Mr. Macfarlane discusses Australia's position in light of recent events in Asia (Central Bank Articles and Speeches, 26 Mar 98)

## Mr. Macfarlane discusses Australia's position in light of recent events in

Speech delivered by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane the Australian Stock Exchange, the Australian Institute of Company Directors and the Se Institute of Australia in Brisbane on 26/3/98.

It is a pleasure to be here in Brisbane addressing the Australian Stock Ex the Australian Institute of Company Directors and The Securities Institute of Austral combined Bull and Bear Luncheon. I do not know whether I should nominate myself as a b a bear. Members of this audience will be able to make up their own minds after they ha my story today.

## 1. Introduction

In the period since the collapse of Asian currencies - roughly since the fl the Thai baht on 2 July 1997 - I have spent a fair amount of time, as have many others understand the reasons for that collapse. It has been a salutary experience, and it many of us to re-examine some cherished views. I have already spoken twice on this sub I do not intend to cover the same material today. What I hope to do, however, is to lessons from it, and to apply them to Australia.

In a previous speech 1 , I tried to identify the list of economic characteristi would make a country vulnerable to a currency crisis or, worse, to a full-blown econom As you probably know, there is no definitive list that enables us to forecast these eve precision, but there are about a dozen factors that seem to increase a country's vulner country scores a very low mark on all of these factors, or at least most of these facto good chance that it would be subject to an international loss of confidence and ensuing problems. You will not be surprised to hear that Australia is not in this catego Australia scores a very high mark on most of these factors and thus should be in a ve position. But we can never be complacent. Like all countries, we do not achieve a per and therefore it is worthwhile to go through a systematic examination of our stren weaknesses in light of the recent events.

## 2. Criteria for vulnerability

The list of factors identified from our research 2 on the Asian crisis that pointed to the likelihood of a currency crisis or a wider economic crisis was as follows:

1. Does the country have a fixed exchange rate and free movement o international capital?

2. Is the exchange rate over-valued?

3. Has a country with similar economic characteristics recently experie currency crisis?

4. Is there a large budget deficit and a lot of government debt outstan

1 "The Asian Situation: An Australian Perspective", Reserve Bank of Australia Bulletin, March 1998.

2 We drew heavily on other work in this area, for example, Morris Goldstein, "Comments on Early Warning Indicators of Financial Instability in Emerging Economies", Federal Reserve Bank of Kansas City (forthcom and Graciela Kaminsky, Saul Lizondo and Carmen Reinhart, "Leading Indicators of Currency Crises", IMF Working Paper, July 1997

5. Is there loose monetary policy and high inflation?

6. Is the domestic economy in, or at risk of, a recession?

7. Is there a large current account deficit?

8. Is there a large amount of foreign debt?

9. Is there an asset price boom (especially credit-driven) occurring?

10. Are there a lot of bad debts in the banking system, and a poor sys bank supervision?

11. Has there been a lot of unhedged foreign currency borrowing?

12. Are there poor accounting standards, few disclosure ambiguous bankruptcy procedures, etc.?

requireme

A brief scan of this list should reassure people that Australia is in go That is, it would receive a very favourable mark on the vast majority of these indicat should be able to handle the current international turmoil without too much disruption are not perfect, and there are two items on the list - the current account and external our score is low by international standards. In the remainder of my talk today I would out in more detail how Australia stacks up against the above list, starting with the t which we receive a very high score, and following roughly the same order as in the list will cover the factors where we receive a high score quite quickly in order to leave closer examination of the two weak points.

## 3. Australia's strengths

Australia allows the free movement of international capital, but we certa not have a fixed exchange rate. The Australian dollar was floated in December 1983, an few years of turbulence in the mid 1980s, has generally behaved as a floating rate sho period since then. While it was more volatile in the 1980s than the major currencies US dollar, yen and Deutschemark, in the nineties it has generally been less volatile have. It has varied cyclically over the past dozen years, but around a flat trend.

