniques -could become increasingly less adequate to trace price trends over time? However, so long as individuals make contractual arrangements for future payments valued in dollars and other currencies, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output, and hence of price, that is recognizable to producers and consumers and upon which they will base their decisions. The emergence of inflation-indexed bonds does not solve the problem of pinning down an economically meaningful measure of the general price level. While there is, of course, an inflation expectation premium embodied in all nominal interest rates, it is fundamentally unobservable. Returns on indexed bonds are tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Doubtless, we will develop new techniques of measurement to unearth those true prices as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. It should be evident from my remarks that ample challenges will continue to face monetary policy. I have concentrated on how we have tried to identify and analyze new developments, and endeavored to use that analysis to fashion and balance policy responses. I have also tried to highlight the questions about how to specify and measure the ultimate goals of policy. Nonetheless, all of us could easily add to the list. In dealing with these issues, policy can only benefit from focused and relevant academic research. I look forward to learning about and utilizing the contributions made under the sponsorship of the Center for Economic Policy Research over the years to come.	["mr. greenspan considers the recent history of the federal reserve system's policy process remarks by the chairman of the board of governors of the us federal reserve system, mr. alan greenspan, at the 15th anniversary conference of the center for economic policy research at stanford university, stanford, california on 5/9/97.", 'it is a pleasure to be at this conference marking the fifteenth anniversary of the center for economic policy research.', 'the center, by encouraging academic research into public policy and bringing that research to the attention of policymakers, is performing a most valuable role in our society.', 'i am particularly pleased that milton friedman has taken time to join us.', 'his views have had as much, if not more, impact on the way we think about monetary policy and many other important economic issues as those of any person in the last half of the twentieth century.', 'federal reserve policy, over the years, has been subject to criticism, often with justification, from professor friedman and others.', 'it has been argued, for example, that policy failed to anticipate the emerging inflation of the 1970s, and by fostering excessive monetary creation, contributed to the inflationary upsurge.', 'surely, it was maintained, some monetary policy rule, however imperfect, would have delivered far superior performance.', 'even if true in this case, though, policy rules might not always be preferable.', 'policy rules, at least in a general way, presume some understanding of how economic forces work.', 'moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly.', 'use of a rule presupposes that action x will, with a reasonably high probability, be followed over time by event y. another premise behind many rule-based policy prescriptions, however, is that our knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse.', 'in this view, ad hoc or discretionary policy can cause uncertainty for private decision makers and be wrong for extended periods if there is no anchor to bring it back into line.', "in addition, discretionary policy is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't those of elected representatives supersede those of unelected officials?", 'the monetary policy of the federal reserve has involved varying degrees of rule- and discretionary-based modes of operation over time.', 'recognizing the potential drawbacks of purely discretionary policy, the federal reserve frequently has sought to exploit past patterns and regularities to operate in a systematic way.', 'but we have found that very often historical regularities have been disrupted by unanticipated change, especially in technologies.', 'the evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations.', 'accordingly we are constantly evaluating how much we can infer from the past and how relationships might have changed.', 'in an ever changing world, some element of discretion appears to be an unavoidable aspect of policymaking.', 'such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy.', 'still, sensible policy does presuppose a conceptual framework, or implicit model, however incompletely specified, of how the economic system operates.', 'of necessity, we make judgments based importantly on historical regularities in behavior inferred from data relationships.', 'these perceived regularities can be embodied in formal empirical models, often covering only a portion of the economic system.', 'generally, the regularities inform our interpretation of "experience" and tell us what to look for to determine whether history is in the process of repeating itself, and if not, why not.', 'from such an examination, along with an assessment of past policy actions, we attempt to judge to what extent our current policies should deviate from our past patterns of behavior.', "when this center was founded 15 years ago, the rules versus discretion debate focused on the appropriate policy role of the monetary aggregates, and this discussion was echoed in the federal reserve's policy process.", "in the late 1970s, the federal reserve's actions to deal with developing inflationary instabilities were shaped in part by the reality portrayed by milton friedman's analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs, followed on the heels of similar patterns of average money growth.", 'the federal reserve, in response to such evaluations, acted aggressively under newly installed chairman paul volcker.', 'a considerable tightening of the average stance of policy -- based on intermediate m1 targets tied to reserve operating objectives -- eventually reversed the surge in inflation.', 'the last fifteen years have been a period of consolidating the gains of the early 1980s and extending them to their logical end -- the achievement of price stability.', 'we are not quite there yet, but we trust it is on the horizon.', 'although the ultimate goals of policy have remained the same over these past fifteen years, the techniques used in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation.', 'focusing on m1, and following operating procedures that imparted a considerable degree of automaticity to short-term interest rate movements, was extraordinarily useful in the early volcker years.', 'but after nationwide now accounts were introduced, the demand for m1 in the judgment of the federal open market committee became too interest-sensitive for that aggregate to be useful in implementing policy.', 'because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for m1 growth in its judgment no longer were reliable guides for outcomes in nominal spending and inflation.', 'in response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending.', 'as a consequence, by late 1982, m1 was de-emphasized and policy decisions per force became more discretionary.', 'however, in recognition of the longer-run relationship of prices and m2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting our policy stance.', 'as an indicator, m2 served us well for a number of years.', 'but by the early 1990s, its usefulness was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors that led to a restructuring of business and household balance sheets.', 'the apparent result was a significant rise in the velocity of m2, which was especially unusual given continuing declines in short-term market interest rates.', 'by 1993, this extraordinary velocity behavior had become so pronounced that the federal reserve was forced to begin disregarding the signals m2 was sending, at least for the time being.', 'data since mid-1994 do seem to show the re-emergence of a relationship of m2 with nominal income and short-term interest rates similar to that experienced during the three decades of the 1960s through the 1980s.', 'as i indicated to the congress recently, however, the period of predictable velocity is too brief to justify restoring m2 to its role of earlier years, though clearly persistent outsized changes would get our attention.', 'increasingly since 1982 we have been setting the funds rate directly in response to a wide variety of factors and forecasts.', 'we recognize that, in fixing the short-term rate, we lose much of the information on the balance of money supply and demand that changing market rates afford, but for the moment we see no alternative.', 'in the current state of our knowledge, money demand has become too difficult to predict.', 'although our operating target is a nominal short-term rate, we view its linkages to spending and prices as indirect and complex.', 'for one, arguably, it is real, not nominal, rates that are more relevant to spending.', 'for another, spending, prices and other economic variables respond to a whole host of financial variables.', 'hence, in judging the stance of policy we routinely look at the financial impulses coming from foreign exchange, bond, and equity markets, along with supply conditions in credit markets generally, including at financial intermediaries.', 'nonetheless, we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates.', 'in current circumstances, however, determining which financial data should be aggregated to provide an appropriate empirical proxy for the money stock that tracks income and spending represents a severe challenge for monetary analysts.', 'the absence of a monetary aggregate anchor, however, has not left policy completely adrift.', 'from a longer-term perspective we have been guided by a firm commitment to contain any forces that would undermine economic expansion and efficiency by raising inflation, and we have kept our focus firmly on the ultimate goal of achieving price stability.', 'within that framework we have attempted not only to lean against the potential for an overheating economy, but also to cushion shortfalls in economic growth.', 'and, recognizing the lags in the effects of policy, we have tried to move in anticipation of such disequilibria developing.', 'but this is a very general framework and does not present clear guidance for day-to-day policy decisions.', 'thus, as the historic relationship between measured money supply and spending deteriorated, policymaking, seeing no alternative, turned more eclectic and discretionary.', 'nonetheless, we try to develop as best we can a stable conceptual framework, so policy actions are as regular and predictable as possible -- that is, governed by systematic behavior but open to evidence of structural macroeconomic changes that require policy to adapt.', 'the application of such an approach is illustrated by a number of disparate events we have confronted since 1982 that were in some important respects outside our previous experience.', 'in the early and mid-1980s, the fomc faced most notably the sharp swings in fiscal policy, the unprecedented rise and fall of the dollar, and the associated shifts in international trade and capital flows.', 'but i will concentrate on several events of the last decade where i personally participated in forming the judgments used in policy implementation.', 'one such event was the stock market crash of october 1987 shortly after i arrived.', 'unlike many uncertain situations that have confronted monetary policy, there was little question that the appropriate central bank action was to ease policy significantly.', 'we knew we would soon have to sop up the excess liquidity that we added to the system, but the timing and, i believe, the magnitude of our actions were among our easier decisions.', 'our concerns at that time reflected questions about how the financial markets and the economy would respond to the shock of a decline of more than one-fifth in stock prices in one day, and whether monetary policy alone could stabilize the system.', 'by the early spring of 1988 it was evident that the economy had stabilized and we needed to begin reversing the easy stance of policy.', 'another development that confronted policy was the commercial property price bust of the late 1980s and early 1990s.', 'since a large volume of bank and thrift loans was tied to the real estate market and backed by real estate collateral, the fall in property prices impaired the capital of a large number of depositories.', 'these institutions reacted by curtailing new lending -the unprecedented "credit crunch" of 1990 and 1991. not unexpectedly, our policy response was to move toward significant ease.', "our primary concern was the state of the credit markets and the economy, but we could also see that these broader issues were linked inextricably to the state of depository institutions' balance sheets and profitability.", 'a satisfactory recovery from the recession of that period, in our judgment, required the active participation of a viable banking system.', 'the extraordinary circumstances dictated a highly unusual path for monetary policy.', 'the stance of policy eased substantially even after the economy began to recover from the 1990-91 recession, and a stimulative policy was deliberately maintained well into the early expansion period.', 'by mid-1993, however, property prices stabilized and the credit crunch gradually began to dissipate.', 'it was clear as the year moved toward a close that monetary policy, characterized by a real federal funds rate of virtually zero, was now far too easy in light of the strengthening economy on the horizon.', 'financial and economic conditions were returning to more traditional relationships, and policy had to shift from a situation-specific formulation to one based more closely on previous historical patterns.', 'although it was difficult at that time to discern any overt inflationary signals, the balance of risks, in our judgment, clearly dictated pre-emptive action.', 'the 1994 to 1995 period was most instructive.', 'it appears we were successful in moving pre-emptively to throttle down an impending unstable boom, which almost surely would have resulted in the current expansion coming to an earlier halt.', 'because this was the first change in the stance of policy after a prolonged period of unusual ease, we took special care to spell out our analysis and expectations for policy in an unusually explicit way to inform the markets well before we began to tighten.', 'in addition, we began for the first time to issue explanatory statements as changes in the stance of policy were implemented.', 'even so, the idea of tightening to head off inflation before it was visible in the data was not universally applauded or perhaps understood.', 'financial markets reacted unusually strongly to our 1994 policy actions, often ratcheting up their expectations for further rate increases when we actually tightened, resulting in very large increases in longer-term interest rates.', 'at the time, these reactions seemed to reflect the extent to which investment strategies had been counting on a persistence of low interest rates.', 'this was a classic case in which we had to be careful not to allow market expectations of federal reserve actions to be major elements of policy determination.', 'we are always concerned about assuming that short-term movements in market prices are reflections of changes in underlying supply and demand conditions when we may be observing nothing more than fluctuating expectations about our own policy actions.', 'most recently, the economy has demonstrated a remarkable confluence of robust growth, high resource utilization, and damped inflation.', 'once again we have been faced with analyzing and reacting to a situation in which incoming data have not readily conformed to historical experience.', 'specifically, the persistence of rising profit margins in the face of stable or falling inflation raises the question of what is happening to productivity.', 'if data on profits and prices are even approximately accurate, total consolidated corporate unit costs have, of necessity, been materially contained.', 'with labor costs constituting three-fourths of costs, unless growth in compensation per hour is falling, which seems most unlikely from other information, it is difficult to avoid the conclusion that output per hour has to be rising at a pace significantly in excess of the officially published annual growth rate of nonfarm productivity of one percent over recent quarters.', 'the degree to which these data may be understated is underlined by backing out from the total what appears to be a reasonably accurate, or at least consistent, measure of productivity of corporate businesses.', 'the level of nonfarm noncorporate productivity implied by this exercise has been falling continuously since 1973 despite reasonable earnings margins for proprietorships and partnerships.', 'presumably this reflects the significant upward bias in our measurement of service prices, which dominate our noncorporate sector.', 'nonetheless, the still open question is whether productivity growth is in the process of picking up.', 'for it is the answer to this question that is material to the current debate between those who argue that the economy is entering a "new era" of greatly enhanced sustainable growth and unusually high levels of resource utilization, and those who do not.', 'a central bank, while needing to be open to evidence of structural economic change, also needs to be cautious.', 'supplying excess liquidity to support growth that turns out to have been ephemeral would undermine the very good economic performance we have enjoyed.', 'we raised the federal funds rate in march to help protect against this latter possibility, and with labor resources currently stretched tight, we need to remain on alert.', 'whatever its successes, the current monetary policy regime is far from ideal.', 'each episode has had to be treated as unique or nearly so.', 'it may have been the best we could do at the moment.', 'but we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the federal open market committee to analyze developments and make predictions.', 'gold was such an anchor or rule, prior to world war i, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value.', 'a fixed, or even adaptive, rule on the expansion of the monetary base would anchor the system, but it is hard to envision acceptance for that approach because it also limits economic policy discretion.', 'moreover, flows of u.s. currency abroad, which are variable and difficult to estimate, and bank reserves avoidance are subverting any relationship that might have existed between growth in the monetary base and u.s. economic performance.', "another type of rule using readings on output and prices to help guide monetary policy, such as john taylor's, has attracted widening interest in recent years in the financial markets, the academic community, and at central banks.", 'taylor-type rules or reaction functions have a number of attractive features.', "they assume that central banks can appropriately pay attention simultaneously to developments in both output and inflation, provided their reactions occur in the context of a longer-run goal of price stability and that they recognize that activity is limited by the economy's sustainable potential.", 'as taylor himself has pointed out, these types of formulations are at best "guideposts" to help central banks, not inflexible rules that eliminate discretion.', 'one reason is that their formulation depends on the values of certain key variables -- most crucially the equilibrium real federal funds rate and the production potential of the economy.', 'in practice these have been obtained by observation of past macroeconomic behavior -- either through informal inspection of the data, or more formally as embedded in models.', 'in that sense, like all rules, as i noted earlier, they embody a forecast that the future will be like the past.', 'unfortunately, however, history is not an infallible guide to the future, and the levels of these two variables are currently under active debate.', 'the mechanics of monetary policy that i have been addressing are merely means to an end.', 'what are we endeavoring to achieve, and why?', 'the goal of macroeconomic policy should be maximum sustainable growth over the long term, and evidence has continued to accumulate around the world that price stability is a necessary condition for the achievement of that goal.', 'beyond this very general statement, however, lie difficult issues of concept and measurement for policymakers and academicians to keep us occupied for the next fifteen years and more.', 'inflation impairs economic efficiency in part because people have difficulty separating movements in relative prices from movements in the general price level.', 'but what prices matter?', 'certainly prices of goods and services now being produced -- our basic measure of inflation -- matter.', 'but what about prices of claims on future goods and services, like equities, real estate or other earning assets?', 'is stability in the average level of these prices essential to the stability of the economy?', 'recent japanese economic history only underlines the difficulty and importance of this question.', 'the prices of final goods and services were stable in japan in the mid-to-late 1980s, but soaring asset prices distorted resource allocation and ultimately undermined the performance of the macroeconomy.', 'in the united states, evaluating the effects on the economy of shifts in balance sheets and variations in asset prices has been an integral part of the development of monetary policy.', 'in recent years, for example, we have expended considerable effort to understand the implications of changes in household balance sheets in the form of high and rising consumer debt burdens and increases in market wealth from the run-up in the stock market.', "and the equity market itself has been the subject of analysis as we attempt to assess the implications for financial and economic stability of the extraordinary rise in equity prices -- a rise based apparently on continuing upward revisions in estimates of our corporations' already robust long-term earning prospects.", 'but, unless they are moving together, prices of assets and of goods and services cannot both be an objective of a particular monetary policy, which, after all, has one effective instrument -- the short-term interest rate.', 'we have chosen product prices as our primary focus on the grounds that stability in the average level of these prices is likely to be consistent with financial stability as well as maximum sustainable growth.', 'history, however, is somewhat ambiguous on the issue of whether central banks can safely ignore asset markets, except as they affect product prices.', 'over the coming decades, moreover, what constitutes product price and, hence, price stability will itself become harder to measure.', 'when industrial product was the centerpiece of the economy during the first two-thirds of this century, our overall price indexes served us well.', 'pricing a pound of electrolytic copper presented few definitional problems.', 'the price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a period of years.', 'i have already noted the problems in defining price and output and, hence, in measuring productivity over the past twenty years.', 'the simple notion of price has turned decidedly complex.', 'what is the price of a unit of software or of a medical procedure?', 'how does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has been altered so radically?', 'the pace of change and the shifting to harder-to-measure types of output are more likely to quicken than to slow down.', 'indeed, how will we measure inflation in the future when our data -- using current techniques -could become increasingly less adequate to trace price trends over time?', 'however, so long as individuals make contractual arrangements for future payments valued in dollars and other currencies, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money.', 'no matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services.', 'hence, we must assume that embodied in all products is some unit of output, and hence of price, that is recognizable to producers and consumers and upon which they will base their decisions.', 'the emergence of inflation-indexed bonds does not solve the problem of pinning down an economically meaningful measure of the general price level.', 'while there is, of course, an inflation expectation premium embodied in all nominal interest rates, it is fundamentally unobservable.', "returns on indexed bonds are tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money.", 'to the extent they do not, of course, the implicit real interest rate is biased in the opposite direction.', 'doubtless, we will develop new techniques of measurement to unearth those true prices as the years go on.', 'it is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it.', 'it should be evident from my remarks that ample challenges will continue to face monetary policy.', 'i have concentrated on how we have tried to identify and analyze new developments, and endeavored to use that analysis to fashion and balance policy responses.', 'i have also tried to highlight the questions about how to specify and measure the ultimate goals of policy.', 'nonetheless, all of us could easily add to the list.', 'in dealing with these issues, policy can only benefit from focused and relevant academic research.', 'i look forward to learning about and utilizing the contributions made under the sponsorship of the center for economic policy research over the years to come.']	Alan Greenspan	Board of Governors of the US Federal Reserve System	Chairman of the Board of Governors	US
https://www.bis.org/review/r970912a.pdf	Mr. de Swaan discusses the background, advantages and implementation of the core principles for effective banking supervision (Central Bank Articles and Speeches, 1 Sep 97)	Speech by Mr. de Swaan, an Executive Director of the Netherlands Bank and Chairman of the Basle Committee on Banking Supervision, at the 14th Annual Meeting of the Latin American and Caribbean Banking Supervisory Organisations held in Santiago, Chile on 1/9/97.	1997-09-01 00:00:00	Mr. de Swaan discusses the background, advantages and implementation of the core principles for effective banking supervision Speech by Mr. de Swaan, an Executive Director of the Netherlands Bank and Chairman of the Basle Committee on Banking Supervision, at the 14th Annual Meeting of the Latin American and Caribbean Banking Supervisory Organisations held in Santiago, Chile on 1/9/97. The banking system is sometimes compared to traffic. This comparison is justified for at least two reasons: first, the causes of traffic accidents are essentially the same around the world, just like the causes of banking crises. It is therefore not surprising that almost all countries adopt the same type of rules, like speed limits in the case of traffic, or some kind of limitation of risk exposures in the case of banking. A second similarity between banking systems and traffic is that with the increase of cross-border activity, such as air traffic, the need for harmonisation of national regulations has grown. The minimum requirements for banking supervision which the Basle Committee has recently developed in conjunction with supervisors in emerging markets are an important step in this direction. Today, I would like to discuss with you the background, advantages and implementation of these core principles. Background l. Banking crises in countries are no new phenomena at all. In this part of the world a number of countries experienced severe banking problems in the early 1980s. In some western countries, notably in the Scandinavian, the banking community also faced substantial difficulties, albeit of a different nature. Since the Mexico crisis of 1995, awareness among policy-makers of the potential damage that can result from banking problems has grown significantly. In emerging markets, banking problems often result in much deeper recessions than in industrialised countries. Generally, these economies are more vulnerable to banking problems because almost all financial intermediation is carried out by banks. Most industrialised countries are less dependent on banks, because the function of financial intermediation is also performed by institutional investors and well-developed capital markets. Since the Mexico crisis, it has also been recognised that the frequency of banking problems is significantly higher in emerging markets. Recent research has shown that 85% of the severe banking crises which have occurred in the past fifteen years concerned developing and transition economies. My explanation for this striking fact is that the factors which cause banking crises are generally more prevalent, but not essentially different in emerging markets than in industrialised countries. This basic idea is the rationale behind the common set of core principles I would like to discuss with you today. 2. But before that a short word on the way the principles have been developed because it shows an important development in the cooperation between the members of the Basle Committee and other countries. The principles were first drafted by a joint working group consisting of a number of Basle Committee members and representatives from 15 other countries. Subsequently a very lively exchange of views took place in a meeting in Basle in March of this year in which representatives of approximately 40 countries, including the chairmen of all regional groups, participated. To my satisfaction the consultation period following that meeting produced a large number of reactions, nearly all of them favourable. These reactions will be incorporated in the core principles. To endorse the final text of the principles, a similar meeting to the one in March will take place on September 10th in Basle. Two weeks later, in conjunction with the annual meeting in Hong Kong, the IMF and the Basle Committee will co-sponsor a conference to introduce the principles to as wide as possible an audience of Ministries of Finance and central banks. 3. As I said, the main rational behind the core principles has been the increased awareness among policy-makers that banking crises can aggravate recessions. Another reason for the formulation of core principles is the increased globalisation of economic activity. With the strong growth of trade and financial flows between national economies, banking problems in one country have much more potential to spread to other parts of the world. A specific form of globalisation concerns the increasing international activities of large banks. Policy makers generally welcome cross-border banking, because of the beneficial effects on the efficiency, liquidity and depth of financial markets. However, the internationalisation of banking also increases the risk of contagion of banking problems. In order to reduce this risk, the core principles pay special attention to the supervision of cross-border banking. On this subject, the most important message from the core principles is that home country supervisors should practise consolidated supervision over their internationally-active banks. In order to enable home country supervisors to fulfil this task most effectively, host country supervisors must share information with them about the local operations of foreign banks. Finally, the core principles state that banking supervisors must require the local operations of foreign banks to meet the same high standards as are required of domestic institutions. Advantages 4. You may wonder whether the core principles will really be able to reduce the severity and frequency of banking problems around the world. Let me try to answer this question by reviewing the main causes of banking crises and the way in which the core principles deal with these causes. One important cause of banking crises is macro-economic instability. High and variable inflation rates, booms and busts in economic activity and exchange rate volatility complicate credit assessments by banks. Moreover, during the expansion phase of a business cycle, there is often a tendency towards over-optimism and excessive lending by banks, which in turn can result in asset price bubbles. This factor can be regarded as the main cause of the current fragility of the Japanese financial sector. Thus, inadequate risk management by banks is frequently a crucial link between macro-economic instability and banking problems. Macro-economic instability is on average greater in emerging markets, reflecting less diversification and greater structural rigidities. Unsound fiscal and monetary policies can add further to this problem. As a consequence, the risks faced by banks in emerging markets tend to be higher. 5. The core principles formulate prudential regulations and requirements in order to promote a framework to control the risks inherent in banking. The application of this framework can limit the negative influence of macro-economic volatility on the soundness of the financial system. The requirements concerned cover capital adequacy, loan loss reserves, asset concentrations, liquidity, risk management and internal controls. Of this group of principles, I think those regarding risk management and internal controls deserve special attention. For example, core principles 12 and 13 state that banking supervisors must be satisfied that banks have in place risk management systems which accurately identify, measure, monitor and control market risks and all other material risks. Furthermore, banks are required to hold an adequate amount of capital against these risks. These principles reflect the growing recognition that banks bear the principal responsibility for adequate risk management themselves. The main task of supervisors is to set minimum standards and to monitor the policies and procedures through which banks control their risks. 6. I would like to emphasise that adequate risk management by banks can reduce but not eliminate the negative effects of macro-economic instability on the soundness of financial systems. But it is evident that a sound financial sector is an important precondition for macroeconomic stability. For instance, when macro-economic stabilisation calls for monetary tightening, concerns about the effect of higher interest rates on the loan portfolios of weak banks may delay policy action. In Mexico, this delay contributed to a sudden reversal of capital flows and a deep recession in 1995. These so-called feedback effects from financial to macro-economic instability underscore the need for the application of the core principles. 7. The second main cause of financial fragility is premature financial liberalisation. It is widely recognised that financial liberalisation promotes competition among banks, thereby improving the efficient allocation of financial resources in the long run. However, during the transition, bank managers and supervisors often lack the expertise to deal with the higher risks associated with the new activities in which their institutions get involved. This lack of experience increases the probability of banking crises. Moreover, increased competition from foreign banks often encourages domestic banks to finance riskier investments in order to keep up their earnings. This chain of events has unfolded not only in emerging economies, but also in well-developed Nordic countries and the United States. Policy makers have drawn an important lesson from these banking crises, namely that financial liberalisation should be preceded by a strengthening of risk management systems by banks. The core principles regarding risk management and internal controls which I have just discussed can serve as a guide for the supervision of the risk management systems adopted by banks. 8. The third culprit is government involvement in banking. One way in which government policy can undermine the soundness of banks is by means of the tax treatment of financial institutions. For example, tax systems which do not allow the deduction of loan loss provisions from taxable earnings reduce the incentive of banks to recognise these losses on a timely basis. A perhaps more damaging way of government involvement is the use of state banks to finance government expenditures at below market rates. This channel has two apparent advantages to the government; for one thing, it is cheap, at least in the short run. In addition, bank financing does not show up in the official measurements of the budget deficit, which reduces the possibilities for public scrutiny. Although state-owned banks are most prone to this kind of political exploitation, privately-owned banks can also function as quasi-fiscal agents, for example when they are forced to lend to particular sectors or industries. Obviously, these financing practices reduce the viability of banks in the medium and long term. 9. I would point out that, while political involvement in banking tends to occur more frequently in developing countries, it is not restricted to them. In South Korea and France, for example, recent banking problems seem to be linked at least in part to government involvement. However, in less wealthy countries the pressure on government funds is usually larger, which increases the temptation to turn to state banks for funding. The risk of government influence on banks in emerging markets is also larger, because state banks tend to control a much bigger share of banking assets. 10. Core principle l contains a description of the preconditions for effective banking supervision. In the context of problems related to government involvement, the following elements of this first principle seem particularly relevant. First, the explanation of core principle 1 says that each supervisory agency should possess operational independence to pursue a sound banking system free from political pressure. A second important precondition is that each supervisory agency should have adequate resources to meet the objectives set. These resources should be provided on terms that do not undermine the autonomy and independence of the supervisory agency. The emphasis of the first core principle on the independence of supervisory agencies is important, first of all because independent supervisors are in a better position to prevent political exploitation of banks. And secondly because it can limit forbearance in dealing with problems in individual banks. A number of banking crises could have been prevented or alleviated if the supervisory authorities would have had the independence and the instruments to intervene in a timely and adequate way. In addition, the appendix of the core principles explicitly mentions the need for supervisors to apply their supervisory methods in the same manner to government-owned commercial banks as to other commercial banks. The implementation of this advice should also reduce the opportunities for governments to use state banks as a source of cheap funding. ll. A related cause of banking problems is connected lending, which refers to loans extended to banks' managers, shareholders or to parties connected to them. Just like loans to governments, loans to connected parties are often granted on a non-arm's length basis and at below market rates. Another similarity with government involvement is that there is reason to believe that connected lending is a more serious problem in emerging than in advanced economies. The risks of connected lending encompass a lack of objectivity in credit assessment and undue concentration of credit risk. Core principle 10 explicitly addresses the problem of connected lending. This principle states that banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm's length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. Moreover, core principle 9 calls for prudential limits to restrict bank exposures to single borrowers or groups of related borrowers. If these principles are implemented on a global scale, they will raise a significant barrier against connected lending. 12. I now turn to a fourth set of causes of banking problems, that can be labelled inadequate corporate governance. This term refers to an absence of the right incentive structure for bank owners, managers, depositors and supervisors to show prudent behaviour. Perhaps the best way to throw light on these types of problems is by means of a well-known example, namely the downfall of the US savings and loans institutions. In the early 1980s, the supervisory authorities in the US sought ways to enable savings and loans institutions, which were generally in bad shape, to continue in business. The range of activities in which these institutions were permitted to engage was expanded, capital standards were relaxed and the level of deposit insurance was increased. As a consequence, many savings and loans institutions tried to grow out of their problems by investing in high-risk assets, such as property and so-called 'junk bonds'. The point is that depositors were content to finance these risky investments, because of the generosity of the US deposit insurance at that time. Moreover, with low capital standards, equity holders or owners had little to lose. Finally, banking regulation in the US did not penalise bank managers for excessive risk-taking and allowed supervisors to delay corrective measures. When the property market started to collapse in the mid-eighties, many savings and loans institutions became insolvent, which eventually resulted in a loss of at least $150 billion for the US taxpayers. In order to prevent similar banking problems, bank regulation in advanced and emerging economies must incorporate the right incentives for all participants in the banking system. 13. If you look at the core principles you will find various sorts of incentives in this field. Firstly, principle 3 requires that the licensing process should consist of, among other things, an assessment of the bank's ownership structure as well as of its directors and senior management. The explanation of this principle makes clear that if the supervisory agency doubts the integrity and standing of a bank's owner or manager, it should have the authority to prevent a specific ownership structure or the appointment of a certain bank manager. In this way, past imprudent behaviour of bank owners and managers is penalised by excluding them from responsible functions in the banking sector. 14. Secondly, core principle 6 prescribes that capital requirements for banks should be no less than those established in the so-called Basle Capital Accord. The Basle Accord sets minimum capital requirements of 8% of the risk-adjusted assets of banks. Bank capital essentially serves three functions; it is a base for further growth, it provides a cushion against exceptional losses and it promotes better governance. The governance function relates to the fact that if shareholders have more money at stake, they have stronger incentives to ensure that banks are managed in a safe and sound manner. Regarding the loss-absorption function of capital, it must be stressed that the Basle capital requirements are considered a minimum standard. In emerging economies, higher minimum capital requirements seem appropriate, because banks there usually operate in a more volatile and therefore riskier environment. I therefore welcome the initiatives of the supervisory authorities in Argentina and Colombia, who have already raised their minimum capital requirements to 11.5 and 9% respectively. 15. As the example of the US thrift crisis showed, the design of deposit insurance deserves special attention. The second appendix of the core principles contains a balanced view on this delicate issue, which can be summarised as follows: On the one hand, deposit insurance is desirable because it limits the effect that problems at one bank might have on other banks. This obviously increases the stability of the financial system. However, deposit insurance can also increase the risk of imprudent behaviour by banks, because depositors will be less inclined to withdraw funds even if the bank pursues high-risk strategies. Therefore, governments should incorporate mechanisms in the system of depositor protection that prevent excessive risk-taking by banks. This can for example be achieved by a partial deposit insurance, so that depositors still have funds at risk. Another method is withholding deposit insurance from large, institutional investors. The precise form of such a program should be tailored to the specific circumstances of each country. 16. The last item on my list of crisis factors is a poor market infrastructure. It is widely accepted that imperfect accounting systems, limited disclosure practices and inadequate legal frameworks can hinder effective banking supervision and market discipline. Again, these deficiencies are more pronounced in developing countries, but deserve continuous efforts for improvement in developed countries as well. The first problem concerns the accuracy of accounting systems. In many countries, the accounting standards for classifying bank loans as non-performing are not tight enough to prevent banks from making bad loans look good. If non-performing loans are systematically understated and are not properly provided against, figures about profitability and bank capital become meaningless. On the disclosure side, the ability to distinguish healthy from unhealthy banks is often hampered by the absence of financial statements on a consolidated basis. Differences in accounting standards across countries and the absence of serious penalties for publishing inaccurate information can also obstruct a meaningful assessment of banks. Finally, the legal system sometimes impedes prudent banking, for example when it hinders banks to seize collateral behind delinquent loans. 17. Core principle 21 relates to the information requirements of bank organisations, which is an important part of the market infrastructure. This principle states that banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices. This information should enable supervisors to obtain a true and fair view of the financial condition and profitability of banks. Banks should also publish financial statements that fairly reflect their condition on a regular basis. Moreover. the explanation of this principle prescribes that if a bank provides false or misleading information, supervisory action or criminal prosecution should be taken against the individuals involved and the institution. 18. Having elaborated on the contribution that the core principles can make towards alleviating the main causes of banking problems, I think it is now time for an overall assessment. First of all, it would be an illusion to think that a global application of the core principles can by itself prevent financial crises occurring in the future. As I already mentioned with regard to capital standards, the core principles contain minimum requirements. Individual countries, particularly those in emerging areas, should therefore consider to what extent they need to supplement the core principles with requirements addressing particular risks of their financial systems. Moreover, banking supervision is a dynamic function that needs to respond to changes in the marketplace. Therefore, the principles will need periodic, but not necessarily frequent, refinement and readjustment. Finally, the core principles provide guidelines for bank regulation. I hope my description of the causes of financial crises has made clear that financial stability not only requires prudential behaviour by banks, but also macro-economic stability, a transparent government budget and an adequate legal framework. In these areas, which all have to do with government policy, the World Bank and the International Monetary Fund can make an important contribution to financial stability. Implementation 19. In the near future, the implementation of the core principles should be a top priority. Of course the main burden of this lies with the governments of the individual countries. I don't underestimate the wide-ranging legal, infrastructural and educational changes the implementation of the principles call for in a large number of countries. Every country should put in place an ambitious program with clear time-frames for the implementation. It is obvious that the IMF and the World Bank should have a leading role with regard to monitoring the implementation of the core principles. The main argument for this structure is that the international financial institutions already send missions to almost all countries in the world. However, it is generally acknowledged that the Basle Committee possesses great expertise in bank regulation. I therefore plead for a model in which the Basle Committee, the IMF and the World Bank each and together assist countries in realising financial stability in their respective fields of competence. In this model, the IMF and the World Bank are primarily responsible for creating a sound environment for banking, which is highly dependent on viable government policies. As part of the assessment of government policies, these institutions will of course also pay attention to the quality of bank supervision. 20. The Basle Committee is primarily responsible for the amendment and interpretation of the principles and will review compliance with the principles at the International Conference of Banking Supervisors in October 1998 and bi-annually thereafter. The Basle Committee can furthermore make a major contribution towards the implementation of the principles by offering technical assistance and courses to supervisors in emerging countries. In this respect, banking and traffic again look alike. It is all a matter of knowing your responsibility; if you do not make a timely agreement about who drives home, you both end up drinking too much.	['mr. de swaan discusses the background, advantages and implementation of the core principles for effective banking supervision speech by mr. de swaan, an executive director of the netherlands bank and chairman of the basle committee on banking supervision, at the 14th annual meeting of the latin american and caribbean banking supervisory organisations held in santiago, chile on 1/9/97.', 'the banking system is sometimes compared to traffic.', 'this comparison is justified for at least two reasons: first, the causes of traffic accidents are essentially the same around the world, just like the causes of banking crises.', 'it is therefore not surprising that almost all countries adopt the same type of rules, like speed limits in the case of traffic, or some kind of limitation of risk exposures in the case of banking.', 'a second similarity between banking systems and traffic is that with the increase of cross-border activity, such as air traffic, the need for harmonisation of national regulations has grown.', 'the minimum requirements for banking supervision which the basle committee has recently developed in conjunction with supervisors in emerging markets are an important step in this direction.', 'today, i would like to discuss with you the background, advantages and implementation of these core principles.', 'background l. banking crises in countries are no new phenomena at all.', 'in this part of the world a number of countries experienced severe banking problems in the early 1980s.', 'in some western countries, notably in the scandinavian, the banking community also faced substantial difficulties, albeit of a different nature.', 'since the mexico crisis of 1995, awareness among policy-makers of the potential damage that can result from banking problems has grown significantly.', 'in emerging markets, banking problems often result in much deeper recessions than in industrialised countries.', 'generally, these economies are more vulnerable to banking problems because almost all financial intermediation is carried out by banks.', 'most industrialised countries are less dependent on banks, because the function of financial intermediation is also performed by institutional investors and well-developed capital markets.', 'since the mexico crisis, it has also been recognised that the frequency of banking problems is significantly higher in emerging markets.', 'recent research has shown that 85% of the severe banking crises which have occurred in the past fifteen years concerned developing and transition economies.', 'my explanation for this striking fact is that the factors which cause banking crises are generally more prevalent, but not essentially different in emerging markets than in industrialised countries.', 'this basic idea is the rationale behind the common set of core principles i would like to discuss with you today.', '2. but before that a short word on the way the principles have been developed because it shows an important development in the cooperation between the members of the basle committee and other countries.', 'the principles were first drafted by a joint working group consisting of a number of basle committee members and representatives from 15 other countries.', 'subsequently a very lively exchange of views took place in a meeting in basle in march of this year in which representatives of approximately 40 countries, including the chairmen of all regional groups, participated.', 'to my satisfaction the consultation period following that meeting produced a large number of reactions, nearly all of them favourable.', 'these reactions will be incorporated in the core principles.', 'to endorse the final text of the principles, a similar meeting to the one in march will take place on september 10th in basle.', 'two weeks later, in conjunction with the annual meeting in hong kong, the imf and the basle committee will co-sponsor a conference to introduce the principles to as wide as possible an audience of ministries of finance and central banks.', '3. as i said, the main rational behind the core principles has been the increased awareness among policy-makers that banking crises can aggravate recessions.', 'another reason for the formulation of core principles is the increased globalisation of economic activity.', 'with the strong growth of trade and financial flows between national economies, banking problems in one country have much more potential to spread to other parts of the world.', 'a specific form of globalisation concerns the increasing international activities of large banks.', 'policy makers generally welcome cross-border banking, because of the beneficial effects on the efficiency, liquidity and depth of financial markets.', 'however, the internationalisation of banking also increases the risk of contagion of banking problems.', 'in order to reduce this risk, the core principles pay special attention to the supervision of cross-border banking.', 'on this subject, the most important message from the core principles is that home country supervisors should practise consolidated supervision over their internationally-active banks.', 'in order to enable home country supervisors to fulfil this task most effectively, host country supervisors must share information with them about the local operations of foreign banks.', 'finally, the core principles state that banking supervisors must require the local operations of foreign banks to meet the same high standards as are required of domestic institutions.', 'advantages 4. you may wonder whether the core principles will really be able to reduce the severity and frequency of banking problems around the world.', 'let me try to answer this question by reviewing the main causes of banking crises and the way in which the core principles deal with these causes.', 'one important cause of banking crises is macro-economic instability.', 'high and variable inflation rates, booms and busts in economic activity and exchange rate volatility complicate credit assessments by banks.', 'moreover, during the expansion phase of a business cycle, there is often a tendency towards over-optimism and excessive lending by banks, which in turn can result in asset price bubbles.', 'this factor can be regarded as the main cause of the current fragility of the japanese financial sector.', 'thus, inadequate risk management by banks is frequently a crucial link between macro-economic instability and banking problems.', 'macro-economic instability is on average greater in emerging markets, reflecting less diversification and greater structural rigidities.', 'unsound fiscal and monetary policies can add further to this problem.', 'as a consequence, the risks faced by banks in emerging markets tend to be higher.', '5. the core principles formulate prudential regulations and requirements in order to promote a framework to control the risks inherent in banking.', 'the application of this framework can limit the negative influence of macro-economic volatility on the soundness of the financial system.', 'the requirements concerned cover capital adequacy, loan loss reserves, asset concentrations, liquidity, risk management and internal controls.', 'of this group of principles, i think those regarding risk management and internal controls deserve special attention.', 'for example, core principles 12 and 13 state that banking supervisors must be satisfied that banks have in place risk management systems which accurately identify, measure, monitor and control market risks and all other material risks.', 'furthermore, banks are required to hold an adequate amount of capital against these risks.', 'these principles reflect the growing recognition that banks bear the principal responsibility for adequate risk management themselves.', 'the main task of supervisors is to set minimum standards and to monitor the policies and procedures through which banks control their risks.', '6. i would like to emphasise that adequate risk management by banks can reduce but not eliminate the negative effects of macro-economic instability on the soundness of financial systems.', 'but it is evident that a sound financial sector is an important precondition for macroeconomic stability.', 'for instance, when macro-economic stabilisation calls for monetary tightening, concerns about the effect of higher interest rates on the loan portfolios of weak banks may delay policy action.', 'in mexico, this delay contributed to a sudden reversal of capital flows and a deep recession in 1995. these so-called feedback effects from financial to macro-economic instability underscore the need for the application of the core principles.', '7. the second main cause of financial fragility is premature financial liberalisation.', 'it is widely recognised that financial liberalisation promotes competition among banks, thereby improving the efficient allocation of financial resources in the long run.', 'however, during the transition, bank managers and supervisors often lack the expertise to deal with the higher risks associated with the new activities in which their institutions get involved.', 'this lack of experience increases the probability of banking crises.', 'moreover, increased competition from foreign banks often encourages domestic banks to finance riskier investments in order to keep up their earnings.', 'this chain of events has unfolded not only in emerging economies, but also in well-developed nordic countries and the united states.', 'policy makers have drawn an important lesson from these banking crises, namely that financial liberalisation should be preceded by a strengthening of risk management systems by banks.', 'the core principles regarding risk management and internal controls which i have just discussed can serve as a guide for the supervision of the risk management systems adopted by banks.', '8. the third culprit is government involvement in banking.', 'one way in which government policy can undermine the soundness of banks is by means of the tax treatment of financial institutions.', 'for example, tax systems which do not allow the deduction of loan loss provisions from taxable earnings reduce the incentive of banks to recognise these losses on a timely basis.', 'a perhaps more damaging way of government involvement is the use of state banks to finance government expenditures at below market rates.', 'this channel has two apparent advantages to the government; for one thing, it is cheap, at least in the short run.', 'in addition, bank financing does not show up in the official measurements of the budget deficit, which reduces the possibilities for public scrutiny.', 'although state-owned