Speech by Mr Wellink to the 73rd Annual General Meeting
Speech delivered by Nout Wellink
President of the BIS and Chairman of the Board of Directors
on the occasion of the Bank's Annual General Meeting in Basel on 30 June 2003
On the occasion of the BIS Annual General Meeting, it is my privilege and pleasure to extend a warm welcome to all the delegates from our shareholding central banks, the representatives of non-member central banks and international institutions and our distinguished guests, including many from the international banking and financial community.
As last year, there will be two speeches at this meeting: a commentary on the world economy, followed by a report on the general situation of the BIS by Malcolm Knight, who as you know succeeded Andrew Crockett as the Bank's General Manager in April this year.
First, therefore, let me turn to an assessment of the world economy. I will begin by looking back over the past year and then turn my gaze forward to the potential challenges ahead. In doing so, as befits a prudent central banker, I will focus on the risks to the outlook and their policy implications.
Economic developments since the spring of 2002 have been disappointing. After very promising signs early on, especially in the United States, the hoped-for global recovery lost momentum. Growth was particularly disappointing in the euro area, where it actually weakened, contrary to widely held expectations. Japan continued to struggle to break out of its protracted slump. Among the emerging economies, the recovery in much of Latin America was held back by external financing constraints and domestic concerns, which dissipated only slowly. The main bright spots were to be found in Asia and in central and eastern Europe, where growth showed considerable resilience. And growth did prove quite robust in a handful of industrial countries.
Performance was lacklustre overall despite very supportive macroeconomic policies. Monetary policy remained generally accommodative. Inflation-adjusted policy interest rates typically stayed below their long-term equilibrium levels following the easing that had started in the wake of the global slowdown. Policy rates were cut further, after a pause, where signs of a faltering recovery became clearer. Similarly, to varying degrees, fiscal policy supported economic activity. This was especially true in the United States, where discretionary measures pushed the fiscal position into a large deficit, and in most emerging markets. In the euro area and Japan, automatic stabilisers were allowed to work, but initial conditions constrained the room for manoeuvre.
On the positive side, inflation remained generally subdued, allowing central banks to use their ammunition to underpin demand. No doubt, the slack in the world economy contributed to this. But the hard-earned credibility of the central banking community also played a role. In contrast to experience in the 1970s and early 1980s, oil price hikes failed to trigger lasting increases in wages and prices, while inflation expectations proved remarkably well anchored. Admittedly, until recently the inflation picture was less satisfactory in Latin America, where those countries experiencing large currency depreciations saw prices rising well in excess of their inflation objectives. Even there, however, the exchange rate pass-through to prices appeared weaker than in the past.
At the same time, subdued inflationary pressures are not necessarily synonymous with desirable price stability. In fact, some countries in Asia saw actual declines in the overall price level. In some cases, as in China, these were rather benign, as they occurred alongside fast productivity and output growth. In others, however, they were far less welcome, notably in Japan and Hong Kong. And for the first time in the postwar period, questions arose about the possibility of such deflationary tendencies becoming more widespread. Even in some cases outside Asia, once the typical upward biases in price indices are taken into account, prices became nearly flat as the period progressed.
One bright spot in this otherwise mixed picture was the continued resilience of the financial system, an important source of strength for the global economy. Although insurance companies did face strains, banks generally fared well, by past standards, during the slowdown. This was so despite the extraordinary loss of global wealth induced by the three-year decline in equity prices and despite the problems of the corporate sector in the largest economies. In fact, in the period under review corporate rating downgrades, defaults and losses given default were often above those experienced in the early 1990s. To be sure, not all banking systems performed equally well. German banks, for instance, produced disappointing results. And Japanese banks continued to face serious financial difficulties. By and large, however, profits elsewhere declined only modestly or, as in the United States, actually improved while asset quality was generally well maintained. True, a number of specific features of the current slowdown contributed to this positive outcome. But, importantly, efforts to cut costs, improve risk management and exercise greater prudence during the boom years all played a role. Bank supervisors, too, played their part.
Looking ahead, will the recovery get back on track, or will it remain elusive for some time yet? And what are the risks to the outlook? To answer these questions, it is worth reflecting a moment on how the world economy has arrived at this juncture. I would like to highlight three points.
First, some three years after the initial downturn in economic activity, the contours of the recent slowdown have become much clearer. What at the beginning might understandably have been interpreted as a normal inventory cycle turned out to be an unusual business fluctuation by postwar standards. This time the slowdown was not primarily triggered by a monetary policy tightening aimed at fending off inflationary pressures. Rather, it was largely brought about by a spontaneous contraction in investment spending, associated with lower profits and a collapse in equity prices. This followed a long period of rapid expansion, booming asset prices and debt accumulation, particularly in the United States. Obvious differences aside, we have previously seen somewhat similar features in episodes whose echoes are still with us, including in Japan and a number of East Asian countries.