There is no evidence to suggest that it is over-valued. Opinions will alwa on such a subject, but at the moment there are probably more, including some inf offshore institutions, inclining to the opposite view. Like most currencies, it has against the US dollar over the past 18 months, but against the Trade-Weighted Index it relatively stable. Judged by other measures of the exchange rate designed to capture c with imports or against export competitors, it has shown a small increase in competitiv 3

The issue of contagion can be addressed by asking whether another country similar economic characteristics has recently experienced a currency crisis. The answe negative: all the countries that have recently experienced a currency crisis have been

3 See "Alternative Measures of the Effects of Exchange Rate Movements on Competitiveness", Reserve Bank Australia Bulletin, January 1998.

stage of economic development than Australia, particularly in respect of the depth financial infrastructure and the degree of prudence exercised by borrowers and lende financial markets have made a clear distinction between troubled Asian economies like T Indonesia and Korea and countries like Australia.

On fiscal policy, little needs to be said other than that Australia has a underlying budget deficit by world standards and is expecting a surplus next financial stock of government debt to GDP (which effectively measures the extent of accumulate deficits) is exceptionally low by international standards. On monetary policy, seven y inflation has finally received the international recognition it deserves. The inter markets have expressed their confidence in Australia's fiscal and monetary policies by the spread between Australian and US yields to the lowest margin in a generation.

In the aftermath of the currency crisis which resulted in the partial brea the European Monetary System in 1992, the view developed that if a country was in o recession, it would be particularly vulnerable to a currency crisis. This is because be able to resist the currency crisis with tighter policies. (Whether it should, of depend upon the circumstances.) Whatever the strength of this argument - and it is str fixed exchange rate cases - it clearly does not apply to Australia, as we have a buoya economy. Furthermore, Australia is recognised internationally as having had one of growth records among OECD countries this decade. (Only Ireland and Norway - two very s economies - have done better.)

I will delay discussion of the current account, the balance of payments and debt until after I have completed the list of positive factors for the Australian econo factor on my list was whether the country was in the midst of an asset price boom. The with asset price booms is that they are usually followed by asset price busts, which c to company insolvencies and banking problems. Clearly, this is not the case in Aus present, although we do have fresh in our memories the events of the late eighties and be too censorious of recent Asian events. While the Australian share market has ri recent years, it has done so by a smaller amount than the United States or most of Commercial property prices have also been relatively restrained, and while house pr rising, the large rises have been confined mainly to inner Sydney and Melbourne.

I think we can be confident that our system of bank supervision is at wor practice, and the ratio of bad debts to total loans, at 0.9 per cent, is at its lo statistics have been collected (admittedly, the collection only dates back to 1991). what currently seems to be a good loan can become a bad debt if circumstances change. so, I have a lot of confidence that our figures are a good guide to the health of system. 4

I think it is true to say that there has not been a lot of unhedged foreig borrowing occurring among Australian corporates since the days of the "Swiss franc lo the mid-eighties, but I will postpone discussion of that topic until I deal with forei second half of this talk. Accounting standards, disclosure requirements and ba procedures are what might be termed financial infrastructure. So is the existence group of equity analysts and financial journalists, the ASC and stock market

4 In many developing countries, official statistics on bad loans are thought to greatly under-estimate t Even so, Mexico and Thailand reported ratios of 10.5 per cent and 7.7 per cent in the year before their e crises.

requirements. We tend to take a lot of this for granted, but it is very important that best international practice. Again, we should not feel too superior to our Asian ne this respect; it takes decades or more to develop these, and as recently as the late ei had some glaring deficiencies. I think we are now at international best practice, involves continued improvement to stay there.

## 4. Australia's weaknesses

While I am satisfied that the underlying structure of our economy, particul financial underpinning, is sound, there is no sensible way we can avoid a widening of o account deficit in the short term. It is virtually inevitable because a significant countries that make up our major export markets are likely to contract, or not grow a over the next 18 months. It is what economists call an "external shock". It is a course, that if exports are weaker, then GDP growth will also be lower than it would h without the "external shock". These "real" effects on exports and growth are already though their full effects will take some time to be clear. In the case of financial the exchange rate, bond yields, commodity prices and share prices, of course, the ad occur at once, as market participants can immediately adjust prices to reflect their of what is to come.

What I wish to do in the remainder of this talk is to try to address two q First, how will the Australian and international financial community accept the wideni Australian current account? This is important because it has implications in the first financial prices. Second, what are the prospects for our exports, and hence economic will not answer this question in a quantitative way, which may disappoint those wh numerical forecasts; in fact, I will be making a few criticisms of the simple models th employed for this purpose.