banks are most prone to this kind of political exploitation, privately-owned banks can also function as quasi-fiscal agents, for example when they are forced to lend to particular sectors or industries.', 'obviously, these financing practices reduce the viability of banks in the medium and long term.', '9. i would point out that, while political involvement in banking tends to occur more frequently in developing countries, it is not restricted to them.', 'in south korea and france, for example, recent banking problems seem to be linked at least in part to government involvement.', 'however, in less wealthy countries the pressure on government funds is usually larger, which increases the temptation to turn to state banks for funding.', 'the risk of government influence on banks in emerging markets is also larger, because state banks tend to control a much bigger share of banking assets.', '10. core principle l contains a description of the preconditions for effective banking supervision.', 'in the context of problems related to government involvement, the following elements of this first principle seem particularly relevant.', 'first, the explanation of core principle 1 says that each supervisory agency should possess operational independence to pursue a sound banking system free from political pressure.', 'a second important precondition is that each supervisory agency should have adequate resources to meet the objectives set.', 'these resources should be provided on terms that do not undermine the autonomy and independence of the supervisory agency.', 'the emphasis of the first core principle on the independence of supervisory agencies is important, first of all because independent supervisors are in a better position to prevent political exploitation of banks.', 'and secondly because it can limit forbearance in dealing with problems in individual banks.', 'a number of banking crises could have been prevented or alleviated if the supervisory authorities would have had the independence and the instruments to intervene in a timely and adequate way.', 'in addition, the appendix of the core principles explicitly mentions the need for supervisors to apply their supervisory methods in the same manner to government-owned commercial banks as to other commercial banks.', 'the implementation of this advice should also reduce the opportunities for governments to use state banks as a source of cheap funding.', "a related cause of banking problems is connected lending, which refers to loans extended to banks' managers, shareholders or to parties connected to them.", "just like loans to governments, loans to connected parties are often granted on a non-arm's length basis and at below market rates.", 'another similarity with government involvement is that there is reason to believe that connected lending is a more serious problem in emerging than in advanced economies.', 'the risks of connected lending encompass a lack of objectivity in credit assessment and undue concentration of credit risk.', 'core principle 10 explicitly addresses the problem of connected lending.', "this principle states that banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm's length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks.", 'moreover, core principle 9 calls for prudential limits to restrict bank exposures to single borrowers or groups of related borrowers.', 'if these principles are implemented on a global scale, they will raise a significant barrier against connected lending.', '12. i now turn to a fourth set of causes of banking problems, that can be labelled inadequate corporate governance.', 'this term refers to an absence of the right incentive structure for bank owners, managers, depositors and supervisors to show prudent behaviour.', 'perhaps the best way to throw light on these types of problems is by means of a well-known example, namely the downfall of the us savings and loans institutions.', 'in the early 1980s, the supervisory authorities in the us sought ways to enable savings and loans institutions, which were generally in bad shape, to continue in business.', 'the range of activities in which these institutions were permitted to engage was expanded, capital standards were relaxed and the level of deposit insurance was increased.', "as a consequence, many savings and loans institutions tried to grow out of their problems by investing in high-risk assets, such as property and so-called 'junk bonds'.", 'the point is that depositors were content to finance these risky investments, because of the generosity of the us deposit insurance at that time.', 'moreover, with low capital standards, equity holders or owners had little to lose.', 'finally, banking regulation in the us did not penalise bank managers for excessive risk-taking and allowed supervisors to delay corrective measures.', 'when the property market started to collapse in the mid-eighties, many savings and loans institutions became insolvent, which eventually resulted in a loss of at least $150 billion for the us taxpayers.', 'in order to prevent similar banking problems, bank regulation in advanced and emerging economies must incorporate the right incentives for all participants in the banking system.', '13. if you look at the core principles you will find various sorts of incentives in this field.', "firstly, principle 3 requires that the licensing process should consist of, among other things, an assessment of the bank's ownership structure as well as of its directors and senior management.", "the explanation of this principle makes clear that if the supervisory agency doubts the integrity and standing of a bank's owner or manager, it should have the authority to prevent a specific ownership structure or the appointment of a certain bank manager.", 'in this way, past imprudent behaviour of bank owners and managers is penalised by excluding them from responsible functions in the banking sector.', '14. secondly, core principle 6 prescribes that capital requirements for banks should be no less than those established in the so-called basle capital accord.', 'the basle accord sets minimum capital requirements of 8% of the risk-adjusted assets of banks.', 'bank capital essentially serves three functions; it is a base for further growth, it provides a cushion against exceptional losses and it promotes better governance.', 'the governance function relates to the fact that if shareholders have more money at stake, they have stronger incentives to ensure that banks are managed in a safe and sound manner.', 'regarding the loss-absorption function of capital, it must be stressed that the basle capital requirements are considered a minimum standard.', 'in emerging economies, higher minimum capital requirements seem appropriate, because banks there usually operate in a more volatile and therefore riskier environment.', 'i therefore welcome the initiatives of the supervisory authorities in argentina and colombia, who have already raised their minimum capital requirements to 11.5 and 9% respectively.', '15. as the example of the us thrift crisis showed, the design of deposit insurance deserves special attention.', 'the second appendix of the core principles contains a balanced view on this delicate issue, which can be summarised as follows: on the one hand, deposit insurance is desirable because it limits the effect that problems at one bank might have on other banks.', 'this obviously increases the stability of the financial system.', 'however, deposit insurance can also increase the risk of imprudent behaviour by banks, because depositors will be less inclined to withdraw funds even if the bank pursues high-risk strategies.', 'therefore, governments should incorporate mechanisms in the system of depositor protection that prevent excessive risk-taking by banks.', 'this can for example be achieved by a partial deposit insurance, so that depositors still have funds at risk.', 'another method is withholding deposit insurance from large, institutional investors.', 'the precise form of such a program should be tailored to the specific circumstances of each country.', '16. the last item on my list of crisis factors is a poor market infrastructure.', 'it is widely accepted that imperfect accounting systems, limited disclosure practices and inadequate legal frameworks can hinder effective banking supervision and market discipline.', 'again, these deficiencies are more pronounced in developing countries, but deserve continuous efforts for improvement in developed countries as well.', 'the first problem concerns the accuracy of accounting systems.', 'in many countries, the accounting standards for classifying bank loans as non-performing are not tight enough to prevent banks from making bad loans look good.', 'if non-performing loans are systematically understated and are not properly provided against, figures about profitability and bank capital become meaningless.', 'on the disclosure side, the ability to distinguish healthy from unhealthy banks is often hampered by the absence of financial statements on a consolidated basis.', 'differences in accounting standards across countries and the absence of serious penalties for publishing inaccurate information can also obstruct a meaningful assessment of banks.', 'finally, the legal system sometimes impedes prudent banking, for example when it hinders banks to seize collateral behind delinquent loans.', '17. core principle 21 relates to the information requirements of bank organisations, which is an important part of the market infrastructure.', 'this principle states that banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices.', 'this information should enable supervisors to obtain a true and fair view of the financial condition and profitability of banks.', 'banks should also publish financial statements that fairly reflect their condition on a regular basis.', 'the explanation of this principle prescribes that if a bank provides false or misleading information, supervisory action or criminal prosecution should be taken against the individuals involved and the institution.', '18. having elaborated on the contribution that the core principles can make towards alleviating the main causes of banking problems, i think it is now time for an overall assessment.', 'first of all, it would be an illusion to think that a global application of the core principles can by itself prevent financial crises occurring in the future.', 'as i already mentioned with regard to capital standards, the core principles contain minimum requirements.', 'individual countries, particularly those in emerging areas, should therefore consider to what extent they need to supplement the core principles with requirements addressing particular risks of their financial systems.', 'moreover, banking supervision is a dynamic function that needs to respond to changes in the marketplace.', 'therefore, the principles will need periodic, but not necessarily frequent, refinement and readjustment.', 'finally, the core principles provide guidelines for bank regulation.', 'i hope my description of the causes of financial crises has made clear that financial stability not only requires prudential behaviour by banks, but also macro-economic stability, a transparent government budget and an adequate legal framework.', 'in these areas, which all have to do with government policy, the world bank and the international monetary fund can make an important contribution to financial stability.', 'implementation 19. in the near future, the implementation of the core principles should be a top priority.', 'of course the main burden of this lies with the governments of the individual countries.', "i don't underestimate the wide-ranging legal, infrastructural and educational changes the implementation of the principles call for in a large number of countries.", 'every country should put in place an ambitious program with clear time-frames for the implementation.', 'it is obvious that the imf and the world bank should have a leading role with regard to monitoring the implementation of the core principles.', 'the main argument for this structure is that the international financial institutions already send missions to almost all countries in the world.', 'however, it is generally acknowledged that the basle committee possesses great expertise in bank regulation.', 'i therefore plead for a model in which the basle committee, the imf and the world bank each and together assist countries in realising financial stability in their respective fields of competence.', 'in this model, the imf and the world bank are primarily responsible for creating a sound environment for banking, which is highly dependent on viable government policies.', 'as part of the assessment of government policies, these institutions will of course also pay attention to the quality of bank supervision.', '20. the basle committee is primarily responsible for the amendment and interpretation of the principles and will review compliance with the principles at the international conference of banking supervisors in october 1998 and bi-annually thereafter.', 'the basle committee can furthermore make a major contribution towards the implementation of the principles by offering technical assistance and courses to supervisors in emerging countries.', 'in this respect, banking and traffic again look alike.', 'it is all a matter of knowing your responsibility; if you do not make a timely agreement about who drives home, you both end up drinking too much.']	Tom de Swaan	De Nederlandsche Bank	Executive Director	Netherlands
https://www.bis.org/review/r970905d.pdf	Mr. Brash discusses fluctuations and long-term trends in exchange rates and their effects on export commodities and comments on the Reserve Bank's Monetary Conditions Index (Central Bank Articles and Speeches, 22 Aug 97)	Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Counties Kiwifruit Growers Association in Pukekohe on 22/8/97.	1997-08-22 00:00:00	Mr. Brash discusses fluctuations and long-term trends in exchange rates and their effects on export commodities and comments on the Reserve Bank's Monetary Conditions Index Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Counties Kiwifruit Growers Association in Pukekohe on 22/8/97. Mr Chairman, I am delighted to be back in Pukekohe, though I must admit I'd rather be next door in my orchard instead of in here, explaining the impact of monetary policy on the fruit-growing industry! Two months ago, when you asked me to speak this afternoon, you asked me to focus on exchange rates. In particular, you suggested I speak about 'fluctuations and long term trends in exchange rates and their effects on export commodity pricing'. I am happy to do that, but I also want to make a few comments on the Reserve Bank's Monetary Conditions Index, both because it is relevant to the subject you have asked me to address and because the MCI has become the subject of a good deal of public discussion and debate over the last month or two. Indeed, some claim it is only the Reserve Bank's obsession with the MCI that has seen exchange rate and interest rates pushed around in a rather volatile manner over the last couple of months. The exchange rate First let me talk a little about the exchange rate. Here the concerns seem to be partly about fluctuations in the exchange rate and partly about the long-term trends, as your suggested subject for my speech indicates. I have to say that I do not have a great deal of sympathy for those who complain about the fluctuations in the exchange rate, and that for two quite different reasons. First, and most obviously, there is now a very well-developed market in forward foreign exchange contracts, so that it is readily possible for exporters to fix the exchange rate at which they sell their products long before they actually want to repatriate the proceeds to New Zealand. Exporters may, of course, choose not to use that market and instead gamble that they might get a more favourable exchange rate at some stage in the future. They should be free to make that choice. But it is important to recognise that they are deliberately taking on foreign exchange risk in the hope of getting something better in the future. They are not obliged to gamble in this way. This point is perhaps particularly relevant at the moment, when a number of farmers are lamenting the fact that, while the exchange rate is now much more attractive, that doesn't help farmers because few have stock to sell at the moment. But there is nothing at all stopping farmers who have no stock to sell, or meat companies on their behalf, from buying foreign exchange forward at the currently prevailing rates, and locking in current exchange rates. By doing that, they eliminate the risk that the exchange rate may rise before their stock is ready for sale, but of course they also pass up the additional benefit they might get if the exchange rate were to fall further. Secondly, although the New Zealand dollar has been subject to quite marked fluctuations over the last few months, by and large the New Zealand dollar is not a volatile currency by the standards of other floating rate currencies. Certainly measured on a tradeweighted basis, the New Zealand dollar has in recent years been less volatile on a week-to-week basis than, say, the Australian dollar, the US dollar, the pound sterling, or the Japanese yen. What about the longer-term trends? Since at least the beginning of the seventies, the trade-weighted measure of the New Zealand dollar has tended to move to reflect differences between inflation in New Zealand and inflation in our trading partners (graph 1). Graph 1: Relative Consumer Prices and Nominal TWI (1970 - June 1997 average equals 100) Index Index 160 160 Nominal TWI 140 140 Foreign/Domestic price level 120 120 100 100 80 80 60 60 40 40 70 72 74 76 78 80 82 84 86 88 90 92 94 96 In other words, when inflation was higher than in our trading partners, the New Zealand dollar had a tendency to depreciate. When inflation was lower than in our trading partners, the New Zealand dollar had a tendency to appreciate. Occasionally, the exchange rate Graph 2: Nominal and 'Real' Trade Weighted Exchange Rate (1970 - June 1997 average equals 100) Index Index 160 160 Nominal TWI 140 Foreign/Domestic price level 140 'Real' exchange rate 120 120 100 100 80 80 60 60 40 40 would depreciate a little faster than seemed warranted by a relatively poor inflation performance in New Zealand, and exporters enjoyed the experience. Occasionally, as in the period from early 1993 to early 1997, the exchange rate appreciated faster than seemed warranted by a relatively good inflation performance, and exporters found the experience anything but enjoyable (graph 2). If historical relationships hold, one would expect the New Zealand dollar to move broadly in line with inflation differentials over the longer term, and a few months ago this led a number of commentators to suggest that, at that time, the New Zealand dollar was clearly over-valued. Last December I also expressed the view that, at that time, the New Zealand dollar did indeed seem somewhat over-valued on that basis, though it should be noted that, to the extent that productivity growth is higher in New Zealand than in our trading partners, one would expect to see the exchange rate rise somewhat faster than inflation differentials alone would suggest. I have no difficulty at all in acknowledging the fact that the appreciation in the New Zealand dollar from its floor of around 53 (on a trade-weighted basis) in January 1993 to 69.3 in March 1997, an increase of some 30 percent over just four years, put significant pressure on a great many exporters. But four points need to be made in qualification. First, it is very likely that an exchange rate of 53 on a trade-weighted basis was as unsustainable as an exchange rate of 69.3. Neither represents an 'equilibrium' level of the exchange rate, so to measure exchange rate appreciation from that artificially low level risks creating quite a false impression. Secondly, while acknowledging the pressure which the rising exchange rate from 1993 to early 1997 placed on exporters, I am bound to express a degree of cynicism about the way in which some producer boards have described this impact. To hear some tell it, the impact of the rising exchange rate on the gross incomes of farmers and orchardists is the same as the impact of the exchange rate on their net incomes, and of course that it not correct. Granted, our land-based export industries are not heavy users of imports, but they do use diesel, they do use tractors, they do use fertilisers, and they are heavily affected by the costs of transport to and from the farm-gate. And from their net incomes they still spend money on petrol for the family car, they still buy clothes, they still buy other goods which are imported. The New Zealand dollar price of all these items would have been significantly higher over the last few years had it not been for the appreciation of the currency. Indeed, it is very likely that wage increases would also have been significantly higher if there had been no currency appreciation. So while the increase in the New Zealand dollar in recent years has undoubtedly had a severe impact on gross farm incomes, the impact on farmers' living standards was rather less severe. Thirdly, while the exchange rate appreciation has clearly made matters worse, the basic problem facing our land-based exporters is that the inflation-adjusted, or real, price of many of the items which they produce has been declining, and that for a long period. The New Zealand Meat and Wool Boards' Economic Service tells me that between 1948 (prior to the Korean War boom) and 1996, the inflation-adjusted price of lamb fell by 45 percent in the US market; the price of dairy products fell by 55 percent; the price of beef fell by 69 percent; and the price of wool fell by 79 percent. I don't know that anybody was noticing the price of kiwifruit in the US market in 1948, but I can still recall that in 1982, just 15 years ago, the orchard-gate price of New Zealand kiwifruit was $11 per tray. Nobody yet knows what we will realise in 1997, but if the orchard-gate price for this year's crop is, say, $4.30 per tray, that will be an inflation-adjusted fall in the orchard-gate price of some 85 percent in just 15 years - and that over a period during which the New Zealand dollar has fallen quite substantially against the currencies of virtually all our trading partners, and especially against the Japanese yen and the German mark, the two currencies of most direct relevance to kiwifruit exports. The basic reality is that the market price of kiwifruit has fallen substantially over that time. And in case New Zealand exporters feel hard done by by this reality, remember that very substantial falls in inflation-adjusted prices are common for most commodities, and indeed for a great many other goods and services as well. Productivity improves, and international competition often ensures that the benefit of that improvement is passed on to consumers, rather than retained by producers. Reflect on the huge fall in the real price of computers - a fall which dwarfs the falls suffered by New Zealand land-based exporters - or the price of television sets, or of motor vehicles, or of international air travel, or of long-distance telephone calls. Large price falls are by no means unique to the products which New Zealand exports. To remain viable, all producers must be constantly seeking new ways to improve productivity or add value, and if they do that successfully, they can maintain profitability despite a trend decline in prices. Finally, apart altogether from the tendency for the prices of many commodities to decline in the long term, commodity prices tend to be volatile and in recent years this volatility has tended to swamp the impact of exchange rate trends. The best illustration is the experience of beef farmers in the three years to the middle of 1996: of the fall in the farm-gate price of bull beef over that period, more than three-quarters was caused by a fall in overseas market prices, and less than one-quarter by the rise in the exchange rate. In other words, the fall in the market price of bull beef was substantially greater in its impact on farmers than the effect of the increase in the exchange rate. Our land-based exporters operate in inherently volatile markets, and would face major swings in prices even if, in some way, the New Zealand dollar could be held absolutely stable. This should influence what can sensibly be paid for farming and orcharding assets. So yes, monetary policy does have an impact on the exchange rate, but that in turn has much less impact on exporters' net incomes than on gross incomes, and has been of very much less significance to land-based exporters than the fluctuations in international commodity prices and the long-term decline in the real prices of many of the commodities which New Zealand exports. The Monetary Conditions Index But what of the Reserve Bank's Monetary Conditions Index? Is the MCI, as some have suggested, really to blame for much of the current economic slowdown, or at very least for the sharp increase in interest rates recently? Before answering those questions, it is worth recalling briefly that, once every three months, the Reserve Bank does a comprehensive projection of the New Zealand economy and of inflation for a period of two or three years. That projection takes into account all the information available to the Bank at that time - the official statistics covering GDP, prices, wages, employment, imports, exports, and all the rest; the data collected by the Bank itself on the money and credit aggregates, and the path of interest and exchange rates; the survey data covering business and consumer confidence; the views expressed to us, formally and informally, about individual businesses and the economy; and much more. At the end of that process, we reach a view on how firm monetary conditions need to be to keep inflation moving towards the middle part of the 0 to 3 percent inflation target we have agreed with Government. But of course neither we nor any other central bank can control the mix of monetary conditions. In other words, we can tighten monetary conditions, but we can not determine whether that tightening takes the form of an increase in interest rates with little or no increase in the exchange rate; or an increase in the exchange rate with little or no increase in interest rates; or an increase in the exchange rate with a decrease in interest rates; or an increase in interest rates and a fall in the exchange rate. The mix depends on the perceptions and reactions of a great many people, here and abroad, and indeed on what other central banks are doing or are expected to do. What to do? In a small open economy like New Zealand, it is impossible to ignore the fact that monetary policy affects inflation through both interest rates and the exchange rate, and for a number of years we have factored that into our policy setting. What the Monetary Conditions Index seeks to do is to give the public and financial markets a broad indication of how we see the relative impact of interest rates and the exchange rate on medium-term inflation with a 'rule of thumb' combining both. Nobody can be dogmatic about the precise nature of this relative impact - it clearly differs between economies depending on the importance of international trade, and almost certainly varies depending on the stage of the economic cycle. On the basis of research to date we believe it is reasonable to suggest that a 1 percent increase in 90 day interest rates has roughly the same effect on inflation, in the medium-term, as a 2 percent increase in the (trade-weighted) exchange rate. This ratio is particularly helpful in helping us to assess how the overall degree of monetary restraint is evolving when interest rates and the exchange rate are moving in opposite directions, as has often been the case over the last year. In June this year, we expressed this relationship in numerical form, called it the Monetary Conditions Index, and indicated that our projected inflation track was based on monetary conditions being at 825 on that Index through the September quarter. Has this increased openness been constructive or destructive? On balance, I have no doubt that it has been constructive. Financial markets now know explicitly what in the past they could only guess at, namely how we 'translated' movements in exchange rates into movements in interest rates in assessing their effect on inflation. In the last few months, we have experienced the sharpest decline in the New Zealand dollar since late 1991 without any kind of drama or crisis. Interest rates have adjusted upwards to offset the effect of that depreciation on the medium-term inflation rate, and that with only a couple of brief comments from the Reserve Bank. Of course, a sharp fall in the exchange rate is almost inevitably going to be associated with rising interest rates, since the fall is likely to prompt many investors to want to withdraw funds from New Zealand investments, and this inevitably leads to higher interest rates. But the fact that interest rates moved to keep the MCI broadly unchanged - certainly over the sharpest movements in the exchange rate - suggests that the system has worked well. For the record, I think the MCI is working at least as well as other approaches - better in some respects - and I am in no hurry to change it. Let me put this another way. I'm sure that if the Reserve Bank had not published an MCI actual monetary conditions would have evolved in a broadly similar way, but probably with more anguish. Without the early interest rate reaction, the exchange rate fall would have left monetary conditions very much looser than we wanted. We would then have had to move to recover the lost ground by tightening policy, probably requiring specific policy actions. In other words, the MCI is only an indicator. It isn't driving events in a substantive way, so people blaming the MCI are misdirecting their complaints. Give me stick, if you want, for misreading inflationary pressures out there, but 'don't shoot the messenger', for that's all the MCI is. What of criticism that the Bank has been operating the MCI mechanistically, or robotically, and thus causing excessive volatility in financial markets? Should the Bank have been more willing than it has been to allow actual monetary conditions to diverge from its announced 'desired' conditions of 825, or, alternatively, should we have adjusted policy instruments to ensure that actual conditions kept within the plus or minus 50 points of 825 announced as 'desired' on 27 June? It is perhaps worth recalling what I said on 27 June, in releasing our latest Monetary Policy Statement: 'It is clear that deviations from desired monetary conditions can be very large indeed without threatening either edge of our inflation target if those deviations are of relatively short duration. This suggests that the Bank should be relatively tolerant of quite large deviations from desired. On the other hand, large deviations, even for relatively short periods, may raise doubts - either about the Bank's determination to achieve the inflation goals we have been set or about the possibility that the Bank, in accepting those large deviations, may have changed its view of desired conditions. These doubts can create uncertainty, and that uncertainty has real costs, both short-term and long-term. We already allow monetary conditions to move within a range, without reaction from the Bank, which is at least as wide as that allowed in other developed countries. I am reluctant to be too precise about how much deviation we are willing to accept and for how long. Much will depend on the circumstances in which the deviation occurs. We may, for example, be more tolerant of deviations which appear to arise out of sharp movements in overseas exchange rates, where local interest rates or exchange rates may take a brief period to adjust. We may be more tolerant of deviations during the weeks immediately preceding our next quarterly inflation projection, since it is at that time when our last comprehensive review of desired conditions is, by definition, getting most dated. We are likely to be less tolerant if monetary conditions change very rapidly, and appear to be building some momentum, without any obvious explanation in terms of overseas exchange rates or changed prospects for inflation. As a very approximate guideline, we would expect actual monetary conditions to be within a range of plus or minus 50 MCI points from desired in the weeks immediately following a comprehensive inflation projection. As more data comes to hand over the ensuing three months, and as our last comprehensive inflation projection recedes into history, we may be rather more tolerant. But this is not, repeat not, a binding rule which the market can expect us to follow under all circumstances, and those expecting us to do so are likely to be disappointed.' That is what I said on 27 June, and looking back with the wisdom of hindsight I think the comments have stood the test of time rather well. Did we signal a tight band of plus or minus 50 points around 'desired'? Hardly. On the contrary, we made it clear that we would judge monetary conditions in the light of emerging data, and the factors we believed were driving conditions. Should we therefore leap to change the target for settlement cash as soon as conditions stray by more than 50 points from the designated level? Absolutely not, and nobody should expect us to do so. My only regret is that I did not mention, as one reason for being tolerant of deviation of actual monetary conditions from desired monetary conditions, the complication created by a sharp change in the mix of conditions. Clearly, the Index is based on the assumption that a 1 percent movement in interest rates is equivalent, in medium-term effect, to a 2 percent change in the exchange rate, and that is our best estimate at this stage. But it is only an estimate, and we recognise that the relationship may well change over time and in response to very sharp movements in either interest or exchange rates. In the jargon, the relationship may not be linear. It is partly for this reason that we have been willing to accept quite a marked divergence between actual and desired conditions in recent weeks. It is important also to recall that, as indicated a moment ago, we can not control the mix of monetary conditions. This was very clearly indicated between September 1996 and March 1997. Over that period, 90 day interest rates fell from around 10 percent to around 7.5 percent, while the exchange rate rose from around 66 on the Trade-Weighted Index to over 69. On the face of it, this period of rising exchange rate and falling interest rates was the very reverse of what might have been desirable - given that there was already little or no inflation in the export and import-competing sectors of the economy, and plenty of inflation in the domestic sectors - and I expressed my unhappiness about this mix on several occasions, all to no avail. For a whole host of reasons - perceptions of the likely trend of monetary policy in New Zealand and overseas, perhaps concerns about the balance of payments deficit, perhaps general concern about currencies in this part of the world - the mix has changed quite sharply in the last few months, with an increase in interest rates, which has taken them about half way back to where they were last September, and a sharp fall in the exchange rate. Overall, conditions have eased considerably, and I am sure that there won't be an exporter in the country who is not a good deal happier with the present mix than with the one we had three or four months ago. But aren't monetary conditions still too tight, given the low level of business and consumer confidence, the general flatness of the economy, and the fact that, on the Reserve Bank's own figures, we will have inflation at or slightly below 1 percent by the end of this year and into 1998? In less than a month, the Bank will be publishing its next comprehensive inflation projection, so I don't want to give a substantive answer to that at this stage. But let me just remind you of a couple of relevant points. It is hardly surprising, or a matter for regret, that our June Monetary Policy Statement projected that inflation would fall to 1 percent by the end of this year: through all of last year, until 10 December, we were targeting inflation at between 0 and 2 percent, with a mid-point of 1 percent, because that's what our Policy Targets Agreement with the Government required at that time. We were battling to reduce inflation, which had been somewhat above the top of that range throughout 1996. Given that it takes a minimum of 12 months for monetary policy to have its impact on inflation, it would be surprising if inflation were not projected to be moving towards 1 percent at the end of this year. The inflation projection which the Bank published at the end of June was not only based on monetary conditions being around 825 on the MCI during the September 1997 quarter, it was also based on a particular combination of interest rates and exchange rate. We assumed that, during the September quarter, the trade-weighted exchange rate would average around 67.3, and 90 day interest rates would average around 7 percent. We also explicitly recognised that if the mix of conditions changed, the short-term track of inflation could be different. With the exchange rate in fact significantly lower than assumed in the June Monetary Policy Statement, and interest rates significantly higher than assumed, it is possible that the immediate inflation track may be a little higher than projected in June because of the impact which the lower New Zealand dollar may have on the prices of goods like television sets, cars, and other imports. In other words, a lower dollar may increase inflation more quickly than higher interest rates will reduce it. Although there are many people who feel that monetary conditions are inappropriately tight, and some who just feel that the combined wisdom of financial markets is more likely to be right than is the Reserve Bank, it is worth recalling that for the first four months of 1997, until the very end of April, financial markets kept monetary conditions appreciably tighter than the Bank had indicated was necessary or appropriate, despite our saying that we would be happier if conditions were somewhat easier. In other words, financial markets are not infallible. It is interesting that in the latest Consensus survey of New Zealand forecasters, representing views in mid-July 1997, 39 percent felt that conditions were unduly firm, but 54 percent felt that they were about right - and conditions have eased somewhat since that survey was conducted. Monetary conditions have eased substantially over the last six or eight months from an average of 1000 on the MCI in the December 1996 quarter to an average during the first half of August of 730. Put in more familiar terms, conditions have eased by the equivalent of a 2.7 percent fall in interest rates with unchanged exchange rate; or by the equivalent of a 5.4 percent fall in the exchange rate, with unchanged interest rates. This is a considerable easing in monetary conditions, which will not have its main effect on activity and inflation until well into 1998 - at about the time the economy is also experiencing a strong stimulus from reduced tax rates and increased government expenditure. In other words, the suggestion that the Reserve Bank has been braking the economy in recent months is factually wrong. In fact, over recent months the opposite is true. We will, of course, be weighing all these factors and more in reaching our judgement for the appropriate level of monetary conditions in the December quarter. We will publish our considered judgement on 18 September. Unfortunately, given the long lags between actions taken by the Reserve Bank today and the impact of those actions on inflation, nobody will know until at least the second half of next year whether we should have eased rather more in June 1997, or indeed whether we should have kept things a little firmer. Of one thing you can be certain. We will do everything in our power to keep inflation within the target which has been agreed with the Government. That will not guarantee you a profit in fruit-growing, or in exporting more generally. It will, however, be the best contribution which the Reserve Bank can make to the creation of an environment where you and others can make rational investment decisions, to the ultimate benefit of all New Zealanders.	["mr. brash discusses fluctuations and long-term trends in exchange rates and their effects on export commodities and comments on the reserve bank's monetary conditions index address by the governor of the reserve bank of new zealand, dr. donald brash, to the counties kiwifruit growers association in pukekohe on 22/8/97.", "mr chairman, i am delighted to be back in pukekohe, though i must admit i'd rather be next door in my orchard instead of in here, explaining the impact of monetary policy on the fruit-growing industry!", 'two months ago, when you asked me to speak this afternoon, you asked me to focus on exchange rates.', "in particular, you suggested i speak about 'fluctuations and long term trends in exchange rates and their effects on export commodity pricing'.", "i am happy to do that, but i also want to make a few comments on the reserve bank's monetary conditions index, both because it is relevant to the subject you have asked me to address and because the mci has become the subject of a good deal of public discussion and debate over the last month or two.", "indeed, some claim it is only the reserve bank's obsession with the mci that has seen exchange rate and interest rates pushed around in a rather volatile manner over the last couple of months.", 'the exchange rate first let me talk a little about the exchange rate.', 'here the concerns seem to be partly about fluctuations in the exchange rate and partly about the long-term trends, as your suggested subject for my speech indicates.', 'i have to say that i do not have a great deal of sympathy for those who complain about the fluctuations in the exchange rate, and that for two quite different reasons.', 'first, and most obviously, there is now a very well-developed market in forward foreign exchange contracts, so that it is readily possible for exporters to fix the exchange rate at which they sell their products long before they actually want to repatriate the proceeds to new zealand.', 'exporters may, of course, choose not to use that market and instead gamble that they might get a more favourable exchange rate at some stage in the future.', 'they should be free to make that choice.', 'but it is important to recognise that they are deliberately taking on foreign exchange risk in the hope of getting something better in the future.', 'they are not obliged to gamble in this way.', "this point is perhaps particularly relevant at the moment, when a number of farmers are lamenting the fact that, while the exchange rate is now much more attractive, that doesn't help farmers because few have stock to sell at the moment.", 'but there is nothing at all stopping farmers who have no stock to sell, or meat companies on their behalf, from buying foreign exchange forward at the currently prevailing rates, and locking in current exchange rates.', 'by doing that, they eliminate the risk that the exchange rate may rise before their stock is ready for sale, but of course they also pass up the additional benefit they might get if the exchange rate were to fall further.', 'secondly, although the new zealand dollar has been subject to quite marked fluctuations over the last few months, by and large the new zealand dollar is not a volatile currency by the standards of other floating rate currencies.', 'certainly measured on a tradeweighted basis, the new zealand dollar has in recent years been less volatile on a week-to-week basis than, say, the australian dollar, the us dollar, the pound sterling, or the japanese yen.', 'what about the longer-term trends?', 'since at least the beginning of the seventies, the trade-weighted measure of the new zealand dollar has tended to move to reflect differences between inflation in new zealand and inflation in our trading partners (graph 1).', 'graph 1: relative consumer prices and nominal twi (1970 - june 1997 average equals 100) index index 160 160 nominal twi 140 140 foreign/domestic price level 120 120 100 100 80 80 60 60 40 40 70 72 74 76 78 80 82 84 86 88 90 92 94 96 in other words, when inflation was higher than in our trading partners, the new zealand dollar had a tendency to depreciate.', 'when inflation was lower than in our trading partners, the new zealand dollar had a tendency to appreciate.', "occasionally, the exchange rate graph 2: nominal and 'real' trade weighted exchange rate (1970 - june 1997 average equals 100) index index 160 160 nominal twi 140 foreign/domestic price level 140 'real' exchange rate 120 120 100 100 80 80 60 60 40 40 would depreciate a little faster than seemed warranted by a relatively poor inflation performance in new zealand, and exporters enjoyed the experience.", 'occasionally, as in the period from early 1993 to early 1997, the exchange rate appreciated faster than seemed warranted by a relatively good inflation performance, and exporters found the experience anything but enjoyable (graph 2).', 'if historical relationships hold, one would expect the new zealand dollar to move broadly in line with inflation differentials over the longer term, and a few months ago this led a number of commentators to suggest that, at that time, the new zealand dollar was clearly over-valued.', 'last december i also expressed the view that, at that time, the new zealand dollar did indeed seem somewhat over-valued on that basis, though it should be noted that, to the extent that productivity growth is higher in new zealand than in our trading partners, one would expect to see the exchange rate rise somewhat faster than inflation differentials alone would suggest.', 'i have no difficulty at all in acknowledging the fact that the appreciation in the new zealand dollar from its floor of around 53 (on a trade-weighted basis) in january 1993 to 69.3 in march 1997, an increase of some 30 percent over just four years, put significant pressure on a great many exporters.', 'but four points need to be made in qualification.', "first, it is very likely that an exchange rate of 53 on a trade-weighted basis was as unsustainable as an exchange rate of 69.3. neither represents an 'equilibrium' level of the exchange rate, so to measure exchange rate appreciation from that artificially low level risks creating quite a false impression.", 'secondly, while acknowledging the pressure which the rising exchange rate from 1993 to early 1997 placed on exporters, i am bound to express a degree of cynicism about the way in which some producer boards have described this impact.', 'to hear some tell it, the impact of the rising exchange rate on the gross incomes of farmers and orchardists is the same as the impact of the exchange rate on their net incomes, and of course that it not correct.', 'granted, our land-based export industries are not heavy users of imports, but they do use diesel, they do use tractors, they do use fertilisers, and they are heavily affected by the costs of transport to and from the farm-gate.', 'and from their net incomes they still spend money on petrol for the family car, they still buy clothes, they still buy other goods which are imported.', 'the new zealand dollar price of all these items would have been significantly higher over the last few years had it not been for the appreciation of the currency.', 'indeed, it is very likely that wage increases would also have been significantly higher if there had been no currency appreciation.', "so while the increase in the new zealand dollar in recent years has undoubtedly had a severe impact on gross farm incomes, the impact on farmers' living standards was rather less severe.", 'thirdly, while the exchange rate appreciation has clearly made matters worse, the basic problem facing our land-based exporters is that the inflation-adjusted, or real, price of many of the items which they produce has been declining, and that for a long period.', "the new zealand meat and wool boards' economic service tells me that between 1948 (prior to the korean war boom) and 1996, the inflation-adjusted price of lamb fell by 45 percent in the us market; the price of dairy products fell by 55 percent; the price of beef fell by 69 percent; and the price of wool fell by 79 percent.", "i don't know that anybody was noticing the price of kiwifruit in the us market in 1948, but i can still recall that in 1982, just 15 years ago, the orchard-gate price of new zealand kiwifruit was $11 per tray.", "nobody yet knows what we will realise in 1997, but if the orchard-gate price for this year's crop is, say, $4.30 per tray, that will be an inflation-adjusted fall in the orchard-gate price of some 85 percent in just 15 years - and that over a period during which the new zealand dollar has fallen quite substantially against the currencies of virtually all our trading partners, and especially against the japanese yen and the german mark, the two currencies of most direct relevance to kiwifruit exports.", 'the basic reality is that the market price of kiwifruit has fallen substantially over that time.', 'and in case new zealand exporters feel hard done by by this reality, remember that very substantial falls in inflation-adjusted prices are common for most commodities, and indeed for a great many other goods and services as well.', 'productivity improves, and international competition often ensures that the benefit of that improvement is passed on to consumers, rather than retained by producers.', 'reflect on the huge fall in the real price of computers - a fall which dwarfs the falls suffered by new zealand land-based exporters - or the price of television sets, or of motor vehicles, or of international air travel, or of long-distance telephone calls.', 'large price falls are by no means unique to the products which new zealand exports.', 'to remain viable, all producers must be constantly seeking new ways to improve productivity or add value, and if they do that successfully, they can maintain profitability despite a trend decline in prices.', 'finally, apart altogether from the tendency for the prices of many commodities to decline in the long term, commodity prices tend to be volatile and in recent years this volatility has tended to swamp the impact of exchange rate trends.', 'the best illustration is the experience of beef farmers in the three years to the middle of 1996: of the fall in the farm-gate price of bull beef over that period, more than three-quarters was caused by a fall in overseas market prices, and less than one-quarter by the rise in the exchange rate.', 'in other words, the fall in the market price of bull beef was substantially greater in its impact on farmers than the effect of the increase in the exchange rate.', 'our land-based exporters operate in inherently volatile markets, and would face major swings in prices even if, in some way, the new zealand dollar could be held absolutely stable.', 'this should influence what can sensibly be paid for farming and orcharding assets.', "so yes, monetary policy does have an impact on the exchange rate, but that in turn has much less impact on exporters' net incomes than on gross incomes, and has been of very much less significance to land-based exporters than the fluctuations in international commodity prices and the long-term decline in the real prices of many of the commodities which new zealand exports.", "the monetary conditions index but what of the reserve bank's monetary conditions index?", 'is the mci, as some have suggested, really to blame for much of the current economic slowdown, or at very least for the sharp increase in interest rates recently?', 'before answering those questions, it is worth recalling briefly that, once every three months, the reserve bank does a comprehensive projection of the new zealand economy and of inflation for a period of two or three years.', 'that projection takes into account all the information available to the bank at that time - the official statistics covering gdp, prices, wages, employment, imports, exports, and all the rest; the data collected by the bank itself on the money and credit aggregates, and the path of interest and exchange rates; the survey data covering business and consumer confidence; the views expressed to us, formally and informally, about individual businesses and the economy; and much more.', 'at the end of that process, we reach a view on how firm monetary conditions need to be to keep inflation moving towards the middle part of the 0 to 3 percent inflation target we have agreed with government.', 'but of course neither we nor any other central bank can control the mix of monetary conditions.', 'in other words, we can tighten monetary conditions, but we can not determine whether that tightening takes the form of an increase in interest rates with little or no increase in the exchange rate; or an increase in the exchange rate with little or no increase in interest rates; or an increase in the exchange rate with a decrease in interest rates; or an increase in interest rates and a fall in the exchange rate.', 'the mix depends on the perceptions and reactions of a great many people, here and abroad, and indeed on what other central banks are doing or are expected to do.', 'in a small open economy like new zealand, it is impossible to ignore the fact that monetary policy affects inflation through both interest rates and the exchange rate, and for a number of years we have factored that into our policy setting.', "what the monetary conditions index seeks to do is to give the public and financial markets a broad indication of how we see the relative impact of interest rates and the exchange rate on medium-term inflation with a 'rule of thumb' combining both.", 'nobody can be dogmatic about the precise nature of this relative impact - it clearly differs between economies depending on the importance of international trade, and almost certainly varies depending on the stage of the economic cycle.', 'on the basis of research to date we believe it is reasonable to suggest that a 1 percent increase in 90 day interest rates has roughly the same effect on inflation, in the medium-term, as a 2 percent increase in the (trade-weighted) exchange rate.', 'this ratio is particularly helpful in helping us to assess how the overall degree of monetary restraint is evolving when interest rates and the exchange rate are moving in opposite directions, as has often been the case over the last year.', 'in june this year, we expressed this relationship in numerical form, called it the monetary conditions index, and indicated that our projected inflation track was based on monetary conditions being at 825 on that index through the september quarter.', 'has this increased openness been constructive or destructive?', 'on balance, i have no doubt that it has been constructive.', "financial markets now know explicitly what in the past they could only guess at, namely how we 'translated' movements in exchange rates into movements in interest rates in assessing their effect on inflation.", 'in the last few months, we have experienced the sharpest decline in the new zealand dollar since late 1991 without any kind of drama or crisis.', 'interest rates have adjusted upwards to offset the effect of that depreciation on the medium-term inflation rate, and that with only a couple of brief comments from the reserve bank.', 'of course, a sharp fall in the exchange rate is almost inevitably going to be associated with rising interest rates, since the fall is likely to prompt many investors to want to withdraw funds from new zealand investments, and this inevitably leads to higher interest rates.', 'but the fact that interest rates moved to keep the mci broadly unchanged - certainly over the sharpest movements in the exchange rate - suggests that the system has worked well.', 'for the record, i think the mci is working at least as well as other approaches - better in some respects - and i am in no hurry to change it.', 'let me put this another way.', "i'm sure that if the reserve bank had not published an mci actual monetary conditions would have evolved in a broadly similar way, but probably with more anguish.", 'without the early interest rate reaction, the exchange rate fall would have left monetary conditions very much looser than we wanted.', 'we would then have had to move to recover the lost ground by tightening policy, probably requiring specific policy actions.', 'in other words, the mci is only an indicator.', "it isn't driving events in a substantive way, so people blaming the mci are misdirecting their complaints.", "give me stick, if you want, for misreading inflationary pressures out there, but 'don't shoot the messenger', for that's all the mci is.", 'what of criticism that the bank has been operating the mci mechanistically, or robotically, and thus causing excessive volatility in financial markets?', "should the bank have been more willing than it has been to allow actual monetary conditions to diverge from its announced 'desired' conditions of 825, or, alternatively, should we have adjusted policy instruments to ensure that actual conditions kept within the plus or minus 50 points of 825 announced as 'desired' on 27 june?", "it is perhaps worth recalling what i said on 27 june, in releasing our latest monetary policy statement: 'it is clear that deviations from desired monetary conditions can be very large indeed without threatening either edge of our inflation target if those deviations are of relatively short duration.", 'this suggests that the bank should be relatively tolerant of quite large deviations from desired.', "on the other hand, large deviations, even for relatively short periods, may raise doubts - either about the bank's determination to achieve the inflation goals we have been set or about the possibility that the bank, in accepting those large deviations, may have changed its view of desired conditions.", 'these doubts can create uncertainty, and that uncertainty has real costs, both short-term and long-term.', 'we already allow monetary conditions to move within a range, without reaction from the bank, which is at least as wide as that allowed in other developed countries.', 'i am reluctant to be too precise about how much deviation we are willing to accept and for how long.', 'much will depend on the circumstances in which the deviation occurs.', 'we may, for example, be more tolerant of deviations which appear to arise out of sharp movements in overseas exchange rates, where local interest rates or exchange rates may take a brief period to adjust.', 'we may be more tolerant of deviations during the weeks immediately preceding our next quarterly inflation projection, since it is at that time when our last comprehensive review of desired conditions is, by definition, getting most dated.', 'we are likely to be less tolerant if monetary conditions change very rapidly, and appear to be building some momentum, without any obvious explanation in terms of overseas exchange rates or changed prospects for inflation.', 'as a very approximate guideline, we would expect actual monetary conditions to be within a range of plus or minus 50 mci points from desired in the weeks immediately following a comprehensive inflation projection.', 'as more data comes to hand over the ensuing three months, and as our last comprehensive inflation projection recedes into history, we may be rather more tolerant.', "but this is not, repeat not, a binding rule which the market can expect us to follow under all circumstances, and those expecting us to do so are likely to be disappointed.'", 'that is what i said on 27 june, and looking back with the wisdom of hindsight i think the comments have stood the test of time rather well.', "did we signal a tight band of plus or minus 50 points around 'desired'?", 'on the contrary, we made it clear that we would judge monetary conditions in the light of emerging data, and the factors we believed were driving conditions.', 'should we therefore leap to change the target for settlement cash as soon as conditions stray by more than 50 points from the designated level?', 'absolutely not, and nobody should expect us to do so.', 'my only regret is that i did not mention, as one reason for being tolerant of deviation of actual monetary conditions from desired monetary conditions, the complication created by a sharp change in the mix of conditions.', 'clearly, the index is based on the assumption that a 1 percent movement in interest rates is equivalent, in medium-term effect, to a 2 percent change in the exchange rate, and that is our best estimate at this stage.', 'but it is only an estimate, and we recognise that the relationship may well change over time and in response to very sharp movements in either interest or exchange rates.', 'in the jargon, the relationship may not be linear.', 'it is partly for this reason that we have been willing to accept quite a marked divergence between actual and desired conditions in recent weeks.', 'it is important also to recall that, as indicated a moment ago, we can not control the mix of monetary conditions.', 'this was very clearly indicated between september 1996 and march 1997. over that period, 90 day interest rates fell from around 10 percent to around 7.5 percent, while the exchange rate rose from around 66 on the trade-weighted index to over 69. on the face of it, this period of rising exchange rate and falling interest rates was the very reverse of what might have been desirable - given that there was already little or no inflation in the export and import-competing sectors of the economy, and plenty of inflation in the domestic sectors - and i expressed my unhappiness about this mix on several occasions, all to no avail.', 'for a whole host of reasons - perceptions of the likely trend of monetary policy in new zealand and overseas, perhaps concerns about the balance of payments deficit, perhaps general concern about currencies in this part of the world - the mix has changed quite sharply in the last few months, with an increase in interest rates, which has taken them about half way back to where they were last september, and a sharp fall in the exchange rate.', "overall, conditions have eased considerably, and i am sure that there won't be an exporter in the country who is not a good deal happier with the present mix than with the one we had three or four months ago.", "but aren't monetary conditions still too tight, given the low level of business and consumer confidence, the general flatness of the economy, and the fact that, on the reserve bank's own figures, we will have inflation at or slightly below 1 percent by the end of this year and into 1998?", "in less than a month, the bank will be publishing its next comprehensive inflation projection, so i don't want to give a substantive answer to that at this stage.", 'but let me just remind you of a couple of relevant points.', "it is hardly surprising, or a matter for regret, that our june monetary policy statement projected that inflation would fall to 1 percent by the end of this year: through all of last year, until 10 december, we were targeting inflation at between 0 and 2 percent, with a mid-point of 1 percent, because that's what our policy targets agreement with the government required at that time.", 'we were battling to reduce inflation, which had been somewhat above the top of that range throughout 1996. given that it takes a minimum of 12 months for monetary policy to have its impact on inflation, it would be surprising if inflation were not projected to be moving towards 1 percent at the end of this year.', 'the inflation projection which the bank published at the end of june was not only based on monetary conditions being around 825 on the mci during the september 1997 quarter, it was also based on a particular combination of interest rates and exchange rate.', 'we assumed that, during the september quarter, the trade-weighted exchange rate would average around 67.3, and 90 day interest rates would average around 7 percent.', 'we also explicitly recognised that if the mix of conditions changed, the short-term track of inflation could be different.', 'with the exchange rate in fact significantly lower than assumed in the june monetary policy statement, and interest rates significantly higher than assumed, it is possible that the immediate inflation track may be a little higher than projected in june because of the impact which the lower new zealand dollar may have on the prices of goods like television sets, cars, and other imports.', 'in other words, a lower dollar may increase inflation more quickly than higher interest rates will reduce it.', 'although there are many people who feel that monetary conditions are inappropriately tight, and some who just feel that the combined wisdom of financial markets is more likely to be right than is the reserve bank, it is worth recalling that for the first four months of 1997, until the very end of april, financial markets kept monetary conditions appreciably tighter than the bank had indicated was necessary or appropriate, despite our saying that we would be happier if conditions were somewhat easier.', 'in other words, financial markets are not infallible.', 'it is interesting that in the latest consensus survey of new zealand forecasters, representing views in mid-july 1997, 39 percent felt that conditions were unduly firm, but 54 percent felt that they were about right - and conditions have eased somewhat since that survey was conducted.', 'monetary conditions have eased substantially over the last six or eight months from an average of 1000 on the mci in the december 1996 quarter to an average during the first half of august of 730. put in more familiar terms, conditions have eased by the equivalent of a 2.7 percent fall in interest rates with unchanged exchange rate; or by the equivalent of a 5.4 percent fall in the exchange rate, with unchanged interest rates.', 'this is a considerable easing in monetary conditions, which will not have its main effect on activity and inflation until well into 1998 - at about the time the economy is also experiencing a strong stimulus from reduced tax rates and increased government expenditure.', 'in other words, the suggestion that the reserve bank has been braking the economy in recent months is factually wrong.', 'in fact, over recent months the opposite is true.', 'we will, of course, be weighing all these factors and more in reaching our judgement for the appropriate level of monetary conditions in the december quarter.', 'we will publish our considered judgement on 18 september.', 'unfortunately, given the long lags between actions taken by the reserve bank today and the impact of those actions on inflation, nobody will know until at least the second half of next year whether we should have eased rather more in june 1997, or indeed whether we should have kept things a little firmer.', 'of one thing you can be certain.', 'we will do everything in our power to keep inflation within the target which has been agreed with the government.', 'that will not guarantee you a profit in fruit-growing, or in exporting more generally.', 'it will, however, be the best contribution which the reserve bank can make to the creation of an environment where you and others can make rational investment decisions, to the ultimate benefit of all new zealanders.']	Donald T Brash	Reserve Bank of New Zealand	Governor	New Zealand