Second, the nature of the slowdown largely explains the characteristics of the hesitant recovery so far. Investment has been particularly weak, as companies have tried to work off the capital overhang and rebuild their balance sheets, caught between the collapse in asset prices and high levels of debt. By contrast, consumer spending has generally been the crucial element underpinning activity. Expenditures on housing, in particular, have greatly benefited from the reductions in short and long interest rates, sometimes to postwar lows, while housing prices have been unusually buoyant in many countries. In addition, the loosening of fiscal positions has provided a substantial support to demand.
Finally, the lopsided configuration of world growth has resulted in a further widening of external balances at the global level. The US current account deficit grew larger in the period under review, reflecting the country's role as the ultimate source of demand for an otherwise anaemic world economy. And this seemingly started to take its toll on the dollar, which reversed its long appreciating trend.
The key question now is whether stimulative policies and consumer spending can provide a bridge to the recovery of investment, and whether they can do so without generating imbalances that could at some point threaten the sustainability of the expansion. From this perspective, the outlook is mixed.
There are, indeed, a number of encouraging signs. As uncertainties surrounding the war in Iraq dissipated, oil prices declined, the "war premium" that had been holding back confidence evaporated and equity markets rallied strongly. Well into May, credit spreads continued to narrow from their peak last year, in part reflecting a degree of renewed investor confidence following the corporate governance improprieties that had shaken markets in 2002. Meanwhile, corporate deleveraging proceeded apace and profits seemed to regain some vigour. This has been especially true in the United States, where productivity growth has been remarkably resilient. Given low inventories and the policy stimulus still in the pipeline, the preconditions for a quickening recovery seem to be largely in place.
At the same time, a number of closely related risks remain. They pertain both to conditions in financial markets and to those in the real economy.
First, there are questions surrounding the relationship between prevailing asset prices and economic fundamentals. Despite the major correction over the past three years, price/earnings ratios still appear to incorporate rather optimistic projections of corporate profitability in some countries. In some cases, where smoothing provisions are in place, they may also fail to take fully into account the lagged effects of the market's decline on the underfunding of corporate pension schemes. Similarly, while perceptions of improving creditworthiness no doubt played a part, the narrowing of credit spreads has also been driven by a search for yield triggered by historically low rates on government bonds. And, after strong increases, there are some indications that housing prices might be losing steam in a number of countries. Thus, the historical relationship in which peaks in equity prices have been harbingers of peaks in housing prices could be reasserting itself, albeit with a longer lag partly induced by the supportive monetary easing.
Second, consumer spending might fail to hold up for sufficiently long. The drag on investment from the need to cleanse balance sheets could prove more persistent than anticipated, as debt levels remain well above historical averages and equity financing remains elusive. Even if extreme, the Japanese experience is quite telling in this regard. And the longer the recovery is postponed, the harder it will be for consumption to sustain growth. In many countries, household debt-to-income ratios have risen to record highs. Just as companies have, households could come under some pressure to retrench should housing prices and labour markets soften further.
Third, the present configuration of global current account balances adds a layer of complexity to this picture. On the one hand, the depreciation of the dollar is one mechanism that would tend to narrow the US external imbalance. By providing room for easing monetary policy elsewhere, it could also contribute to a welcome boost to global demand. The risk here is that, were the depreciation to take place at an uncomfortable pace, the necessary adjustments might not proceed smoothly, owing among other things to possible losses on unhedged positions, and protectionist tendencies might intensify. Sluggish domestic demand growth elsewhere adds to this risk. Those creditor countries that have relied heavily on export-led growth should naturally be better placed to bear part of the adjustment. On the other hand, it is not possible to rule out a less welcome correction of the external balance through a fall in US domestic demand and output. In particular, the household saving rate has only partially retraced its steps towards more normal historical levels.
Finally, if a period of prolonged weakness in the world economy did ensue, it would be unlikely to leave the financial system unscathed. It would, over time, erode further existing cushions. And it might bring to light potential weaknesses in the functioning of some financial markets. One possible case in point is the market for credit transfer instruments, which has grown rapidly in recent years but has not yet been fully tested in adverse conditions.
Against this background, the key policy challenge is to promote sustainable world growth while facilitating a gradual absorption of the imbalances, real and financial, domestic and international, built up over the last decade of unprecedented expansion. This is especially important in the slower-growing economies outside the United States. It will be no easy task, as those imbalances constrain the room for manoeuvre and complicate the trade-off between short-term benefits and longer-term costs. Moreover, if some of the risks materialised, policymakers could find themselves navigating in altogether unfamiliar waters. For, if economic weakness persisted for long enough, falling price levels beyond the Asian region could not be ruled out.
The room for manoeuvre to address a more protracted period of weakness, should it occur, varies across countries and policy levers.