## 4(a) Reaction in financial markets

In the mid-eighties, Australian financial markets - particularly the exchange and bond markets - experienced a major reaction to the widening current a deficit. The reason the reaction was so large was that doubts began to emerge about wh economic situation was sustainable, particularly in view of the implications for for There is always the possibility that the same or similar doubts will re-emerge over t months, but I am inclined to think that will not be the case. The reasons for my view below.

If we look at the history of the current account since the early 1980s (Dia it is apparent that the deficit has varied between about 3 1/2 per cent and 6 1/2 per with an average of 4 3/4 per cent. Most importantly, there has been no on-goin deterioration - the trade account has improved at a rate sufficient to offset the in income payable abroad. The widening in the current account deficit that we expect in will be the fifth such cyclical widening in the past 20 years, and I think that peopl this as a part of our economic cycle.

You will note that I am only talking about cyclical movements in the cu account. The broader issue of whether we should accept an average current account de 4 3/4 per cent of GDP in the long run would require another paper as long as the o presenting today. It would focus on our national savings performance, both in re governments and to the incentives that are provided to the private sector. But that i day.

On previous occasions, the cyclical widening of the current account deficit reflected a mixture of external influences, such as a fall in the terms of trade significant internal imbalances or policy deficiencies. As examples of the latter demand in the earlier widenings ran at unsustainably fast rates, usually in excess of per annum for a time. Similarly, in all but one of the earlier widenings, Australia's was higher than the world average, and again on two occasions, we were running a sign budget deficit. On this occasion, we have none of these imbalances. The widening current account deficit will be essentially the result of an external contraction of domestic demand running only slightly faster than trend.

The foreign debt situation is not as threatening now as the most pessimisti in the mid-eighties feared. Looking at a graph of the ratio of foreign debt to GDP ( shows that it nearly tripled between 1982 and 1986 (from 12 per cent to 33 per cent) people feared that it would continue to rise at this rate, but it has not. In the averaged a little over 40 per cent, where it currently is. Another widely used meas sustainability - the ratio of debt servicing to exports (Diagram 3) - showed a somewh pattern. It rose from 6 per cent to 22 per cent in the 1980s, but then reversed sharpl nineties, and is currently at about 12 per cent. The strong growth of Australian expo fall in world interest rates are largely responsible for this favourable development.

In the 1980s, when the sharp rises in foreign debt and its servicing cos occurring, the Australian economic debate was, not surprisingly, pre-occupied with thes At the time, there were no official statistics comparing foreign debt levels in countries, and in their absence there was a tendency for people to assume the worst assume that Australia was the highest on the list. Now that the IMF and OECD publish statistics on the subject (Table 1), we see that we should not have assumed the wors Australia is certainly in the top quartile of countries ranked by the net foreign debt it is not the highest - New Zealand, Sweden and Canada are higher. Looking at th external debt to GDP ratio, Australia is in the bottom half of the table. 5

## Table 1: External Debt as per cent of GDP

143.1

101.7

96.0

89.0

|--------------------|------------|--------------------|--------------|

5 Depending on the purpose at hand, there can be a case for looking at either net debt or gross debt. I is to ask how vulnerable a country is to a currency crisis, gross debt (as has been used in the recent As is the better measure. It shows the amount of foreign lending that potentially would not be renewed if s doubts developed over a country's future. The fact that the domestic private sector also had some foreig (as taken into account in net debt measures) would be of little assistance in such a currency crisis.

88.3

77.7

75.6

74.0

73.4

62.4

57.2

55.9

54.0

49.0

48.6

44.3

42.6

33.0

n.a.

Source: IMF, Balance of Payments Statistics Yearbook 1997

|----------------------|--------|----------------------|--------|

The other aspect of foreign debt that has received a lot of attention in t recent Asian developments is the extent of unhedged foreign currency borrowing. O figures only tell us that 60 per cent of Australian borrowing is denominated in foreig Of that, a significant proportion has been borrowed by banks, and this is virtually Our assessment is that major Australian corporates normally hedge their foreign c borrowing unless they choose not to because they have a natural hedge through their exp

As I mentioned, financial markets tend to be forward looking, and it is li a significant deterioration in the current account is already factored into importa prices. The reaction of financial markets to date has been more measured than was th the 1980s, no doubt reflecting their assessment of the much improved "fundamentals" Australian economy. But we should not take this for granted. We have seen in Asia past year just how fast the international capital markets can react if they come to t that a country is not being managed in a sustainable way.