https://www.bis.org/review/r970905c.pdf	Bank of Japan presents summaries of articles published in the August edition of its Quarterly Bulletin (Central Bank Articles and Speeches, 29 Aug 97)	BANK OF JAPAN, COMMUNICATION, 29/8/97.	1997-08-29 00:00:00	Bank of Japan presents summaries of articles published in the August edition of its Quarterly Bulletin BANK OF JAPAN, COMMUNICATION, 29/8/97. Revision of Japan's Flow of Funds Accounts Introduction Bank of Japan compiled the first flow of funds accounts in 1958, covering data for the years from 1954 to 1957. Since then, the flow of funds accounts have been used extensively, for example, as a source for producing the capital finance account of the national accounts, and as the only statistical material that provides an overall picture of Japan's financial structure. However, the present flow of funds accounts require improvement in many respects. For example, although the framework of the flow of funds accounts basically conforms to that of the System of National Accounts established in 1968 by the United Nations (hereafter, 1968 SNA), various inconsistencies remain between the two due to inadequate availability of data. This results in various limitations when one tries to obtain a combined picture of real economic activity and financial activity using the flow of funds accounts and the national accounts. It should also be noted that the 1968 SNA itself does not fully reflect the changes in economic and financial structures that have occurred in the years since it was established. In 1993, therefore, the Statistical Commission under the Economic and Social Council of the United Nations (hereafter, ECOSOC Statistical Commission) adopted a draft amendment to the SNA (1993 SNA) with a view to creating a framework that better reflects the recent economic and financial environment. Further, in response to increasing demand for internationally standardized financial statistics, the International Monetary Fund (IMF), at the behest of the ECOSOC Statistical Commission, is preparing a Manual on Monetary and Financial Statistics (hereafter, the IMF Manual) to supplement the 1993 SNA. A number of countries have initiated reviews of their flow of funds accounts in accordance with these developments. Statistics that provide a highly reliable overview of financial activities are indispensable for tracing changes in the financial structure, for examining the roles of each economic sector, and for considering the implications of these factors for the real economy. Such statistics are also useful in considering various issues concerning financial systems. If these statistics are compiled in accordance with international standards, international comparability of these statistics will be improved. It is for these reasons that the Bank is revising Japan's flow of funds accounts. In doing so, the Bank has decided to make public its basic thinking underlying the revision, together with the outline of the revision, to thereby seek the users' opinions, which the Bank believes is invaluable for the improvement of the statistics. This paper describes the revision in some detail, including changes in sectoral classification and expansion of transaction categories, and explains the new types of information obtainable from the revised flow of funds accounts. Improvement of statistics often involves a trade-off between users' convenience and reporting burden. Improvement of the flow of funds accounts is no exception. Although the intention is to make full use of existing statistics in producing the accounts, the reporting burden may be increased in some areas. This paper will also be useful in evaluating the costs and benefits involved in the revision of the flow of funds accounts. The Framework for Restructuring the BOJ-NET Funds Transfer System Introduction In December 1996, the Bank of Japan published a consultation paper that outlined its plans to restructure the funds transfer system of the Bank of Japan Financial Network System (BOJ-NET). The Bank plans to abolish designated-time settlement and make real-time gross settlement (RTGS) the only settlement mode by the end of the year 2000. The paper also drafted the main features of RTGS after the restructuring, and the Bank requested comments and suggestions from current account holders with the Bank of Japan (BOJ account holders), the operators of private clearing systems, and other interested parties. Overall, the Bank's proposal was strongly supported, and the Bank received a number of constructive comments and suggestions on its proposal. On the basis of its December proposal and the comments and suggestions received, the Bank released on April 1, 1997 a framework for abolishing designated-time settlement and making RTGS the only settlement mode in the BOJ-NET funds transfer system.	['bank of japan presents summaries of articles published in the august edition of its quarterly bulletin bank of japan, communication, 29/8/97.', "revision of japan's flow of funds accounts introduction bank of japan compiled the first flow of funds accounts in 1958, covering data for the years from 1954 to 1957. since then, the flow of funds accounts have been used extensively, for example, as a source for producing the capital finance account of the national accounts, and as the only statistical material that provides an overall picture of japan's financial structure.", 'however, the present flow of funds accounts require improvement in many respects.', 'for example, although the framework of the flow of funds accounts basically conforms to that of the system of national accounts established in 1968 by the united nations (hereafter, 1968 sna), various inconsistencies remain between the two due to inadequate availability of data.', 'this results in various limitations when one tries to obtain a combined picture of real economic activity and financial activity using the flow of funds accounts and the national accounts.', 'it should also be noted that the 1968 sna itself does not fully reflect the changes in economic and financial structures that have occurred in the years since it was established.', 'in 1993, therefore, the statistical commission under the economic and social council of the united nations (hereafter, ecosoc statistical commission) adopted a draft amendment to the sna (1993 sna) with a view to creating a framework that better reflects the recent economic and financial environment.', 'further, in response to increasing demand for internationally standardized financial statistics, the international monetary fund (imf), at the behest of the ecosoc statistical commission, is preparing a manual on monetary and financial statistics (hereafter, the imf manual) to supplement the 1993 sna.', 'a number of countries have initiated reviews of their flow of funds accounts in accordance with these developments.', 'statistics that provide a highly reliable overview of financial activities are indispensable for tracing changes in the financial structure, for examining the roles of each economic sector, and for considering the implications of these factors for the real economy.', 'such statistics are also useful in considering various issues concerning financial systems.', 'if these statistics are compiled in accordance with international standards, international comparability of these statistics will be improved.', "it is for these reasons that the bank is revising japan's flow of funds accounts.", "in doing so, the bank has decided to make public its basic thinking underlying the revision, together with the outline of the revision, to thereby seek the users' opinions, which the bank believes is invaluable for the improvement of the statistics.", 'this paper describes the revision in some detail, including changes in sectoral classification and expansion of transaction categories, and explains the new types of information obtainable from the revised flow of funds accounts.', "improvement of statistics often involves a trade-off between users' convenience and reporting burden.", 'improvement of the flow of funds accounts is no exception.', 'although the intention is to make full use of existing statistics in producing the accounts, the reporting burden may be increased in some areas.', 'this paper will also be useful in evaluating the costs and benefits involved in the revision of the flow of funds accounts.', 'the framework for restructuring the boj-net funds transfer system introduction in december 1996, the bank of japan published a consultation paper that outlined its plans to restructure the funds transfer system of the bank of japan financial network system (boj-net).', 'the bank plans to abolish designated-time settlement and make real-time gross settlement (rtgs) the only settlement mode by the end of the year 2000. the paper also drafted the main features of rtgs after the restructuring, and the bank requested comments and suggestions from current account holders with the bank of japan (boj account holders), the operators of private clearing systems, and other interested parties.', "overall, the bank's proposal was strongly supported, and the bank received a number of constructive comments and suggestions on its proposal.", 'on the basis of its december proposal and the comments and suggestions received, the bank released on april 1, 1997 a framework for abolishing designated-time settlement and making rtgs the only settlement mode in the boj-net funds transfer system.']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r970905b.pdf	Bank of Japan's summary of the annual review of monetary and economic developments in fiscal 1996	BANK OF JAPAN, ANNUAL REVIEW 1997.	1997-09-04 22:00:00	Bank of Japan's summary of the annual review of monetary and economic developments in fiscal 1996 BANK OF JAPAN, ANNUAL REVIEW 1997. Overview Japan's economy followed a moderate recovery trend in fiscal 1996. The pace of recovery began to accelerate at the end of 1995, aided by substantially stimulative monetary and fiscal policy measures, and the recovery continued in fiscal 1996. In the second half of the fiscal year, the economic recovery firmed, particularly in private demand, driven in part by the depreciation of the yen since the previous year. With respect to final demand in the first half of fiscal 1996, net exports declined sharply, reflecting such factors as the appreciation of the yen until the middle of 1995 and the increase in imports of manufactured goods from Japanese affiliates overseas. However, the economic recovery was underpinned by policy-related demand factors, such as the increase in public-sector investment reflecting the economic stimulus package of autumn 1995, and the high level of housing investment induced by low interest rates. In the middle of fiscal 1996, public-sector investment began to decline gradually from its peak, while net exports, which had been restraining the economic recovery, started to rise, partly reflecting the depreciation of the yen. Regarding private demand, business fixed investment increased steadily throughout the fiscal year, reflecting recovery in corporate profits, progress in stock adjustments, and a rise in autonomous investment, such as in information technology, and the increase spread across industries from large manufacturing firms to small nonmanufacturing firms. Personal consumption followed a moderate recovery trend in line with a recovery in compensation of employees despite fluctuations caused by factors such as the weather. From autumn 1996, automobile sales, which have a large influence on production, accelerated. Housing investment remained high, owing both to the increase in demand ahead of the rise in the consumption tax rate, implemented in April 1997, and to low interest rates. Industrial production remained virtually unchanged until the middle of 1996, reflecting the decrease in net exports, and adjustments in the excessive inventories of some producer goods. However, growth in production has gradually gathered pace since the middle of the year, as private demand has increased steadily, net exports have begun to increase, and the increase in final demand has led more directly to a rise in production because of progress in inventory adjustments. At the end of the fiscal year, both industrial production and shipments recovered to the levels recorded at the previous peak in the economic cycle reflecting the increase in demand before the rise in the consumption tax rate. In these circumstances, corporate profits continued to recover primarily among large manufacturing firms, driven in part by a rise in profits of processing industries reflecting the depreciation of the yen and the success of corporate restructuring efforts. Business confidence also improved gradually, according to the Bank of Japan's "Tankan-Short-Term Economic Survey of Enterprises in Japan." The improvement in profits of large manufacturing firms was reflected in an increase in their expenditures, which in turn contributed to a recovery in the business conditions of corporate service industries and small manufacturing firms. As for labor market conditions, the unemployment rate remained high and growth in the number of the regularly employed stagnated owing to persistent adjustment pressures on personnel expenses in the corporate sector. However, overtime working hours and the number of new job offers increased steadily, reflecting production growth and improvements in corporate profits, and compensation of employees rose gradually, particularly in special cash earnings. In sum, the overall labor market conditions followed a recovery trend. While substantially stimulative monetary and fiscal policy measures in fiscal 1995 continued to underpin economic recovery in early fiscal 1996, a positive cycle of demand, production, and income began to operate, underpinning the economic recovery throughout fiscal 1996. That is, an increase in final demand pushed up production and led to an improvement in corporate profits, particularly among large manufacturing firms. This in turn led to an improvement in profits and a rise in compensation of employees among nonmanufacturing firms and small firms, thereby expanding expenditures. During the second half of fiscal 1996, the recovery in private demand firmed, reflecting the positive effects of the depreciation of the yen on corporate profits, despite a decrease in public-sector investment. In other words, although the pace of the economic recovery remained moderate, a recovery led by policy demand is gradually shifting toward one led by private demand. Although Japan's economy bottomed out at the end of 1993, the pace of recovery remains relatively moderate, owing to various structural adjustment pressures on industries. These include (1) pressures for the industrial structure to change in response to global competition resulting from the expansion of supply capacity in Asian countries, and to the constant appreciation of the yen until the middle of 1995; and (2) balance-sheet adjustment pressures owing to the sharp and significant decline in asset prices since the bursting of the economic "bubble" in the late 1980s. Steady progress has been made in dealing with the pressures for the industrial structure to change, as reflected in (1) a significant improvement in corporate profits, particularly among large manufacturing firms, resulting from the successful restructuring efforts and the depreciation of the yen from the middle of 1995; (2) progress in the reorganization of the international production system as seen in the shift in Japan's exports and production toward more capital- and technology-intensive goods; and (3) increased business fixed investment in new sectors owing to technological innovations and deregulation in information and communications industries. With regard to balance-sheet adjustments, strong adjustment pressures remained throughout fiscal 1996, as seen in the persistently high level of the ratio of debts to assets, especially among small nonmanufacturing firms. In fiscal 1996, weakening of prices came to a halt. Domestic wholesale prices followed a downward trend until the middle of 1996, but in the second half of fiscal 1996 they virtually stopped declining, owing to a moderate improvement in domestic supply and demand conditions, as well as a rise in import prices reflecting the depreciation of the yen and the rise in crude oil prices. In March 1997, the year-to-year change shifted from decline to increase. Although corporate service prices continued to decline compared to the level of the previous year, reflecting the decrease in leasing prices and real estate rents, the year-to-year declines were smaller in the second half of fiscal 1996, due to a recovery in demand for services following the improvement in corporate profits. Consumer prices (nationwide, excluding perishables) also increased by a slightly wider margin from the previous year owing to a smaller decline in commodity prices as a result of the depreciation of the yen, and the halt in the decline in domestic wholesale prices, as well as a gradual increase in service prices. While prices seemed to have stopped declining, the increase in import prices from the depreciation of the yen and higher crude oil prices had little impact on domestic prices, as there remained persistent downward pressures on prices from imports of manufactured goods, particularly final goods, and technological innovations. As for commercial land, prices for large and well-located plots of land suitable for development virtually stopped declining owing mainly to the gradual progress in stock adjustment for office space. However, the prices of smaller plots of land with limited commercial value continued to decline. The recent development in commercial land prices thus indicates a distinct splitting into two groups. Meanwhile, residential land prices are bottoming out, reflecting the high level of residential housing construction. The cyclical momentum for economic recovery gathered strength in fiscal 1996. However, the pace of the recovery remained moderate owing to continued structural adjustment pressures, including the balance-sheet problems. Although weakening of prices had come to a halt by the second half of fiscal 1996, prices were unlikely to follow an upward trend. Against the background of these economic and price conditions, the Bank of Japan maintained an easy monetary policy, keeping the official discount rate at its September 1995 level of 0.5 percent to establish a solid foundation for the economic recovery. As for financial developments, the overnight call rate (uncollateralized) remained on average slightly below the official discount rate following monetary adjustments by the Bank of Japan. Long-term interest rates continued to rise with some fluctuations in the first half of 1996, but fell sharply in the second half. Interest rates on short-term instruments, namely 3-month certificate of deposit (CD) rates, followed a similar trend, although with smaller fluctuations than those in long-term interest rates. Stock prices continued to rise during the first half of 1996, but began to weaken in the summer, and fell sharply from the end of the year. The year-to-year growth rate of M2+CDs, a representative indicator of monetary aggregates, generally remained around 3.0-4.0 percent, but declined slightly in the second half of the fiscal year, partly due to the slow growth in funding in the private sector. Despite the firm recovery of the real economy, particularly in the private sector during the second half of fiscal 1996, the financial markets during this period adopted a more cautious stance. This was because (1) the financial markets reacted in anticipation of the fiscal tightening measures-such as the rise in the consumption tax rate and the termination of special tax reductions in fiscal 1997-and this had restraining effects on economic conditions; and (2) there was renewed awareness that various adjustment pressures, especially balance-sheet adjustment pressures, remained strong among small nonmanufacturing firms and financial institutions. Under these circumstances, the cyclical developments of the economic recovery were not immediately reflected in financial indicators through the confidence of market participants. Meanwhile, significant progress was made in fiscal 1996 in the solution of the jusen (housing loan companies) problem, and steady progress was also made in solving the problem of nonperforming assets of financial institutions, including improvements in the framework for the resolution of failed financial institutions. With respect to the outlook, the probability that Japan's economy will continue to recover is rising, although the pace of recovery may decelerate temporarily. This expectation is based on the fact that the positive cycle of production and consumption has not been deterred by the reaction to the increase in demand ahead of the consumption tax rate rise. Despite the continued economic recovery, the private sector has not gained sufficient confidence in its future growth, reflecting persistent uncertainty about structural adjustments. Under the structural adjustment pressures, expected growth rates are unlikely to rise at the same pace in different industries and firms. However, from a long-term perspective, the establishment of a new industrial structure based on the principle of comparative advantage can be expected to enhance growth by promoting the efficiency of resource allocation. In order for Japan's economy to achieve sustainable growth, it is vital to create investment opportunities and raise expected growth rates of economic entities through effective reforms of the economic structure. Such efforts are essential in adapting to the medium- to long-term changes in economic environment, including increasing global competitive pressures, and the further aging of the population, and in maintaining Japan's economic strength. Considering the important role that the financial sector must play in the reforms of the economic structure, it will be necessary to continue implementing measures to stabilize the Japanese financial system, and increase domestic and overseas confidence in the system. At the same time, the financial system must be reorganized to enhance its functions and competitiveness, by improving the infrastructure in order to promote competition in accordance with the Japanese "Big Bang" deregulation package.	["bank of japan's summary of the annual review of monetary and economic developments in fiscal 1996 bank of japan, annual review 1997. overview japan's economy followed a moderate recovery trend in fiscal 1996. the pace of recovery began to accelerate at the end of 1995, aided by substantially stimulative monetary and fiscal policy measures, and the recovery continued in fiscal 1996. in the second half of the fiscal year, the economic recovery firmed, particularly in private demand, driven in part by the depreciation of the yen since the previous year.", 'with respect to final demand in the first half of fiscal 1996, net exports declined sharply, reflecting such factors as the appreciation of the yen until the middle of 1995 and the increase in imports of manufactured goods from japanese affiliates overseas.', 'however, the economic recovery was underpinned by policy-related demand factors, such as the increase in public-sector investment reflecting the economic stimulus package of autumn 1995, and the high level of housing investment induced by low interest rates.', 'in the middle of fiscal 1996, public-sector investment began to decline gradually from its peak, while net exports, which had been restraining the economic recovery, started to rise, partly reflecting the depreciation of the yen.', 'regarding private demand, business fixed investment increased steadily throughout the fiscal year, reflecting recovery in corporate profits, progress in stock adjustments, and a rise in autonomous investment, such as in information technology, and the increase spread across industries from large manufacturing firms to small nonmanufacturing firms.', 'personal consumption followed a moderate recovery trend in line with a recovery in compensation of employees despite fluctuations caused by factors such as the weather.', 'from autumn 1996, automobile sales, which have a large influence on production, accelerated.', 'housing investment remained high, owing both to the increase in demand ahead of the rise in the consumption tax rate, implemented in april 1997, and to low interest rates.', 'industrial production remained virtually unchanged until the middle of 1996, reflecting the decrease in net exports, and adjustments in the excessive inventories of some producer goods.', 'however, growth in production has gradually gathered pace since the middle of the year, as private demand has increased steadily, net exports have begun to increase, and the increase in final demand has led more directly to a rise in production because of progress in inventory adjustments.', 'at the end of the fiscal year, both industrial production and shipments recovered to the levels recorded at the previous peak in the economic cycle reflecting the increase in demand before the rise in the consumption tax rate.', 'in these circumstances, corporate profits continued to recover primarily among large manufacturing firms, driven in part by a rise in profits of processing industries reflecting the depreciation of the yen and the success of corporate restructuring efforts.', 'business confidence also improved gradually, according to the bank of japan\'s "tankan-short-term economic survey of enterprises in japan."', 'the improvement in profits of large manufacturing firms was reflected in an increase in their expenditures, which in turn contributed to a recovery in the business conditions of corporate service industries and small manufacturing firms.', 'as for labor market conditions, the unemployment rate remained high and growth in the number of the regularly employed stagnated owing to persistent adjustment pressures on personnel expenses in the corporate sector.', 'however, overtime working hours and the number of new job offers increased steadily, reflecting production growth and improvements in corporate profits, and compensation of employees rose gradually, particularly in special cash earnings.', 'in sum, the overall labor market conditions followed a recovery trend.', 'while substantially stimulative monetary and fiscal policy measures in fiscal 1995 continued to underpin economic recovery in early fiscal 1996, a positive cycle of demand, production, and income began to operate, underpinning the economic recovery throughout fiscal 1996. that is, an increase in final demand pushed up production and led to an improvement in corporate profits, particularly among large manufacturing firms.', 'this in turn led to an improvement in profits and a rise in compensation of employees among nonmanufacturing firms and small firms, thereby expanding expenditures.', 'during the second half of fiscal 1996, the recovery in private demand firmed, reflecting the positive effects of the depreciation of the yen on corporate profits, despite a decrease in public-sector investment.', 'in other words, although the pace of the economic recovery remained moderate, a recovery led by policy demand is gradually shifting toward one led by private demand.', "although japan's economy bottomed out at the end of 1993, the pace of recovery remains relatively moderate, owing to various structural adjustment pressures on industries.", 'these include (1) pressures for the industrial structure to change in response to global competition resulting from the expansion of supply capacity in asian countries, and to the constant appreciation of the yen until the middle of 1995; and (2) balance-sheet adjustment pressures owing to the sharp and significant decline in asset prices since the bursting of the economic "bubble" in the late 1980s.', "steady progress has been made in dealing with the pressures for the industrial structure to change, as reflected in (1) a significant improvement in corporate profits, particularly among large manufacturing firms, resulting from the successful restructuring efforts and the depreciation of the yen from the middle of 1995; (2) progress in the reorganization of the international production system as seen in the shift in japan's exports and production toward more capital- and technology-intensive goods; and (3) increased business fixed investment in new sectors owing to technological innovations and deregulation in information and communications industries.", 'with regard to balance-sheet adjustments, strong adjustment pressures remained throughout fiscal 1996, as seen in the persistently high level of the ratio of debts to assets, especially among small nonmanufacturing firms.', 'in fiscal 1996, weakening of prices came to a halt.', 'domestic wholesale prices followed a downward trend until the middle of 1996, but in the second half of fiscal 1996 they virtually stopped declining, owing to a moderate improvement in domestic supply and demand conditions, as well as a rise in import prices reflecting the depreciation of the yen and the rise in crude oil prices.', 'in march 1997, the year-to-year change shifted from decline to increase.', 'although corporate service prices continued to decline compared to the level of the previous year, reflecting the decrease in leasing prices and real estate rents, the year-to-year declines were smaller in the second half of fiscal 1996, due to a recovery in demand for services following the improvement in corporate profits.', 'consumer prices (nationwide, excluding perishables) also increased by a slightly wider margin from the previous year owing to a smaller decline in commodity prices as a result of the depreciation of the yen, and the halt in the decline in domestic wholesale prices, as well as a gradual increase in service prices.', 'while prices seemed to have stopped declining, the increase in import prices from the depreciation of the yen and higher crude oil prices had little impact on domestic prices, as there remained persistent downward pressures on prices from imports of manufactured goods, particularly final goods, and technological innovations.', 'as for commercial land, prices for large and well-located plots of land suitable for development virtually stopped declining owing mainly to the gradual progress in stock adjustment for office space.', 'however, the prices of smaller plots of land with limited commercial value continued to decline.', 'the recent development in commercial land prices thus indicates a distinct splitting into two groups.', 'meanwhile, residential land prices are bottoming out, reflecting the high level of residential housing construction.', 'the cyclical momentum for economic recovery gathered strength in fiscal 1996. however, the pace of the recovery remained moderate owing to continued structural adjustment pressures, including the balance-sheet problems.', 'although weakening of prices had come to a halt by the second half of fiscal 1996, prices were unlikely to follow an upward trend.', 'against the background of these economic and price conditions, the bank of japan maintained an easy monetary policy, keeping the official discount rate at its september 1995 level of 0.5 percent to establish a solid foundation for the economic recovery.', 'as for financial developments, the overnight call rate (uncollateralized) remained on average slightly below the official discount rate following monetary adjustments by the bank of japan.', 'long-term interest rates continued to rise with some fluctuations in the first half of 1996, but fell sharply in the second half.', 'interest rates on short-term instruments, namely 3-month certificate of deposit (cd) rates, followed a similar trend, although with smaller fluctuations than those in long-term interest rates.', 'stock prices continued to rise during the first half of 1996, but began to weaken in the summer, and fell sharply from the end of the year.', 'the year-to-year growth rate of m2+cds, a representative indicator of monetary aggregates, generally remained around 3.0-4.0 percent, but declined slightly in the second half of the fiscal year, partly due to the slow growth in funding in the private sector.', 'despite the firm recovery of the real economy, particularly in the private sector during the second half of fiscal 1996, the financial markets during this period adopted a more cautious stance.', 'this was because (1) the financial markets reacted in anticipation of the fiscal tightening measures-such as the rise in the consumption tax rate and the termination of special tax reductions in fiscal 1997-and this had restraining effects on economic conditions; and (2) there was renewed awareness that various adjustment pressures, especially balance-sheet adjustment pressures, remained strong among small nonmanufacturing firms and financial institutions.', 'under these circumstances, the cyclical developments of the economic recovery were not immediately reflected in financial indicators through the confidence of market participants.', 'meanwhile, significant progress was made in fiscal 1996 in the solution of the jusen (housing loan companies) problem, and steady progress was also made in solving the problem of nonperforming assets of financial institutions, including improvements in the framework for the resolution of failed financial institutions.', "with respect to the outlook, the probability that japan's economy will continue to recover is rising, although the pace of recovery may decelerate temporarily.", 'this expectation is based on the fact that the positive cycle of production and consumption has not been deterred by the reaction to the increase in demand ahead of the consumption tax rate rise.', 'despite the continued economic recovery, the private sector has not gained sufficient confidence in its future growth, reflecting persistent uncertainty about structural adjustments.', 'under the structural adjustment pressures, expected growth rates are unlikely to rise at the same pace in different industries and firms.', 'however, from a long-term perspective, the establishment of a new industrial structure based on the principle of comparative advantage can be expected to enhance growth by promoting the efficiency of resource allocation.', "in order for japan's economy to achieve sustainable growth, it is vital to create investment opportunities and raise expected growth rates of economic entities through effective reforms of the economic structure.", "such efforts are essential in adapting to the medium- to long-term changes in economic environment, including increasing global competitive pressures, and the further aging of the population, and in maintaining japan's economic strength.", 'considering the important role that the financial sector must play in the reforms of the economic structure, it will be necessary to continue implementing measures to stabilize the japanese financial system, and increase domestic and overseas confidence in the system.', 'at the same time, the financial system must be reorganized to enhance its functions and competitiveness, by improving the infrastructure in order to promote competition in accordance with the japanese "big bang" deregulation package.']	Bank of Japan	Bank of Japan	Governor	Japan
https://www.bis.org/review/r970905a.pdf	Mr. Stals reports on major economic developments in South Africa over the past twelve months (Central Bank Articles and Speeches, 26 Aug 97)	Address by the Governor of the South African Reserve Bank, Dr. C. Stals, at the 77th Ordinary General Meeting of Shareholders of the Bank on 26/8/97.	1997-08-26 00:00:00	Mr. Stals reports on major economic developments in South Africa over the past twelve months Address by the Governor of the South African Reserve Bank, Dr. C. Stals, at the 77th Ordinary General Meeting of Shareholders of the Bank on 26/8/97. Introduction The turbulences in the South African market for foreign exchange from February 1996, and the subsequent destabilisation of the balance of payments, contributed to a weakening of overall economic growth and to an upturn in inflation. The major task for monetary policy over the past year has accordingly been to restore both external equilibrium and domestic financial stability which are important preconditions for sustained investor confidence and economic growth. The process of restoring external economic equilibrium had to begin at home. Many adverse factors converged to contribute to the sudden exchange rate shock of February 1996. Some were of a non-economic nature while others were rooted in macroeconomic developments over the preceding two years. The problems caused by non-economic factors diminished as concern about the finalisation of the Constitution of the Republic of South Africa, the delay of local authority elections in certain provinces, and the political composition of the Government of National Unity were fortunately allayed during the course of the past year. Equally important has been the fact that the Minister of Finance, newly appointed in April 1996, has stood the test of the markets with acclaim and soon established himself as an effective leader of the country's overall financial policy. Many of the disturbing economic problems which emerged last year were addressed by appropriate policy responses, while the private sector has on the whole endured the inevitable painful adjustments with much understanding. During both 1994 and 1995, growth in real domestic expenditure by far outpaced growth in real domestic production. This was clearly not a sustainable situation, and growth in domestic demand had to be curtailed to ensure a better balance in the overall economy. The untenable developments in domestic economic activity created a widening deficit in the current account of the balance of payments which was being financed by an inflow of volatile short-term foreign capital. When these short-term capital inflows switched into outflows after February 1996, however, a downward adjustment in the rate of growth in overall domestic expenditure, and therefore in the growing demand for imports, became imperative. The divergent rates of expansion in domestic production and expenditure, respectively, were also being financed to an increasing extent with domestic bank credit, or simply the creation of additional money. With insufficient domestic saving and a sudden decline in the inflow of foreign capital after February 1996, the pressure to accelerate the creation of more money increased even further. Assessed against this background, an untenable macroeconomic disequilibrium was rapidly being perceived to be developing at the then level of the exchange rate of the rand. Large foreign capital inflows in 1995, as well as the early weeks of 1996, exerted upward pressure on the value of the rand. Within a floating exchange rate regime, the rand appreciated in real terms, despite heavy Reserve Bank intervention to absorb part of the excess supply of foreign exchange. The appreciation of the rand at the time was clearly irreconcilable with South Africa's otherwise weak position in a very competitive world economic environment. A stronger rand could not be sustained in the long term. Also instructive in this regard is that similar experiences by other emerging economies over the past year proved that alternative exchange rate systems, based on fixed or managed floating exchange rates, could also not cope with such divergent economic trends. In some of those countries, even more painful economic adjustments were required to restore financial stability than in the case of South Africa. The monetary policy approach adopted by the Reserve Bank under the circumstances was to let market forces take their course, with some short-term intervention by the Bank only to support an orderly process of adjustment. The exchange rate was therefore allowed to take its market-determined run while liquidity was drained from the domestic money market, interest rates were guided in a gradual upward path, and the resultant adverse consequences of the adjustment in real economic activity were accepted as essential to avoid even greater disruption later on. Domestic financial stability had to be restored first and must now be maintained in order to raise the production capacity of the economy to higher levels on a sustainable basis. These developments over the past year again exposed the urgent need for longer-term structural economic reforms. In June 1996, the Government released a Macroeconomic Strategy for Growth, Employment and Redistribution (GEAR). The full implementation of this programme over the next few years will undoubtedly raise the potential of the economy and enable South Africa to meet the vast basic social and economic needs of the people of the country more adequately. It will also provide the economy with better armour to withstand with more vigour similar adverse macroeconomic developments that may recur in future. In retrospect, the economic policies of the past year contributed significantly towards improving equilibrium when emerging imbalances threatened to frustrate the primary objective of achieving sustainable optimum economic growth and development. Recent improvements in the current account of the balance of payments, the firmer exchange rate of the rand, the increased inflow of foreign capital, and the rise in official foreign exchange reserves, provide sufficient evidence to the effect that the serious danger of a collapse in South Africa's external economic relations a year ago has been successfully averted. Moreover, there are encouraging, although as yet still only tentative, signs, emanating from both the production and the expenditure sides, that the economy recovered slightly during the second quarter of 1997. This preliminary indication is also confirmed by some hopeful signs that the inflationary pressures which arose from the economic imbalances experienced last year are now subsiding. At the same time, however, the overall financial situation still provides reason for concern, particularly in view of the continued high rates of increase in bank credit extension and in broad money supply. For reasons that will be explained in more detail below, the monetary authorities must persist with their vigil against the threat of overall financial instability that can only lead to stagflation in due course. There are many examples in the world today, both among industrial and emerging economies, where this lesson is again being learnt the hard way after years of reluctance to apply appropriate but unpopular short-term disciplinary monetary policies in a timely fashion. The Reserve Bank is not prepared to consider any short-term expediencies and implement monetary policies that will in the long term lead to serious disruption of financial stability. The country just cannot afford unsound monetary policies for short-term gain. Such policies would gradually undermine the value of the rand and lead to an eventual collapse of the financial system, with serious adverse implications also for the level of real economic activity. Recent economic developments The Reserve Bank's Annual Economic Report released this morning serves as a background to the following brief summary of major economic developments over the past twelve months: A year of economic consolidation The pattern of developments in real economic activity over the past twelve months can best be described as the outcome of a necessary process of consolidation after three years of positive growth. The rate of expansion in gross domestic product reached a seasonally adjusted and annualised rate of 311⁄2 per cent in the second half of 1996, but then slowed down to only 1 per cent in the first half of 1997, indicating a lower rate of growth for the full calendar year of 1997 compared with that experienced during any one of the past two years. During the first quarter of 1997, total gross domestic product actually declined by 1 per cent, setting off alarm bells of a pending recession. During the second quarter, however, there was a distinct recovery when overall economic activity again turned to positive growth, equal to an annualised rate of 211⁄2 per cent. With a continued decline in agricultural production during the second quarter and only moderate growth in mining production, total value added by the primary sectors declined by a further 1 per cent. Against this poor performance, however, production in the rest of the economy was back on track with an expansion equal to 311⁄2 per cent on an annualised basis. With growth of 7 per cent in manufacturing, 6 per cent in electricity, gas and water, and 411⁄2 per cent in transport and communication, together with positive growth in all the other sub-sectors, the fears of a pending recession must at least for now have been allayed. Gross domestic expenditure, on the other hand, remained fairly depressed. An estimated small decline in total expenditure in the first half of 1997 contributed to the consolidation process of restoring a better balance between total domestic production and effective demand. Further declines in the growth rates of private consumption expenditure and gross domestic fixed investment, coupled with a substantial reduction in total inventories, were partly offset by a continued high level of expansion in general government consumption expenditure, particularly at the level of provincial and local government. During the second quarter of 1997 there was, however, a noticeable recovery in demand when total gross domestic expenditure expanded again by 2 per cent, after having declined by 1 per cent in the first quarter. Small increases from the first to the second quarter in the rates of growth in private consumption expenditure as well as domestic fixed investment were strongly supported by a further rise at an annualised rate of more than 511⁄2 per cent in general government consumption expenditure. Excluding the effect of a substantial reduction in inventories, total domestic expenditure actually increased by 211⁄2 per cent in the second quarter. These disparate movements in real economic aggregates between the first and second quarters of 1997 underline the importance of correctly interpreting short-term indicators of current economic developments. The Reserve Bank will conscientiously analyse all economic information that becomes available over the next few months with the necessary sensitivity to the pressing needs of the country. Better equilibrium in the balance of payments The salutary effects on the balance of payments of slower growth in total domestic expenditure are clearly reflected in the rapid decline in the deficit of the current account. On a seasonally adjusted and annualised basis, this deficit declined from R13 billion in the second quarter of 1996 to only R3.5 billion in the second quarter of 1997. In unadjusted figures, the negative balance declined from R5.5 billion in the first half of 1996 to R3.0 billion in the second half of last year, and R2.4 billion in the first half of 1997. Both imports and exports of merchandise responded to the depreciation of the rand last year. In the second quarter of 1997, the level of merchandise exports at current prices was 25 per cent higher than in the second quarter of 1996, whereas the value of imports increased by only 11 per cent. This was, however, not all due to the price effect of the depreciation of the rand. Growth in the volume of imports also slowed down as a result of the decline in gross domestic expenditure. In the case of the value of exports, an increase of 25 per cent was already experienced in the year prior to the depreciation, partly as a result of the removal of international sanctions, which no doubt continued to affect exports in 1996 and the first half of 1997. The improvement in the current account was supported by a larger net inflow of funds reflected in the capital account of the balance of payments. The pressure on the exchange rate of the rand, which continued from February to October 1996, subsided again after October, almost as suddenly as it had appeared. During the first three quarters of 1996, the net capital inflow amounted to only R585 million, but this was followed by a net inflow of R3.3 billion in the fourth quarter, and by no less than R16.7 billion in the first half of 1997. After the rand had depreciated by as much as 23.5 per cent in nominal terms between 14 February 1996 and the end of October 1996, it appreciated by 10 per cent over the next five months. From the end of March to the end of July 1997, however, the rand depreciated again by 3.6 per cent to give a net increase of 6.0 per cent in the external value of the currency from November 1996 to the end of July 1997. It should be noted, however, that the average level of the exchange rate of the rand over the first seven months of 1997, compared with its average value over the same period in 1996, showed a depreciation in nominal terms of 8.4 per cent. Although the initial appreciation after October 1996 was accepted as a partial correction of an over-reaction, the Reserve Bank nevertheless, already in November 1996, started to intervene again in the market as a net buyer of foreign exchange. The country's gross foreign reserves held by the consolidated banking sector indeed increased by R17.2 billion over the past three quarters to reach a level of R31.1 billion at the end of June 1997. This was sufficient to cover about 911⁄2 weeks of imports of goods and services. Currency depreciation as a means to achieve greater international competitiveness only has a chance to succeed in countries where inflation is not sensitive to depreciation. The events of the past year proved once again that in South Africa inflation reacts with a time lag of only about six months to major changes in the exchange rate. The quarter-to-quarter increase in the seasonally adjusted and annualised rate of change in the production price index for imported goods escalated from 6.0 per cent in the first quarter of 1996 to no less than 18.1 per cent in the fourth quarter, before it declined again to 12.4 per cent in the first quarter of 1997. In the second quarter of 1997, that is approximately six months after the turnaround in the trend of the exchange rate in November 1996, the production price index for imported goods actually declined by 10.7 per cent. Monetary aggregates slow to respond Over the past two years, the Reserve Bank has on various occasions advanced reasons why changes in the M3 money supply may have lost some of its usefulness as a reliable anchor for monetary policy. At this juncture, the Bank regards changes in M3 only as one among several important financial indicators. It no longer bases its monetary policy decisions automatically on any rigid formula linking actual changes in M3 to the predetermined money supply guidelines issued by the Bank at the beginning of each year. In 1996, for example, monetary policy was aimed more directly towards the restoration of external financial stability. More recently, the Bank has become more concerned about the excessive increase in domestic bank credit extension, not only because of its influence on the money supply, but also for other reasons. There has, for example, been growing anxiety about the over-extension of the private sector's indebtedness relative to disposable income, and the increasing vulnerability of the banking sector to adverse developments in a possibly less favourable future macroeconomic environment. No central bank can, of course, disregard developments in the money supply or in bank credit extension, even if such developments can be explained as temporary distortions caused by major structural economic reforms. Although changes in M3 and its shorter-term components should be interpreted with circumspection in the present South African environment, they cannot be discarded or ignored. The relationship between the money supply and nominal production, or the velocity of circulation of M3, may be changing, but new relationships are being established in the process of transformation. Over the longer term, it remains true that inflation cannot be sustained indefinitely unless it is fuelled by continuous excessive money creation. Throughout 1996, the annual rate of increase in the M3 money supply fluctuated within a narrow range of between 13.6 and 16.1 per cent. By January 1997 it reached a peak of 16.8 per cent, and then declined gradually to 12.7 per cent in June 1997. As a guideline the Reserve Bank currently regards a rate of increase of not more than 10 per cent per year in the M3 money supply as consistent with the prime objective of reducing inflation gradually to a level that will be more in line with the average rate of inflation in the economies of South Africa's major trading partners. The increase in M3 has now consistently exceeded the rate of growth in the nominal value of gross domestic product for more than three years, with the result that the ratio of the total amount of money in circulation to gross domestic product has risen to 58 per cent, which is the highest level since 1980. A lack of availability of money can therefore hardly be advanced as a reason for the slowdown in real economic activity over the past eighteen months. The relatively high level of the money supply or, inversely, its low level of velocity of circulation, holds a potential danger for future inflation. Although a substantial part of the excess amount of money in circulation may at this stage be confined to the