Terms of Reference 1


The implications of the globalisation of international financial markets for the conduct of fiscal and monetary policies in Australia, including medium-term and other strategies to cope with potential volatility in markets.

  1. The focus of macroeconomic policy is to provide an economic environment in which output, employment, and thus living standards can grow as fast as possible in a sustainable way. From this policy perspective, the role of financial markets is to contribute to growth in living standards by promoting an efficient allocation of capital to profitable investments and through this to growth in output and employment.

  2. As financial market globalisation has developed over the past 25 years and regulation of capital flows has declined, financial market players have become a much more important determinant of the allocation of capital both domestically and internationally. Because of the increasing potential for capital flows to affect growth, employment and living standards, macro (and micro) economic policy has had to increasingly recognise, and adjust to, the impact and behaviour of financial markets.

  3. Managing globalisation in the 1990s

  4. While many economists would agree that there have been important benefits from globalisation, a key element of the critique of globalisation is that there are important potential costs, principally in terms of additional instability of capital flows and volatility in domestic financial markets. This section discusses both costs and benefits and the role of policy in relation to these issues.

  5. Indicators of volatility

  6. Given the increasing share of capital flows accounted for by short-term or portfolio capital and the increased use of derivatives and leveraging, there is a concern that financial market volatility has increased significantly.

  7. Clearly, exchange rate volatility is now higher than in periods when exchange rates were fixed and interest rate controls formed part of Australias regulatory framework. However, it is not clear that there has been a general trend increase in financial market instability across major economies and for Australia in particular in the period following deregulation. Market instability in major economies, in general terms, appears to have peaked in the early 1980s, showing a decline thereafter.

  8. By way of example, Table 3 below shows several measures of volatility in Australias financial markets since the 1970s.

  9. Table 3: Volatility in Australian financial markets (standard deviations of monthly percentage change)

    Table 3: Volatility in Australian financial markets (standard deviations of monthly percentage change)

    Volatility measured as standard deviation of monthly changes ¾ per cent with exception of percentage point for 10-year bonds. Source: Treasury estimates.

  10. The data in Table 3 suggest that volatility appears to have diminished during the 1990s, relative to the period immediately following significant financial market deregulation in the early 1980s. Other evidence also supports the view that there has been a trend decline in Australian financial market volatility over the period 1987 to 1996. This evidence suggests that the apparent volatility associated with deregulation appears to decline following what might be described as a learning period.

  1. However, episodes of instability in the global economy can increase volatility in Australian financial markets. The market most affected in the late 1980s was equities, not suprisingly since the source of the instability was the correction in the US equity market. In the period since the onset of the Asian crisis in 1997, volatility in the $A/$US exchange rate has risen. However, the extent of volatility has been much lower than in the late 1980s.


Potential effects of volatility

  1. Some commentators have suggested that globalisation has actually increased the exposure of the economy to macroeconomic shocks.

  • It is argued that financial markets may extrapolate developments in one country to another with incomplete or inaccurate understanding of an economys fundamentals. This effect can be exaggerated by the tendency for herd-behavior leading to overshooting in financial markets.

  • In 1997 and 1998 there were abrupt falls in the $A in response to developments in Korea, Indonesia, Russia and Brazil. The markets, by correlating Australias economic fortunes with those of our export markets and other commodity producing countries, forecast dire consequences for the Australian economy. In the event, this over reaction was not sustained, although there were times when the exchange rate market was unstable.

  • Financial markets over-riding goal of short-term profitability may increase the potential for destabilisation of the real economy and push an economy to a lower equilibrium growth path.

  • This may occur, for example, if the volatility associated with this phenomenon: adds to business and investment uncertainty, leads to a higher risk premium on equity and long-term debt, deters foreign trade and long-term direct investment or causes higher risks of financial system failure.

  • Finally, it is speculated that an increase in financial market volatility could impose considerable potential costs because it would lead to increased volatility in output and inflation and thus potentially contribute to the ratcheting up of unemployment.

  • However, as noted above, there is no evidence of an upward trend in financial market volatility in Australia, although there have been episodes of significant instability.

  • The episodes of volatility in the early stages of the floating exchange rate regime were associated with weaknesses in the policy framework and immaturity in financial markets. Recent volatility has tended to be short lived, and output and employment growth has continued to be strong throughout these periods, a testament to a much improved policy framework.

  1. While there does not appear to be a structural increase in financial market volatility in Australia, there can be periods of instability that may increase volatility in Australian financial markets. Increases in volatility may in some circumstances serve to highlight weaknesses in an economys policy framework, suggesting a need for reform.

  2. However, financial market volatility may occur even when the economys policy framework is sound. Speculative attacks on currencies can be destabilising. The Reserve Bank of Australias submission to this inquiry discusses in some detail the role of hedge funds, and provides some evidence of their recent involvement in Australia.