## 4(b) Slowdown in exports

We would all like to know how large the current slowdown in exports will p to be. But, because we have not been through this type of situation before, there uncertainty about how to go about this.

To date, those trying to be scientific and quantitative have tended to use which I would term a "fixed co-efficient input-output model". This approach st forecasting the fall in import volumes which each of our trading partners will exper assumes that the volume of our exports to each country will fall by a similar amoun adding together the results for each country, it arrives at a figure for Australian region. This is a time-honoured approach, but I am sceptical of how appropriate i country in Australia's position.

Despite Australia's impressive export diversification of the past decade, a per cent of our exports are still essentially rural and resource commodities which ar

world markets. Most of these are fungible - they are sold to wherever the demand is. demand for base metals falls, Australia will still probably sell the same amount of b worldwide as before, but with more sales to countries other than Korea. Of course, demand has weakened, the price will have to fall to clear the market. That is what happening - commodity prices are now 9 per cent lower than at their March 1997 high i terms. Thus, from Australia's perspective, the Asian slowdown may have its biggest ef through lower export volumes, but through a fall in commodity prices, some (or, concei lot) of which has already happened because these markets are forward looking. There i effect on the economy, of course, since lower prices, other things being equal, me export income, which in turn means lower demand and so on. It is important to note, h that other things have not been equal: the Australian dollar has depreciated such t terms, commodity prices are actually higher than a year ago.

A good example of exporters seeking other markets is shown when we consid the recent history of our exports to Japan, by far our largest export market during th you know, the Japanese economy has been extremely weak over the past five years, an exports to Japan have been flat over most of that period. 6 But this has not stopped overall Australian export volumes growing strongly; they have risen at an average annual rate per cent in real terms over the past five years. Where has the growth come from? J everywhere but Japan, including, until recently, the other Asian countries that are c trouble. The most striking feature, however, has been the growth in a group of cou have always called "other". As you can see from Diagram 4, this is our fastest growin in recent years. To satisfy your curiosity, "other" is what we have left after we excl United States and Europe: that means it includes the Middle East, New Zealand, the Ind Continent, the Former Soviet Union, Eastern Europe, South America, etc.

1954

1995

1996

Another reason why the conventional approach to estimating the effects of on Australian exports may overstate the slowdown is that a significant proportion of o are inputs into Asian exports, rather than final consumer or investment goods. This s the case particularly for the two largest Asian markets - Japan and Korea. The situati clear for some other countries, but as a general rule, we are probably better off circumstances than most suppliers because of the weight of commodities, foodstuffs and into exports" in our mix. After the transitional export finance problems are solved,

6 Until the last nine months, when they rose apparently in line with a pick-up in Japanese exports.

expect to see strong growth in Asian exports as a result of their large in competitiveness. I would be a lot more worried if Australian exports consisted of products. Incidentally, this is one of the reasons why tourism has been hit so hard our biggest export that is aimed directly at households, and is considered by them some luxury.

I hope I have not gilded the lily too much in the above discussion. Ther doubt we will find the going tough on the export side, and we will not be able to re short term the sort of figures we have become used to over the past five years. But enough account in popular discussions has been taken of our particular mix of exports capacity to find new markets.

## 5. Conclusion

The events in Asia have confronted us with a challenge that was not fores year ago. In deciding how to handle it, the first step is to recognise that the ou economy is less favourable than it would have been in the absence of these events. Th policy response will be to accept that the effects should be spread across several variables, rather than attempting to adhere closely to earlier aspirations for any one letting the others do all the adjustment. It is clear that we should be prepared for a account deficit in the short run - to try to avoid it would place intolerable strains the economy. Similarly, we will have to accept a somewhat lower rate of economic grow slightly higher inflation than seemed likely not so long ago. Notwithstanding these c feel that over the next 12 months, Australia will continue to experience an economic which will place it among the better performers in the OECD area. We also believe economic fundamentals will hold us in good stead, and that we will retain our ha reputation as a country with responsible economic and financial management.