financial sector, possibly contributing to financial asset inflation, the Reserve Bank will have little control over the situation once holders of financial assets decide again to divert their spending to the acquisition of goods and services. Central bank policy must therefore always be forward-looking and attempt to pre-empt the danger of overspending or rising inflation at some future inopportune stage. Total bank credit extended to the private sector likewise continued to increase at a high rate throughout 1996, and fluctuated between a peak of 18.9 per cent in July and a low of 16.1 per cent in December. During the first six months of 1997, it peaked at 17.4 per cent in April, and then declined only marginally to 16.3 per cent over the twelve months up to June. As in the case of the money supply, the total amount of bank credit outstanding has risen as a percentage of gross domestic product over the past few years. At the end of June 1997, it amounted to 75 per cent of gross domestic product, compared with 67 per cent at the end of 1993. Bank credit is, of course, not only extended for the purpose of financing purchases of goods and services. Indeed, particularly in recent months, a substantial amount of the additional bank credit created may have been linked to the explosive increases in the volume of transactions in the financial markets, particularly in the equity and bond markets. Nevertheless, all forms of bank credit create money, and the initial reason for which money is created is only of limited significance for monetary policy purposes. Once the money has been created, it becomes part of the amorphous pool of the total money supply and, depending on the strength of the multiplier effect, is available to be used a number of times over, and for many purposes other than its first application. Many explanations can be offered for the persistently high rates of increase in bank credit extension and in the money supply, despite the slowdown in real economic activity over the past eighteen months. It could partly be linked to a switching of international trade financing from foreign to domestic sources, or partly to the financing of summer crops in the agricultural sector that are being harvested late this year. It is also known that bank credit extended to local authorities increased by no less than R2.7 billion from 31 December 1996 to 30 June 1997. These explanations, however, do not detract from the need for a curtailment of the excessive rates of increase in these important monetary aggregates at this juncture. In light of the unfavourable experiences of a number of other countries in recent years, ranging from a well-developed country such as Japan to an emerging economy such as Thailand, central bankers elsewhere are increasingly concentrating on restricting the provision of bank credit for investment in financial assets and property. In a bull market, even at high interest rates, borrowers will continue to borrow funds to buy assets that are rapidly appreciating in value; and banks will continue to lend because the value of their collateral is rising. This could easily cause a speculative bubble that, should it burst, can create major difficulties for both lenders and borrowers. In such a situation, it is not unusual for the money supply to continue to rise, in conflict with the objectives of the monetary authorities, and often also in contrast to the slowdown in real economic activity. South Africa is hopefully not yet in such a position. In the implementation of monetary policy more than in anything else, prevention is almost without exception less costly in terms of a possible temporary loss of production and employment that can in any case not be sustained, than the sacrifices that will eventually be required to fight high inflation once it has become entrenched. In the present situation, the Reserve Bank feels that a cautious monetary policy stance remains justified. This has been the approach throughout the past year and undoubtedly has had a major influence on developments in the money market. The shortage of funds in this market, as reflected by the amount of accommodation required by banking institutions from the Reserve Bank, first increased from a daily average of R4.9 billion in January 1996 to R10.6 billion in March 1997, before it declined to R7.3 billion in July 1997. As the recovery in the balance of payments recently gained momentum, the Reserve Bank has been prepared to allow a natural downward adjustment in the money market shortage, paving the way for a gradual decline in money market interest rates. The Reserve Bank raised its lending rate to banking institutions, the Bank rate, from 15 per cent at the end of 1995 to 16 per cent in April 1996, and then to 17 per cent in November 1996. The rate on three-month bankers' acceptances first increased sharply from 14.6 per cent at the end of December 1995 to 17.0 per cent a year later, but has since declined gradually to 15.0 per cent in the middle of August 1997. As the South African financial markets are being integrated more in the global financial system, the comparison between South African and international interest rates takes on greater significance. Too low a level of interest rates locally will eventually be reflected in a weak currency, and lead to a further depreciation of the rand. Too high a level, on the other hand, will attract speculative short-term capital from abroad, and lead to an undesirable appreciation of the currency, and/or an unhealthy expansion of domestic liquidity. The sharply inverted shape of the yield curve in South Africa makes the comparison of the level of local interest rates with the international markets more difficult. At the long end of the spectrum, the yield on long-term government bonds in South Africa seems to be on the low side in real terms. Short-term interest rates, and particularly bank lending rates at the other end of the yield curve, seem to be high in South Africa, reflecting negative expectations on inflation, high risks involved in more short-term lending to an already overborrowed community, and a relatively high demand for funds. The conservative monetary policy measures applied by the Reserve Bank over the past eighteen months have paid off by containing the increase in inflation to below 10 per cent, despite the pressures arising from the depreciation of the rand last year. Measured over a period of twelve months, the rate of increase in the overall production price index rose from 5.3 per cent in April 1996 to 9.6 per cent in March 1997, but then declined to 7.5 per cent in June 1997. Movements in the consumer price index followed a similar path and the increase in consumer prices, measured over twelve months, rose from 5.5 per cent in April 1996 to 9.9 per cent in April 1997, before declining to 8.8 per cent in June 1997. At the time of the depreciation of the rand in 1996, a much higher rate of inflation was predicted on the basis of previous experience. There is, however, no reason for complacency. As long as the South African rate of inflation remains significantly higher than that in the major countries of the world, the integration of South Africa into the global financial markets will be slow and turbulent. In view of the complex interaction between the level of interest rates, the rate of inflation, and the exchange rate in the process of financial globalisation, disruptive adjustments will be demanded from time to time. This will continue to complicate decisions for investors and cross-border traders. Participation in the process of financial globalisation ultimately requires a high degree of convergence between countries in these basic financial aggregates. The domestic levels for interest and exchange rates can no longer be determined by governments or central banks in isolation. These financial prices will indeed increasingly be driven by international market consensus. At this stage, the international market imperative requires of South Africa to bring its rate of inflation gradually in line with the rest of the world. Alternatively, the country's drive towards greater participation as an important borrower of funds in the world financial markets will be constrained. Furthermore, what is even more important is that the existing imbalances of income and wealth in the domestic economy will further deteriorate in an inflationary environment. It is relatively easy for those more fortunate members of society to protect themselves against inflation as they have easy access to credit and can spend more in today's terms, hoping to repay with depreciated money sometime in the future. Less fortunate members of the society find that wage increases do not keep up with inflation, especially run-away rising inflation, and their savings and buying power deteriorate continuously. Financial market reforms pay dividends The major reforms in South Africa's financial markets over the past few years paid good dividends in the form of substantial increases in the volume of business done through these various markets. Structural improvements introduced by the Johannesburg Stock Exchange, the Bond Exchange of South Africa, and the South African Futures Exchange (SAFEX), were also boosted by the further relaxation of exchange controls. The value of bonds traded in the Bond Exchange of South Africa increased by 51 per cent in 1996 to exceed the R3,000 billion level. In the first half of 1997, the total turnover in this market already exceeded R1,700 billion. These higher values included a substantial increase in transactions effected by non-residents in the market. The value of shares traded in the secondary share market increased from R63 billion in 1995 to R117 billion in 1996, and to R92 billion for the first half of 1997. As in the case of the Bond Exchange, non-residents also made an important contribution to the increase in business transacted through the Johannesburg Stock Exchange. The turnover in options and futures contracts traded through SAFEX performed likewise, showing sharp increases over the past eighteen months. The importance of the formal capital markets for the economic development of South Africa can be clearly illustrated by two basic statistics. Firstly, over the eighteen months from the beginning of 1996 up to the middle of 1997, the amount of new capital raised through issues on the Stock Exchange and net issues of fixed interest-bearing securities in the primary bond market amounted to approximately R50 billion. Secondly, over the same period, net purchases by non-residents of South African securities listed on the exchanges amounted to about R34 billion. Supportive fiscal policies The Minister of Finance applied further disciplines in his Budget proposals for 1997/98 with a commitment to reduce both government dissaving and the deficit before borrowing during the current fiscal year. In the preceding year net dissaving by government was equal to 3.1 per cent, and the budget deficit equal to 5.6 per cent of gross domestic product. The deficit for the current fiscal year is expected to be reduced to 4.0 per cent of gross domestic product. The Government also made an important contribution to the official foreign reserves of the country by way of two bond issues in international capital markets during June 1997. The total proceeds from these two loans amounted to R3.8 billion. A few smaller and one major privatisation transaction - the sale of an equity stake of 30 per cent in Telkom - raised more than R6 billion over the past year. Part of these funds was used to contain total government debt to a level of about 56 per cent of gross domestic product. The better harmonisation of monetary and fiscal policies over the past year made a major contribution to the success achieved with the objective of restoring overall financial stability after the foreign exchange market disruption of February last year. Financial co-operation in Southern Africa The Committee of Governors of the Central Banks of the twelve members of the Southern African Development Community (SADC) met twice during the past twelve months to discuss matters of financial co-operation. The Secretariat of the Committee within the Reserve Bank has made good progress in the compilation of a computerised data base of financial statistics of the region and information on the functions and responsibilities of the twelve participating central banks. Officials from all the central banks participated in a number of courses presented by the Reserve Bank's Training Institute, and a course was again presented for bank regulators and supervisors in the East and Southern Africa Banking Supervisors Group (ESAF). A special study is being undertaken with the support of the World Bank on the development of national payment and clearing systems with a view to the eventual establishment of a cross-border payment and settlement system for all SADC countries. Over the next year, the co-ordination of financial co-operation in the region will be extended also to include the activities of commercial (private) banks and stock exchanges. A need for more flexible monetary policy operations Developments over the past year revealed a need for greater flexibility in the market for short-term funds. The transformation in the South African financial markets since 1994, and in particular the further integration into the global financial system, will in future require more prompt action and decisive direction for movements in financial asset prices, interest rates and exchange rates. Part of the explanation for the rigidities in the South African money market lies with the present system used by the Reserve Bank to provide accommodation to banking institutions at the discount window. Banking institutions have unlimited access at the Bank rate to overnight loans from the discount window, provided they have at their disposal acceptable collateral. The Bank accepts Treasury bills, Land Bank bills, South African Reserve Bank paper and Government bonds, all with an outstanding maturity of less than 91 days, as security for such overnight loans. A second-tier facility is also available, but at a penalty rate of 75 percentage points above the Bank rate against similar securities as collateral, but with outstanding maturities of between 91 days and three years. The Bank rate is, of course, changed from time to time to adapt to changes in underlying financial market conditions. To make the system work effectively, the market must react with sensitivity to changes in underlying demand and supply conditions, and must also emit clear and comprehensible signals to the authorities. For exampl	['mr. stals reports on major economic developments in south africa over the past twelve months address by the governor of the south african reserve bank, dr. c. stals, at the 77th ordinary general meeting of shareholders of the bank on 26/8/97.', 'introduction the turbulences in the south african market for foreign exchange from february 1996, and the subsequent destabilisation of the balance of payments, contributed to a weakening of overall economic growth and to an upturn in inflation.', 'the major task for monetary policy over the past year has accordingly been to restore both external equilibrium and domestic financial stability which are important preconditions for sustained investor confidence and economic growth.', 'the process of restoring external economic equilibrium had to begin at home.', 'many adverse factors converged to contribute to the sudden exchange rate shock of february 1996. some were of a non-economic nature while others were rooted in macroeconomic developments over the preceding two years.', 'the problems caused by non-economic factors diminished as concern about the finalisation of the constitution of the republic of south africa, the delay of local authority elections in certain provinces, and the political composition of the government of national unity were fortunately allayed during the course of the past year.', "equally important has been the fact that the minister of finance, newly appointed in april 1996, has stood the test of the markets with acclaim and soon established himself as an effective leader of the country's overall financial policy.", 'many of the disturbing economic problems which emerged last year were addressed by appropriate policy responses, while the private sector has on the whole endured the inevitable painful adjustments with much understanding.', 'during both 1994 and 1995, growth in real domestic expenditure by far outpaced growth in real domestic production.', 'this was clearly not a sustainable situation, and growth in domestic demand had to be curtailed to ensure a better balance in the overall economy.', 'the untenable developments in domestic economic activity created a widening deficit in the current account of the balance of payments which was being financed by an inflow of volatile short-term foreign capital.', 'when these short-term capital inflows switched into outflows after february 1996, however, a downward adjustment in the rate of growth in overall domestic expenditure, and therefore in the growing demand for imports, became imperative.', 'the divergent rates of expansion in domestic production and expenditure, respectively, were also being financed to an increasing extent with domestic bank credit, or simply the creation of additional money.', 'with insufficient domestic saving and a sudden decline in the inflow of foreign capital after february 1996, the pressure to accelerate the creation of more money increased even further.', 'assessed against this background, an untenable macroeconomic disequilibrium was rapidly being perceived to be developing at the then level of the exchange rate of the rand.', 'large foreign capital inflows in 1995, as well as the early weeks of 1996, exerted upward pressure on the value of the rand.', 'within a floating exchange rate regime, the rand appreciated in real terms, despite heavy reserve bank intervention to absorb part of the excess supply of foreign exchange.', "the appreciation of the rand at the time was clearly irreconcilable with south africa's otherwise weak position in a very competitive world economic environment.", 'a stronger rand could not be sustained in the long term.', 'also instructive in this regard is that similar experiences by other emerging economies over the past year proved that alternative exchange rate systems, based on fixed or managed floating exchange rates, could also not cope with such divergent economic trends.', 'in some of those countries, even more painful economic adjustments were required to restore financial stability than in the case of south africa.', 'the monetary policy approach adopted by the reserve bank under the circumstances was to let market forces take their course, with some short-term intervention by the bank only to support an orderly process of adjustment.', 'the exchange rate was therefore allowed to take its market-determined run while liquidity was drained from the domestic money market, interest rates were guided in a gradual upward path, and the resultant adverse consequences of the adjustment in real economic activity were accepted as essential to avoid even greater disruption later on.', 'domestic financial stability had to be restored first and must now be maintained in order to raise the production capacity of the economy to higher levels on a sustainable basis.', 'these developments over the past year again exposed the urgent need for longer-term structural economic reforms.', 'in june 1996, the government released a macroeconomic strategy for growth, employment and redistribution (gear).', 'the full implementation of this programme over the next few years will undoubtedly raise the potential of the economy and enable south africa to meet the vast basic social and economic needs of the people of the country more adequately.', 'it will also provide the economy with better armour to withstand with more vigour similar adverse macroeconomic developments that may recur in future.', 'in retrospect, the economic policies of the past year contributed significantly towards improving equilibrium when emerging imbalances threatened to frustrate the primary objective of achieving sustainable optimum economic growth and development.', "recent improvements in the current account of the balance of payments, the firmer exchange rate of the rand, the increased inflow of foreign capital, and the rise in official foreign exchange reserves, provide sufficient evidence to the effect that the serious danger of a collapse in south africa's external economic relations a year ago has been successfully averted.", 'moreover, there are encouraging, although as yet still only tentative, signs, emanating from both the production and the expenditure sides, that the economy recovered slightly during the second quarter of 1997. this preliminary indication is also confirmed by some hopeful signs that the inflationary pressures which arose from the economic imbalances experienced last year are now subsiding.', 'at the same time, however, the overall financial situation still provides reason for concern, particularly in view of the continued high rates of increase in bank credit extension and in broad money supply.', 'for reasons that will be explained in more detail below, the monetary authorities must persist with their vigil against the threat of overall financial instability that can only lead to stagflation in due course.', 'there are many examples in the world today, both among industrial and emerging economies, where this lesson is again being learnt the hard way after years of reluctance to apply appropriate but unpopular short-term disciplinary monetary policies in a timely fashion.', 'the reserve bank is not prepared to consider any short-term expediencies and implement monetary policies that will in the long term lead to serious disruption of financial stability.', 'the country just cannot afford unsound monetary policies for short-term gain.', 'such policies would gradually undermine the value of the rand and lead to an eventual collapse of the financial system, with serious adverse implications also for the level of real economic activity.', "recent economic developments the reserve bank's annual economic report released this morning serves as a background to the following brief summary of major economic developments over the past twelve months: a year of economic consolidation the pattern of developments in real economic activity over the past twelve months can best be described as the outcome of a necessary process of consolidation after three years of positive growth.", 'the rate of expansion in gross domestic product reached a seasonally adjusted and annualised rate of 311⁄2 per cent in the second half of 1996, but then slowed down to only 1 per cent in the first half of 1997, indicating a lower rate of growth for the full calendar year of 1997 compared with that experienced during any one of the past two years.', 'during the first quarter of 1997, total gross domestic product actually declined by 1 per cent, setting off alarm bells of a pending recession.', 'during the second quarter, however, there was a distinct recovery when overall economic activity again turned to positive growth, equal to an annualised rate of 211⁄2 per cent.', 'with a continued decline in agricultural production during the second quarter and only moderate growth in mining production, total value added by the primary sectors declined by a further 1 per cent.', 'against this poor performance, however, production in the rest of the economy was back on track with an expansion equal to 311⁄2 per cent on an annualised basis.', 'with growth of 7 per cent in manufacturing, 6 per cent in electricity, gas and water, and 411⁄2 per cent in transport and communication, together with positive growth in all the other sub-sectors, the fears of a pending recession must at least for now have been allayed.', 'gross domestic expenditure, on the other hand, remained fairly depressed.', 'an estimated small decline in total expenditure in the first half of 1997 contributed to the consolidation process of restoring a better balance between total domestic production and effective demand.', 'further declines in the growth rates of private consumption expenditure and gross domestic fixed investment, coupled with a substantial reduction in total inventories, were partly offset by a continued high level of expansion in general government consumption expenditure, particularly at the level of provincial and local government.', 'during the second quarter of 1997 there was, however, a noticeable recovery in demand when total gross domestic expenditure expanded again by 2 per cent, after having declined by 1 per cent in the first quarter.', 'small increases from the first to the second quarter in the rates of growth in private consumption expenditure as well as domestic fixed investment were strongly supported by a further rise at an annualised rate of more than 511⁄2 per cent in general government consumption expenditure.', 'excluding the effect of a substantial reduction in inventories, total domestic expenditure actually increased by 211⁄2 per cent in the second quarter.', 'these disparate movements in real economic aggregates between the first and second quarters of 1997 underline the importance of correctly interpreting short-term indicators of current economic developments.', 'the reserve bank will conscientiously analyse all economic information that becomes available over the next few months with the necessary sensitivity to the pressing needs of the country.', 'better equilibrium in the balance of payments the salutary effects on the balance of payments of slower growth in total domestic expenditure are clearly reflected in the rapid decline in the deficit of the current account.', 'on a seasonally adjusted and annualised basis, this deficit declined from r13 billion in the second quarter of 1996 to only r3.5 billion in the second quarter of 1997. in unadjusted figures, the negative balance declined from r5.5 billion in the first half of 1996 to r3.0 billion in the second half of last year, and r2.4 billion in the first half of 1997. both imports and exports of merchandise responded to the depreciation of the rand last year.', 'in the second quarter of 1997, the level of merchandise exports at current prices was 25 per cent higher than in the second quarter of 1996, whereas the value of imports increased by only 11 per cent.', 'this was, however, not all due to the price effect of the depreciation of the rand.', 'growth in the volume of imports also slowed down as a result of the decline in gross domestic expenditure.', 'in the case of the value of exports, an increase of 25 per cent was already experienced in the year prior to the depreciation, partly as a result of the removal of international sanctions, which no doubt continued to affect exports in 1996 and the first half of 1997. the improvement in the current account was supported by a larger net inflow of funds reflected in the capital account of the balance of payments.', 'the pressure on the exchange rate of the rand, which continued from february to october 1996, subsided again after october, almost as suddenly as it had appeared.', 'during the first three quarters of 1996, the net capital inflow amounted to only r585 million, but this was followed by a net inflow of r3.3 billion in the fourth quarter, and by no less than r16.7 billion in the first half of 1997. after the rand had depreciated by as much as 23.5 per cent in nominal terms between 14 february 1996 and the end of october 1996, it appreciated by 10 per cent over the next five months.', 'from the end of march to the end of july 1997, however, the rand depreciated again by 3.6 per cent to give a net increase of 6.0 per cent in the external value of the currency from november 1996 to the end of july 1997. it should be noted, however, that the average level of the exchange rate of the rand over the first seven months of 1997, compared with its average value over the same period in 1996, showed a depreciation in nominal terms of 8.4 per cent.', 'although the initial appreciation after october 1996 was accepted as a partial correction of an over-reaction, the reserve bank nevertheless, already in november 1996, started to intervene again in the market as a net buyer of foreign exchange.', "the country's gross foreign reserves held by the consolidated banking sector indeed increased by r17.2 billion over the past three quarters to reach a level of r31.1 billion at the end of june 1997. this was sufficient to cover about 911⁄2 weeks of imports of goods and services.", 'currency depreciation as a means to achieve greater international competitiveness only has a chance to succeed in countries where inflation is not sensitive to depreciation.', 'the events of the past year proved once again that in south africa inflation reacts with a time lag of only about six months to major changes in the exchange rate.', 'the quarter-to-quarter increase in the seasonally adjusted and annualised rate of change in the production price index for imported goods escalated from 6.0 per cent in the first quarter of 1996 to no less than 18.1 per cent in the fourth quarter, before it declined again to 12.4 per cent in the first quarter of 1997. in the second quarter of 1997, that is approximately six months after the turnaround in the trend of the exchange rate in november 1996, the production price index for imported goods actually declined by 10.7 per cent.', 'monetary aggregates slow to respond over the past two years, the reserve bank has on various occasions advanced reasons why changes in the m3 money supply may have lost some of its usefulness as a reliable anchor for monetary policy.', 'at this juncture, the bank regards changes in m3 only as one among several important financial indicators.', 'it no longer bases its monetary policy decisions automatically on any rigid formula linking actual changes in m3 to the predetermined money supply guidelines issued by the bank at the beginning of each year.', 'in 1996, for example, monetary policy was aimed more directly towards the restoration of external financial stability.', 'more recently, the bank has become more concerned about the excessive increase in domestic bank credit extension, not only because of its influence on the money supply, but also for other reasons.', "there has, for example, been growing anxiety about the over-extension of the private sector's indebtedness relative to disposable income, and the increasing vulnerability of the banking sector to adverse developments in a possibly less favourable future macroeconomic environment.", 'no central bank can, of course, disregard developments in the money supply or in bank credit extension, even if such developments can be explained as temporary distortions caused by major structural economic reforms.', 'although changes in m3 and its shorter-term components should be interpreted with circumspection in the present south african environment, they cannot be discarded or ignored.', 'the relationship between the money supply and nominal production, or the velocity of circulation of m3, may be changing, but new relationships are being established in the process of transformation.', 'over the longer term, it remains true that inflation cannot be sustained indefinitely unless it is fuelled by continuous excessive money creation.', 'throughout 1996, the annual rate of increase in the m3 money supply fluctuated within a narrow range of between 13.6 and 16.1 per cent.', "by january 1997 it reached a peak of 16.8 per cent, and then declined gradually to 12.7 per cent in june 1997. as a guideline the reserve bank currently regards a rate of increase of not more than 10 per cent per year in the m3 money supply as consistent with the prime objective of reducing inflation gradually to a level that will be more in line with the average rate of inflation in the economies of south africa's major trading partners.", 'the increase in m3 has now consistently exceeded the rate of growth in the nominal value of gross domestic product for more than three years, with the result that the ratio of the total amount of money in circulation to gross domestic product has risen to 58 per cent, which is the highest level since 1980. a lack of availability of money can therefore hardly be advanced as a reason for the slowdown in real economic activity over the past eighteen months.', 'the relatively high level of the money supply or, inversely, its low level of velocity of circulation, holds a potential danger for future inflation.', 'although a substantial part of the excess amount of money in circulation may at this stage be confined to the financial sector, possibly contributing to financial asset inflation, the reserve bank will have little control over the situation once holders of financial assets decide again to divert their spending to the acquisition of goods and services.', 'central bank policy must therefore always be forward-looking and attempt to pre-empt the danger of overspending or rising inflation at some future inopportune stage.', 'total bank credit extended to the private sector likewise continued to increase at a high rate throughout 1996, and fluctuated between a peak of 18.9 per cent in july and a low of 16.1 per cent in december.', 'during the first six months of 1997, it peaked at 17.4 per cent in april, and then declined only marginally to 16.3 per cent over the twelve months up to june.', 'as in the case of the money supply, the total amount of bank credit outstanding has risen as a percentage of gross domestic product over the past few years.', 'at the end of june 1997, it amounted to 75 per cent of gross domestic product, compared with 67 per cent at the end of 1993. bank credit is, of course, not only extended for the purpose of financing purchases of goods and services.', 'indeed, particularly in recent months, a substantial amount of the additional bank credit created may have been linked to the explosive increases in the volume of transactions in the financial markets, particularly in the equity and bond markets.', 'nevertheless, all forms of bank credit create money, and the initial reason for which money is created is only of limited significance for monetary policy purposes.', 'once the money has been created, it becomes part of the amorphous pool of the total money supply and, depending on the strength of the multiplier effect, is available to be used a number of times over, and for many purposes other than its first application.', 'many explanations can be offered for the persistently high rates of increase in bank credit extension and in the money supply, despite the slowdown in real economic activity over the past eighteen months.', 'it could partly be linked to a switching of international trade financing from foreign to domestic sources, or partly to the financing of summer crops in the agricultural sector that are being harvested late this year.', 'it is also known that bank credit extended to local authorities increased by no less than r2.7 billion from 31 december 1996 to 30 june 1997. these explanations, however, do not detract from the need for a curtailment of the excessive rates of increase in these important monetary aggregates at this juncture.', 'in light of the unfavourable experiences of a number of other countries in recent years, ranging from a well-developed country such as japan to an emerging economy such as thailand, central bankers elsewhere are increasingly concentrating on restricting the provision of bank credit for investment in financial assets and property.', 'in a bull market, even at high interest rates, borrowers will continue to borrow funds to buy assets that are rapidly appreciating in value; and banks will continue to lend because the value of their collateral is rising.', 'this could easily cause a speculative bubble that, should it burst, can create major difficulties for both lenders and borrowers.', 'in such a situation, it is not unusual for the money supply to continue to rise, in conflict with the objectives of the monetary authorities, and often also in contrast to the slowdown in real economic activity.', 'south africa is hopefully not yet in such a position.', 'in the implementation of monetary policy more than in anything else, prevention is almost without exception less costly in terms of a possible temporary loss of production and employment that can in any case not be sustained, than the sacrifices that will eventually be required to fight high inflation once it has become entrenched.', 'in the present situation, the reserve bank feels that a cautious monetary policy stance remains justified.', 'this has been the approach throughout the past year and undoubtedly has had a major influence on developments in the money market.', 'the shortage of funds in this market, as reflected by the amount of accommodation required by banking institutions from the reserve bank, first increased from a daily average of r4.9 billion in january 1996 to r10.6 billion in march 1997, before it declined to r7.3 billion in july 1997. as the recovery in the balance of payments recently gained momentum, the reserve bank has been prepared to allow a natural downward adjustment in the money market shortage, paving the way for a gradual decline in money market interest rates.', "the reserve bank raised its lending rate to banking institutions, the bank rate, from 15 per cent at the end of 1995 to 16 per cent in april 1996, and then to 17 per cent in november 1996. the rate on three-month bankers' acceptances first increased sharply from 14.6 per cent at the end of december 1995 to 17.0 per cent a year later, but has since declined gradually to 15.0 per cent in the middle of august 1997. as the south african financial markets are being integrated more in the global financial system, the comparison between south african and international interest rates takes on greater significance.", 'too low a level of interest rates locally will eventually be reflected in a weak currency, and lead to a further depreciation of the rand.', 'too high a level, on the other hand, will attract speculative short-term capital from abroad, and lead to an undesirable appreciation of the currency, and/or an unhealthy expansion of domestic liquidity.', 'the sharply inverted shape of the yield curve in south africa makes the comparison of the level of local interest rates with the international markets more difficult.', 'at the long end of the spectrum, the yield on long-term government bonds in south africa seems to be on the low side in real terms.', 'short-term interest rates, and particularly bank lending rates at the other end of the yield curve, seem to be high in south africa, reflecting negative expectations on inflation, high risks involved in more short-term lending to an already overborrowed community, and a relatively high demand for funds.', 'the conservative monetary policy measures applied by the reserve bank over the past eighteen months have paid off by containing the increase in inflation to below 10 per cent, despite the pressures arising from the depreciation of the rand last year.', 'measured over a period of twelve months, the rate of increase in the overall production price index rose from 5.3 per cent in april 1996 to 9.6 per cent in march 1997, but then declined to 7.5 per cent in june 1997. movements in the consumer price index followed a similar path and the increase in consumer prices, measured over twelve months, rose from 5.5 per cent in april 1996 to 9.9 per cent in april 1997, before declining to 8.8 per cent in june 1997. at the time of the depreciation of the rand in 1996, a much higher rate of inflation was predicted on the basis of previous experience.', 'there is, however, no reason for complacency.', 'as long as the south african rate of inflation remains significantly higher than that in the major countries of the world, the integration of south africa into the global financial markets will be slow and turbulent.', 'in view of the complex interaction between the level of interest rates, the rate of inflation, and the exchange rate in the process of financial globalisation, disruptive adjustments will be demanded from time to time.', 'this will continue to complicate decisions for investors and cross-border traders.', 'participation in the process of financial globalisation ultimately requires a high degree of convergence between countries in these basic financial aggregates.', 'the domestic levels for interest and exchange rates can no longer be determined by governments or central banks in isolation.', 'these financial prices will indeed increasingly be driven by international market consensus.', 'at this stage, the international market imperative requires of south africa to bring its rate of inflation gradually in line with the rest of the world.', "alternatively, the country's drive towards greater participation as an important borrower of funds in the world financial markets will be constrained.", 'furthermore, what is even more important is that the existing imbalances of income and wealth in the domestic economy will further deteriorate in an inflationary environment.', "it is relatively easy for those more fortunate members of society to protect themselves against inflation as they have easy access to credit and can spend more in today's terms, hoping to repay with depreciated money sometime in the future.", 'less fortunate members of the society find that wage increases do not keep up with inflation, especially run-away rising inflation, and their savings and buying power deteriorate continuously.', "financial market reforms pay dividends the major reforms in south africa's financial markets over the past few years paid good dividends in the form of substantial increases in the volume of business done through these various markets.", 'structural improvements introduced by the johannesburg stock exchange, the bond exchange of south africa, and the south african futures exchange (safex), were also boosted by the further relaxation of exchange controls.', 'the value of bonds traded in the bond exchange of south africa increased by 51 per cent in 1996 to exceed the r3,000 billion level.', 'in the first half of 1997, the total turnover in this market already exceeded r1,700 billion.', 'these higher values included a substantial increase in transactions effected by non-residents in the market.', 'the value of shares traded in the secondary share market increased from r63 billion in 1995 to r117 billion in 1996, and to r92 billion for the first half of 1997. as in the case of the bond exchange, non-residents also made an important contribution to the increase in business transacted through the johannesburg stock exchange.', 'the turnover in options and futures contracts traded through safex performed likewise, showing sharp increases over the past eighteen months.', 'the importance of the formal capital markets for the economic development of south africa can be clearly illustrated by two basic statistics.', 'firstly, over the eighteen months from the beginning of 1996 up to the middle of 1997, the amount of new capital raised through issues on the stock exchange and net issues of fixed interest-bearing securities in the primary bond market amounted to approximately r50 billion.', 'secondly, over the same period, net purchases by non-residents of south african securities listed on the exchanges amounted to about r34 billion.', 'supportive fiscal policies the minister of finance applied further disciplines in his budget proposals for 1997/98 with a commitment to reduce both government dissaving and the deficit before borrowing during the current fiscal year.', 'in the preceding year net dissaving by government was equal to 3.1 per cent, and the budget deficit equal to 5.6 per cent of gross domestic product.', 'the deficit for the current fiscal year is expected to be reduced to 4.0 per cent of gross domestic product.', 'the government also made an important contribution to the official foreign reserves of the country by way of two bond issues in international capital markets during june 1997. the total proceeds from these two loans amounted to r3.8 billion.', 'a few smaller and one major privatisation transaction - the sale of an equity stake of 30 per cent in telkom - raised more than r6 billion over the past year.', 'part of these funds was used to contain total government debt to a level of about 56 per cent of gross domestic product.', 'the better harmonisation of monetary and fiscal policies over the past year made a major contribution to the success achieved with the objective of restoring overall financial stability after the foreign exchange market disruption of february last year.', 'financial co-operation in southern africa the committee of governors of the central banks of the twelve members of the southern african development community (sadc) met twice during the past twelve months to discuss matters of financial co-operation.', 'the secretariat of the committee within the reserve bank has made good progress in the compilation of a computerised data base of financial statistics of the region and information on the functions and responsibilities of the twelve participating central banks.', "officials from all the central banks participated in a number of courses presented by the reserve bank's training institute, and a course was again presented for bank regulators and supervisors in the east and southern africa banking supervisors group (esaf).", 'a special study is being undertaken with the support of the world bank on the development of national payment and clearing systems with a view to the eventual establishment of a cross-border payment and settlement system for all sadc countries.', 'over the next year, the co-ordination of financial co-operation in the region will be extended also to include the activities of commercial (private) banks and stock exchanges.', 'a need for more flexible monetary policy operations developments over the past year revealed a need for greater flexibility in the market for short-term funds.', 'the transformation in the south african financial markets since 1994, and in particular the further integration into the global financial system, will in future require more prompt action and decisive direction for movements in financial asset prices, interest rates and exchange rates.', 'part of the explanation for the rigidities in the south african money market lies with the present system used by the reserve bank to provide accommodation to banking institutions at the discount window.', 'banking institutions have unlimited access at the bank rate to overnight loans from the discount window, provided they have at their disposal acceptable collateral.', 'the bank accepts treasury bills, land bank bills, south african reserve bank paper and government bonds, all with an outstanding maturity of less than 91 days, as security for such overnight loans.', 'a second-tier facility is also available, but at a penalty rate of 75 percentage points above the bank rate against similar securities as collateral, but with outstanding maturities of between 91 days and three years.', 'the bank rate is, of course, changed from time to time to adapt to changes in underlying financial market conditions.', 'to make the system work effectively, the market must react with sensitivity to changes in underlying demand and supply conditions, and must also emit clear and comprehensible signals to the authorities.']	Chris Stals	South African Reserve Bank	Governor	South Africa
https://www.bis.org/review/r970829b.pdf	Mr. Reddy reports on the dilemmas of exchange rate management in India (Central Bank Articles and Speeches, 15 Aug 97)	Inaugural Address by the Deputy Governor of the Reserve Bank of India, Dr. Y.V. Reddy, at the XIth National Assembly Forex Association of India held in Goa on 15/8/97.	1997-08-15 00:00:00	Mr. Reddy reports on the dilemmas of exchange rate management in India Inaugural Address by the Deputy Governor of the Reserve Bank of India, Dr. Y.V. Reddy, at the XIth National Assembly Forex Association of India held in Goa on 15/8/97. I am thankful to the organisers of the XIth National Assembly of the Forex Association of India for giving me an opportunity to share with you the dilemmas that we face in foreign exchange management. The fifty years since independence have seen significant changes in our exchange rate regime. The exchange rate policy has evolved from the rupee being pegged to the pound sterling until 1975, pegged to an undisclosed currency basket until 1992 and after a year's experience with dual exchange rate system to a market-related system by March 1993. This has helped to bring about flexibility in exchange rate management. A couple of years ago, my predecessor, distinguished Dr. S. S. Tarapore, addressed this Assembly on some of the burning issues of foreign exchange markets. Last year, my colleague, Mrs. Usha Thorat gave an authentic and analytical account of the recent developments in forex markets and on the role of authorised dealers (ADs) in forex markets. Today, I will address the dilemmas that we, as policy makers, face in the conduct of exchange rate policy. International Parity 2. I will briefly, as a backdrop, revisit the four parity conditions, that you are familiar with. First, the Purchasing Power Parity (PPP) which links the spot exchange rate and inflation. Secondly, the International Fisher Relation which links interest rates and inflation. Thirdly, the Foreign Exchange Expectations which link forward exchange rates and expected future spot exchange rates. Fourthly, the Interest Rate Parity, which links spot exchange rates, forward exchange rates and interest rates. The four parity relations could be combined in several ways to throw light on the four critical variables that are often used in exchange rate management policies, viz., the interest rate differential, the inflation differential, the forward discount/premium, and the exchange rate movement. The theories built around the parity relations help us to understand the foreign exchange markets better, but, they rarely give us ready-made solutions to the problems that arise in day-to-day, say, minute-to-minute operations in the exchange markets. 3. What could be the explanation for such a phenomenon? In the real world, expectations cannot be easily subjected to definitive formulae; goods cannot be transferred across countries simultaneously; shipping and other transactions costs can turn out to be much different from the initial conditions; trade and other restrictions often exist, distorting prices. Even in the most efficient markets, 'ideal' conditions do not exist, and forward premia as a result have not been able to predict future spot rates accurately. The actual exchange rates are usually overvalued or undervalued in terms of the purchasing power parity. Under Indian conditions, however, there are some additional questions. For instance, which is the correct risk-free interest rate to be compared while calculating interest rate differentials? Should we consider the 91-day T-bill rate or some other short-term rate? The theoretical forward premia could vary depending on the interest rate chosen. In the quest for answers to some questions, dilemmas do arise. Objectives and Purposes of Exchange Rate Management 4. The main objective of India's exchange rate policy is to ensure that economic fundamentals are reflected in the external value of the rupee. Subject to this predominant objective, the conduct of exchange rate policy is guided by three major purposes. First, to reduce excess volatility in exchange rates, while ensuring that the market correction of overvalued or undervalued exchange rate is orderly and calibrated. Second, to help maintain an adequate level of foreign exchange reserves. Third, to help eliminate market constraints with a view to the development of a healthy foreign exchange market. Let us relate the above approach to the current context. Current Context 5. The elements of continuity, contextual response and change would be present in the conduct of any policy, including the exchange rate policy. In this address, I will be focusing on the contextual response. After all, exchange rate policy will form part of the overall macroeconomic policy and will, therefore, have to be subservient to overall macroeconomic targets. The conduct of exchange rate policy during 1996-97 was primarily guided by market conditions resulting from the contraction in the current account deficit and resurgence of capital inflows. Foreign exchange reserves (including gold) scaled a peak of US$ 26.4 billion by end-March 1997, without sacrificing exchange rate stability. In regard to 1997-98, the exchange rate policy needs to be seen in the context of the Monetary Policy Statement of April 15, 1997. The Statement indicates, given the real GDP growth for 1997-98 of 6.0 - 7.0 per cent, the expansion in M3 would be sought to be maintained in the range of 15.0 - 15.5 per cent to keep the inflation rate at around 6.0 per cent. Monetary policy would, in other words, continue to be directed towards maintaining a stable financial environment in relation to price, interest rate and exchange rate. 6. Against these broad parameters, we have to look at the variables that have a bearing on contemporary exchange rate management. Some of the crucial variables at this juncture, apart from price stability and money supply, which are always dominant, are, in my view, the revenue and expenditure position of the Government, the oil pool deficit, the buoyancy in industrial activity, the progress in infrastructure sector, and the developments in trade and capital flows. Besides, leads and lags operate, affecting the market. Moreover, major players in the market influence exchange rate movements and thereby the perceptions about policy. Let me illustrate this point with reference to the oil pool deficit. The IOC has, in the recent past, increasingly resorted to foreign currency borrowing rather than domestic borrowing to finance the deficit, presumably in view of the lower cost and the perceived stability of the rupee. To the extent the IOC resorts to additional overseas borrowing for oil purchases, the demand in the forex market is depressed, leading to pressure on the rupee to appreciate even further. There would be an exactly opposite effect when the IOC starts reducing the exposure to short term borrowing, simultaneously making the cash payment for current purchases, with implications for exchange rate management. External Value of the Rupee 7. The deceleration in export growth during 1996-97 has emerged as an area of policy concern and exchange rate is often blamed for that. The slow down in export growth during 1996-97 could as well be attributed to the decline in world trade coupled with sluggishness in manufacturing goods prices in the global market, variations in cross-currency exchange rates and deceleration in domestic industrial activities. However, we should accept that, beyond a point, real appreciation of a currency can hurt exports. Given the disparate movements over time of the exchange rates of the domestic currency and the domestic inflation rate relative to important trading partners, the Real Effective Exchange Rate (REER) is reckoned as one of the most important determinants of the country's external competitiveness. Using the trade based REER (1985=100), the REER was 61.02 per cent in August 1993 and 65.78 per cent in August 1995, i.e. an appreciation of 7.8 per cent. In August 1995, the volatility in the exchange rate of the rupee started and in the following months, the rupee depreciated and corrected for real appreciation by January 1996 when the REER was 59.32. For most of 1996, the REER remained stable. However, with the sharp appreciation of the US dollar vis-à-vis other major currencies since the last quarter of 1996, the rupee also appreciated in real terms. In August 1996, the trade based REER (1985=100) was 62.26 which rose to 65.41 in April 1997, i.e. an appreciation of around five per cent. Over January 1996, the appreciation in April 1997 was 10.3 per cent. There is considerable discussion as to whether the rupee is overvalued or not. As per the REER, it would certainly appear so, irrespective of the base chosen. The overvaluation has got exacerbated with the sharp appreciation of the US dollar against other major currencies, viz., the DM and the Yen. The relative "cheapening" of imports may not have resulted in increasing imports and larger current account deficits. This is because imports are relatively less responsive to exchange rate changes and are more sensitive to the level of economic activity. There could be a potential larger current account deficit as industrial activity rebounds - even at the present exchange rates and if oil demand picks up, a correction cannot be ruled out. The optimal size of the external current account deficit, of course, depends upon the degree of openness of the economy. In the Indian context, the ratio of current receipts to GDP of 15 per cent, as at present, could sustain a current account deficit of the order of two per cent of GDP and would still enable a decline in the debt service ratio from the present level of 25 per cent. A current account deficit of two per cent of GDP in conjunction with the domestic savings rate of 25-26 per cent could ensure an investment rate of around 28 per cent which, even with ICOR of around 4.0 should be able to sustain a real GDP growth of seven per cent per annum. Since 1991-92, however, the current account deficit has averaged around only one per cent of GDP. Thus, enlargement of the current account deficit beyond the present level is sustainable. Volatility 8. The Reserve Bank has been intervening in both the spot and forward markets to prevent undue fluctuations. In the context of large capital flows (inflows as well as outflows) within a short period, it may not be possible to prevent movements in the exchange rate away from the fundamentals. Hence, the management of rate fluctuations becomes passive, i.e., one of preventing undue appreciation in the context of large inflows and providing a supply of dollars in the market to prevent sharp depreciation. But, the correction, if any, has to be gradual and not sudden. Level of Reserves 9. Adequacy of reserves is, as I mentioned, an important consideration. The level of foreign exchange reserves rose to US$ 29.8 billion by August 1, 1997 - equivalent to seven months of imports. In the context of the changing interface with the external sector and the importance of the capital account, we have to evaluate reserve adequacy in terms of both conventional indicators and non-conventional norms. The present level of foreign exchange reserves is equivalent to about 30 months of debt service payments and 5.7 months of payments for import and debt service taken together. In the context of mobile capital flows, it may be useful to assess the level of reserves in terms of the volume of short-term debt which can be covered by reserves. At the end of March 1997, the ratio of short-term debt to the level of reserves amounted to a little over 25 per cent, compared to about 100 per cent for Indonesia, 50 per cent for Argentina, and 25 per cent for Malaysia. In fact, the level of reserves exceeds the total stock of short-term debt and portfolio flows which, taken together, constitute little less than 75 per cent of the level of reserves. The present level of external reserves is a source of comfort as it provides a measure of insulation against unforeseen external shocks or shocks created by domestic supply shortages. Besides, it helps to meet the precautionary motive and satisfy the need for liquidity, which in itself instils confidence in the Indian economy among international investors and financial markets. Such confidence has also a bearing on the extent and of course cost of external borrowings. As the economy becomes more open, external shocks need a cushion which reserves alone can provide. The volatility of some of the capital flows needs to be kept in mind. It is true that reserves are not required to meet the transaction motive which is to be taken care of by changes that will naturally occur in the market determined exchange rates. But, in a period of transition, when structural shifts can release strong excess demand or throw up temporary bottlenecks, reserves smoothen the process of change and mitigate pains of adjustment. So, some addition to reserves, in my view, would give additional comfort. Forex Markets 10. Developing exchange markets is another important consideration in exchange rate management. Recently, several measures were initiated to further integrate the Indian forex market with the global financial system. Banks were permitted to fix their own position limits and Aggregate Gap Limits (AGLs) in January 1996. Banks were permitted in October 1996 to provide foreign currency denominated loans to their customers out of the pool of FCNR - B deposits. In order to achieve greater integration between domestic and overseas money markets, authorised dealers (ADs) were permitted in April 1997 to borrow from their overseas offices/correspondents as well as to invest funds in overseas money market instruments up to US $10 million. With a view to imparting flexibility to corporates and improving liquidity in the forward markets for periods beyond six months, ADs were also permitted to book forward cover for exporters and importers on the basis of a declaration of exposure supported by past performance and business projection, provided the total forward contracts outstanding at any point of time did not exceed the average export/import turnover of the last two years. ADs were also allowed to arrange forex-rupee swaps between corporates and run a swap-book within their open positions/gap limits without prior approval of the Reserve Bank. Now, as per the decision taken last week, FIIs are allowed to cover as a first step their debt exposures in the forward market. In order to further facilitate integration between domestic and overseas markets, banks with adequate capital strength may be encouraged to have higher limits for investments in overseas markets. This will help in developing further the forward markets. East Asian Experience: Relevance to India 11. Speaking of correction in external value and of volatility in forex markets, the question that is often asked is "would India go the East Asian way?" In the early stages of development, East Asian countries adopted a conscious policy of export-led growth stimulated by real depreciation of their currencies. It was only much later, when capital inflows became strong, after 1992, that their currencies appreciated in real terms. The currency overvaluation, declining exports, overheated property markets and the fragile banking system had fuelled intense foreign currency speculation, as the market participants felt that the natural course of the currency was to depreciate. Given the huge short-term borrowings, the fund managers started exiting the economy with the first sign of trouble, leading to a de facto devaluation of the Thai baht. An important point to be noted here is that the currency crises in these countries was managed quite efficiently with the help of reserves which most of these countries had to defend their currencies. Thailand, as also other East Asian economies, despite a large current account deficit, are high-saving economies with good underlying growth rate and strong competitiveness. What are the lessons for India? 