At one end of the spectrum, Japan has little ammunition left. With policy interest rates at zero, the Bank of Japan's strategy of quantitative easing has not proved as effective as hoped and the efficacy of more unconventional monetary policy measures is far from certain. In addition, the longer-term fiscal situation has deteriorated markedly. The priority is to use the scarce fiscal resources available in support of the corporate and financial system restructuring necessary to relax supply constraints, release pent-up demand in the business sector and restore a measure of efficacy to monetary policy. This will call for close cooperation between monetary, fiscal and prudential authorities. Upward pressure on the exchange rate remains an unwelcome constraint on policy.
In the euro area the options are unevenly distributed across instruments. Fiscal policy options have been drastically narrowed by the failure to pursue the necessary structural adjustments in good times so as to contribute to the credibility of the medium-term frameworks in place. By contrast, monetary policy has both the room and the anti-inflation credentials to ease should circumstances require it. But beyond this, the major challenge is to increase the growth potential of the area. There are no alternatives now to in-depth measures to improve the flexibility of labour and product markets. Badly needed product market liberalisation could also provide a welcome boost to demand in the short term. Were the euro to appreciate further as part of the global adjustment process, this should be taken as a catalyst for the necessary reforms, rather than as an excuse to fall back into dangerous protectionism.
In the United States the constellation is different yet again. Monetary policy has been approaching the zone where its effectiveness could become less certain. And fiscal policy has been rapidly consuming the partly illusory structural cushion built up during the expansion, to the point where questions could be raised about its long-term sustainability on current trends. The main strengths of the economy are its rapid underlying productivity growth and its adaptability, as evidenced by the flexibility of product and factor markets. These strengths could turn out to be very valuable in the period ahead.
The picture elsewhere is more mixed. On balance, however, a common feature across many countries, especially in emerging markets, is that questions concerning fiscal sustainability, dormant during much of the 1990s, are again coming to the fore. This is especially true in Latin America. Monetary policy remains an important resource, except where constrained by external financing vulnerabilities, again as in Latin America, or where much of the room for manoeuvre has been used up, as in some Asian countries experiencing deflation. In many emerging markets, continuing to build an effective financial infrastructure remains a priority.
What general lessons can we draw from this analysis? I would highlight three.
First, policy frameworks should combine constraints ensuring medium-term sustainability with mechanisms that allow a flexible response to short-term cyclical developments or possibly extraordinary circumstances. It is precisely a transparent commitment to sustainability in the long run that lends credibility and effectiveness to discretionary measures in the short run. This simple lesson is all too often forgotten when times look good. It is vividly illustrated by the current limitations on recourse to countercyclical fiscal policy in a number of countries. But the lesson applies equally to other policy spheres, including monetary policy and prudential frameworks. Heeding it consistently will be just as much a challenge in the future as it has been in the past.
Second, the times ahead may put a premium on the need for cooperation between monetary, fiscal and, in some cases, prudential authorities. Cooperation does not necessarily mean compromise but, rather, an agreed set of policy actions based on a common and clear understanding of the respective roles. The need for such an approach is clearest in the case of Japan, where the critical situation has de facto blurred the distinction between monetary and fiscal measures. But it has come to the fore more generally in light of the prolonged period of sub-par growth.
Finally, the global nature of the challenges is likely to test further the process of international cooperation. This has faced a number of difficult challenges recently in the economic field and beyond. In some cases, as highlighted by the Doha round of trade liberalisation, it has been found wanting. We must all redouble our efforts in our own spheres of competence if we are to pass the test successfully.
Before I hand over to the General Manager, let me mention the main changes in the Board of Directors.
In December 2002, Urban Bäckström resigned as Governor of Sveriges Riksbank and vacated his seat on the Board. From January 2003, the Board elected Lars Heikensten, his successor at Sveriges Riksbank, as a Board member.
In March 2003, Masaru Hayami retired as Governor of the Bank of Japan and vacated his seat on the Board. In May 2003, the Board elected his successor as Governor of the Bank of Japan, Toshihiko Fukui, as a member of the Board.
In June 2003, Bill McDonough relinquished his position as an Appointed Director on the Board. Alan Greenspan appointed as his successor Jamie Stewart, the Acting Chief Executive Officer of the New York Fed.
Lord Kingsdown, former Governor of the Bank of England and the longest-standing BIS Board member, will vacate his seat as a BIS Director with effect from tomorrow. He does this after 20 years of service, for the last seven of which he served as the Board's Vice-Chairman. In this capacity, he will be succeeded by Hans Tietmeyer, former President of the Deutsche Bundesbank.
I should like to mention that a major focus of the work of the Board in the past financial year was on enhancing the transparency of the BIS for its stakeholders. This concerned the area of financial reporting in particular. The General Manager will provide you with more information on this and other matters in his speech, so let me hand over to him now. Thank you very much.