12. The recent experience of the emerging economies shows that any currency could come under speculative attack if its exchange rate is out of alignment with fundamentals for a prolonged period of time. Second, once the speculative attack is launched on any currency, the neighbouring currencies are also vulnerable, no matter how sound their policies may be. Third, the overvaluation of a currency acts as a catalyst when there is a run on the currency as all the market players base their action on the information that the currency is due for correction. Presently, compared to March 1993, the appreciation of the Indian rupee in real effective terms is around 14 per cent. The Indian economy does have certain favourable factors in terms of a moderate CAD/GDP ratio, high foreign exchange reserves and a ratio of short-term debt to reserves much lower than that of the East Asian countries. Our inflation rate is also edging downwards. We have a fairly solid banking system despite the NPAs; the number of NBFCs are not that large; and the financial sector is subject to reasonably effective regulation by the RBI. Our financial sector is, therefore, less vulnerable than many of the East Asian economies, notwithstanding the fact that there are corporates operating with unhedged positions. It is unlikely that any turmoil in South East Asian economies would have a direct impact upon the Indian rupee as India's trade with the five countries of the South East Asian region (Thailand, Indonesia, Malaysia, Philippines and Singapore) constituted only 7.8 per cent in 1996-97. Also, the currencies of this region are more internationally traded, larger number of hedging products are available, and the central banks of several South East Asian economies pool their resources to counter any attack on their currencies. It is possible that the sentiments that govern the interest of investors in these countries are different from the sentiments of investors coming to India. In brief, the experience of these countries should provide some lessons for us in terms of potential risks. Of immediate relevance to us is the impact of their devaluation on export competitiveness if the rupee continues to appreciate. Capital Inflow 13. Capital inflows constitute a major factor affecting the value of the rupee now. With the resurgence in capital inflows, the net surplus on the capital account more than doubled to about US$ 11,600 million during 1996-97, thereby exceeding the previous peak of US$ 9,695 million touched in 1993-94. Reflecting these developments, surplus conditions prevailed in the foreign exchange market throughout the year. In general, the policy response has taken the form of partial sterilised intervention through open market operations, liberalisation of capital outflows, raising of reserve requirements and deepening of the foreign exchange market by routing increased volumes of transactions through the market. To prevent appreciation of the rupee, and to protect international competitiveness, the Reserve Bank made substantial purchases of US dollars in the market. During 1997, the RBI intervened in the spot and forward markets, both in the outright and swap segments. Outright spot and forward purchases of US dollars during 1996-97 amounted to $7.9 billion and $0.9 billion, respectively. Swap purchases amounted to $2.4 billion. While spot sale of US dollars was marginal, forward and swap sales amounted to $0.3 billion and $3.1 billion, respectively. Thus, net purchases of US dollars during 1996-97 amounted to $7.8 billion. The influx of capital continues during 1997-98. The Reserve Bank has accumulated US$ 3.9 billion of foreign currency assets until August 8, during the current financial year. Total spot and forward purchases and swap sales of US dollars up to end-July 1997, totalled $4.3 billion, $1.1 billion and 0.9 billion, respectively. Thus, net purchases of US dollars by the Reserve Bank of India up to end July, during the financial year 1997-98 amounted to about $4.6 billion. The optimal policy response to capital inflows is very much a function of the anticipated persistence of capital inflows. The design of policy depends upon the expectation of whether the inflow of capital is temporary or is expected to continue. A temporary increase in inflow, perceived as such by the public, which may lead to a temporary real appreciation of the exchange rate, is unlikely to have major effects. Problems, however, arise if the inflow is temporary, but the public expects the inflow to continue. But, in real life, nobody knows with confidence, what is temporary, how temporary it is, and what the public perception is, and indeed how temporary the public perception is! So, let me straightaway go into the instruments. Internationally, a number of instruments have been used to sterilise capital inflows, the chief among them being the sale of government bonds through open market operations. This policy is useful temporarily and if used for long, leads to renewed inflows. We in the Reserve Bank are, however, well equipped with physical stock of government securities. We have been active in the repo market in recent months to manage temporary liquidity conditions. The idea is to realise a fine balance in order to achieve the objectives of sterilisation without putting pressure on yields. Discount policy, which implies restricting the access of banks to central bank credit or raising the cost of refinance, has also been used by countries to sterilise capital inflows. This instrument cannot, however, be used in the current context when there is plenty of liquidity in the money market and there is no borrowing from the central bank. However, this instrument may go against the long-term objectives of monetary and credit policy. Varying the reserve requirements is yet another policy tool. Mobilising Government deposits has served as a variation to absorption of reserves in some countries. Variable deposit requirements in the nature of interest-free deposits with the central bank is another form of discouraging capital inflows. This measure, while it reduces the need for costly sterilisation through the sale of bonds, may result in misallocation of resources and reduce the facility to borrowers to take advantage of lower international interest rates. We have used the CRR successfully in the past to stem inflows. After the imposition of CRR on incremental NRI deposits there has been some deceleration in the growth of foreign currency deposits during the current financial year. Entering into foreign currency swaps (spot sell - forward buy) is another way of sterilising capital inflows. The foreign currency purchased by banks may be used to finance domestic activities or for investment abroad. Our experience shows that the market is fairly thin and, in such a market, the use of foreign currency swaps for sterilisation only adds volatility to the forward market unless there is a constant swap window. Central banks can employ outright forward exchange transaction, i.e., buy outright forward instead of spot. This will have the desired effect on the spot rate only if it is not countered by very large spot inflows from participants like FIIs and forward supplies by exporters who wish to take advantage of the increase in premium. Taxing on capital inflows is yet another form of dissuading flows. For foreign investors, it effectively lowers the rate of return on local assets. This instrument also carries the disadvantage of raising the cost of capital. This option was considered at one time, but deferred, considering its disadvantages. Conclusion 14. I have explained the dilemmas, mainly to show that we are committed to the stated objectives, and assert that we are equipped to handle the problems - equipped with the requisite will and skill. However, some believe that we are cautious - whether in allowing the rupee to appreciate or inducing adequate depreciation. Perhaps some explanation would be in order. First, we are going through a process of economic reform. In a democratic federal set-up, going through such economic reform, we require a general mandate on essential complementary policies. Second, we are vulnerable to supply shocks, especially food stock and oil prices. Third, the East Asian countries support each other. The G-10 countries coordinate with each other. The Latin American countries are generally supported by North America. We are not members of any blocks. We have gone through the trauma of a balance-of-payments crisis in the early 1990s and we cannot ignore the threat to economic sovereignty if we take undue risks. Fourth, and most important, price stability is critical to the economy as a whole, to both the poor and exporters. In fact, as our Governor at the Reserve Bank of India, Dr. C. Rangarajan, mentioned in his address at the Annual Presentation Ceremony of the Engineering Export Promotion Council earlier this month, "containment of domestic price increase has the same beneficial effect as the depreciation of the nominal exchange rate. If the nominal exchange rate is stabilised at a certain level by letting the foreign exchange assets of the central bank increase, it may have an adverse effect on the exporters through price increases arising from more than the desired increase in money supply. There can therefore, be no rigid formula governing exchange rate determination. Monetary authorities need continually to perform a balancing act between ensuring an exchange rate which will be supportive of exports and the need to contain monetary expansion within reasonable limits." During the current financial year up to August 1, deposits have grown rapidly by 4.1 per cent (3.7 per cent in the corresponding period last year). M3 has grown by 4.4 per cent up to July 18 (3.7 per cent last year). The year-on-year growth in M3 is 16.7 per cent. The positive features during the current year are that interest rates have come down, both in the short and long term, and so has the inflation rate. The area of concern relates to money supply. Any further measures in terms of exchange rate should consider the money supply effect so that the gains already made on the interest rate and inflation fronts are not eroded. This is the critical aspect of the current exchange rate management stance. Finally, the extent, the pace and the manner of correction of the exchange rate will have to be taken in conjunction with money supply, since price stability continues to be the dominant objective of monetary policy. We in the Reserve Bank seek your assistance, advice, cooperation and understanding. For my part, I am happy to announce that henceforth the Reserve Bank will make available weekly data relating to its intervention in the forex market.	['mr. reddy reports on the dilemmas of exchange rate management in india inaugural address by the deputy governor of the reserve bank of india, dr. y.v.', 'reddy, at the xith national assembly forex association of india held in goa on 15/8/97.', 'i am thankful to the organisers of the xith national assembly of the forex association of india for giving me an opportunity to share with you the dilemmas that we face in foreign exchange management.', 'the fifty years since independence have seen significant changes in our exchange rate regime.', "the exchange rate policy has evolved from the rupee being pegged to the pound sterling until 1975, pegged to an undisclosed currency basket until 1992 and after a year's experience with dual exchange rate system to a market-related system by march 1993. this has helped to bring about flexibility in exchange rate management.", 'a couple of years ago, my predecessor, distinguished dr. s. s. tarapore, addressed this assembly on some of the burning issues of foreign exchange markets.', 'last year, my colleague, mrs. usha thorat gave an authentic and analytical account of the recent developments in forex markets and on the role of authorised dealers (ads) in forex markets.', 'today, i will address the dilemmas that we, as policy makers, face in the conduct of exchange rate policy.', 'international parity 2. i will briefly, as a backdrop, revisit the four parity conditions, that you are familiar with.', 'first, the purchasing power parity (ppp) which links the spot exchange rate and inflation.', 'secondly, the international fisher relation which links interest rates and inflation.', 'thirdly, the foreign exchange expectations which link forward exchange rates and expected future spot exchange rates.', 'fourthly, the interest rate parity, which links spot exchange rates, forward exchange rates and interest rates.', 'the four parity relations could be combined in several ways to throw light on the four critical variables that are often used in exchange rate management policies, viz., the interest rate differential, the inflation differential, the forward discount/premium, and the exchange rate movement.', 'the theories built around the parity relations help us to understand the foreign exchange markets better, but, they rarely give us ready-made solutions to the problems that arise in day-to-day, say, minute-to-minute operations in the exchange markets.', '3. what could be the explanation for such a phenomenon?', 'in the real world, expectations cannot be easily subjected to definitive formulae; goods cannot be transferred across countries simultaneously; shipping and other transactions costs can turn out to be much different from the initial conditions; trade and other restrictions often exist, distorting prices.', "even in the most efficient markets, 'ideal' conditions do not exist, and forward premia as a result have not been able to predict future spot rates accurately.", 'the actual exchange rates are usually overvalued or undervalued in terms of the purchasing power parity.', 'under indian conditions, however, there are some additional questions.', 'for instance, which is the correct risk-free interest rate to be compared while calculating interest rate differentials?', 'should we consider the 91-day t-bill rate or some other short-term rate?', 'the theoretical forward premia could vary depending on the interest rate chosen.', 'in the quest for answers to some questions, dilemmas do arise.', "objectives and purposes of exchange rate management 4. the main objective of india's exchange rate policy is to ensure that economic fundamentals are reflected in the external value of the rupee.", 'subject to this predominant objective, the conduct of exchange rate policy is guided by three major purposes.', 'first, to reduce excess volatility in exchange rates, while ensuring that the market correction of overvalued or undervalued exchange rate is orderly and calibrated.', 'second, to help maintain an adequate level of foreign exchange reserves.', 'third, to help eliminate market constraints with a view to the development of a healthy foreign exchange market.', 'let us relate the above approach to the current context.', 'current context 5. the elements of continuity, contextual response and change would be present in the conduct of any policy, including the exchange rate policy.', 'in this address, i will be focusing on the contextual response.', 'after all, exchange rate policy will form part of the overall macroeconomic policy and will, therefore, have to be subservient to overall macroeconomic targets.', 'the conduct of exchange rate policy during 1996-97 was primarily guided by market conditions resulting from the contraction in the current account deficit and resurgence of capital inflows.', 'foreign exchange reserves (including gold) scaled a peak of us$ 26.4 billion by end-march 1997, without sacrificing exchange rate stability.', 'in regard to 1997-98, the exchange rate policy needs to be seen in the context of the monetary policy statement of april 15, 1997. the statement indicates, given the real gdp growth for 1997-98 of 6.0 - 7.0 per cent, the expansion in m3 would be sought to be maintained in the range of 15.0 - 15.5 per cent to keep the inflation rate at around 6.0 per cent.', 'monetary policy would, in other words, continue to be directed towards maintaining a stable financial environment in relation to price, interest rate and exchange rate.', '6. against these broad parameters, we have to look at the variables that have a bearing on contemporary exchange rate management.', 'some of the crucial variables at this juncture, apart from price stability and money supply, which are always dominant, are, in my view, the revenue and expenditure position of the government, the oil pool deficit, the buoyancy in industrial activity, the progress in infrastructure sector, and the developments in trade and capital flows.', 'besides, leads and lags operate, affecting the market.', 'moreover, major players in the market influence exchange rate movements and thereby the perceptions about policy.', 'let me illustrate this point with reference to the oil pool deficit.', 'the ioc has, in the recent past, increasingly resorted to foreign currency borrowing rather than domestic borrowing to finance the deficit, presumably in view of the lower cost and the perceived stability of the rupee.', 'to the extent the ioc resorts to additional overseas borrowing for oil purchases, the demand in the forex market is depressed, leading to pressure on the rupee to appreciate even further.', 'there would be an exactly opposite effect when the ioc starts reducing the exposure to short term borrowing, simultaneously making the cash payment for current purchases, with implications for exchange rate management.', 'external value of the rupee 7. the deceleration in export growth during 1996-97 has emerged as an area of policy concern and exchange rate is often blamed for that.', 'the slow down in export growth during 1996-97 could as well be attributed to the decline in world trade coupled with sluggishness in manufacturing goods prices in the global market, variations in cross-currency exchange rates and deceleration in domestic industrial activities.', 'however, we should accept that, beyond a point, real appreciation of a currency can hurt exports.', "given the disparate movements over time of the exchange rates of the domestic currency and the domestic inflation rate relative to important trading partners, the real effective exchange rate (reer) is reckoned as one of the most important determinants of the country's external competitiveness.", 'using the trade based reer (1985=100), the reer was 61.02 per cent in august 1993 and 65.78 per cent in august 1995, i.e.', 'an appreciation of 7.8 per cent.', 'in august 1995, the volatility in the exchange rate of the rupee started and in the following months, the rupee depreciated and corrected for real appreciation by january 1996 when the reer was 59.32. for most of 1996, the reer remained stable.', 'however, with the sharp appreciation of the us dollar vis-à-vis other major currencies since the last quarter of 1996, the rupee also appreciated in real terms.', 'in august 1996, the trade based reer (1985=100) was 62.26 which rose to 65.41 in april 1997, i.e.', 'an appreciation of around five per cent.', 'over january 1996, the appreciation in april 1997 was 10.3 per cent.', 'there is considerable discussion as to whether the rupee is overvalued or not.', 'as per the reer, it would certainly appear so, irrespective of the base chosen.', 'the overvaluation has got exacerbated with the sharp appreciation of the us dollar against other major currencies, viz., the dm and the yen.', 'the relative "cheapening" of imports may not have resulted in increasing imports and larger current account deficits.', 'this is because imports are relatively less responsive to exchange rate changes and are more sensitive to the level of economic activity.', 'there could be a potential larger current account deficit as industrial activity rebounds - even at the present exchange rates and if oil demand picks up, a correction cannot be ruled out.', 'the optimal size of the external current account deficit, of course, depends upon the degree of openness of the economy.', 'in the indian context, the ratio of current receipts to gdp of 15 per cent, as at present, could sustain a current account deficit of the order of two per cent of gdp and would still enable a decline in the debt service ratio from the present level of 25 per cent.', 'a current account deficit of two per cent of gdp in conjunction with the domestic savings rate of 25-26 per cent could ensure an investment rate of around 28 per cent which, even with icor of around 4.0 should be able to sustain a real gdp growth of seven per cent per annum.', 'since 1991-92, however, the current account deficit has averaged around only one per cent of gdp.', 'thus, enlargement of the current account deficit beyond the present level is sustainable.', 'volatility 8. the reserve bank has been intervening in both the spot and forward markets to prevent undue fluctuations.', 'in the context of large capital flows (inflows as well as outflows) within a short period, it may not be possible to prevent movements in the exchange rate away from the fundamentals.', 'hence, the management of rate fluctuations becomes passive, i.e., one of preventing undue appreciation in the context of large inflows and providing a supply of dollars in the market to prevent sharp depreciation.', 'but, the correction, if any, has to be gradual and not sudden.', 'level of reserves 9. adequacy of reserves is, as i mentioned, an important consideration.', 'the level of foreign exchange reserves rose to us$ 29.8 billion by august 1, 1997 - equivalent to seven months of imports.', 'in the context of the changing interface with the external sector and the importance of the capital account, we have to evaluate reserve adequacy in terms of both conventional indicators and non-conventional norms.', 'the present level of foreign exchange reserves is equivalent to about 30 months of debt service payments and 5.7 months of payments for import and debt service taken together.', 'in the context of mobile capital flows, it may be useful to assess the level of reserves in terms of the volume of short-term debt which can be covered by reserves.', 'at the end of march 1997, the ratio of short-term debt to the level of reserves amounted to a little over 25 per cent, compared to about 100 per cent for indonesia, 50 per cent for argentina, and 25 per cent for malaysia.', 'in fact, the level of reserves exceeds the total stock of short-term debt and portfolio flows which, taken together, constitute little less than 75 per cent of the level of reserves.', 'the present level of external reserves is a source of comfort as it provides a measure of insulation against unforeseen external shocks or shocks created by domestic supply shortages.', 'besides, it helps to meet the precautionary motive and satisfy the need for liquidity, which in itself instils confidence in the indian economy among international investors and financial markets.', 'such confidence has also a bearing on the extent and of course cost of external borrowings.', 'as the economy becomes more open, external shocks need a cushion which reserves alone can provide.', 'the volatility of some of the capital flows needs to be kept in mind.', 'it is true that reserves are not required to meet the transaction motive which is to be taken care of by changes that will naturally occur in the market determined exchange rates.', 'but, in a period of transition, when structural shifts can release strong excess demand or throw up temporary bottlenecks, reserves smoothen the process of change and mitigate pains of adjustment.', 'so, some addition to reserves, in my view, would give additional comfort.', 'forex markets 10. developing exchange markets is another important consideration in exchange rate management.', 'recently, several measures were initiated to further integrate the indian forex market with the global financial system.', 'banks were permitted to fix their own position limits and aggregate gap limits (agls) in january 1996. banks were permitted in october 1996 to provide foreign currency denominated loans to their customers out of the pool of fcnr - b deposits.', 'in order to achieve greater integration between domestic and overseas money markets, authorised dealers (ads) were permitted in april 1997 to borrow from their overseas offices/correspondents as well as to invest funds in overseas money market instruments up to us $10 million.', 'with a view to imparting flexibility to corporates and improving liquidity in the forward markets for periods beyond six months, ads were also permitted to book forward cover for exporters and importers on the basis of a declaration of exposure supported by past performance and business projection, provided the total forward contracts outstanding at any point of time did not exceed the average export/import turnover of the last two years.', 'ads were also allowed to arrange forex-rupee swaps between corporates and run a swap-book within their open positions/gap limits without prior approval of the reserve bank.', 'now, as per the decision taken last week, fiis are allowed to cover as a first step their debt exposures in the forward market.', 'in order to further facilitate integration between domestic and overseas markets, banks with adequate capital strength may be encouraged to have higher limits for investments in overseas markets.', 'this will help in developing further the forward markets.', 'east asian experience: relevance to india 11. speaking of correction in external value and of volatility in forex markets, the question that is often asked is "would india go the east asian way?"', 'in the early stages of development, east asian countries adopted a conscious policy of export-led growth stimulated by real depreciation of their currencies.', 'it was only much later, when capital inflows became strong, after 1992, that their currencies appreciated in real terms.', 'the currency overvaluation, declining exports, overheated property markets and the fragile banking system had fuelled intense foreign currency speculation, as the market participants felt that the natural course of the currency was to depreciate.', 'given the huge short-term borrowings, the fund managers started exiting the economy with the first sign of trouble, leading to a de facto devaluation of the thai baht.', 'an important point to be noted here is that the currency crises in these countries was managed quite efficiently with the help of reserves which most of these countries had to defend their currencies.', 'thailand, as also other east asian economies, despite a large current account deficit, are high-saving economies with good underlying growth rate and strong competitiveness.', 'what are the lessons for india?', '12. the recent experience of the emerging economies shows that any currency could come under speculative attack if its exchange rate is out of alignment with fundamentals for a prolonged period of time.', 'second, once the speculative attack is launched on any currency, the neighbouring currencies are also vulnerable, no matter how sound their policies may be.', 'third, the overvaluation of a currency acts as a catalyst when there is a run on the currency as all the market players base their action on the information that the currency is due for correction.', 'presently, compared to march 1993, the appreciation of the indian rupee in real effective terms is around 14 per cent.', 'the indian economy does have certain favourable factors in terms of a moderate cad/gdp ratio, high foreign exchange reserves and a ratio of short-term debt to reserves much lower than that of the east asian countries.', 'our inflation rate is also edging downwards.', 'we have a fairly solid banking system despite the npas; the number of nbfcs are not that large; and the financial sector is subject to reasonably effective regulation by the rbi.', 'our financial sector is, therefore, less vulnerable than many of the east asian economies, notwithstanding the fact that there are corporates operating with unhedged positions.', "it is unlikely that any turmoil in south east asian economies would have a direct impact upon the indian rupee as india's trade with the five countries of the south east asian region (thailand, indonesia, malaysia, philippines and singapore) constituted only 7.8 per cent in 1996-97. also, the currencies of this region are more internationally traded, larger number of hedging products are available, and the central banks of several south east asian economies pool their resources to counter any attack on their currencies.", 'it is possible that the sentiments that govern the interest of investors in these countries are different from the sentiments of investors coming to india.', 'in brief, the experience of these countries should provide some lessons for us in terms of potential risks.', 'of immediate relevance to us is the impact of their devaluation on export competitiveness if the rupee continues to appreciate.', 'capital inflow 13. capital inflows constitute a major factor affecting the value of the rupee now.', 'with the resurgence in capital inflows, the net surplus on the capital account more than doubled to about us$ 11,600 million during 1996-97, thereby exceeding the previous peak of us$ 9,695 million touched in 1993-94. reflecting these developments, surplus conditions prevailed in the foreign exchange market throughout the year.', 'in general, the policy response has taken the form of partial sterilised intervention through open market operations, liberalisation of capital outflows, raising of reserve requirements and deepening of the foreign exchange market by routing increased volumes of transactions through the market.', 'to prevent appreciation of the rupee, and to protect international competitiveness, the reserve bank made substantial purchases of us dollars in the market.', 'during 1997, the rbi intervened in the spot and forward markets, both in the outright and swap segments.', 'outright spot and forward purchases of us dollars during 1996-97 amounted to $7.9 billion and $0.9 billion, respectively.', 'swap purchases amounted to $2.4 billion.', 'while spot sale of us dollars was marginal, forward and swap sales amounted to $0.3 billion and $3.1 billion, respectively.', 'thus, net purchases of us dollars during 1996-97 amounted to $7.8 billion.', 'the influx of capital continues during 1997-98. the reserve bank has accumulated us$ 3.9 billion of foreign currency assets until august 8, during the current financial year.', 'total spot and forward purchases and swap sales of us dollars up to end-july 1997, totalled $4.3 billion, $1.1 billion and 0.9 billion, respectively.', 'thus, net purchases of us dollars by the reserve bank of india up to end july, during the financial year 1997-98 amounted to about $4.6 billion.', 'the optimal policy response to capital inflows is very much a function of the anticipated persistence of capital inflows.', 'the design of policy depends upon the expectation of whether the inflow of capital is temporary or is expected to continue.', 'a temporary increase in inflow, perceived as such by the public, which may lead to a temporary real appreciation of the exchange rate, is unlikely to have major effects.', 'problems, however, arise if the inflow is temporary, but the public expects the inflow to continue.', 'but, in real life, nobody knows with confidence, what is temporary, how temporary it is, and what the public perception is, and indeed how temporary the public perception is!', 'so, let me straightaway go into the instruments.', 'internationally, a number of instruments have been used to sterilise capital inflows, the chief among them being the sale of government bonds through open market operations.', 'this policy is useful temporarily and if used for long, leads to renewed inflows.', 'we in the reserve bank are, however, well equipped with physical stock of government securities.', 'we have been active in the repo market in recent months to manage temporary liquidity conditions.', 'the idea is to realise a fine balance in order to achieve the objectives of sterilisation without putting pressure on yields.', 'discount policy, which implies restricting the access of banks to central bank credit or raising the cost of refinance, has also been used by countries to sterilise capital inflows.', 'this instrument cannot, however, be used in the current context when there is plenty of liquidity in the money market and there is no borrowing from the central bank.', 'however, this instrument may go against the long-term objectives of monetary and credit policy.', 'varying the reserve requirements is yet another policy tool.', 'mobilising government deposits has served as a variation to absorption of reserves in some countries.', 'variable deposit requirements in the nature of interest-free deposits with the central bank is another form of discouraging capital inflows.', 'this measure, while it reduces the need for costly sterilisation through the sale of bonds, may result in misallocation of resources and reduce the facility to borrowers to take advantage of lower international interest rates.', 'we have used the crr successfully in the past to stem inflows.', 'after the imposition of crr on incremental nri deposits there has been some deceleration in the growth of foreign currency deposits during the current financial year.', 'entering into foreign currency swaps (spot sell - forward buy) is another way of sterilising capital inflows.', 'the foreign currency purchased by banks may be used to finance domestic activities or for investment abroad.', 'our experience shows that the market is fairly thin and, in such a market, the use of foreign currency swaps for sterilisation only adds volatility to the forward market unless there is a constant swap window.', 'central banks can employ outright forward exchange transaction, i.e., buy outright forward instead of spot.', 'this will have the desired effect on the spot rate only if it is not countered by very large spot inflows from participants like fiis and forward supplies by exporters who wish to take advantage of the increase in premium.', 'taxing on capital inflows is yet another form of dissuading flows.', 'for foreign investors, it effectively lowers the rate of return on local assets.', 'this instrument also carries the disadvantage of raising the cost of capital.', 'this option was considered at one time, but deferred, considering its disadvantages.', 'conclusion 14. i have explained the dilemmas, mainly to show that we are committed to the stated objectives, and assert that we are equipped to handle the problems - equipped with the requisite will and skill.', 'however, some believe that we are cautious - whether in allowing the rupee to appreciate or inducing adequate depreciation.', 'perhaps some explanation would be in order.', 'first, we are going through a process of economic reform.', 'in a democratic federal set-up, going through such economic reform, we require a general mandate on essential complementary policies.', 'second, we are vulnerable to supply shocks, especially food stock and oil prices.', 'third, the east asian countries support each other.', 'the g-10 countries coordinate with each other.', 'the latin american countries are generally supported by north america.', 'we are not members of any blocks.', 'we have gone through the trauma of a balance-of-payments crisis in the early 1990s and we cannot ignore the threat to economic sovereignty if we take undue risks.', 'fourth, and most important, price stability is critical to the economy as a whole, to both the poor and exporters.', 'in fact, as our governor at the reserve bank of india, dr. c. rangarajan, mentioned in his address at the annual presentation ceremony of the engineering export promotion council earlier this month, "containment of domestic price increase has the same beneficial effect as the depreciation of the nominal exchange rate.', 'if the nominal exchange rate is stabilised at a certain level by letting the foreign exchange assets of the central bank increase, it may have an adverse effect on the exporters through price increases arising from more than the desired increase in money supply.', 'there can therefore, be no rigid formula governing exchange rate determination.', 'monetary authorities need continually to perform a balancing act between ensuring an exchange rate which will be supportive of exports and the need to contain monetary expansion within reasonable limits."', 'during the current financial year up to august 1, deposits have grown rapidly by 4.1 per cent (3.7 per cent in the corresponding period last year).', 'm3 has grown by 4.4 per cent up to july 18 (3.7 per cent last year).', 'the year-on-year growth in m3 is 16.7 per cent.', 'the positive features during the current year are that interest rates have come down, both in the short and long term, and so has the inflation rate.', 'the area of concern relates to money supply.', 'any further measures in terms of exchange rate should consider the money supply effect so that the gains already made on the interest rate and inflation fronts are not eroded.', 'this is the critical aspect of the current exchange rate management stance.', 'finally, the extent, the pace and the manner of correction of the exchange rate will have to be taken in conjunction with money supply, since price stability continues to be the dominant objective of monetary policy.', 'we in the reserve bank seek your assistance, advice, cooperation and understanding.', 'for my part, i am happy to announce that henceforth the reserve bank will make available weekly data relating to its intervention in the forex market.']	Y V Reddy	Reserve Bank of India	Deputy Governor	India
https://www.bis.org/review/r970829a.pdf	Mr. Reddy discusses gold banking in India (Central Bank Articles and Speeches, 2 Aug 97)	Address by the Deputy Governor of the Reserve Bank of India, Dr. Y.V. Reddy, at the World Gold Council Conference held in New Delhi on 02/08/97.	1997-08-02 00:00:00	Mr. Reddy discusses gold banking in India Address by the Deputy Governor of the Reserve Bank of India, Dr. Y.V. Reddy, at the World Gold Council Conference held in New Delhi on 02/08/97. I am thankful to the World Gold Council for inviting me to participate in this Conference. It is unusual for the organisers to seek the same speaker and even more unusual for the speaker to accept such an invitation within a span of nine months. That happens in academic circles. It is of course, routine in the Toast Masters Club, of which I was a member decades ago. But, this is a gathering of hard-headed finance and business people. I presume that the organisers felt that I should be called upon to squarely address the issues that I raised in the last meeting, in a somewhat less inconclusive manner this time. Well, it should be possible to address these issues with a little more confidence now, since the last conference has generated pretty well-informed and wide-ranging debate on most of the issues posed. Today, I will briefly recall the issues that I had posed in November last. We could trace policy developments since then. I would also share with you the response we received on the subject, not only from intellectual circles and the media but also through letters addressed to the Government and the Reserve Bank of India (RBI) - from people in many walks of life. Against this background, and keeping in view the recent developments in economic reform, it is possible to examine the rationale for a New Gold Policy (NGP) at this juncture. The possible objectives and the immediate tasks of an NGP need our attention. If some changes in policy towards NGP are considered necessary, the role of the RBI, banks, government and industry/trade would have to be redefined and re-oriented. I will elaborate on the re-orientation. In my normal style, I will conclude with a set of issues. Deliberately, I am avoiding going into details of gold banking since these aspects will be elaborated by Mrs. Usha Thorat, who is one of our resident experts on gold in the RBI. Issues: A Recall The issues raised in the last meeting related to demand, supply and use of gold. On the demand side, the need for and the effectiveness of restricting demand were the main concerns. On the supply side, limits to domestic production and the implications of import through various channels were touched upon. The fiscal dimensions, trade policy implications, balance of payments (BOP) impact and the desirability of restricting gold import to corporates or banks were also flagged. The role of the RBI in gold policy, sequencing of changes in such a policy and finally the link with capital account convertibility were flagged for further debate. As you are aware, many of these issues have been debated since then, and there has been policy response also. Policy Response: A Summary We have made some progress in liberalising gold policy since we met last. The policy on gold import has been further relaxed and non-resident Indians (NRIs) are allowed to import 10 kgs of gold, against 5 kgs allowed previously. The EXIM policy for 1997-2002 has been modified and now, in addition to the existing canalising agencies, the RBI will be authorising banks to act as nominated agencies for importing gold into the country under various schemes viz., NRI, SIL and export replenishment/loans, etc. The Tarapore Committee on Capital Account Convertibility has submitted its report and has made wide-ranging recommendations relating to gold, including a more liberal import policy for domestic consumption. The RBI has issued guidelines to banks to apply to it for becoming nominated agencies, and the first set of applications will be considered shortly. In the meantime, the customs have also modified the procedures for the import of gold - no longer requiring banks to be totally accountable for export obligations of the exporters. The Standing Committee on Gold and Precious Metals in the RBI (Subrahmanyam Committee) has been expanded to include representatives of the Ministries of Finance and Commerce. The Committee is more active now in rendering advice to the RBI and the Government. General Response: A Review The general response to the issues raised in the previous seminar can be described as one dominated by aggressive liberalisers, some advocating caution, only a few favouring no change in the existing policy and virtually none seeking total roll-back of the policy. There has been no mention of the mobilisation of idle gold for productive purposes or the establishment of a Gold Bank to raise resources. (i) Let me summarise the arguments of aggressive liberalisers. - The gold industry, employing goldsmiths numbering about five lakhs, involving an annual turnover of about Rs.25,000 crore, is kept out of any serious consideration in the current reform process. This reflects continuation of a gold-control mindset and the identification of all import, sale or use of gold with black money. Consequently, gold industry exporters of jewellery and genuine purchasers of gold jewellery continue to suffer. - On account of the present policy, the purchaser of gold jewellery pays a higher price of about Rs.3,000 crore every year because of the "hawala" premium, etc. In percentage terms, at wholesale level, it is an extra 17 per cent. Also, because of lack of consumer protection, and improper certification of quality, the purchaser loses about Rs.4,000 crore each year. - The present gold policy shows anti-rural bias. The real purchaser of gold is typically a peasant. Close to seventy per cent of gold jewellery is sold in rural areas and most of gold sales are by way of jewellery. To quote Professor Jeffrey A. Franks, "holding gold has in fact often in history served, from France to India, as the only way the peasant can protect himself against inflation and the vicissitudes of politics". - Similarly, there is a gender bias, since most of the jewellery is sought by women. While macho consumer durable components are imported and their production or even consumption financed, a non-depreciating asset like gold is discriminated against. It makes no sense to constrain the demand for "a multi-purpose indestructible asset" like gold or gold jewellery, which is a lifetime asset, a hedge against inflation, a source of liquidity and a preferred form of saving. - From a fiscal point of view, the NRI route generated about Rs.500 crore towards customs in a year. The "officialising" of gold import by liberal import of gold will give Rs.250 crore per annum more towards customs, with duties at the same rate as for NRIs. Further, if gold is imported freely under OGL, gold trade down the line becomes traceable and will provide sales tax to State Governments and octroi to local bodies. - From a trade policy point of view, the existing restrictions on gold jewellery-producing units like EOUs constrain the participants in the export market and hamper export growth. Free import under OGL and free export are pre-conditions for capturing world markets - as is evident from the Turkish experience. - Some advocate free import of gold or import under OGL on the ground that there may be a fall in reserves and a desirable impact on the exchange rate. However, most argue that there will be only "officialising" of gold import and use of foreign exchange under hawala, resulting in no net loss of reserves. In fact, once gold jewellery exports pick up, consequent upon gold-import liberalisation, there will be a positive impact on the trade balance. - There is no way of getting rid of or at least drastically reducing the hawala market in foreign exchange, so harmful to the social and moral fabric of India, unless gold import is freed and the scope for gold smuggling reduced. - As pointed out by the Committee on Capital Account Convertibility, a pre-condition for further reforms in the external sector is free import of gold. - Finally, while bank credit is available for import, domestic production or processing and easy acquisition or consumption of luxury goods, no such bank credit is available for gold and gold jewellery employing half a million and providing first-rate security for banks. In fact, the only way of penetrating the informal credit sector without generating non-performing assets is encouraging the flow of bank credit against gold and silver without reference to enduse. (ii) The cautious liberalisers avoid the subject of liberal bank credit or regulating the gold market altogether, but concentrate on possible balance of payments impact. Hence, they advocate limited import through designated agencies to meet both exporters and domestic industry. (iii) The no-changers feel that the existing import regime is foreign exchange neutral; and existing policy is a reluctant admission of our incapacity to change the mindset of Indians who are wasting their savings on gold. There is no need to assist or develop this "unproductive" sector or activity. (iv) There is little support for a total roll-back of policy. There was, however, a suggestion in the context of an analysis of the Report on Capital Account Convertibility in the Economic and Political Weekly (EPW, June 1997). This article reiterated the possible impact of liberalisation of gold import on domestic savings in an adverse way; on diversion of productive resources into unproductive channels; on aiding the process of tax-evasion and hoarding of incomes and assets. Having expressed this, the article states, and I quote, "a more viable policy from the point of healthy and egalitarian development was to recommend the banning of gold imports (other than for jewellery exports and for industrial use), and strict enforcement measures against smuggling". Rationale for New Gold Policy Now Responses to the issues raised by me last year thus show a distinct preference for an NGP. It is possible to highlight the important reasons for a re-look at the existing gold policy. Firstly, it is argued that import or use of gold should be discouraged since it affects domestic savings adversely and implies diversion of resources for unproductive purposes. In reality, our household savings, unlike government savings, have been increasing since independence, while gold was, in spite of the policy, being imported, traded and used. The diversion of savings to unproductive purposes did not happen in the household sector. Further, the idea of mobilisation of resources for productive purposes as defined by planners has yielded place to a slightly different form of policy management of disposition of resources under the post-reform era. Now, even depreciating luxury goods are produced and traded in our economy. Why discriminate against gold? Secondly, it is also held that we should not waste scarce foreign exchange on unproductive purposes. With current account convertibility and a market-determined exchange rate, it is not appropriate to place a premium on foreign exchange. Further, the recent liberalisation of imports through the NRI and SIL route has shown that, in reality, there is no adverse impact of a liberalised gold import. In fact, this recent experience should provide reason enough for a review now, with a view to liberalising further. Thirdly, it is felt that gold is an important instrument for black money deals and hence restrictions on gold amount to restrictions on black money. Since gold is not the only instrument of black money deals, making gold availability difficult will not deter either generation of black money, or its disposition in many ways, including illegal gold. In any case, with the reduction of income tax rates and the launch of the Voluntary Disclosure Scheme in the current year, the fiscal stance is clear - remove incentives for generating black money. Hence, gold policy as an important instrument of anti-black money policy loses its significance, in view of the recent Budget. Fourthly, international experience, especially with Turkey, where conditions are similar, has shown that liberal imports and organised trade in gold benefits the economy, including the external sector. Also, our neighbours in the SAARC region have liberalised and officialised gold imports at nominal duties. These developments make it imperative that we review our policies urgently. Finally, gold plays an important role in our external trade (next only to oil) and in the domestic economy. The reform process would be incomplete without a review and update of the gold policy. Objectives and Tasks of a New Gold Policy What should be the possible objectives of an NGP? The review of our policy so far and the rationale for an NGP that we considered indicate clearly the desirable objectives of an NGP. The major objectives should perhaps be to: - recognise the importance of gold in the Indian economic system and enable gold to play a transparent and positive role in the industrial development, employment and export sectors of the economy, - ensure orderly development of a gold-related industry in India in terms of physical standards and consumer protection, - create and nurture appropriate official regulatory framework and self-regulatory trade bodies, - exploit the scope for generating revenues to the central, state and local governments, - align the regulatory framework and institutional capabilities in the financial sector - especially banking sector - to enable the above, including gold banking, and - enable fuller integration of gold with other areas of the domestic economy and closer integration with the world gold economy, consistent with our economic reform policies. If we accept the above objectives of an NGP, four broad sets of measures may need our attention now. These are (i) gold and trade policy (ii) regulation and development of domestic trading, including quality markup (iii) bank financing for import, export and domestic activities and (iv) gold banking. First, on gold and trade policy, the broad thrust has to be liberalisation of import and export, but there are many options in this regard, and these need to be debated. First, place gold under OGL. This would be an ideal situation for free trade and freely tradeable good. However, as an immediate measure, some scepticism could be expressed. Gold has some characteristics of currency, a financial asset and has quasi-foreign exchange attributes. However, free import by members of the organised bullion market or designated agencies should serve the purpose, with some scope for regulation. Import of gold through designated agencies including banks would help regulate the gold market, besides assuring the quality of gold and bringing more transparency in prices. The advantage of restricting import of gold to designated agencies is that the regulators can fix monetary limits on import during the transition. The domestic transactions of gold imported through the designated agencies could be more easily tracked and would be channelled for making jewellery for domestic use or export. This would also boost exports substantially. On this logic, it will be necessary to discourage liberalised import through NRIs. However, it is possible to charge less import duty when designated agencies import, to discourage the NRI route. In any case, nominal import duty is a pre-condition for liberalised imports. Incidentally, under the liberalised regime, the sale of gold by designated agencies has to be freely permitted to domestic jewellery units. Also, the stipulation of payment of duty in foreign exchange may have to be dispensed with in view of the avoidable irritants, the undermining of domestic currency and market-determined exchange rate. Second, impetus to active domestic trading in gold is a logical consequence of an NGP. Currently, the industry is fragmented. It will be essential to tackle major operational issues required to give a fillip to the gold market, such as the development of refining capacity, accredition of refineries and the introduction of the system of hallmarking as a consumer protection and export promotion measure. Further, serial number, fineness and assay mark of the melter and assayer should be found stamped on bars. We may have to allow foreign companies with expertise in this area to set up shop in India. The melters and refiners, both from within and outside India may have to be permitted based on net worth, turnover, etc. Perhaps we have a lot of catching up to do. Third, it may be necessary to recognise financing as an important policy component of developing the gold market. As would be explained later, the legal and institutional framework is available. Finally, the development of gold banking will be derived from the policy stance. On this subject, I expect the deliberations in this conference to throw up some ideas. The Role of the Reserve Bank of India Central banks the world over have a special concern and role in gold economy. The RBI is no exception. Broadly speaking, the role of the RBI spans five areas. First, and very obvious, is the management of gold reserves. Since October 1990, the Bank's gold holdings have been valued on the basis of international market prices. We recognise the price risk on the gold holdings and have considered the use of gold options and futures to hedge our risk. However, the RBI Act in its present form does not have enabling provisions. There is also a view that exemption notification by the Government would be required under Section 27 of the Forward Contracts (Regulations) Act to enable the RBI to enter into gold - currency swaps. Second, the RBI had played an active part in the local bullion market. The RBI had, in the past, close links with Bullion Market Association, and the RBI's nominee was a member. In the 1970s, gold sale was organised domestically by the RBI, even as it continued its interest in the study of gold and precious metals, monitoring prices, trade, etc., and constantly advised the Government on policies. The RBI in future under the NGP, could play a role similar to the Bank of England in the bullion market. Third, the licensing of import of gold and silver bullion was for a long time a function of the RBI and not of the Import Trade Control. It was only through the amendment to the Foreign Exchange Regulation Act, 1973 in 1992 that the import of gold/silver and the export of gold, jewellery and precious stones ceased to be regulated by the RBI. Now, policy with regard to the import and export of gold is under the purview of EXIM policy. However, as per the recent EXIM Policy, the RBI can designate an agency to import gold for selling it to exporters only. Fourth, in terms of Section 6 of the Banking Regulation Act, 1949, in addition to the business of banking, a banking company may engage in the buying, selling and dealing in bullion and specie. In fact, the Act allows banks to trade in bullion. Banks extend credit against gold. The regulatory role of RBI arises out of its supervisory functions over banks. Fifth, the RBI has and continues to play its rightful role in influencing the gold policy in the country. We have in fact established a framework for ongoing review of policy in gold. We established a Standing Committee on Gold and other Precious Metals in 1992 which has since been enlarged and activated in 1997. The Committee is also addressing issues relating to the development of the gold market and gold based instruments, with providing a significant boost to jewellery export being one of its objectives. We expect this committee to take an active interest in matters relating to gold banking also. The Role of Government I have alluded, earlier today, to the need for an amendment to the RBI Act and also to issuance of notification by the Government under Section 27 of the Forward Contracts (Regulation) Act, 1954. These measures are needed to enable the RBI and banks to enter into derivative contracts in gold. Further, it is not clear whether gold-denominated certificates and other gold-related products would be deemed to be a security in terms of Securities Contracts (Regulation) Act. There are also wide-ranging issues related to taxation. In the European Community, transactions in gold are subject to VAT at rates which vary from country to country. In some countries, gold is subject to sales tax as well. In the UK, there is a formal agreement between the Commissioner of Customs and Excise and the London Bullion Market, on matters relating to tax treatment, and no doubt with the support of the Bank of England. The Government's role is critical in creating an enabling environment, especially through changes in the legal framework. The Role of Trade and Industry In the early part of this century, there existed an active gold market in India - both physical and financial - and gold options and futures were actively traded in the Bombay Bullion Exchange. It is possible to revive this market now. Futures trading is already active in other commodities like pepper, etc. and perhaps there is no reason for disallowing gold to be traded again, though under an appropriate regulatory framework. The focus of the regulation could be to ensure that trading is undertaken within prudential limits and correlated to risk-taking capacity, to prevent systemic weakness and to induce transparency in trading practices. We could draw lessons from the British experience. The London Bullion Market Association has the formal responsibility for the supervision of its wholesale bullion market. The Bank of England, with assistance from the London Bullion Market Association, has drawn up a Code of Conduct for the market which covers such matters as confidentiality, market ethics, inducement and conflicts of interest. It is the responsibility of the Association to monitor its members' adherence both in letter and in spirit, and bring any breaches to the central bank's attention. In addition, the Association has taken over the functions previously performed by the London Gold Market and the London Silver Market in connection with the technical aspects of deliverable material, the rules governing application for inclusion in the list of acceptable Melters and Assayers and the codification of market practices as far as clearing and settlement are concerned. The Role of Banks Currently, the role of commercial banks is limited to investment in gold as an SLR asset and to lend against bullion and specie. As mentioned, banks could play a more active role in financing gold-related activities. As an immediate measure, perhaps banks may be (a) permitted to be designated agencies for import, (b) encouraged to lend against gold or silver jewellery as security up to - say Rs.2 lakh without any stipulation on end-use to help peasants and penetrate the informal credit sector, (c) advised to devise gold acquisition plans, (d) permitted to lend liberally to gold jewellery business, and (e) allowed to draw upon international experience to deal in the gold industry. Issues As you would notice, I have not gone into the details of gold banking. Similarly, on gold policy and capital account convertibility, my distinguished predecessor, friend, philosopher and guide Dr. Tarapore, will address you later. Deliberately, I have not gone into the issue of the current price situation of gold or use of gold as reserves by central banks. I feel that those issues, though of contemporary interest, are not directly relevant. I am thus, left with issues that flow from my presentation today. First: what should be the possible objectives of an NGP? And when should we launch an NGP? Second: is mere liberalisation of import of gold enough of a reform? If not, what are the other measures? Third: who should be the promoter/regulator for gold trade? Fourth: what should be the objectives of regulating gold trade? Fifth: what are the measures that are possible under the existing legal framework? What changes in legal framework are needed to achieve a globally strategic position for India in world gold economy? Sixth: what should be the tax regime, since in many countries the tax regime for gold is somewhat special. Seventh: how soon could the physical facilities, like quality assaying, marking, designs etc. of international standards be established? What will be the role of foreign investment and technology in this area? Eighth: how should the banks equip themselves to do gold banking - immediately, with the present legal and policy frame - and soon, to exploit the opportunities under a possible NGP? Ninth: and this is critical from the RBI's point of view - what is expected of the RBI in the context of developing gold banking now, and under a possible NGP? Let me conclude by thanking the audience for patiently listening to me and assuring the organisers that we in the RBI are eagerly looking forward to the benefit of deliberations here.	['mr. reddy discusses gold banking in india address by the deputy governor of the reserve bank of india, dr. y.v.', 'reddy, at the world gold council conference held in new delhi on 02/08/97.', 'i am thankful to the world gold council for inviting me to participate in this conference.', 'it is unusual for the organisers to seek the same speaker and even more unusual for the speaker to accept such an invitation within a span of nine months.', 'that happens in academic circles.', 'it is of course, routine in the toast masters club, of which i was a member decades ago.', 'but, this is a gathering of hard-headed finance and business people.', 'i presume that the organisers felt that i should be called upon to squarely address the issues that i raised in the last meeting, in a somewhat less inconclusive manner this time.', 'well, it should be possible to address these issues with a little more confidence now, since the last conference has generated pretty well-informed and wide-ranging debate on most of the issues posed.', 'today, i will briefly recall the issues that i had posed in november last.', 'we could trace policy developments since then.', 'i would also share with you the response we received on the subject, not only from intellectual circles and the media but also through letters addressed to the government and the reserve bank of india (rbi) - from people in many walks of life.', 'against this background, and keeping in view the recent developments in economic reform, it is possible to examine the rationale for a new gold policy (ngp) at this juncture.', 'the possible objectives and the immediate tasks of an ngp need our attention.', 'if some changes in policy towards ngp are considered necessary, the role of the rbi, banks, government and industry/trade would have to be redefined and re-oriented.', 'i will elaborate on the re-orientation.', 'in my normal style, i will conclude with a set of issues.', 'deliberately, i am avoiding going into details of gold banking since these aspects will be elaborated by mrs. usha thorat, who is one of our resident experts on gold in the rbi.', 'issues: a recall the issues raised in the last meeting related to demand, supply and use of gold.', 'on the demand side, the need for and the effectiveness of restricting demand were the main concerns.', 'on the supply side, limits to domestic production and the implications of import through various channels were touched upon.', 'the fiscal dimensions, trade policy implications, balance of payments (bop) impact and the desirability of restricting gold import to corporates or banks were also flagged.', 'the role of the rbi in gold policy, sequencing of changes in such a policy and finally the link with capital account convertibility were flagged for further debate.', 'as you are aware, many of these issues have been debated since then, and there has been policy response also.', 'policy response: a summary we have made some progress in liberalising gold policy since we met last.', 'the policy on gold import has been further relaxed and non-resident indians (nris) are allowed to import 10 kgs of gold, against 5 kgs allowed previously.', 'the exim policy for 1997-2002 has been modified and now, in addition to the existing canalising agencies, the rbi will be authorising banks to act as nominated agencies for importing gold into the country under various schemes viz., nri, sil and export replenishment/loans, etc.', 'the tarapore committee on capital account convertibility has submitted its report and has made wide-ranging recommendations relating to gold, including a more liberal import policy for domestic consumption.', 'the rbi has issued guidelines to banks to apply to it for becoming nominated agencies, and the first set of applications will be considered shortly.', 'in the meantime, the customs have also modified the procedures for the import of gold - no longer requiring banks to be totally accountable for export obligations of the exporters.', 'the standing committee on gold and precious metals in the rbi (subrahmanyam committee) has been expanded to include representatives of the ministries of finance and commerce.', 'the committee is more active now in rendering advice to the rbi and the government.', 'general response: a review the general response to the issues raised in the previous seminar can be described as one dominated by aggressive liberalisers, some advocating caution, only a few favouring no change in the existing policy and virtually none seeking total roll-back of the policy.', 'there has been no mention of the mobilisation of idle gold for productive purposes or the establishment of a gold bank to raise resources.', '(i) let me summarise the arguments of aggressive liberalisers.', '- the gold industry, employing goldsmiths numbering about five lakhs, involving an annual turnover of about rs.25,000 crore, is kept out of any serious consideration in the current reform process.', 'this reflects continuation of a gold-control mindset and the identification of all import, sale or use of gold with black money.', 'consequently, gold industry exporters of jewellery and genuine purchasers of gold jewellery continue to suffer.', '- on account of the present policy, the purchaser of gold jewellery pays a higher price of about rs.3,000 crore every year because of the "hawala" premium, etc.', 'in percentage terms, at wholesale level, it is an extra 17 per cent.', 'also, because of lack of consumer protection, and improper certification of quality, the purchaser loses about rs.4,000 crore each year.', '- the present gold policy shows anti-rural bias.', 'the real purchaser of gold is typically a peasant.', 'close to seventy per cent of gold jewellery is sold in rural areas and most of gold sales are by way of jewellery.', 'to quote professor jeffrey a. franks, "holding gold has in fact often in history served, from france to india, as the only way the peasant can protect himself against inflation and the vicissitudes of politics".', '- similarly, there is a gender bias, since most of the jewellery is sought by women.', 'while macho consumer durable components are imported and their production or even consumption financed, a non-depreciating asset like gold is discriminated against.', 'it makes no sense to constrain the demand for "a multi-purpose indestructible asset" like gold or gold jewellery, which is a lifetime asset, a hedge against inflation, a source of liquidity and a preferred form of saving.', '- from a fiscal point of view, the nri route generated about rs.500 crore towards customs in a year.', 'the "officialising" of gold import by liberal import of gold will give rs.250 crore per annum more towards customs, with duties at the same rate as for nris.', 'further, if gold is imported freely under ogl, gold trade down the line becomes traceable and will provide sales tax to state governments and octroi to local bodies.', '- from a trade policy point of view, the existing restrictions on gold jewellery-producing units like eous constrain the participants in the export market and hamper export growth.', 'free import under ogl and free export are pre-conditions for capturing world markets - as is evident from the turkish experience.', '- some advocate free import of gold or import under ogl on the ground that there may be a fall in reserves and a desirable impact on the exchange rate.', 'however, most argue that there will be only "officialising" of gold import and use of foreign exchange under hawala, resulting in no net loss of reserves.', 'in fact, once gold jewellery exports pick up, consequent upon gold-import liberalisation, there will be a positive impact on the trade balance.', '- there is no way of getting rid of or at least drastically reducing the hawala market in foreign exchange, so harmful to the social and moral fabric of india, unless gold import is freed and the scope for gold smuggling reduced.', '- as pointed out by the committee on capital account convertibility, a pre-condition for further reforms in the external sector is free import of gold.', '- finally, while bank credit is available for import, domestic production or processing and easy acquisition or consumption of luxury goods, no such bank credit is available for gold and gold jewellery employing half a million and providing first-rate security for banks.', 'in fact, the only way of penetrating the informal credit sector without generating non-performing assets is encouraging the flow of bank credit against gold and silver without reference to enduse.', '(ii) the cautious liberalisers avoid the subject of liberal bank credit or regulating the gold market altogether, but concentrate on possible balance of payments impact.', 'hence, they advocate limited import through designated agencies to meet both exporters and domestic industry.', '(iii) the no-changers feel that the existing import regime is foreign exchange neutral; and existing policy is a reluctant admission of our incapacity to change the mindset of indians who are wasting their savings on gold.', 'there is no need to assist or develop this "unproductive" sector or activity.', '(iv) there is little support for a total roll-back of policy.', 'there was, however, a suggestion in the context of an analysis of the report on capital account convertibility in the economic and political weekly (epw, june 1997).', 'this article reiterated the possible impact of liberalisation of gold import on domestic savings in an adverse way; on diversion of productive resources into unproductive channels; on aiding the process of tax-evasion and hoarding of incomes and assets.', 'having expressed this, the article states, and i quote, "a more viable policy from the point of healthy and egalitarian development was to recommend the banning of gold imports (other than for jewellery exports and for industrial use), and strict enforcement measures against smuggling".', 'rationale for new gold policy now responses to the issues raised by me last year thus show a distinct preference for an ngp.', 'it is possible to highlight the important reasons for a re-look at the existing gold policy.', 'firstly, it is argued that import or use of gold should be discouraged since it affects domestic savings adversely and implies diversion of resources for unproductive purposes.', 'in reality, our household savings, unlike government savings, have been increasing since independence, while gold was, in spite of the policy, being imported, traded and used.', 'the diversion of savings to unproductive purposes did not happen in the household sector.', 'further, the idea of mobilisation of resources for productive purposes as defined by planners has yielded place to a slightly different form of policy management of disposition of resources under the post-reform era.', 'now, even depreciating luxury goods are produced and traded in our economy.', 'why discriminate against gold?', 'secondly, it is also held that we should not waste scarce foreign exchange on unproductive purposes.', 'with current account convertibility and a market-determined exchange rate, it is not appropriate to place a premium on foreign exchange.', 'further, the recent liberalisation of imports through the nri and sil route has shown that, in reality, there is no adverse impact of a liberalised gold import.', 'in fact, this recent experience should provide reason enough for a review now, with a view to liberalising further.', 'thirdly, it is felt that gold is an important instrument for black money deals and hence restrictions on gold amount to restrictions on black money.', 'since gold is not the only instrument of black money deals, making gold availability difficult will not deter either generation of black money, or its disposition in many ways, including illegal gold.', 'in any case, with the reduction of income tax rates and the launch of the voluntary disclosure scheme in the current year, the fiscal stance is clear - remove incentives for generating black money.', 'hence, gold policy as an important instrument of anti-black money policy loses its significance, in view of the recent budget.', 'fourthly, international experience, especially with turkey, where conditions are similar, has shown that liberal imports and organised trade in gold benefits the economy, including the external sector.', 'also, our neighbours in the saarc region have liberalised and officialised gold imports at nominal duties.', 'these developments make it imperative that we review our policies urgently.', 'finally, gold plays an important role in our external trade (next only to oil) and in the domestic economy.', 'the reform process would be incomplete without a review and update of the gold policy.', 'objectives and tasks of a new gold policy what should be the possible objectives of an ngp?', 'the review of our policy so far and the rationale for an ngp that we considered indicate clearly the desirable objectives of an ngp.', 'the major objectives should perhaps be to: - recognise the importance of gold in the indian economic system and enable gold to play a transparent and positive role in the industrial development, employment and export sectors of the economy, - ensure orderly development of a gold-related industry in india in terms of physical standards and consumer protection, - create and nurture appropriate official regulatory framework and self-regulatory trade bodies, - exploit the scope for generating revenues to the central, state and local governments, - align the regulatory framework and institutional capabilities in the financial sector - especially banking sector - to enable the above, including gold banking, and - enable fuller integration of gold with other areas of the domestic economy and closer integration with the world gold economy, consistent with our economic reform policies.', 'if we accept the above objectives of an ngp, four broad sets of measures may need our attention now.', 'these are (i) gold and trade policy (ii) regulation and development of domestic trading, including quality markup (iii) bank financing for import, export and domestic activities and (iv) gold banking.', 'first, on gold and trade policy, the broad thrust has to be liberalisation of import and export, but there are many options in this regard, and these need to be debated.', 'first, place gold under ogl.', 'this would be an ideal situation for free trade and freely tradeable good.', 'however, as an immediate measure, some scepticism could be expressed.', 'gold has some characteristics of currency, a financial asset and has quasi-foreign exchange attributes.', 'however, free import by members of the organised bullion market or designated agencies should serve the purpose, with some scope for regulation.', 'import of gold through designated agencies including banks would help regulate the gold market, besides assuring the quality of gold and bringing more transparency in prices.', 'the advantage of restricting import of gold to designated agencies is that the regulators can fix monetary limits on import during the transition.', 'the domestic transactions of gold imported through the designated agencies could be more easily tracked and would be channelled for making jewellery for domestic use or export.', 'this would also boost exports substantially.', 'on this logic, it will be necessary to discourage liberalised import through nris.', 'however, it is possible to charge less import duty when designated agencies import, to discourage the nri route.', 'in any case, nominal import duty is a pre-condition for liberalised imports.', 'incidentally, under the liberalised regime, the sale of gold by designated agencies has to be freely permitted to domestic jewellery units.', 'also, the stipulation of payment of duty in foreign exchange may have to be dispensed with in view of the avoidable irritants, the undermining of domestic currency and market-determined exchange rate.', 'second, impetus to active domestic trading in gold is a logical consequence of an ngp.', 'currently, the industry is fragmented.', 'it will be essential to tackle major operational issues required to give a fillip to the gold market, such as the development of refining capacity, accredition of refineries and the introduction of the system of hallmarking as a consumer protection and export promotion measure.', 'further, serial number, fineness and assay mark of the melter and assayer should be found stamped on bars.', 'we may have to allow foreign companies with expertise in this area to set up shop in india.', 'the melters and refiners, both from within and outside india may have to be permitted based on net worth, turnover, etc.', 'perhaps we have a lot of catching up to do.', 'third, it may be necessary to recognise financing as an important policy component of developing the gold market.', 'as would be explained later, the legal and institutional framework is available.', 'finally, the development of gold banking will be derived from the policy stance.', 'on this subject, i expect the deliberations in this conference to throw up some ideas.', 'the role of the reserve bank of india central banks the world over have a special concern and role in gold economy.', 'the rbi is no exception.', 'broadly speaking, the role of the rbi spans five areas.', 'first, and very obvious, is the management of gold reserves.', "since october 1990, the bank's gold holdings have been valued on the basis of international market prices.", 'we recognise the price risk on the gold holdings and have considered the use of gold options and futures to hedge our risk.', 'however, the rbi act in its present form does not have enabling provisions.', 'there is also a view that exemption notification by the government would be required under section 27 of the forward contracts (regulations) act to enable the rbi to enter into gold - currency swaps.', 'second, the rbi had played an active part in the local bullion market.', "the rbi had, in the past, close links with bullion market association, and the rbi's nominee was a member.", 'in the 1970s, gold sale was organised domestically by the rbi, even as it continued its interest in the study of gold and precious metals, monitoring prices, trade, etc., and constantly advised the government on policies.', 'the rbi in future under the ngp, could play a role similar to the bank of england in the bullion market.', 'third, the licensing of import of gold and silver bullion was for a long time a function of the rbi and not of the import trade control.', 'it was only through the amendment to the foreign exchange regulation act, 1973 in 1992 that the import of gold/silver and the export of gold, jewellery and precious stones ceased to be regulated by the rbi.', 'now, policy with regard to the import and export of gold is under the purview of exim policy.', 'however, as per the recent exim policy, the rbi can designate an agency to import gold for selling it to exporters only.', 'fourth, in terms of section 6 of the banking regulation act, 1949, in addition to the business of banking, a banking company may engage in the buying, selling and dealing in bullion and specie.', 'in fact, the act allows banks to trade in bullion.', 'banks extend credit against gold.', 'the regulatory role of rbi arises out of its supervisory functions over banks.', 'fifth, the rbi has and continues to play its rightful role in influencing the gold policy in the country.', 'we have in fact established a framework for ongoing review of policy in gold.', 'we established a standing committee on gold and other precious metals in 1992 which has since been enlarged and activated in 1997. the committee is also addressing issues relating to the development of the gold market and gold based instruments, with providing a significant boost to jewellery export being one of its objectives.', 'we expect this committee to take an active interest in matters relating to gold banking also.', 'the role of government i have alluded, earlier today, to the need for an amendment to the rbi act and also to issuance of notification by the government under section 27 of the forward contracts (regulation) act, 1954. these measures are needed to enable the rbi and banks to enter into derivative contracts in gold.', 'further, it is not clear whether gold-denominated certificates and other gold-related products would be deemed to be a security in terms of securities contracts (regulation) act.', 'there are also wide-ranging issues related to taxation.', 'in the european community, transactions in gold are subject to vat at rates which vary from country to country.', 'in some countries, gold is subject to sales tax as well.', 'in the uk, there is a formal agreement between the commissioner of customs and excise and the london bullion market, on matters relating to tax treatment, and no doubt with the support of the bank of england.', "the government's role is critical in creating an enabling environment, especially through changes in the legal framework.", 'the role of trade and industry in the early part of this century, there existed an active gold market in india - both physical and financial - and gold options and futures were actively traded in the bombay bullion exchange.', 'it is possible to revive this market now.', 'futures trading is already active in other commodities like pepper, etc.', 'and perhaps there is no reason for disallowing gold to be traded again, though under an appropriate regulatory framework.', 'the focus of the regulation could be to ensure that trading is undertaken within prudential limits and correlated to risk-taking capacity, to prevent systemic weakness and to induce transparency in trading practices.', 'we could draw lessons from the british experience.', 'the london bullion market association has the formal responsibility for the supervision of its wholesale bullion market.', 'the bank of england, with assistance from the london bullion market association, has drawn up a code of conduct for the market which covers such matters as confidentiality, market ethics, inducement and conflicts of interest.', "it is the responsibility of the association to monitor its members' adherence both in letter and in spirit, and bring any breaches to the central bank's attention.", 'in addition, the association has taken over the functions previously performed by the london gold market and the london silver market in connection with the technical aspects of deliverable material, the rules governing application for inclusion in the list of acceptable melters and assayers and the codification of market practices as far as clearing and settlement are concerned.', 'the role of banks currently, the role of commercial banks is limited to investment in gold as an slr asset and to lend against bullion and specie.', 'as mentioned, banks could play a more active role in financing gold-related activities.', 'as an immediate measure, perhaps banks may be (a) permitted to be designated agencies for import, (b) encouraged to lend against gold or silver jewellery as security up to - say rs.2 lakh without any stipulation on end-use to help peasants and penetrate the informal credit sector, (c) advised to devise gold acquisition plans, (d) permitted to lend liberally to gold jewellery business, and (e) allowed to draw upon international experience to deal in the gold industry.', 'issues as you would notice, i have not gone into the details of gold banking.', 'similarly, on gold policy and capital account convertibility, my distinguished predecessor, friend, philosopher and guide dr. tarapore, will address you later.', 'deliberately, i have not gone into the issue of the current price situation of gold or use of gold as reserves by central banks.', 'i feel that those issues, though of contemporary interest, are not directly relevant.', 'i am thus, left with issues that flow from my presentation today.', 'first: what should be the possible objectives of an ngp?', 'and when should we launch an ngp?', 'second: is mere liberalisation of import of gold enough of a reform?', 'if not, what are the other measures?', 'third: who should be the promoter/regulator for gold trade?', 'fourth: what should be the objectives of regulating gold trade?', 'fifth: what are the measures that are possible under the existing legal framework?', 'what changes in legal framework are needed to achieve a globally strategic position for india in world gold economy?', 'sixth: what should be the tax regime, since in many countries the tax regime for gold is somewhat special.', 'seventh: how soon could the physical facilities, like quality assaying, marking, designs etc.', 'of international standards be established?', 'what will be the role of foreign investment and technology in this area?', 'eighth: how should the banks equip themselves to do gold banking - immediately, with the present legal and policy frame - and soon, to exploit the opportunities under a possible ngp?', "ninth: and this is critical from the rbi's point of view - what is expected of the rbi in the context of developing gold banking now, and under a possible ngp?", 'let me conclude by thanking the audience for patiently listening to me and assuring the organisers that we in the rbi are eagerly looking forward to the benefit of deliberations here.']	Y V Reddy	Reserve Bank of India	Deputy Governor	India
https://www.bis.org/review/r970819.pdf	Mr. Macfarlane discusses monetary policy and economic growth in Australia (Central Bank Articles and Speeches, 12 Aug 97)	Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the Australian Institute of Company Directors (Western Australia Division) Winter Dinner held in Perth on 12/8/97.	1997-08-12 00:00:00	Mr. Macfarlane discusses monetary policy and economic growth in Australia Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the Australian Institute of Company Directors (Western Australia Division) Winter Dinner held in Perth on 12/8/97. 1. Introduction It is a pleasure to be in Perth to address the Western Australian Division of the Institute of Company Directors. It is also fitting that I should be talking about economic growth, since Western Australia has set an example to the rest of Australia by its high growth rate in the 1990s. Some would say this is inevitable, given its resource base, but we have seen internationally that the fastest growth does not coincide with the biggest resource endowments. Enterprise and a willingness to embrace change are also vital ingredients, and here Western Australia has also distinguished itself. In the Reserve Bank we are often drawn into a discussion of economic growth because of claims that we have a "growth ceiling" of 31⁄2 per cent per annum. I do not know where this perceived ceiling came from, and I have on several occasions denied its existence. I will do so again tonight. It has been suggested to me that one of the reasons for this belief is that I have often highlighted the data contained in Table 1 below, particularly when I have been doing my patriotic duty in Table 1: OECD GDP Growth Over the Past Six Years (Average annualised growth) Real GDP Ireland 6.4 Australia 3.5 Norway 3.5 New Zealand 3.4 United States 2.7 United Kingdom 2.4 Canada 2.2 Denmark 2.1 Netherlands 2.0 Austria 1.7 Japan 1.6 Spain 1.5 Finland 1.5 Germany 1.4 Belgium 1.3 France 1.3 Italy 0.9 Sweden 0.9 Switzerland -0.1 Source: OECD front of audiences of overseas investors. It shows that over the past six years, that is the period of the current expansion, we have grown at an annual average growth rate of 3.5 per cent. This is very good by the standards of the "high income OECD countries". Only Ireland has done better, and Norway and New Zealand have grown at about the same rate as we have. These are all much smaller countries than we are (their combined GDP is less than Australia's). The other thing that stands out from this table is how well the English-speaking countries have done in the nineties; the six English-speaking countries are in the top seven spots. The 31⁄2 per cent per annum contained in this table is there for international comparisons, not as a yardstick for what we can do this year, next year or the year after. For a start, that six-year average of 31⁄2 per cent contains years like the past 12 months where we have achieved only 2.4 per cent, but there are other periods like the year to September 1994 when we managed 51⁄2 per cent. 2. Economic growth over the cycle While we do not have a growth target or growth ceiling, we do have an inflation target. This says that inflation should average somewhere between 2 and 3 per cent over the medium term. That is, when we look back, we should see that it has averaged 2 point something per cent, even if we have been over 3 per cent on some occasions and below 2 per cent on others. This approach is not, as some might think, anti-growth. It is, in fact, pro growth by favouring forward looking management of the business cycle, which will help in achieving a stable platform for long-run growth. The other way of expressing an inflation target is to say that the economy should grow as fast as possible consistent with maintaining low inflation, but no faster. We say no faster because post-war experience in a number of countries has shown us that allowing inflation to rise too much actually harms growth prospects in the longer term. Sustained periods of strong growth have always gone hand in hand with low inflation. Weaker growth occurred in the high inflation era, particularly between the mid-seventies and mideighties. We have also emphasised that it is the length of the expansion that is important. Our last two expansions were cut short by inflationary pressures after about six-and-a-half years. It would probably be possible on this occasion to engineer a short-lived boom, characterised by rising output and falling unemployment, but also by increasing inflation, unrealistically high asset values, inflated paper wealth and financial instability - which is, of course, a recipe for a slump thereafter. Recessions may come for some other reasons, but there is no reason to run a high risk of a self-inflicted one. It is important that we take a longer view in order to achieve a longer expansion. The value of the inflation targeting regime is that it forces us to do precisely that. That is why I am confident that, under our present arrangements, we will be able to do all that can be done to foster a long expansion. What does this mean for the next couple of years? That is really a matter of forecasting rather than speed limits. With inflation tamed, and with some slack available, we should be quite capable of growing by 31⁄2 per cent, 4 per cent, 41⁄2 per cent (or possibly even faster) over the next couple of years without any significant detrimental effect on inflation. None of these figures is a target; they are simply illustrative of the sorts of numbers we might reasonably expect to see after a period of sub-par growth such as 1996. Ideally, as we grow fast enough to take up existing slack, businesses would lift investment rates further, pushing the capacity constraints further back. If, at the same time, we found that labour market arrangements were able to bring new employees onto payrolls without generalised pressure on wages, we would be able to sustain faster growth for longer. In other words, by having a longer expansion, we would be able to drive unemployment down further. How likely is that outcome? It is hard to say. We do not have a doctrinaire view on what can be achieved. We will evaluate the evidence as it comes in. Critical in that evidence is the course of prices. The main test of what is sustainable on the growth front is the inflation test: is the rate of growth compatible with achieving the 2-3 per cent average for inflation, looking forward as best we can over a year or two? If the answer is yes, then that growth is sustainable, at least at that point in time. To repeat: we do not have a growth ceiling, beyond which the brakes automatically go on. We have an inflation target, appropriately and flexibly defined, which tells us to tighten when our forecast of inflation has it exceeding the target for any sustained period of time, and to ease when the forecast has inflation sustainably below target. Growth per se does not necessarily trigger this response: it is the inflation outlook which is important. In thinking about the inflation outlook, of course, we need to ask ourselves whether the growth which is occurring now and that which is in prospect are likely to put pressure on capacity to such an extent that inflation might rise noticeably. But that is a judgement based on a range of factors, not a mechanical response to the breaching of some arbitrary growth threshold. Another point I would like to make is that at the moment I do not see that monetary policy is placing any constraint on growth. This is as it should be - one of the advantages of an inflation target is that it makes sure monetary policy is eased when the inflation forecast is below the target average. Hence the five easings over the past year. This might help to reassure those people who think that in order to maintain a low average inflation rate, monetary policy has to be kept continuously tight. It does not - monetary policy will be eased as often as it is tightened. Monetary policy has to be no tighter to maintain an average inflation rate of 21⁄2 per cent, than to maintain an average of 5 or 10 per cent. In fact it probably would have to be tighter at the higher figures as it would be fighting against rising inflationary expectations. Another sign that present monetary policy is not restrictive is to look at the effect it is having on the cost and availability of credit. If this was too expensive, we would not see much being used, but that is not the case at present. All forms of credit - business, housing and personal lending - have been growing at somewhere between 8 and 11 per cent over the past year. This does not suggest that the economy as a whole is finance-constrained, although there will always be some individuals or firms that are. Another manifestation of this that may have escaped many people is that we now have lower interest rates out to five years than the United States, which is the usual benchmark for international comparisons. Now this is entirely fit and proper, given the different cyclical positions of the two economies and given our lower inflation. But even so, it would have been unthinkable even a few years ago. Financial markets took it for granted that Australia would always be a high interest country relative to the United States. (International investors put Australia in with a group of countries called the "high yielders".) I am strongly of the view that these lower interest rates are a substantial benefit for Australian businesses. 3. Economic growth in the long run So far, we have been talking about growth over short time horizons such as a couple of years or so. Over this horizon, growth can vary quite a lot, and monetary policy will have some influence on the outcome. While monetary policy's major long-term influence will be on the rate of inflation, over shorter periods it can have a significant influence on economic activity and employment. If it is too tight, it will unnecessarily constrain them, and if it is too loose, it could set up the conditions for an inflationary boom. The relationship between monetary policy and economic growth is thus essentially a short-term or cyclical one. But this is not what a lot of people are interested in. They want to know what is Australia's long-term growth potential. Is our potential growth rate relatively low like all the standard OECD countries in Table 1? Is it a bit higher? Or, alternatively could it be as high, or nearly as high, as the newly-industrialising countries of Asia? How could it be raised to a higher figure? These are all difficult questions to answer, and I shall only attempt a very cursory one. But before I do that, I want to make an important point - whatever our potential growth rate is, monetary policy will have little to do with it compared with other factors. Monetary policy mainly works by affecting aggregate demand in the economy. Fluctuations in demand are the normal (though not exclusive) source of business cycles. In thinking about long run trends, however, it is the structure - the economy's capacity to produce and how that can be supply increased - that is crucial. Perhaps I can take the liberty of illustrating this distinction between short and long run with a stylised diagram. An economy could have an average long-term growth rate as shown in the straight line Trend A. Its actual growth will never be a straight line because of the business cycle, so it is likely to look like the wavy line Actual A. If monetary policy was conducted badly, we could end up with a boom and bust given by the dotted line Actual A Alternatively, if monetary policy was conducted well, we should expect to have relatively stable1. conditions, including low inflation; with a bit of luck, we should also get longer lasting expansions and milder recessions. Because a reasonably stable aggregate price level does not prompt the distortions in economic decisions seen with high inflation, trend growth should be a little higher. But while that difference will be worth having, it only adds a little to trend A, and many people would have trouble noticing the difference. GDP: : Trend d and d Actual 200 Level l Trend d B 180 of f Rea eal l 160 GDP 140 Actual 120 100 80 Trend d A 60 Actual l A 40 Actual l A' 20 0 10 15 5 20 Yea ears Now, people may be unsatisfied with this outcome and say that they would prefer to be on the faster trend growth line given by Trend B, which is perhaps two or three per cent higher than Trend A. This is a reasonable aspiration, but it cannot be achieved by an adjustment to monetary policy. What factors then explain long-run growth? In simple terms, it is explained by the growth of the productive factors in the economy - the growth of the labour force, expansion of the capital stock and growth in productivity of both labour and capital. This is why there is such focus on micro-economic policies to raise efficiency, rather than manipulation of the macroeconomic instruments, when people talk about long run growth potential. Again, all that monetary policy can do is to minimise the booms and busts around the higher trend. The only way that the economy can move from Trend A to Trend B is by enacting policies that either increase the growth of the productive factors or increase their productivity. I do not intend to say much about the growth of the labour force, which in the long run is determined by population growth and participation in the workforce. Note, however, that in the short run the economy can grow faster than the labour force constraint would suggest because, if there is enough flexibility, we can move people out of unemployment into employment. The other point that I should register is that I do not think in the long run we will be able to maintain our current low male participation rate. With life expectancy still increasing, we will not be able to continue the luxury of having so many people entering the workforce in their early twenties and leaving in their mid fifties. This is a transitory phase, not a permanent increase in leisure. In thinking about how to ensure that the capital side of the production potential is expanded sufficiently, it is hard to go past the simple idea that investment has to be funded by saving, and we would probably have more if we increased our domestic saving. Of course it could be funded by more foreign saving, but that path tends to be a more unstable one. I have no new ideas on how to increase our savings other than through the familiar methods of making sure that the government does not reduce national savings through chronic budget deficits and by enacting measures to make sure that a higher proportion of retirement incomes are funded out of private savings. The really big issue for long-run growth is how we raise productivity. In simple debate, this is often portrayed as producing the same with less people, either by job shedding or by substituting capital for labour. But any business knows that it is not just manning levels which are important. The flexibility of the workforce in using the capital equipment, the skills which they can bring to bear in response to new demands and opportunities, the capacity of the firm to innovate and improve processes in industrial and service applications, the ability to develop and exploit new technology - these are actually more important ingredients in the long run. Of course, all good firms are trying to do this all the time. In a competitive marketplace, they have to keep up with their competitors or fall by the wayside. In a global marketplace, they increasingly have to move towards international best practice, which itself is always advancing as a result of innovation and adoption of new technology. In the process of matching their competitors, the best firms drive the development of productivity and the rise in living standards. Not all firms nor all industries will succeed in doing this. Some will thrive and others will fail. Some industries will grow, and some industries that we do not even know about as yet will emerge. The only thing we know is that there will be continuous change, not just here but in all countries, under the constant pressure of competition, new technologies and globalisation. There is no simple secret to success, but part of the answer must be for both firms and for countries to facilitate change, and to adapt to it, not to resist it. The central issue is that all productivity gains involve change. By their nature they involve producing goods and services in different (and better) ways, or in producing different goods and services. Change is a necessary condition for productivity growth. These major changes are going to occur in the private sector among both large and small firms. The adjustment task will be difficult, but they must try to seek out the profitable and growing areas. While the role of government will be important, the Government will not be able to do the adjustment for the private sector. I find it hard to believe that the Government would be better than the private sector at picking the growth areas, so I believe that the Government's main contribution should be to remove unnecessary obstacles to change, to provide a high quality infrastructure, to encourage saving and to work at lifting and maintaining quality of education. I know this is a difficult message to give to a public which is growing tired of change (not all of it economic). But the alternative of stopping change is really not viable. It has always been the case that the firms and societies that have managed to embrace the challenge of change and seize new opportunities, rather than turning their backs, have been the ones that prospered. It may, of course, be harder for the high income societies like Australia than for the newcomers who feel less attachment to established ideas and who therefore have less to "lose" in embracing change. But we surely have the capacity to adopt change when we see the need. We have to be convinced it is worth it. The advantages of flexibility have been well demonstrated in the nineties by the superior performance, both in terms of growth and in lower levels of unemployment, of the less regulated English-speaking countries compared to the corporatist European ones. I am not suggesting we should remove all regulation and rely totally on laissez faire. There is clearly a large role for government, but we should always ask whether particular government initiatives are forward looking, or whether they are protecting an existing industry or an existing privilege. The first requirement of government is to provide as stable a macro-economic environment as it can. The second requirement of government is to provide first class, low cost infrastructure. This stretches from such items as the legal system and accountancy standards through to more tangible items like the education system and the utilities, including electricity, gas, water and telecommunications. The Government, of course, need not be the provider of each of these, but it will always ultimately set the standards. Inevitably, governments will also be called upon to enact policies which affect one industry at the expense of others. My only plea here is that they do it in a way that encourages adjustment, perhaps even compensates losers, but not to do it in a way which resists change. 4. Conclusion Australia has recorded quite a respectable growth performance by developed country standards during the current upswing. Even our low point in the mid-cycle growth pause - a bit over 2 per cent - is pretty good compared with many countries' average performances. People are disappointed that more progress has not yet been made on reducing unemployment, but we have made some, and further real progress will be made if we can sustain a long running expansion. As I have noted tonight, I think our current monetary policy framework is serving us well in this regard, by requiring us to take a medium-term view in our policy deliberations and maximising the chances for a long recovery. I hope I have helped to explain our thinking. When we shift our focus to the economy's long run growth prospects, however, monetary policy should inevitably attract less attention. Price stability is a necessary condition for faster long-term growth, but there are many other policies which have to be got right. That's why it is so hard. If there is a simple message, I think it is that the heart of the long-term growth process is productivity enhancement through innovation, technological change and so on, and that to reap the benefits of those processes, we have to embrace the forces of competition and globalisation, with all the changes and discomforts they bring.	['mr. macfarlane discusses monetary policy and economic growth in australia talk by the governor of the reserve bank of australia, mr. i.j.', 'macfarlane, to the australian institute of company directors (western australia division) winter dinner held in perth on 12/8/97.', '1. introduction it is a pleasure to be in perth to address the western australian division of the institute of company directors.', 'it is also fitting that i should be talking about economic growth, since western australia has set an example to the rest of australia by its high growth rate in the 1990s.', 'some would say this is inevitable, given its resource base, but we have seen internationally that the fastest growth does not coincide with the biggest resource endowments.', 'enterprise and a willingness to embrace change are also vital ingredients, and here western australia has also distinguished itself.', 'in the reserve bank we are often drawn into a discussion of economic growth because of claims that we have a "growth ceiling" of 31⁄2 per cent per annum.', 'i do not know where this perceived ceiling came from, and i have on several occasions denied its existence.', 'i will do so again tonight.', 'it has been suggested to me that one of the reasons for this belief is that i have often highlighted the data contained in table 1 below, particularly when i have been doing my patriotic duty in table 1: oecd gdp growth over the past six years (average annualised growth) real gdp ireland 6.4 australia 3.5 norway 3.5 new zealand 3.4 united states 2.7 united kingdom 2.4 canada 2.2 denmark 2.1 netherlands 2.0 austria 1.7 japan 1.6 spain 1.5 finland 1.5 germany 1.4 belgium 1.3 france 1.3 italy 0.9 sweden 0.9 switzerland -0.1 source: oecd front of audiences of overseas investors.', 'it shows that over the past six years, that is the period of the current expansion, we have grown at an annual average growth rate of 3.5 per cent.', 'this is very good by the standards of the "high income oecd countries".', 'only ireland has done better, and norway and new zealand have grown at about the same rate as we have.', "these are all much smaller countries than we are (their combined gdp is less than australia's).", 'the other thing that stands out from this table is how well the english-speaking countries have done in the nineties; the six english-speaking countries are in the top seven spots.', 'the 31⁄2 per cent per annum contained in this table is there for international comparisons, not as a yardstick for what we can do this year, next year or the year after.', 'for a start, that six-year average of 31⁄2 per cent contains years like the past 12 months where we have achieved only 2.4 per cent, but there are other periods like the year to september 1994 when we managed 51⁄2 per cent.', '2. economic growth over the cycle while we do not have a growth target or growth ceiling, we do have an inflation target.', 'this says that inflation should average somewhere between 2 and 3 per cent over the medium term.', 'that is, when we look back, we should see that it has averaged 2 point something per cent, even if we have been over 3 per cent on some occasions and below 2 per cent on others.', 'this approach is not, as some might think, anti-growth.', 'it is, in fact, pro growth by favouring forward looking management of the business cycle, which will help in achieving a stable platform for long-run growth.', 'the other way of expressing an inflation target is to say that the economy should grow as fast as possible consistent with maintaining low inflation, but no faster.', 'we say no faster because post-war experience in a number of countries has shown us that allowing inflation to rise too much actually harms growth prospects in the longer term.', 'sustained periods of strong growth have always gone hand in hand with low inflation.', 'weaker growth occurred in the high inflation era, particularly between the mid-seventies and mideighties.', 'we have also emphasised that it is the length of the expansion that is important.', 'our last two expansions were cut short by inflationary pressures after about six-and-a-half years.', 'it would probably be possible on this occasion to engineer a short-lived boom, characterised by rising output and falling unemployment, but also by increasing inflation, unrealistically high asset values, inflated paper wealth and financial instability - which is, of course, a recipe for a slump thereafter.', 'recessions may come for some other reasons, but there is no reason to run a high risk of a self-inflicted one.', 'it is important that we take a longer view in order to achieve a longer expansion.', 'the value of the inflation targeting regime is that it forces us to do precisely that.', 'that is why i am confident that, under our present arrangements, we will be able to do all that can be done to foster a long expansion.', 'what does this mean for the next couple of years?', 'that is really a matter of forecasting rather than speed limits.', 'with inflation tamed, and with some slack available, we should be quite capable of growing by 31⁄2 per cent, 4 per cent, 41⁄2 per cent (or possibly even faster) over the next couple of years without any significant detrimental effect on inflation.', 'none of these figures is a target; they are simply illustrative of the sorts of numbers we might reasonably expect to see after a period of sub-par growth such as 1996. ideally, as we grow fast enough to take up existing slack, businesses would lift investment rates further, pushing the capacity constraints further back.', 'if, at the same time, we found that labour market arrangements were able to bring new employees onto payrolls without generalised pressure on wages, we would be able to sustain faster growth for longer.', 'in other words, by having a longer expansion, we would be able to drive unemployment down further.', 'how likely is that outcome?', 'it is hard to say.', 'we do not have a doctrinaire view on what can be achieved.', 'we will evaluate the evidence as it comes in.', 'critical in that evidence is the course of prices.', 'the main test of what is sustainable on the growth front is the inflation test: is the rate of growth compatible with achieving the 2-3 per cent average for inflation, looking forward as best we can over a year or two?', 'if the answer is yes, then that growth is sustainable, at least at that point in time.', 'to repeat: we do not have a growth ceiling, beyond which the brakes automatically go on.', 'we have an inflation target, appropriately and flexibly defined, which tells us to tighten when our forecast of inflation has it exceeding the target for any sustained period of time, and to ease when the forecast has inflation sustainably below target.', 'growth per se does not necessarily trigger this response: it is the inflation outlook which is important.', 'in thinking about the inflation outlook, of course, we need to ask ourselves whether the growth which is occurring now and that which is in prospect are likely to put pressure on capacity to such an extent that inflation might rise noticeably.', 'but that is a judgement based on a range of factors, not a mechanical response to the breaching of some arbitrary growth threshold.', 'another point i would like to make is that at the moment i do not see that monetary policy is placing any constraint on growth.', 'this is as it should be - one of the advantages of an inflation target is that it makes sure monetary policy is eased when the inflation forecast is below the target average.', 'hence the five easings over the past year.', 'this might help to reassure those people who think that in order to maintain a low average inflation rate, monetary policy has to be kept continuously tight.', 'it does not - monetary policy will be eased as often as it is tightened.', 'monetary policy has to be no tighter to maintain an average inflation rate of 21⁄2 per cent, than to maintain an average of 5 or 10 per cent.', 'in fact it probably would have to be tighter at the higher figures as it would be fighting against rising inflationary expectations.', 'another sign that present monetary policy is not restrictive is to look at the effect it is having on the cost and availability of credit.', 'if this was too expensive, we would not see much being used, but that is not the case at present.', 'all forms of credit - business, housing and personal lending - have been growing at somewhere between 8 and 11 per cent over the past year.', 'this does not suggest that the economy as a whole is finance-constrained, although there will always be some individuals or firms that are.', 'another manifestation of this that may have escaped many people is that we now have lower interest rates out to five years than the united states, which is the usual benchmark for international comparisons.', 'now this is entirely fit and proper, given the different cyclical positions of the two economies and given our lower inflation.', 'but even so, it would have been unthinkable even a few years ago.', 'financial markets took it for granted that australia would always be a high interest country relative to the united states.', '(international investors put australia in with a group of countries called the "high yielders".)', 'i am strongly of the view that these lower interest rates are a substantial benefit for australian businesses.', '3. economic growth in the long run so far, we have been talking about growth over short time horizons such as a couple of years or so.', 'over this horizon, growth can vary quite a lot, and monetary policy will have some influence on the outcome.', "while monetary policy's major long-term influence will be on the rate of inflation, over shorter periods it can have a significant influence on economic activity and employment.", 'if it is too tight, it will unnecessarily constrain them, and if it is too loose, it could set up the conditions for an inflationary boom.', 'the relationship between monetary policy and economic growth is thus essentially a short-term or cyclical one.', 'but this is not what a lot of people are interested in.', "they want to know what is australia's long-term growth potential.", 'is our potential growth rate relatively low like all the standard oecd countries in table 1?', 'is it a bit higher?', 'or, alternatively could it be as high, or nearly as high, as the newly-industrialising countries of asia?', 'how could it be raised to a higher figure?', 'these are all difficult questions to answer, and i shall only attempt a very cursory one.', 'but before i do that, i want to make an important point - whatever our potential growth rate is, monetary policy will have little to do with it compared with other factors.', 'monetary policy mainly works by affecting aggregate demand in the economy.', 'fluctuations in demand are the normal (though not exclusive) source of business cycles.', "in thinking about long run trends, however, it is the structure - the economy's capacity to produce and how that can be supply increased - that is crucial.", 'perhaps i can take the liberty of illustrating this distinction between short and long run with a stylised diagram.', 'an economy could have an average long-term growth rate as shown in the straight line trend a. its actual growth will never be a straight line because of the business cycle, so it is likely to look like the wavy line actual a. if monetary policy was conducted badly, we could end up with a boom and bust given by the dotted line actual a alternatively, if monetary policy was conducted well, we should expect to have relatively stable1.', 'conditions, including low inflation; with a bit of luck, we should also get longer lasting expansions and milder recessions.', 'because a reasonably stable aggregate price level does not prompt the distortions in economic decisions seen with high inflation, trend growth should be a little higher.', 'but while that difference will be worth having, it only adds a little to trend a, and many people would have trouble noticing the difference.', "gdp: : trend d and d actual 200 level l trend d b 180 of f rea eal l 160 gdp 140 actual 120 100 80 trend d a 60 actual l a 40 actual l a' 20 0 10 15 5 20 yea ears now, people may be unsatisfied with this outcome and say that they would prefer to be on the faster trend growth line given by trend b, which is perhaps two or three per cent higher than trend a. this is a reasonable aspiration, but it cannot be achieved by an adjustment to monetary policy.", 'what factors then explain long-run growth?', 'in simple terms, it is explained by the growth of the productive factors in the economy - the growth of the labour force, expansion of the capital stock and growth in productivity of both labour and capital.', 'this is why there is such focus on micro-economic policies to raise efficiency, rather than manipulation of the macroeconomic instruments, when people talk about long run growth potential.', 'again, all that monetary policy can do is to minimise the booms and busts around the higher trend.', 'the only way that the economy can move from trend a to trend b is by enacting policies that either increase the growth of the productive factors or increase their productivity.', 'i do not intend to say much about the growth of the labour force, which in the long run is determined by population growth and participation in the workforce.', 'note, however, that in the short run the economy can grow faster than the labour force constraint would suggest because, if there is enough flexibility, we can move people out of unemployment into employment.', 'the other point that i should register is that i do not think in the long run we will be able to maintain our current low male participation rate.', 'with life expectancy still increasing, we will not be able to continue the luxury of having so many people entering the workforce in their early twenties and leaving in their mid fifties.', 'this is a transitory phase, not a permanent increase in leisure.', 'in thinking about how to ensure that the capital side of the production potential is expanded sufficiently, it is hard to go past the simple idea that investment has to be funded by saving, and we would probably have more if we increased our domestic saving.', 'of course it could be funded by more foreign saving, but that path tends to be a more unstable one.', 'i have no new ideas on how to increase our savings other than through the familiar methods of making sure that the government does not reduce national savings through chronic budget deficits and by enacting measures to make sure that a higher proportion of retirement incomes are funded out of private savings.', 'the really big issue for long-run growth is how we raise productivity.', 'in simple debate, this is often portrayed as producing the same with less people, either by job shedding or by substituting capital for labour.', 'but any business knows that it is not just manning levels which are important.', 'the flexibility of the workforce in using the capital equipment, the skills which they can bring to bear in response to new demands and opportunities, the capacity of the firm to innovate and improve processes in industrial and service applications, the ability to develop and exploit new technology - these are actually more important ingredients in the long run.', 'of course, all good firms are trying to do this all the time.', 'in a competitive marketplace, they have to keep up with their competitors or fall by the wayside.', 'in a global marketplace, they increasingly have to move towards international best practice, which itself is always advancing as a result of innovation and adoption of new technology.', 'in the process of matching their competitors, the best firms drive the development of productivity and the rise in living standards.', 'not all firms nor all industries will succeed in doing this.', 'some will thrive and others will fail.', 'some industries will grow, and some industries that we do not even know about as yet will emerge.', 'the only thing we know is that there will be continuous change, not just here but in all countries, under the constant pressure of competition, new technologies and globalisation.', 'there is no simple secret to success, but part of the answer must be for both firms and for countries to facilitate change, and to adapt to it, not to resist it.', 'the central issue is that all productivity gains involve change.', 'by their nature they involve producing goods and services in different (and better) ways, or in producing different goods and services.', 'change is a necessary condition for productivity growth.', 'these major changes are going to occur in the private sector among both large and small firms.', 'the adjustment task will be difficult, but they must try to seek out the profitable and growing areas.', 'while the role of government will be important, the government will not be able to do the adjustment for the private sector.', "i find it hard to believe that the government would be better than the private sector at picking the growth areas, so i believe that the government's main contribution should be to remove unnecessary obstacles to change, to provide a high quality infrastructure, to encourage saving and to work at lifting and maintaining quality of education.", 'i know this is a difficult message to give to a public which is growing tired of change (not all of it economic).', 'but the alternative of stopping change is really not viable.', 'it has always been the case that the firms and societies that have managed to embrace the challenge of change and seize new opportunities, rather than turning their backs, have been the ones that prospered.', 'it may, of course, be harder for the high income societies like australia than for the newcomers who feel less attachment to established ideas and who therefore have less to "lose" in embracing change.', 'but we surely have the capacity to adopt change when we see the need.', 'we have to be convinced it is worth it.', 'the advantages of flexibility have been well demonstrated in the nineties by the superior performance, both in terms of growth and in lower levels of unemployment, of the less regulated english-speaking countries compared to the corporatist european ones.', 'i am not suggesting we should remove all regulation and rely totally on laissez faire.', 'there is clearly a large role for government, but we should always ask whether particular government initiatives are forward looking, or whether they are protecting an existing industry or an existing privilege.', 'the first requirement of government is to provide as stable a macro-economic environment as it can.', 'the second requirement of government is to provide first class, low cost infrastructure.', 'this stretches from such items as the legal system and accountancy standards through to more tangible items like the education system and the utilities, including electricity, gas, water and telecommunications.', 'the government, of course, need not be the provider of each of these, but it will always ultimately set the standards.', 'inevitably, governments will also be called upon to enact policies which affect one industry at the expense of others.', 'my only plea here is that they do it in a way that encourages adjustment, perhaps even compensates losers, but not to do it in a way which resists change.', '4. conclusion australia has recorded quite a respectable growth performance by developed country standards during the current upswing.', "even our low point in the mid-cycle growth pause - a bit over 2 per cent - is pretty good compared with many countries' average performances.", 'people are disappointed that more progress has not yet been made on reducing unemployment, but we have made some, and further real progress will be made if we can sustain a long running expansion.', 'as i have noted tonight, i think our current monetary policy framework is serving us well in this regard, by requiring us to take a medium-term view in our policy deliberations and maximising the chances for a long recovery.', 'i hope i have helped to explain our thinking.', "when we shift our focus to the economy's long run growth prospects, however, monetary policy should inevitably attract less attention.", 'price stability is a necessary condition for faster long-term growth, but there are many other policies which have to be got right.', "that's why it is so hard.", 'if there is a simple message, i think it is that the heart of the long-term growth process is productivity enhancement through innovation, technological change and so on, and that to reap the benefits of those processes, we have to embrace the forces of competition and globalisation, with all the changes and discomforts they bring.']	Ian J Macfarlane	Reserve Bank of Australia	Governor	Australia
https://www.bis.org/review/r970806d.pdf	Mr. Kelley describes the Federal Reserve System's efforts to address the Year 2000 computer systems problem (Central Bank Articles and Speeches, 30 Jul 97)	Testimony by Mr. Edward W. Kelley, Jr. before the Subcommittee on Financial Services and Technology of the Committee on Banking, Housing and Urban Affairs of the US Senate in Washington DC on 30/7/97.	1997-07-30 00:00:00	Mr. Kelley describes the Federal Reserve System's efforts to address the Year 2000 computer systems problem Testimony by Mr. Edward W. Kelley, Jr. before the Subcommittee on Financial Services and Technology of the Committee on Banking, Housing and Urban Affairs of the US Senate in Washington DC on 30/7/97. I am pleased to appear before the Subcommittee today to discuss the Federal Reserve's efforts to address the Year 2000 computer systems problem. I will discuss what action is being taken by the Federal Reserve System to address internal systems, our supervisory efforts, coordination with the industry, and contingency planning. Year 2000 Readiness It is crucial that the Federal Reserve maintain reliable services to the nation's banking system and financial markets. I want to assure you that the Federal Reserve is giving the Year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness and the bank supervision function is well along in a cooperative, interagency effort, to promote early remediation and testing by the industry. The supervision function is completing an assessment of the industry's readiness, will examine every bank subject to our jurisdiction by mid-1998, and will review their progress as part of all examinations conducted throughout the remaining months before the millennium. We are taking a comprehensive approach to preparedness which includes assessments of readiness, remediation, testing, and updating proven plans and techniques used during other times of operational stress in order to be prepared to address potential century data change difficulties. All Federal Reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. Further, critical financial services systems that interface with customers will be Year 2000 ready by mid-1998, permitting approximately 18 months for customer testing. Many top personnel in the Federal Reserve System are working hard to manage this initiative. Our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated internal systems problem, and enhancing our ability to respond to possible operating failures of depository institutions. While there are challenges before us, I can report that we expect to be fully prepared for the century date change. Federal Reserve Readiness The Federal Reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations. Our new centralized mission-critical applications, such as Fedwire funds transfer, book-entry securities, and Automated Clearing House, were designed from inception with Year 2000 compliance in mind. The mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation. Like our counterparts in the private sector, the Federal Reserve System still faces substantial challenges in achieving Year 2000 readiness. These challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, testing, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our Year 2000 activities. - 2 - According to industry experts, one quarter of an organization's Year 2000 compliance efforts are devoted to project management. Managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements. In addition, Year 2000 preparations must address computerized environmental systems such as power, heating and cooling, voice communications, elevators, and vaults. In the case of the Federal Reserve, management of this project is particularly challenging in that it requires coordination among Reserve Banks, the Board of Governors, government agencies, numerous vendors and service providers, and approximately 13,000 customers. In late 1995, a Federal Reserve System-wide project was initiated, referred to as the Century Date Change (CDC) project, to coordinate the efforts of the Reserve Banks, Federal Reserve Automation Services (FRAS) -- the Reserve Banks' centralized mainframe data processing and data communications services organization -- and the Board of Governors. Our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, and communication. Our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met. The readiness process involves performing risk assessments, modifying automated systems, and testing internally and with depository institutions, service providers, and government agencies. Finally, we are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. Some of our most senior executives are leading the project and the Board is now receiving formal status reports at least every 60 days. Any significant compliance issues will be reported to the Board immediately. A significant challenge in meeting our Year 2000 readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure is comprised of hardware and software products from third-party vendors. Additionally, the Federal Reserve utilizes commercial application software products and services for certain administrative functions and other operations. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000 ready. In many cases, compliance will require upgrading, or even replacing, equipment and software. We have completed an initial inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well. As we continue to assess our systems for Year 2000 readiness, we are preparing a central environment for testing our payment system applications. We are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies. These environments will enable testing for high-risk dates such as year-end 1999, beginning of year 2000, and February 29, 2000 (leap year). Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Our test environments will be available to our customers for testing on a twenty-four hour basis, six days a week. Network communications components will also be tested and certified in a special test lab environment at FRAS. The testing effort for Year 2000 readiness within the Federal Reserve will be extensive and complex. Industry experts estimate that testing for readiness will consume about half of total Year 2000 project resources. To leverage existing resources and processes, we are modelling our Year 2000 testing, both internally and with depository institutions, on proven testing methods and processes. Our customers are already familiar with these processes and testing environment. We will finalize and distribute our testing strategy to depository institutions by the end of September this year and begin coordinating test schedules January 1998. As I noted earlier, the Reserve Banks are targeting June 1998 to commence testing with their customers, which allows an 18-month time period for depository institutions to test their systems with the Federal Reserve. - 3 - The next challenge I would like to discuss regards retaining staff critical to the success of the project. As I mentioned earlier, we have placed a high priority on our CDC project, and as such have allocated many of the best managers and technical staff in the Federal Reserve System to work on the project. The information technology industry is already experiencing market pressures due to the increased demand for technical talent. As the millennium draws closer, the global market requirements for qualified personnel will intensify even further. We are responding as necessary to these market-induced pressures by offering incentives to retain staff members in critical, high-demand positions. Our focus at the Board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure. We are also working hard to address the supervisory issues raised by Year 2000 and are developing contingency plans which I will discuss later. Supervision Program Banks rely heavily on their automated information processing and telecommunications systems to participate in the global payments system, to exchange information with counterparties and regulatory agencies, and to manage their internal control systems and sophisticated computer equipment. As a bank supervisor, the Federal Reserve has worked actively with the other banking agencies to advise the industry of our concerns, and to develop a thorough understanding of the industry's readiness. In this regard, the Federal Reserve is closely monitoring Year 2000 preparations and compliance of the institutions we supervise so that we can act aggressively to identify and resolve problems that arise. Early this year, the Federal Reserve and the other regulatory agencies developed a uniform Year 2000 assessment questionnaire to collect and aggregate information on a national basis. We have received over 1000 responses from financial organizations and service providers supervised by the Federal Reserve. Based on these responses and other information, we believe the banking industry's awareness level has improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated. Generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change. Many larger banks are already renovating their operating systems and have commenced testing of their critical applications. Large organizations appear capable of renovating their critical operating systems by year-end 1998, and will have their testing well underway by then. Some of these organizations have recently come to realize that their initial resource and cost estimates to address this project need to be raised, given the magnitude of the tasks to be performed and the growing scarcity of available programming staff with the skills necessary to renovate older systems. Smaller banks, including the US offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less visible and will be carefully monitored as part of our supervision program. Many of these organizations appear to have underestimated the efforts necessary to ensure that their systems will be compliant. Accordingly, we will direct significant attention to ensure that these banks intensify their efforts to prepare for the Year 2000. We intend to update our assessment periodically in order to maintain a current awareness of the industry's readiness. Our focus on the industry's readiness began last year, when the Federal Reserve commenced examining banks' plans and initiatives for the century date change. Through mid-year 1998 we will continue this program and conduct a thorough Year 2000 preparedness examination of every bank, US branch and agency of a foreign bank, data processing center, and service provider that we supervise. Our examination program includes an extensive review of each institution's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. Our examiners are actively engaged in ensuring that the board of directors and senior management are addressing the issues - 4 - and assembling the necessary resources. Based on the examination results and the findings collected during the current assessment program, we are identifying those institutions that require intensified supervisory attention and establish our priorities for subsequent examinations. Public Awareness We are mindful that extensive communication with the industry and the public is crucial to the success of our efforts. Our public awareness program includes communications related to our testing efforts and our overall concerns about the industry's readiness. We continue to advise our customers of the Federal Reserve's plans and time frames for making our software Year 2000 ready. We have inaugurated a Year 2000 newsletter and have just published our first bulletin addressing specific technical issues. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. To heighten the industry's awareness level, the Federal Financial Institutions Examination Council (FFIEC), issued a policy statement on May 5th entitled "Year 2000 Project Management Awareness," which updates the supervisory guidance first issued in 1996. The statement emphasizes the regulators' concerns that inability to provide a compliant hardware and software environment to support the upcoming century date change would expose a bank to inordinate operational, financial, and legal risks. A set of uniform examination procedures accompanying the statement provides guidance for examiners as well as bank management, stressing the need for sponsorship at the highest levels of the organization to effectively manage the remediation process and address any deficiencies that may surface. Bank management must not only be aware of the many Year 2000 problems, but must also be sensitive to the magnitude of the efforts needed to achieve compliance and the consequent budgetary implications. Industry experts maintain that costs to perform Year 2000 renovation tasks will increase as the demand for skilled information technology professionals grows. Accordingly, the interagency policy statement emphasizes the need for bank management to be aggressive in securing sufficient human and computer resources. The statement also encourages banks to be largely completed with their renovation and well into testing of their major applications by year-end 1998 so that any substantive problems can be addressed in 1999. The statement also calls upon banks to consider the Year 2000 risks posed by their borrowers and customers, as banks could be adversely affected by borrowers who are not prepared for Year 2000 processing. Corporate customers who have not considered Year 2000 issues may experience a disruption in business, resulting in financial difficulties that could negatively influence their creditworthiness. Examiners now verify that a bank incorporates a borrower's Year 2000 preparedness into its underwriting standards, and that loan officers assess the extent of Year 2000 computer problems that may influence a borrower's ability to repay its loans on a timely basis. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet web site and a toll free Fax Back service (888-882- 0982). The web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 web sites available from numerous other sources. The site has been used heavily since its introduction in early May of this year. The FFIEC Year 2000 web site can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness" intended for viewing by a bank's board of directors and senior management. The video presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In my introductory remarks on the video, I note that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of - 5 - attention and sufficient resources to address the issue on a timely basis. The video has already been distributed to banks and their service providers, and can be ordered through the Board's Web site. We are also taking steps to provide this information to foreign bank supervisors. With regard to the international aspects of the Year 2000 issue, US offices of foreign banks pose a unique set of challenges. Based on our assessments, we are concerned that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem, and may not have committed the resources necessary to address the issues effectively. This is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems. Therefore, we are working through the Bank for International Settlements' (BIS) committee of bank supervisors composed of many of the international agencies responsible for the foreign banks that operate in the US Through several presentations and the distribution of the interagency statement and the Year 2000 video to the BIS Supervisors Committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by the century date change and to solicit their assistance in monitoring the state of overall preparedness of foreign bank parents to ensure that they consider the needs of their US offices. We are also participating in the BIS Group of Computer Experts' meeting of G-10 and non-G-10 central banks in September which provides a forum to share views on and approaches to dealing with Year 2000 issues and have been active in various private sector forums. The participants will discuss their involvement with raising bank industry awareness, remediation of payment systems, and the readiness of the central banks' internal systems. Information garnered from this meeting will assist the BIS Committee on Payment and Settlement Systems, as well as the Federal Reserve, in understanding the current state of preparedness of payment systems on a global level. Contingency Planning Because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is our preparedness and the avoidance of problems. But we know from experience that upon occasion, things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. In this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions. Moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with problems in the financial sector that might arise as a result of CDC. We are, of course, developing specific CDC contingency plans to address various operational scenarios. Our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry. We already have arrangements in place to assist financial institutions in the event they are unable to access their own systems. For example, we are able to provide financial institutions with access to Federal Reserve computer terminals on a limited bases for the processing of critical funds transfers. This contingency arrangement has proven highly effective when used from time to time by depository institutions experiencing major hardware/software outages or that have had their operations disrupted due to natural disasters such as the Los Angeles earthquake, hurricane Hugo in the Carolinas, and hurricane Andrew in south Florida. In these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community and also arranged for our operations to function virtually without interruptions for 24 hours a day during the crisis period. We feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by century date change. We are also beginning to formulate responses for augmenting certain functions, such as computer help desk services and off-line funds transfers, to respond to short-term needs for these services. - 6 - Although operational contingency is something that the Federal Reserve is confronted with on a daily basis, preparation for contingencies in the century date change environment does offer some new and significant challenges. For example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option. This underscores the importance of the rigorous assessment and testing to which all applications must be subjected. Beyond reliance on a sound plan and effective execution of the plan, the Federal Reserve is not totally dependent upon any single system for executing payment orders. While we have very sophisticated automated systems in place, such as Fedwire and our Automated Clearing House systems, we also operate paper-based payment systems that offer a set of alternatives in the event of a disruption in a segment of the electronic payment system. Clearly, the Federal Reserve and other bank supervisors expect depository institutions to work diligently and effectively to ensure that automation issues associated with the Year 2000 are resolved fully and in a timely fashion. However, we anticipate that at least a few financial institutions will experience difficulty in completing their Year 2000 preparations in a timely manner, and we are developing plans to address such cases. The Federal Reserve will identify and monitor these organizations closely and work to ensure that senior management and boards of directors are aware of their Year 2000 issues, cost implications, and possible consequences. A bank's need for adequate preparation for the Year 2000 is regarded as a safety and soundness issue. Where progress is deemed to be substantively less than satisfactory, resulting in excessive risk and a possibly unsafe or unsound condition, we will address the issue in a manner consistent with our long-standing supervisory approach to dealing with other safety and soundness issues. The full range of our supervisory tools and remedies are available, including intensified monitoring, progressively more detailed reporting requirements, presentations to the board of directors, insistence on bank commitments to initiate corrective action, and, ultimately, possible use of enforcement actions as appropriate. We recognize, nonetheless, that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and would not necessarily involve funding shortfalls. Nevertheless, the Federal Reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The Federal Reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall. Discussions are also underway with the other federal banking agencies to ensure that we are jointly prepared to address the challenge resulting from serious operating problems. If such operating problems were not correctable within a reasonable time frame, it could necessitate a federal resolution comparable to that used for a bank that has become capital insolvent. Our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the US that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any foreign banking organizations that experience a funding shortfall. Closing Remarks As I indicated at the outset, the Federal Reserve views its Year 2000 preparations with great seriousness. As such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial - 7 - systems we operate. While we have made significant progress in validating our internal systems and planning for testing with depository institutions and others using Federal Reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. We believe that we are well-positioned to meet our objectives and will remain vigilant throughout the process. As a bank supervisor, the Federal Reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance. Lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of Year 2000 issues and provide for the sharing of experiences, ideas, and best practices.	["mr. kelley describes the federal reserve system's efforts to address the year 2000 computer systems problem testimony by mr. edward w. kelley, jr. before the subcommittee on financial services and technology of the committee on banking, housing and urban affairs of the us senate in washington dc on 30/7/97.", "i am pleased to appear before the subcommittee today to discuss the federal reserve's efforts to address the year 2000 computer systems problem.", 'i will discuss what action is being taken by the federal reserve system to address internal systems, our supervisory efforts, coordination with the industry, and contingency planning.', "year 2000 readiness it is crucial that the federal reserve maintain reliable services to the nation's banking system and financial markets.", "i want to assure you that the federal reserve is giving the year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations.", 'the federal reserve system has developed and is executing a comprehensive plan to ensure its own year 2000 readiness and the bank supervision function is well along in a cooperative, interagency effort, to promote early remediation and testing by the industry.', "the supervision function is completing an assessment of the industry's readiness, will examine every bank subject to our jurisdiction by mid-1998, and will review their progress as part of all examinations conducted throughout the remaining months before the millennium.", 'we are taking a comprehensive approach to preparedness which includes assessments of readiness, remediation, testing, and updating proven plans and techniques used during other times of operational stress in order to be prepared to address potential century data change difficulties.', 'all federal reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. further, critical financial services systems that interface with customers will be year 2000 ready by mid-1998, permitting approximately 18 months for customer testing.', 'many top personnel in the federal reserve system are working hard to manage this initiative.', 'our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated internal systems problem, and enhancing our ability to respond to possible operating failures of depository institutions.', 'while there are challenges before us, i can report that we expect to be fully prepared for the century date change.', 'federal reserve readiness the federal reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations.', 'our new centralized mission-critical applications, such as fedwire funds transfer, book-entry securities, and automated clearing house, were designed from inception with year 2000 compliance in mind.', 'the mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation.', 'like our counterparts in the private sector, the federal reserve system still faces substantial challenges in achieving year 2000 readiness.', 'these challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, testing, and establishing contingency plans.', 'we are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our year 2000 activities.', "- 2 - according to industry experts, one quarter of an organization's year 2000 compliance efforts are devoted to project management.", 'managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements.', 'in addition, year 2000 preparations must address computerized environmental systems such as power, heating and cooling, voice communications, elevators, and vaults.', 'in the case of the federal reserve, management of this project is particularly challenging in that it requires coordination among reserve banks, the board of governors, government agencies, numerous vendors and service providers, and approximately 13,000 customers.', "in late 1995, a federal reserve system-wide project was initiated, referred to as the century date change (cdc) project, to coordinate the efforts of the reserve banks, federal reserve automation services (fras) -- the reserve banks' centralized mainframe data processing and data communications services organization -- and the board of governors.", 'our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, and communication.', 'our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met.', 'the readiness process involves performing risk assessments, modifying automated systems, and testing internally and with depository institutions, service providers, and government agencies.', 'finally, we are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally.', 'some of our most senior executives are leading the project and the board is now receiving formal status reports at least every 60 days.', 'any significant compliance issues will be reported to the board immediately.', 'a significant challenge in meeting our year 2000 readiness objectives is our reliance on commercial hardware and software products and services.', 'much of our information processing and communications infrastructure is comprised of hardware and software products from third-party vendors.', 'additionally, the federal reserve utilizes commercial application software products and services for certain administrative functions and other operations.', 'as a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are year 2000 ready.', 'in many cases, compliance will require upgrading, or even replacing, equipment and software.', 'we have completed an initial inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well.', 'as we continue to assess our systems for year 2000 readiness, we are preparing a central environment for testing our payment system applications.', 'we are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies.', 'these environments will enable testing for high-risk dates such as year-end 1999, beginning of year 2000, and february 29, 2000 (leap year).', 'testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions.', 'our test environments will be available to our customers for testing on a twenty-four hour basis, six days a week.', 'network communications components will also be tested and certified in a special test lab environment at fras.', 'the testing effort for year 2000 readiness within the federal reserve will be extensive and complex.', 'industry experts estimate that testing for readiness will consume about half of total year 2000 project resources.', 'to leverage existing resources and processes, we are modelling our year 2000 testing, both internally and with depository institutions, on proven testing methods and processes.', 'our customers are already familiar with these processes and testing environment.', 'we will finalize and distribute our testing strategy to depository institutions by the end of september this year and begin coordinating test schedules january 1998. as i noted earlier, the reserve banks are targeting june 1998 to commence testing with their customers, which allows an 18-month time period for depository institutions to test their systems with the federal reserve.', '- 3 - the next challenge i would like to discuss regards retaining staff critical to the success of the project.', 'as i mentioned earlier, we have placed a high priority on our cdc project, and as such have allocated many of the best managers and technical staff in the federal reserve system to work on the project.', 'the information technology industry is already experiencing market pressures due to the increased demand for technical talent.', 'as the millennium draws closer, the global market requirements for qualified personnel will intensify even further.', 'we are responding as necessary to these market-induced pressures by offering incentives to retain staff members in critical, high-demand positions.', 'our focus at the board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure.', 'we are also working hard to address the supervisory issues raised by year 2000 and are developing contingency plans which i will discuss later.', 'supervision program banks rely heavily on their automated information processing and telecommunications systems to participate in the global payments system, to exchange information with counterparties and regulatory agencies, and to manage their internal control systems and sophisticated computer equipment.', "as a bank supervisor, the federal reserve has worked actively with the other banking agencies to advise the industry of our concerns, and to develop a thorough understanding of the industry's readiness.", 'in this regard, the federal reserve is closely monitoring year 2000 preparations and compliance of the institutions we supervise so that we can act aggressively to identify and resolve problems that arise.', 'early this year, the federal reserve and the other regulatory agencies developed a uniform year 2000 assessment questionnaire to collect and aggregate information on a national basis.', 'we have received over 1000 responses from financial organizations and service providers supervised by the federal reserve.', "based on these responses and other information, we believe the banking industry's awareness level has improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated.", "generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change.", 'many larger banks are already renovating their operating systems and have commenced testing of their critical applications.', 'large organizations appear capable of renovating their critical operating systems by year-end 1998, and will have their testing well underway by then.', 'some of these organizations have recently come to realize that their initial resource and cost estimates to address this project need to be raised, given the magnitude of the tasks to be performed and the growing scarcity of available programming staff with the skills necessary to renovate older systems.', 'smaller banks, including the us offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less visible and will be carefully monitored as part of our supervision program.', 'many of these organizations appear to have underestimated the efforts necessary to ensure that their systems will be compliant.', "accordingly, we will direct significant attention to ensure that these banks intensify their efforts to prepare for the year 2000. we intend to update our assessment periodically in order to maintain a current awareness of the industry's readiness.", "our focus on the industry's readiness began last year, when the federal reserve commenced examining banks' plans and initiatives for the century date change.", 'through mid-year 1998 we will continue this program and conduct a thorough year 2000 preparedness examination of every bank, us branch and agency of a foreign bank, data processing center, and service provider that we supervise.', "our examination program includes an extensive review of each institution's year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan.", 'our examiners are actively engaged in ensuring that the board of directors and senior management are addressing the issues - 4 - and assembling the necessary resources.', 'based on the examination results and the findings collected during the current assessment program, we are identifying those institutions that require intensified supervisory attention and establish our priorities for subsequent examinations.', 'public awareness we are mindful that extensive communication with the industry and the public is crucial to the success of our efforts.', "our public awareness program includes communications related to our testing efforts and our overall concerns about the industry's readiness.", "we continue to advise our customers of the federal reserve's plans and time frames for making our software year 2000 ready.", 'we have inaugurated a year 2000 newsletter and have just published our first bulletin addressing specific technical issues.', "we have also established an internet web site to provide depository institutions with information regarding the federal reserve system's cdc project.", 'this site can be accessed at the following internet address: http://www.frbsf.org/fiservices/cdc.', 'to heighten the industry\'s awareness level, the federal financial institutions examination council (ffiec), issued a policy statement on may 5th entitled "year 2000 project management awareness," which updates the supervisory guidance first issued in 1996. the statement emphasizes the regulators\' concerns that inability to provide a compliant hardware and software environment to support the upcoming century date change would expose a bank to inordinate operational, financial, and legal risks.', 'a set of uniform examination procedures accompanying the statement provides guidance for examiners as well as bank management, stressing the need for sponsorship at the highest levels of the organization to effectively manage the remediation process and address any deficiencies that may surface.', 'bank management must not only be aware of the many year 2000 problems, but must also be sensitive to the magnitude of the efforts needed to achieve compliance and the consequent budgetary implications.', 'industry experts maintain that costs to perform year 2000 renovation tasks will increase as the demand for skilled information technology professionals grows.', 'accordingly, the interagency policy statement emphasizes the need for bank management to be aggressive in securing sufficient human and computer resources.', 'the statement also encourages banks to be largely completed with their renovation and well into testing of their major applications by year-end 1998 so that any substantive problems can be addressed in 1999. the statement also calls upon banks to consider the year 2000 risks posed by their borrowers and customers, as banks could be adversely affected by borrowers who are not prepared for year 2000 processing.', 'corporate customers who have not considered year 2000 issues may experience a disruption in business, resulting in financial difficulties that could negatively influence their creditworthiness.', "examiners now verify that a bank incorporates a borrower's year 2000 preparedness into its underwriting standards, and that loan officers assess the extent of year 2000 computer problems that may influence a borrower's ability to repay its loans on a timely basis.", 'on behalf of the ffiec, the federal reserve has developed a year 2000 information distribution system, including an internet web site and a toll free fax back service (888-882- 0982).', 'the web site provides easy access to policy statements, guidance to examiners, and paths to other year 2000 web sites available from numerous other sources.', 'the site has been used heavily since its introduction in early may of this year.', 'the ffiec year 2000 web site can be accessed at the following internet address: http://www.ffiec.gov/y2k.', 'the federal reserve has also produced a ten-minute video entitled "year 2000 executive awareness" intended for viewing by a bank\'s board of directors and senior management.', 'the video presents a summary of the year 2000 five-phase project management plan outlined in the interagency policy statement.', 'in my introductory remarks on the video, i note that senior bank officials should be directly involved in managing the year 2000 project to ensure that it is given the appropriate level of - 5 - attention and sufficient resources to address the issue on a timely basis.', "the video has already been distributed to banks and their service providers, and can be ordered through the board's web site.", 'we are also taking steps to provide this information to foreign bank supervisors.', 'with regard to the international aspects of the year 2000 issue, us offices of foreign banks pose a unique set of challenges.', 'based on our assessments, we are concerned that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem, and may not have committed the resources necessary to address the issues effectively.', 'this is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems.', "therefore, we are working through the bank for international settlements' (bis) committee of bank supervisors composed of many of the international agencies responsible for the foreign banks that operate in the us through several presentations and the distribution of the interagency statement and the year 2000 video to the bis supervisors committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by the century date change and to solicit their assistance in monitoring the state of overall preparedness of foreign bank parents to ensure that they consider the needs of their us offices.", "we are also participating in the bis group of computer experts' meeting of g-10 and non-g-10 central banks in september which provides a forum to share views on and approaches to dealing with year 2000 issues and have been active in various private sector forums.", "the participants will discuss their involvement with raising bank industry awareness, remediation of payment systems, and the readiness of the central banks' internal systems.", 'information garnered from this meeting will assist the bis committee on payment and settlement systems, as well as the federal reserve, in understanding the current state of preparedness of payment systems on a global level.', 'contingency planning because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is our preparedness and the avoidance of problems.', 'but we know from experience that upon occasion, things can go wrong.', "given our unique role as the nation's central bank, the federal reserve has always stressed contingency planning -- for both systemic risks as well as operational failures.", 'in this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions.', 'moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with problems in the financial sector that might arise as a result of cdc.', 'we are, of course, developing specific cdc contingency plans to address various operational scenarios.', 'our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry.', 'we already have arrangements in place to assist financial institutions in the event they are unable to access their own systems.', 'for example, we are able to provide financial institutions with access to federal reserve computer terminals on a limited bases for the processing of critical funds transfers.', 'this contingency arrangement has proven highly effective when used from time to time by depository institutions experiencing major hardware/software outages or that have had their operations disrupted due to natural disasters such as the los angeles earthquake, hurricane hugo in the carolinas, and hurricane andrew in south florida.', 'in these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community and also arranged for our operations to function virtually without interruptions for 24 hours a day during the crisis period.', 'we feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by century date change.', 'we are also beginning to formulate responses for augmenting certain functions, such as computer help desk services and off-line funds transfers, to respond to short-term needs for these services.', '- 6 - although operational contingency is something that the federal reserve is confronted with on a daily basis, preparation for contingencies in the century date change environment does offer some new and significant challenges.', 'for example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option.', 'this underscores the importance of the rigorous assessment and testing to which all applications must be subjected.', 'beyond reliance on a sound plan and effective execution of the plan, the federal reserve is not totally dependent upon any single system for executing payment orders.', 'while we have very sophisticated automated systems in place, such as fedwire and our automated clearing house systems, we also operate paper-based payment systems that offer a set of alternatives in the event of a disruption in a segment of the electronic payment system.', 'clearly, the federal reserve and other bank supervisors expect depository institutions to work diligently and effectively to ensure that automation issues associated with the year 2000 are resolved fully and in a timely fashion.', 'however, we anticipate that at least a few financial institutions will experience difficulty in completing their year 2000 preparations in a timely manner, and we are developing plans to address such cases.', 'the federal reserve will identify and monitor these organizations closely and work to ensure that senior management and boards of directors are aware of their year 2000 issues, cost implications, and possible consequences.', "a bank's need for adequate preparation for the year 2000 is regarded as a safety and soundness issue.", 'where progress is deemed to be substantively less than satisfactory, resulting in excessive risk and a possibly unsafe or unsound condition, we will address the issue in a manner consistent with our long-standing supervisory approach to dealing with other safety and soundness issues.', 'the full range of our supervisory tools and remedies are available, including intensified monitoring, progressively more detailed reporting requirements, presentations to the board of directors, insistence on bank commitments to initiate corrective action, and, ultimately, possible use of enforcement actions as appropriate.', 'we recognize, nonetheless, that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others.', 'these problems could be manifested in a number of ways and would not necessarily involve funding shortfalls.', 'nevertheless, the federal reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market.', 'the federal reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available.', 'the terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall.', 'discussions are also underway with the other federal banking agencies to ensure that we are jointly prepared to address the challenge resulting from serious operating problems.', 'if such operating problems were not correctable within a reasonable time frame, it could necessitate a federal resolution comparable to that used for a bank that has become capital insolvent.', 'our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the us that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank.', 'such circumstances would necessitate coordination with the home country supervisor.', 'moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any foreign banking organizations that experience a funding shortfall.', 'closing remarks as i indicated at the outset, the federal reserve views its year 2000 preparations with great seriousness.', 'as such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial - 7 - systems we operate.', 'while we have made significant progress in validating our internal systems and planning for testing with depository institutions and others using federal reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion.', 'in particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience.', 'we believe that we are well-positioned to meet our objectives and will remain vigilant throughout the process.', "as a bank supervisor, the federal reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance.", 'lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of year 2000 issues and provide for the sharing of experiences, ideas, and best practices.']	Edward W Kelley, Jr	Board of Governors of the US Federal Reserve System	Member of the Board of Governors	US
https://www.bis.org/review/r970806b.pdf	Ms. Rivlin discusses the Federal Reserve's planning process and the efforts being made to improve performance (Central Bank Articles and Speeches, 29 Jul 97)	Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 29/7/97.	1997-07-29 00:00:00	Ms. Rivlin discusses the Federal Reserve's planning process and the efforts being made to improve performance Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 29/7/97. Mr. Chairman and members of the Committee, I am pleased to be here today to discuss the Federal Reserve's planning process and the efforts we are making to measure and improve our performance in the spirit of the Government Performance and Results Act (GPRA). I am personally a long-term proponent of GPRA and worked hard on its implementation when I was at the Office of Management and Budget. While the Federal Reserve does not receive appropriated funds and is not, strictly speaking, covered by the Act, we are eager to participate in the processes and activities set forth in the Act. GPRA fits well with the new efforts the Federal Reserve has undertaken to plan further ahead, use our resources more effectively and to coordinate activities across the whole system more explicitly. The testimony is a brief progress report on those efforts. Planning at the Fed In its briefest form, the Federal Reserve's mission is to "foster the stability, integrity and efficiency of the nation's financial and payment systems so as to promote optimal macroeconomic performance." This mission derives directly from the Federal Reserve Act of 1913, which established the Federal Reserve as the nation's central bank, and has three main elements: To formulate and conduct monetary policy toward the achievement of maximum sustainable long-term growth; price stability fosters that goal. To promote a safe, sound, competitive, and accessible banking system and stable financial markets through supervision and regulation of the nation's banking and financial systems; through its function as the lender of last resort; and through effective implementation of statutes designed to inform and protect the consumer. To foster the integrity, efficiency, and accessibility of US dollar payments and settlement systems, issue a uniform currency, and act as the fiscal agent and depository of the US government. The activities involved in carrying out this broad mission are extremely diverse, ranging from setting short-term interest rates to processing checks and cash, to examining depository institutions. Allocation of the resources the Federal Reserve uses to do its job depends heavily on the state of the economy (both national and international), how well or badly the financial services system is functioning, and what additional tasks (such as implementation of the Community Reinvestment Act and expansion of our oversight of foreign banks operating in the US pursuant to the Foreign Bank Supervision Enhancement Act of 1991) the Congress assigns to us. To carry out this multi-faceted mission, the Congress established a highly decentralized Federal Reserve System with a complex governance structure. Leadership and direction are vested in the Board of Governors, but only about 1,700 staff (out of about 24,900) work for the Board in Washington. The regional Reserve Banks carry out the bulk of operations and have substantial autonomy. As a result, planning and resource allocation at the Federal Reserve have historically been quite decentralized, and major changes have required painstaking consensus building across the Board/Bank structure. The regional structure of the Federal Reserve is one of its great strengths. The twelve regional Federal Banks work closely with the banks in their region and are closely tied into their regional economies. The development of Federal Reserve policy is greatly enriched by the in-depth knowledge that the regional banks have of the industrial, agricultural and financial forces shaping different parts of the economy. The challenge confronting strategic planning at the Federal Reserve is to find a balance between decentralized regional planning, which preserves the strengths of the regional structure, and the need for a more comprehensive national plan aimed at increasing efficiency by rationalizing the allocation of resources across regions and functions. In recent years, major changes have occurred in the allocation of Federal Reserve resources in response to unfolding events. When serious problems developed in the banking industry in the 1980s and in response to increased supervisory responsibility for foreign banking entities, more Federal Reserve resources were channeled into supervision and regulation. Rapidly changing technology, especially telecommunications and automation, has revolutionized Federal Reserve operations and required considerable investment in hardware, software and expertise. Consolidation of the banking industry, evolution of payment systems patterns and technology, growth in derivatives, globalization of financial services, concerns about equal credit opportunity and fair housing issues, efforts to reduce systemic risk in the payments area, and changes in monetary aggregates, have all caused planning and resource adjustments. Rapid technological change has also created opportunities for system-wide efficiencies resulting from consolidation of activities in one or more Reserve Banks. A number of the twelve regional banks have developed specialized activities serving other regions. For example, Federal Reserve Automation Services (FRAS) is headquartered in Richmond, but provides mainframe data processing and data communications services to all parts of the system. This consolidation and specialization has enabled the Reserve Banks to centralize operations of many of their mission critical applications, such as Fedwire, Automated Clearing House (ACH), and accounting. Continued technological advance, as well as further consolidation in the financial services industry, is likely to lead to further specialization among regional Federal Reserve Banks. New Strategic Planning Activities In the face of accelerating change, the Federal Reserve recently recognized the need for a more comprehensive planning framework. In 1995, a System Strategic Planning Coordinating Group was appointed, consisting of Board members, Reserve Bank Presidents and senior managers, representing the full range of the Federal Reserve's activities. This group produced an "umbrella" framework, designed to enable the Board, the Reserve Banks and product and support offices to produce their own more detailed plans and decision documents under the "umbrella." This framework, which is the basis for the document submitted to the House and Senate Banking Committees, sets forth the mission of the Federal Reserve referred to above. It also discusses the "values" of the Federal Reserve, the goals and objectives of the Fed, key assumptions, as well as the external and internal factors that could affect the achievement of those goals and objectives. With the overall framework as a reference point, strategic planning activities are proceeding with new energy at the Reserve Banks, at the Board, and with respect to cross-cutting major functions such as the payments system and bank supervision and regulation. Individual Reserve Banks have reviewed their operations from the ground up and reassessed their structure and effectiveness in carrying out their missions. Some of the Banks have launched fundamental re-engineering efforts that are resulting in substantial changes in management structure and operations. The Federal Reserve Bank of Chicago calls its effort "Fresh Look"; the Federal Reserve Bank of Cleveland is engaged in "Transformation: 2000." Board planning and budgeting At the Board, we have restructured the annual planning and budget process to put more emphasis on planning (and less on detailed line-item budgeting), to lengthen the planning and budgeting horizon, and to involve the Board itself more heavily in setting priorities. To this end, we have established a Budget Committee of the Board (consisting of myself and Governors Phillips and Kelley) assisted by a staff planning group drawn from across the major functions of the Board. We are working with a four-year planning horizon and intend to produce the Board's first biennial budget (1998/1999) to go into effect on January 1, 1998. Our hope is that the new process and structure will give the Board a better understanding of the options it faces with respect to alternative ways of carrying out the Federal Reserve's mission, and a clearer basis for deciding on priorities. Payments System study A major study of the Federal Reserve's role in the Payments System, currently underway, is another example of strategic planning with respect to a major portion of the Federal Reserve's activities, under the general umbrella of the strategic planning framework. Since payments technology and the structure of the financial services industry are changing rapidly, it seemed important to focus both on how the payment system was evolving (and should evolve) and what role the Federal Reserve should play in that evolution. The United States is amazingly dependent on paper checks -- Americans wrote 64 billion checks in 1996 -while most of the industrial world is shifting rapidly to more efficient electronic based payments. The study, directed by a committee of two Governors and two Federal Reserve Bank Presidents, has drawn on analytic resources across the Federal Reserve System and outside. We began by examining the consequences of substantially altering the role of the Federal Reserve in the retail payments system (checks and wire transfer system know as ACH). We analyzed the impact of scenarios ranging from withdrawal of the Federal Reserve from the check and ACH markets to more aggressive leadership by the Federal Reserve in making the payment system more efficient and less dependent on paper. To get maximum input from the participants in the payment system -- banks, clearinghouses, vendors, consumers and others -- in helping us assess alternatives for the future, we held a series of "forums" around the country in May and June. We had enthusiastic and extremely helpful participation from a wide range of institutions. We learned a lot from the process and are now reassessing the alternatives, conducting additional analyses and preparing to present preliminary options to the Board. I look forward to sharing the study with this Committee. The payments area is a good example of the dilemma posed for planners by rapid technological change. While rapidly evolving technology makes focussing on future options imperative, it also makes it extremely important to remain flexible. Laying out a blueprint for the payments system of the next ten or even five years, and rigidly following it, would almost certainly be a mistake. The technology is moving so rapidly that investments made now may well be obsolete in a short time. Performance Measures A major theme of GPRA is the identification of specific measures of performance of projects and programs which can be used to evaluate their effectiveness. As in most organizations, performance measurement at the Federal Reserve is more advanced -- and more feasible -- in some types of activities than in others. In the payment services areas, the Reserve Banks have measured their performance through various financial measures for many years. For example, the Monetary Control Act of 1980 imposes market discipline on the Federal Reserve by requiring it fully to cover its costs of providing services to depository institutions, and compliance with this requirement is monitored closely. Frequently private competitors provide or could provide these services, and our ability to recover our costs, adjusted to include a factor for imputed profits, taxes and cost of capital, help determine whether it is beneficial for the economy that we stay in the business. In addition, the Federal Reserve has traditionally measured unit costs for its financial services and has developed various indices that allow a Reserve Bank to measure its cost performance over time and in comparison to other Reserve Banks. Private sector benchmarks are also being developed. The Federal Reserve also tracks quality measures for many Reserve Bank services. Finally, the Federal Reserve monitors the progress of the Reserve Banks against various strategic objectives. Similarly, in bank supervision, the Federal Reserve has long used a variety of measures of the effectiveness of its examination process, but the measurement challenge has taken on new importance as supervision becomes more automated and more focused on analyzing risk. To meet this challenge, the Federal Reserve is working closely with other regulators to standardize and improve examination techniques, and has established a Steering Committee to oversee implementation of a risk-focused examination program and to design a management information system that will permit the Board to evaluate better the efficient use of examination resources among the Reserve Banks. For instance, supervisory data are used to determine in advance of on-site examinations what factors (CAMELS rating, asset size, location, and loan types) are most predictive as to the resources needed for examinations, and which institutions, particular lending areas or other service lines may require more intensive review. Such programs are low-cost because they use information that we already collect, and are effective and cost-saving because they provide a systematic way to plan and prioritize our time and resources. In other areas, such as the research and statistical analysis on which monetary policy is based, performance measurement is -- and will remain -- far more problematic. The performance of the economy itself is not so hard to measure and right now is highly positive. But it is not clear how much of the economic progress can be attributed to monetary policy, and even less clear how particular monetary policy actions are related to the quality and quantity of research and analysis produced by the Fed's research staff. Conclusion GPRA provides the opportunity for a major improvement in the management and effectiveness of Federal agencies. It provides the impetus for agencies to clarify their missions and objectives, measure their performance better and improve their efficiency and effectiveness. It must, however, avoid the risk of becoming, like some previous efforts to improve government management, largely a paper exercise which produces many numbers and reports but few real results. The Federal Reserve welcomes the opportunity to participate in the GPRA process. We will work hard to fulfill the vision of the framers of the Act and avoid the pitfalls. We will have to respond in ways that are appropriate to the Federal Reserve's diverse missions and decentralized structure. I believe we have made significant progress toward the GPRA-type strategic planning and are on the track to making more in the immediate future.	["ms. rivlin discusses the federal reserve's planning process and the efforts being made to improve performance testimony of the vice chairman of the board of governors of the us federal reserve system, ms. alice m. rivlin, before the committee on banking and financial services of the us house of representatives on 29/7/97.", "mr. chairman and members of the committee, i am pleased to be here today to discuss the federal reserve's planning process and the efforts we are making to measure and improve our performance in the spirit of the government performance and results act (gpra).", 'i am personally a long-term proponent of gpra and worked hard on its implementation when i was at the office of management and budget.', 'while the federal reserve does not receive appropriated funds and is not, strictly speaking, covered by the act, we are eager to participate in the processes and activities set forth in the act.', 'gpra fits well with the new efforts the federal reserve has undertaken to plan further ahead, use our resources more effectively and to coordinate activities across the whole system more explicitly.', 'the testimony is a brief progress report on those efforts.', 'planning at the fed in its briefest form, the federal reserve\'s mission is to "foster the stability, integrity and efficiency of the nation\'s financial and payment systems so as to promote optimal macroeconomic performance."', "this mission derives directly from the federal reserve act of 1913, which established the federal reserve as the nation's central bank, and has three main elements: to formulate and conduct monetary policy toward the achievement of maximum sustainable long-term growth; price stability fosters that goal.", "to promote a safe, sound, competitive, and accessible banking system and stable financial markets through supervision and regulation of the nation's banking and financial systems; through its function as the lender of last resort; and through effective implementation of statutes designed to inform and protect the consumer.", 'to foster the integrity, efficiency, and accessibility of us dollar payments and settlement systems, issue a uniform currency, and act as the fiscal agent and depository of the us government.', 'the activities involved in carrying out this broad mission are extremely diverse, ranging from setting short-term interest rates to processing checks and cash, to examining depository institutions.', 'allocation of the resources the federal reserve uses to do its job depends heavily on the state of the economy (both national and international), how well or badly the financial services system is functioning, and what additional tasks (such as implementation of the community reinvestment act and expansion of our oversight of foreign banks operating in the us pursuant to the foreign bank supervision enhancement act of 1991) the congress assigns to us.', 'to carry out this multi-faceted mission, the congress established a highly decentralized federal reserve system with a complex governance structure.', 'leadership and direction are vested in the board of governors, but only about 1,700 staff (out of about 24,900) work for the board in washington.', 'the regional reserve banks carry out the bulk of operations and have substantial autonomy.', 'as a result, planning and resource allocation at the federal reserve have historically been quite decentralized, and major changes have required painstaking consensus building across the board/bank structure.', 'the regional structure of the federal reserve is one of its great strengths.', 'the twelve regional federal banks work closely with the banks in their region and are closely tied into their regional economies.', 'the development of federal reserve policy is greatly enriched by the in-depth knowledge that the regional banks have of the industrial, agricultural and financial forces shaping different parts of the economy.', 'the challenge confronting strategic planning at the federal reserve is to find a balance between decentralized regional planning, which preserves the strengths of the regional structure, and the need for a more comprehensive national plan aimed at increasing efficiency by rationalizing the allocation of resources across regions and functions.', 'in recent years, major changes have occurred in the allocation of federal reserve resources in response to unfolding events.', 'when serious problems developed in the banking industry in the 1980s and in response to increased supervisory responsibility for foreign banking entities, more federal reserve resources were channeled into supervision and regulation.', 'rapidly changing technology, especially telecommunications and automation, has revolutionized federal reserve operations and required considerable investment in hardware, software and expertise.', 'consolidation of the banking industry, evolution of payment systems patterns and technology, growth in derivatives, globalization of financial services, concerns about equal credit opportunity and fair housing issues, efforts to reduce systemic risk in the payments area, and changes in monetary aggregates, have all caused planning and resource adjustments.', 'rapid technological change has also created opportunities for system-wide efficiencies resulting from consolidation of activities in one or more reserve banks.', 'a number of the twelve regional banks have developed specialized activities serving other regions.', 'for example, federal reserve automation services (fras) is headquartered in richmond, but provides mainframe data processing and data communications services to all parts of the system.', 'this consolidation and specialization has enabled the reserve banks to centralize operations of many of their mission critical applications, such as fedwire, automated clearing house (ach), and accounting.', 'continued technological advance, as well as further consolidation in the financial services industry, is likely to lead to further specialization among regional federal reserve banks.', 'new strategic planning activities in the face of accelerating change, the federal reserve recently recognized the need for a more comprehensive planning framework.', "in 1995, a system strategic planning coordinating group was appointed, consisting of board members, reserve bank presidents and senior managers, representing the full range of the federal reserve's activities.", 'this group produced an "umbrella" framework, designed to enable the board, the reserve banks and product and support offices to produce their own more detailed plans and decision documents under the "umbrella."', 'this framework, which is the basis for the document submitted to the house and senate banking committees, sets forth the mission of the federal reserve referred to above.', 'it also discusses the "values" of the federal reserve, the goals and objectives of the fed, key assumptions, as well as the external and internal factors that could affect the achievement of those goals and objectives.', 'with the overall framework as a reference point, strategic planning activities are proceeding with new energy at the reserve banks, at the board, and with respect to cross-cutting major functions such as the payments system and bank supervision and regulation.', 'individual reserve banks have reviewed their operations from the ground up and reassessed their structure and effectiveness in carrying out their missions.', 'some of the banks have launched fundamental re-engineering efforts that are resulting in substantial changes in management structure and operations.', 'the federal reserve bank of chicago calls its effort "fresh look"; the federal reserve bank of cleveland is engaged in "transformation: 2000."', 'board planning and budgeting at the board, we have restructured the annual planning and budget process to put more emphasis on planning (and less on detailed line-item budgeting), to lengthen the planning and budgeting horizon, and to involve the board itself more heavily in setting priorities.', 'to this end, we have established a budget committee of the board (consisting of myself and governors phillips and kelley) assisted by a staff planning group drawn from across the major functions of the board.', "we are working with a four-year planning horizon and intend to produce the board's first biennial budget (1998/1999) to go into effect on january 1, 1998. our hope is that the new process and structure will give the board a better understanding of the options it faces with respect to alternative ways of carrying out the federal reserve's mission, and a clearer basis for deciding on priorities.", "payments system study a major study of the federal reserve's role in the payments system, currently underway, is another example of strategic planning with respect to a major portion of the federal reserve's activities, under the general umbrella of the strategic planning framework.", 'since payments technology and the structure of the financial services industry are changing rapidly, it seemed important to focus both on how the payment system was evolving (and should evolve) and what role the federal reserve should play in that evolution.', 'the united states is amazingly dependent on paper checks -- americans wrote 64 billion checks in 1996 -while most of the industrial world is shifting rapidly to more efficient electronic based payments.', 'the study, directed by a committee of two governors and two federal reserve bank presidents, has drawn on analytic resources across the federal reserve system and outside.', 'we began by examining the consequences of substantially altering the role of the federal reserve in the retail payments system (checks and wire transfer system know as ach).', 'we analyzed the impact of scenarios ranging from withdrawal of the federal reserve from the check and ach markets to more aggressive leadership by the federal reserve in making the payment system more efficient and less dependent on paper.', 'to get maximum input from the participants in the payment system -- banks, clearinghouses, vendors, consumers and others -- in helping us assess alternatives for the future, we held a series of "forums" around the country in may and june.', 'we had enthusiastic and extremely helpful participation from a wide range of institutions.', 'we learned a lot from the process and are now reassessing the alternatives, conducting additional analyses and preparing to present preliminary options to the board.', 'i look forward to sharing the study with this committee.', 'the payments area is a good example of the dilemma posed for planners by rapid technological change.', 'while rapidly evolving technology makes focussing on future options imperative, it also makes it extremely important to remain flexible.', 'laying out a blueprint for the payments system of the next ten or even five years, and rigidly following it, would almost certainly be a mistake.', 'the technology is moving so rapidly that investments made now may well be obsolete in a short time.', 'performance measures a major theme of gpra is the identification of specific measures of performance of projects and programs which can be used to evaluate their effectiveness.', 'as in most organizations, performance measurement at the federal reserve is more advanced -- and more feasible -- in some types of activities than in others.', 'in the payment services areas, the reserve banks have measured their performance through various financial measures for many years.', 'for example, the monetary control act of 1980 imposes market discipline on the federal reserve by requiring it fully to cover its costs of providing services to depository institutions, and compliance with this requirement is monitored closely.', 'frequently private competitors provide or could provide these services, and our ability to recover our costs, adjusted to include a factor for imputed profits, taxes and cost of capital, help determine whether it is beneficial for the economy that we stay in the business.', 'in addition, the federal reserve has traditionally measured unit costs for its financial services and has developed various indices that allow a reserve bank to measure its cost performance over time and in comparison to other reserve banks.', 'private sector benchmarks are also being developed.', 'the federal reserve also tracks quality measures for many reserve bank services.', 'finally, the federal reserve monitors the progress of the reserve banks against various strategic objectives.', 'similarly, in bank supervision, the federal reserve has long used a variety of measures of the effectiveness of its examination process, but the measurement challenge has taken on new importance as supervision becomes more automated and more focused on analyzing risk.', 'to meet this challenge, the federal reserve is working closely with other regulators to standardize and improve examination techniques, and has established a steering committee to oversee implementation of a risk-focused examination program and to design a management information system that will permit the board to evaluate better the efficient use of examination resources among the reserve banks.', 'for instance, supervisory data are used to determine in advance of on-site examinations what factors (camels rating, asset size, location, and loan types) are most predictive as to the resources needed for examinations, and which institutions, particular lending areas or other service lines may require more intensive review.', 'such programs are low-cost because they use information that we already collect, and are effective and cost-saving because they provide a systematic way to plan and prioritize our time and resources.', 'in other areas, such as the research and statistical analysis on which monetary policy is based, performance measurement is -- and will remain -- far more problematic.', 'the performance of the economy itself is not so hard to measure and right now is highly positive.', "but it is not clear how much of the economic progress can be attributed to monetary policy, and even less clear how particular monetary policy actions are related to the quality and quantity of research and analysis produced by the fed's research staff.", 'conclusion gpra provides the opportunity for a major improvement in the management and effectiveness of federal agencies.', 'it provides the impetus for agencies to clarify their missions and objectives, measure their performance better and improve their efficiency and effectiveness.', 'it must, however, avoid the risk of becoming, like some previous efforts to improve government management, largely a paper exercise which produces many numbers and reports but few real results.', 'the federal reserve welcomes the opportunity to participate in the gpra process.', 'we will work hard to fulfill the vision of the framers of the act and avoid the pitfalls.', "we will have to respond in ways that are appropriate to the federal reserve's diverse missions and decentralized structure.", 'i believe we have made significant progress toward the gpra-type strategic planning and are on the track to making more in the immediate future.']	Alice M Rivlin	Board of Governors of the US Federal Reserve System	Vice Chairman of the Board of Governors	US
https://www.bis.org/review/r970806a.pdf	Ms. Rivlin reports on the positive performance of the US economy and the policies needed to sustain growth in the future (Central Bank Articles and Speeches, 23 Jul 97)	Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 23/7/97.	1997-07-23 00:00:00	Ms. Rivlin reports on the positive perfomance of the US economy and the Testimony of the Vice Chairman of the Board of policies needed to sustain growth in the future Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 23/7/97. I would like to begin by expressing my appreciation to the Committee for holding this hearing to solicit a wide range of views on appropriate monetary policy at this extremely favorable moment in our economic history. All too often congressional hearings are called when something bad is happening. In a deteriorating situation, Congress finds it necessary to survey the damage, assess responsibility and call for better policies in the future. At the moment, however, the economy as a whole is functioning amazingly well. Employment is high and rising, unemployment is low, incomes are increasing, profits are high, the Federal budget deficit is plummeting, state and local finances are increasingly strong, and inflation is benign. The overriding economic objective -- shared by all participants in the economy -- is to keep the good news flowing. We all want the economy to grow at its highest sustainable rate, to keep unemployment and inflation low, and above all, to avoid recession as long as possible. Thoughtful people, at the Federal Reserve and elsewhere, have somewhat different views about why the economy is doing so well and how best to keep it going. Your invitation to share those views is timely, constructive and welcome. I would like briefly to discuss three questions: 1. Why is the economy performing so well -- and, in particular, why do we have so little inflation with such low unemployment? 2. Why is it so important, especially right now, to keep the economy growing at its highest sustainable rate and to avoid recession? 3. What policies -- monetary and other economic policies -- are most likely to keep economic performance high and sustained? Why is the economy doing so well? Most economists are frankly surprised that the economy has been able to grow fast enough to push unemployment rates below 5 percent without generating accelerating inflation. Until recently, most students of the economy thought that unemployment rates below 5.5 - 6.0 percent (estimates differed) for an appreciable period would lead to rising labor costs that would be passed on in higher prices and start a self-perpetuating wage-price spiral that would be hard to reverse. True, unemployment had been lower in the 1960s while inflation remained low, but the structure of the economy and the characteristics of the labor force subsequently changed in ways that seemed to make the economy more inflation-prone for given levels of unemployment. The experience of the period since about 1970 appeared to confirm that inflationary pressure emerged at unemployment rates appreciably higher than those of the 1960s. Five years ago, most economists would have thought the Federal Reserve irresponsible and derelict in its duty if it had not used monetary policy to slow an economy operating at such a high level that unemployment remained under 5.5 percent for more than a short time. The inflation might not appear immediately, but it was thought to be inevitable, and allowing it to get up a head of steam before acting was taking a high risk of having to react more strongly, perhaps strongly enough to bring on a recession. Nevertheless, the unemployment rate has been below 5.5 percent for over a year and below 5.0 percent in 1997 while inflation has shown no signs of picking up -- indeed, producer prices have actually been falling. The Federal Reserve, except for a quarter point tightening of the federal funds rate in March (after months of inaction), has left the monetary levers alone. Is the Federal Reserve ignoring risks of future inflation? The answer depends on whether the coexistence of higher growth and lower unemployment with benign inflation is explained by a fundamental improvement in the structure of the economy making it less inflation-prone, or by temporary factors that might return to "normal" and kick-off an inflationary wage-price spiral, or by some combination of the two. The honest answer is: We don't know yet. One surprise has been that such tight labor markets have not resulted in more rapid increases in wages and other labor compensation. Part of the explanation, as Chairman Greenspan noted in his testimony on July 22, may lie in less aggressive behavior on the part of workers. Workers may be more reluctant than previously to bargain for higher compensation or to take drastic action, such as striking or quitting to look for a better job. They may be reluctant because they are insecure in the face of rapidly changing technology, for which they fear they may not have the right skills, because they have recent memories of company "downsizing," or because they are less likely than in previous tight labor markets to be members of a union. These explanations of less aggressive worker behavior are plausible, but likely to be temporary. Workers are not likely to get more insecure as low unemployment continues, and union strength is unlikely to ebb further. Part of the explanation of moderate compensation increases may also lie in more aggressive employer resistance to labor cost increases than in previous cycles. Business owners and managers appear to believe strongly that they are operating in such a competitive environment -whether domestic or international -- that they cannot pass cost increases on to their customers in higher prices because they would lose those customers to competitors overseas or down the street. Low import prices resulting from growing international competition and the strong dollar reinforce this perception. Domestic markets have also become more fiercely competitive as the result of deregulation, lower transportation and communication costs, and more competitive business attitudes. These competitive forces, well known to workers, may give employers a plausible reason -- or at least an excuse -- for strong resistance to wage and benefit demands. The subdued inflation rate itself, moreover, has dampened inflationary expectations. These lower expectations contribute both to diminished compensation demands of workers and stiffer employer resistance to those demands. An important contribution to lower total compensation costs has also come from the slowdown in the rise of health benefit costs associated with the shift to managed care and the general reduction in the rate of health care inflation. It is not yet clear how much of this slowdown is temporary. The other surprise is that prices have shown no reaction to the moderate compensation increases that have occurred. Increased foreign and domestic competitiveness is certainly part of the answer, but the remarkable fact is that this competition has not generally eroded profit margins. Persistent high profits suggest that, on the average, employers have been able to increase productivity enough to absorb larger compensation increases without comparable price increases. Whether they will be able to continue to do so is the crucial unanswered question facing monetary policy makers at the moment. Measured productivity has grown slowly for more than two decades and did not accelerate in this expansion as economists hoped it would. Nevertheless, output per hour seems to have picked up a little recently, which is surprising late in an expansion when productivity increase normally slows. If productivity growth were on the verge of sustained acceleration, a possibility discussed in Chairman Greenspan's testimony, it would greatly increase the chances of higher sustained growth without accelerating inflation. There are reasons to be optimistic, but only time will tell if the optimists are right. Why is sustained growth so important now? It is always desirable to live in an economy that is growing at a healthy rate. The general standard of living rises and average people are normally better off. Not only do private resources grow, giving consumers more and better choices, but public resources also grow, making it easier to solve public problems and improve national and community infrastructure. Healthy growth has to be sustainable, not bought at the price of environmental degradation or inflationary overheating that turns a boom into a bust. Nevertheless, there are at least three reasons why it seems especially important for the United States in the next few years to do everything possible to keep the economy growing at a healthy sustainable rate and avoid recession. Welfare reform Recent legislation requires extremely ambitious state and Federal efforts to reduce dependency and channel large portions of the present and future welfare population into selfsupporting jobs. For these efforts to be even moderately successful will require effective skill training and job placement, adequate child care and, above all, low unemployment rates and plentiful entry level jobs. If economic expansion continues and labor markets remain tight, there is a good chance that many families who would otherwise have depended on welfare can acquire the job skills and experience that can enable them to live more independent and satisfying lives. If the economy slides into recession before welfare recipients have time to establish new skills, work patterns and eligibility for unemployment benefits, welfare reform is almost certain to be a failure, if not an outright disaster. Community development Partnerships for community development are beginning to create new hope for some devastated areas of big cities, smaller towns and rural areas. Partners include business and community groups, financial institutions and governments. With continued economic growth and low unemployment, these efforts could transform many blighted areas into viable communities with decent housing and an economic base. Recession, especially a deep one, would dry up public and private resources and greatly reduce the chances of successful community development. Preparing for more older people Perhaps the biggest challenge to the U.S. economy (indeed to all industrial economies) over the next couple of decades is the prospective rise in the ratio of elderly to working age people. Barring a huge increase in working age immigrants or dramatic increases in the length of working life, the number of retirees will rise much faster than the working population beginning early in the next century. No matter what combination of public and private pensions are used to sort out the claims of retirees to a share of the nation's output, the only way to guarantee a rising standard of living for both retirees and workers is to greatly increase the future productivity of that workforce. A high growth economy over the next decade could generate enough saving and investment to make that increased future workforce productivity feasible. Slower growth and repeated recessions could make the burden of an aging population far heavier and policy choices more contentious. What policies are needed? These three challenges to the American economy simply reinforce the need to keep the economy on the highest sustainable growth track attainable and to keep recessions as shallow and infrequent as possible. The biggest problem for monetary policy at the moment is that no one knows what growth rate is sustainable. It may be true that the structure of the economy has changed in ways that make a higher growth rate sustainable without inflation than we thought possible a few years ago -- or it may not be true. The question turns on whether productivity growth has shifted up out of the doldrums of the last couple of decades. It's possible that it has, but by no means certain. This leaves monetary policymakers with the difficult job of watching all the signs, weighing the risks and making a new judgment call every few weeks. At the moment, there seems to be little risk of the economy slowing down too much in the near term and sliding into recession. Growth has already slowed from its clearly unsustainable pace in the first quarter, but all the current signs point to continued economic expansion for the rest of this year and into the next. The risks seem higher on the other side -- that many of the factors holding down inflationary pressures will prove temporary, that the rebound of productivity necessary for higher sustainable growth will not occur or not prove robust and durable. The Federal Open Market Committee has to weigh the risk of slowing the economy unnecessarily against the risk of waiting too long and having to put the brakes on harder later. Waiting longer may increase the possibility of overheating followed by recession. It's a tough call. I can't promise we will make the right decisions, but I can promise we will try. It is important not to overestimate the role of monetary policy and the Federal Reserve. Monetary policy can help keep the economy from falling off the sustainable growth track in either direction -- either by overheating and generating enough inflation to unbalance the economy and threaten growth or by chugging along too slowly with excessive unemployment. But monetary policy cannot do much to determine how high the sustainable growth rate is. How fast the economy can grow is determined by how rapidly the employed labor force is increasing and how fast the productivity of that workforce is growing. There are only two ways to get more output: either more people work or working people produce more (or both). In the 1960s and 1970s, the American workforce was growing rapidly as the large baby boom generation reached working age and women, especially mothers, moved into the workforce in much larger proportions than previously. But those two trends have run their course. The labor force is likely to grow slowly over the next few years, about 1 percent per year. The main hope for increasing labor force growth, besides encouraging more immigration, is that continued tight labor markets plus increased flexibility in employment hours will gradually begin to reverse the trends to early retirement that has reduced labor force participation among older people. Continued employment opportunities combined with well-designed training programs, especially in computer related skills, could also attract into the labor force people who are not actively looking for work because they don't think they have the skills to get a "good" job -- principally older workers and young people who have dropped out of school. Indeed, the shortage of workers with modern technical skills may be the biggest problem facing the American economy at the moment, as well as its biggest opportunity. As long as labor markets stay tight, investment in skill training is likely to pay off handsomely both for individuals and for companies that can retain the trained workers long enough to benefit from their increased productivity. Public investment in training for workers with low skills -- often unsuccessful when jobs are scarce -- also stands a far better chance in tight labor markets of moving workers into jobs in which they can gain increasing skills, experience and higher wages. Continued low unemployment rates, plus public and private investment in skill training are essential, not only for successful welfare reform, but also for modernizing the skills of the portion of the workforce whose real incomes and opportunities have declined both relatively and absolutely in the last couple of decades. The other key to productivity increase, of course, is continued investment, both public and private, in research and development and the technology and infrastructure needed for continuous modernization of the economy. Stable low inflation tends to foster long-term planning and investment by businesses and households. A high growth economy should generate more of the saving needed to finance the investment. Reducing the public dissaving inherent in running a deficit in the Federal budget also adds to national saving. Near term reform of social security and Medicare in ways that add to national saving, public and private, could make a significant contribution to future productivity increase and hence to raising the future rate of sustainable economic growth. In summary, the objective of economic policy -- monetary policy included -- is to keep the economy on the highest sustainable growth path. No one knows exactly what that rate is right now, or what it can be in the future, but a combination of policies, intelligently pursued, can raise it as far as possible. These policies include: wise monetary policy that helps the economy expand, and keeps labor markets tight, without incurring excessive risk of accelerating inflation; investment in skills by individuals, firms and the public and non-profit sectors; increased saving (public and private) invested in research, technology and infrastructure. The Federal Reserve will do its part, in the face of huge uncertainties, to steer an appropriate monetary policy. Fiscal and other policies, both public and private, are needed to take full advantage of the opportunity we have today to keep the American economy operating at a high level in the future.	['ms. rivlin reports on the positive perfomance of the us economy and the testimony of the vice chairman of the board of policies needed to sustain growth in the future governors of the us federal reserve system, ms. alice m. rivlin, before the committee on banking and financial services of the us house of representatives on 23/7/97.', 'i would like to begin by expressing my appreciation to the committee for holding this hearing to solicit a wide range of views on appropriate monetary policy at this extremely favorable moment in our economic history.', 'all too often congressional hearings are called when something bad is happening.', 'in a deteriorating situation, congress finds it necessary to survey the damage, assess responsibility and call for better policies in the future.', 'at the moment, however, the economy as a whole is functioning amazingly well.', 'employment is high and rising, unemployment is low, incomes are increasing, profits are high, the federal budget deficit is plummeting, state and local finances are increasingly strong, and inflation is benign.', 'the overriding economic objective -- shared by all participants in the economy -- is to keep the good news flowing.', 'we all want the economy to grow at its highest sustainable rate, to keep unemployment and inflation low, and above all, to avoid recession as long as possible.', 'thoughtful people, at the federal reserve and elsewhere, have somewhat different views about why the economy is doing so well and how best to keep it going.', 'your invitation to share those views is timely, constructive and welcome.', 'i would like briefly to discuss three questions: 1. why is the economy performing so well -- and, in particular, why do we have so little inflation with such low unemployment?', '2. why is it so important, especially right now, to keep the economy growing at its highest sustainable rate and to avoid recession?', '3. what policies -- monetary and other economic policies -- are most likely to keep economic performance high and sustained?', 'why is the economy doing so well?', 'most economists are frankly surprised that the economy has been able to grow fast enough to push unemployment rates below 5 percent without generating accelerating inflation.', 'until recently, most students of the economy thought that unemployment rates below 5.5 - 6.0 percent (estimates differed) for an appreciable period would lead to rising labor costs that would be passed on in higher prices and start a self-perpetuating wage-price spiral that would be hard to reverse.', 'true, unemployment had been lower in the 1960s while inflation remained low, but the structure of the economy and the characteristics of the labor force subsequently changed in ways that seemed to make the economy more inflation-prone for given levels of unemployment.', 'the experience of the period since about 1970 appeared to confirm that inflationary pressure emerged at unemployment rates appreciably higher than those of the 1960s.', 'five years ago, most economists would have thought the federal reserve irresponsible and derelict in its duty if it had not used monetary policy to slow an economy operating at such a high level that unemployment remained under 5.5 percent for more than a short time.', 'the inflation might not appear immediately, but it was thought to be inevitable, and allowing it to get up a head of steam before acting was taking a high risk of having to react more strongly, perhaps strongly enough to bring on a recession.', 'nevertheless, the unemployment rate has been below 5.5 percent for over a year and below 5.0 percent in 1997 while inflation has shown no signs of picking up -- indeed, producer prices have actually been falling.', 'the federal reserve, except for a quarter point tightening of the federal funds rate in march (after months of inaction), has left the monetary levers alone.', 'is the federal reserve ignoring risks of future inflation?', 'the answer depends on whether the coexistence of higher growth and lower unemployment with benign inflation is explained by a fundamental improvement in the structure of the economy making it less inflation-prone, or by temporary factors that might return to "normal" and kick-off an inflationary wage-price spiral, or by some combination of the two.', "the honest answer is: we don't know yet.", 'one surprise has been that such tight labor markets have not resulted in more rapid increases in wages and other labor compensation.', 'part of the explanation, as chairman greenspan noted in his testimony on july 22, may lie in less aggressive behavior on the part of workers.', 'workers may be more reluctant than previously to bargain for higher compensation or to take drastic action, such as striking or quitting to look for a better job.', 'they may be reluctant because they are insecure in the face of rapidly changing technology, for which they fear they may not have the right skills, because they have recent memories of company "downsizing," or because they are less likely than in previous tight labor markets to be members of a union.', 'these explanations of less aggressive worker behavior are plausible, but likely to be temporary.', 'workers are not likely to get more insecure as low unemployment continues, and union strength is unlikely to ebb further.', 'part of the explanation of moderate compensation increases may also lie in more aggressive employer resistance to labor cost increases than in previous cycles.', 'business owners and managers appear to believe strongly that they are operating in such a competitive environment -whether domestic or international -- that they cannot pass cost increases on to their customers in higher prices because they would lose those customers to competitors overseas or down the street.', 'low import prices resulting from growing international competition and the strong dollar reinforce this perception.', 'domestic markets have also become more fiercely competitive as the result of deregulation, lower transportation and communication costs, and more competitive business attitudes.', 'these competitive forces, well known to workers, may give employers a plausible reason -- or at least an excuse -- for strong resistance to wage and benefit demands.', 'the subdued inflation rate itself, moreover, has dampened inflationary expectations.', 'these lower expectations contribute both to diminished compensation demands of workers and stiffer employer resistance to those demands.', 'an important contribution to lower total compensation costs has also come from the slowdown in the rise of health benefit costs associated with the shift to managed care and the general reduction in the rate of health care inflation.', 'it is not yet clear how much of this slowdown is temporary.', 'the other surprise is that prices have shown no reaction to the moderate compensation increases that have occurred.', 'increased foreign and domestic competitiveness is certainly part of the answer, but the remarkable fact is that this competition has not generally eroded profit margins.', 'persistent high profits suggest that, on the average, employers have been able to increase productivity enough to absorb larger compensation increases without comparable price increases.', 'whether they will be able to continue to do so is the crucial unanswered question facing monetary policy makers at the moment.', 'measured productivity has grown slowly for more than two decades and did not accelerate in this expansion as economists hoped it would.', 'nevertheless, output per hour seems to have picked up a little recently, which is surprising late in an expansion when productivity increase normally slows.', "if productivity growth were on the verge of sustained acceleration, a possibility discussed in chairman greenspan's testimony, it would greatly increase the chances of higher sustained growth without accelerating inflation.", 'there are reasons to be optimistic, but only time will tell if the optimists are right.', 'why is sustained growth so important now?', 'it is always desirable to live in an economy that is growing at a healthy rate.', 'the general standard of living rises and average people are normally better off.', 'not only do private resources grow, giving consumers more and better choices, but public resources also grow, making it easier to solve public problems and improve national and community infrastructure.', 'healthy growth has to be sustainable, not bought at the price of environmental degradation or inflationary overheating that turns a boom into a bust.', 'nevertheless, there are at least three reasons why it seems especially important for the united states in the next few years to do everything possible to keep the economy growing at a healthy sustainable rate and avoid recession.', 'welfare reform recent legislation requires extremely ambitious state and federal efforts to reduce dependency and channel large portions of the present and future welfare population into selfsupporting jobs.', 'for these efforts to be even moderately successful will require effective skill training and job placement, adequate child care and, above all, low unemployment rates and plentiful entry level jobs.', 'if economic expansion continues and labor markets remain tight, there is a good chance that many families who would otherwise have depended on welfare can acquire the job skills and experience that can enable them to live more independent and satisfying lives.', 'if the economy slides into recession before welfare recipients have time to establish new skills, work patterns and eligibility for unemployment benefits, welfare reform is almost certain to be a failure, if not an outright disaster.', 'community development partnerships for community development are beginning to create new hope for some devastated areas of big cities, smaller towns and rural areas.', 'partners include business and community groups, financial institutions and governments.', 'with continued economic growth and low unemployment, these efforts could transform many blighted areas into viable communities with decent housing and an economic base.', 'recession, especially a deep one, would dry up public and private resources and greatly reduce the chances of successful community development.', 'preparing for more older people perhaps the biggest challenge to the u.s. economy (indeed to all industrial economies) over the next couple of decades is the prospective rise in the ratio of elderly to working age people.', 'barring a huge increase in working age immigrants or dramatic increases in the length of working life, the number of retirees will rise much faster than the working population beginning early in the next century.', "no matter what combination of public and private pensions are used to sort out the claims of retirees to a share of the nation's output, the only way to guarantee a rising standard of living for both retirees and workers is to greatly increase the future productivity of that workforce.", 'a high growth economy over the next decade could generate enough saving and investment to make that increased future workforce productivity feasible.', 'slower growth and repeated recessions could make the burden of an aging population far heavier and policy choices more contentious.', 'what policies are needed?', 'these three challenges to the american economy simply reinforce the need to keep the economy on the highest sustainable growth track attainable and to keep recessions as shallow and infrequent as possible.', 'the biggest problem for monetary policy at the moment is that no one knows what growth rate is sustainable.', 'it may be true that the structure of the economy has changed in ways that make a higher growth rate sustainable without inflation than we thought possible a few years ago -- or it may not be true.', 'the question turns on whether productivity growth has shifted up out of the doldrums of the last couple of decades.', "it's possible that it has, but by no means certain.", 'this leaves monetary policymakers with the difficult job of watching all the signs, weighing the risks and making a new judgment call every few weeks.', 'at the moment, there seems to be little risk of the economy slowing down too much in the near term and sliding into recession.', 'growth has already slowed from its clearly unsustainable pace in the first quarter, but all the current signs point to continued economic expansion for the rest of this year and into the next.', 'the risks seem higher on the other side -- that many of the factors holding down inflationary pressures will prove temporary, that the rebound of productivity necessary for higher sustainable growth will not occur or not prove robust and durable.', 'the federal open market committee has to weigh the risk of slowing the economy unnecessarily against the risk of waiting too long and having to put the brakes on harder later.', 'waiting longer may increase the possibility of overheating followed by recession.', "it's a tough call.", "i can't promise we will make the right decisions, but i can promise we will try.", 'it is important not to overestimate the role of monetary policy and the federal reserve.', 'monetary policy can help keep the economy from falling off the sustainable growth track in either direction -- either by overheating and generating enough inflation to unbalance the economy and threaten growth or by chugging along too slowly with excessive unemployment.', 'but monetary policy cannot do much to determine how high the sustainable growth rate is.', 'how fast the economy can grow is determined by how rapidly the employed labor force is increasing and how fast the productivity of that workforce is growing.', 'there are only two ways to get more output: either more people work or working people produce more (or both).', 'in the 1960s and 1970s, the american workforce was growing rapidly as the large baby boom generation reached working age and women, especially mothers, moved into the workforce in much larger proportions than previously.', 'but those two trends have run their course.', 'the labor force is likely to grow slowly over the next few years, about 1 percent per year.', 'the main hope for increasing labor force growth, besides encouraging more immigration, is that continued tight labor markets plus increased flexibility in employment hours will gradually begin to reverse the trends to early retirement that has reduced labor force participation among older people.', 'continued employment opportunities combined with well-designed training programs, especially in computer related skills, could also attract into the labor force people who are not actively looking for work because they don\'t think they have the skills to get a "good" job -- principally older workers and young people who have dropped out of school.', 'indeed, the shortage of workers with modern technical skills may be the biggest problem facing the american economy at the moment, as well as its biggest opportunity.', 'as long as labor markets stay tight, investment in skill training is likely to pay off handsomely both for individuals and for companies that can retain the trained workers long enough to benefit from their increased productivity.', 'public investment in training for workers with low skills -- often unsuccessful when jobs are scarce -- also stands a far better chance in tight labor markets of moving workers into jobs in which they can gain increasing skills, experience and higher wages.', 'continued low unemployment rates, plus public and private investment in skill training are essential, not only for successful welfare reform, but also for modernizing the skills of the portion of the workforce whose real incomes and opportunities have declined both relatively and absolutely in the last couple of decades.', 'the other key to productivity increase, of course, is continued investment, both public and private, in research and development and the technology and infrastructure needed for continuous modernization of the economy.', 'stable low inflation tends to foster long-term planning and investment by businesses and households.', 'a high growth economy should generate more of the saving needed to finance the investment.', 'reducing the public dissaving inherent in running a deficit in the federal budget also adds to national saving.', 'near term reform of social security and medicare in ways that add to national saving, public and private, could make a significant contribution to future productivity increase and hence to raising the future rate of sustainable economic growth.', 'in summary, the objective of economic policy -- monetary policy included -- is to keep the economy on the highest sustainable growth path.', 'no one knows exactly what that rate is right now, or what it can be in the future, but a combination of policies, intelligently pursued, can raise it as far as possible.', 'these policies include: wise monetary policy that helps the economy expand, and keeps labor markets tight, without incurring excessive risk of accelerating inflation; investment in skills by individuals, firms and the public and non-profit sectors; increased saving (public and private) invested in research, technology and infrastructure.', 'the federal reserve will do its part, in the face of huge uncertainties, to steer an appropriate monetary policy.', 'fiscal and other policies, both public and private, are needed to take full advantage of the opportunity we have today to keep the american economy operating at a high level in the future.']	Alice M Rivlin	Board of Governors of the US Federal Reserve System	Vice Chairman of the Board of Governors	US

Subsets and Splits

No community queries yet

The top public SQL queries from the community will appear here once available.