Benefits from exchange rate movements

  1. All volatility is by no means bad.

  2. Assisting economic adjustment

  3. Movements in the Australian exchange
    rate ¾ both overall and via bilateral movements ¾ are a key part of Australias adjustment mechanism. As illustrated over the past two years, a decline in the exchange rate in response to falling commodity prices due to the impact of the Asian economic crisis has provided support to the economy by boosting the competitiveness of Australian exporters. In other words, a worsening of the fundamentals underpinning Australias external position was followed by a partially offsetting, stabilising, reaction in the exchange rate.

  4. Movements in Australias real exchange rate (the nominal exchange rate adjusted for movements in Australian inflation relative to movements in inflation in the economies of our trading partners), if it is flexible enough, will tend to mitigate the effect of external developments on growth, whether they are positive or negative. For example, negative external developments should lead to a depreciation of the real exchange rate, in turn stimulating domestic and foreign demand for Australian goods in an offsetting manner.

  5. The speed with which the real exchange rate moves is of critical importance to both the initial effects of external disturbances on the economy and the subsequent product market adjustments. With the floating of the nominal exchange rate, real exchange rate movements have become more rapid, with movements in the nominal exchange rate driving movements in the real exchange rate.

  6. Before the floating of the Australian dollar, nominal exchange rate movements were restricted by exchange controls, which tended to prevent or delay changes in the nominal exchange rate in the face of external disturbances. Changes in the real exchange rate therefore depended more on changes in Australian inflation. Relatively high inflation over this period meant that real appreciation (a loss of competitiveness) was easily achieved. Less easy was achieving a real depreciation (gain in competitiveness) as this would have required inflation to fall.

  7. Changes in real wages are an essential part of the economys adjustment to external shocks. A fall in real wages is required to maintain the gain in competitiveness from exchange rate depreciation and allow employment to be maintained in the face of an adverse shock, such as a large fall in the terms of trade. Under a floating exchange rate, the downward adjustment occurs through prices increasing, via import price effects, relative to nominal wages. Under a fixed exchange rate, this requires falls in nominal wages, which have tended to be more difficult to achieve.

  8. A key problem with fixed exchange rates is the difficulty for the authorities in determining when the exchange rate is out of line with fundamentals, and what the appropriate level should be. As the experience of the crisis economies of East Asia clearly demonstrates, the process of adjusting a fixed exchange rate can be problematic. Where the authorities have staked their credibility on maintaining a fixed exchange rate, and the private sector has acted on the assumption that it will be maintained, achieving an orderly and timely adjustment can be extremely difficult.

Improving the policy framework

  1. The prospect of financial market volatility can drive policy change to reduce the risk and uncertainty which investors in domestic assets face. Achieving a reduction in financial market perceptions of risk and uncertainty associated with investment in an economy, for example linked to poor corporate governance or a poor macroeconomic policy framework, is likely to reduce the risks of destabilising movements in exchange rates or bond rates.

  2. Effectiveness of macroeconomic policy in a globalised world

  3. Some commentators have argued that globalisation has limited the ability of governments to use fiscal and monetary policy to manage the macroeconomy and achieve full employment (Latham 1998). However, Australian experience casts some doubt on this argument. The history of the 1990s shows well that national governments can run independent economic policies, and that a sound policy framework can facilitate good economic outcomes. Such a policy framework can also reduce the potential for external shocks to destabilise the economy.

  4. What is also clear is that globalised financial markets can impose severe costs on governments that pursue what the markets view as inappropriate policies, and it is probably true that bad policies are more readily penalised by investors than previously.

  5. It is worth noting that the importance of overseas investors views of Australian policy does not arise from globalisation per se. Rather, it arises from the fact that investment opportunities exceed domestic saving. This has been the case over most of our economic history. What has changed is that technology has increased both investors access to information and their ability to act quickly based on that information.

  6. In Australias case, financial markets are essentially concerned with Australias ability to achieve strong sustainable growth, without rising inflation or unsustainable current account deficits. They can certainly react quickly and adversely to policies that they believe would adversely affect these indicators. However, there appears to be very little conflict between what is valued by financial markets and what is in Australias longer-term economic interests.

  7. Achieving sustainable reductions in unemployment depends fundamentally on conducting policy in a way that avoids contributing to inflation and unsustainable current account pressures.

  8. Economists now generally recognise that it is not possible to trade-off higher inflation for lower unemployment beyond the short-term. Hence, there is not generally any long-term benefit in using macroeconomic demand stimulus to push unemployment below the level at which inflation starts to accelerate. Higher inflation imposes economic efficiency costs, because it distorts price signals, and has arbitrary distributional impacts. The appropriate remedy for structural unemployment is to reform workplace relations, labour market regulation, vocational education and training and tax and benefits systems so that the labour market works more efficiently.

  9. Recent US experience does suggest that the structural unemployment rate may not be fixed, but may move downward as unemployment is reduced. However, achieving such a fortunate outcome is likely to require considerable flexibility in labour and other markets and skilful management of policy to achieve a gradual approach toward capacity limits.

  10. Nor is it sustainable for governments to run continuing budget deficits that contribute to unsustainable current account deficits. Ongoing government borrowing that is not used to fund investment that yields adequate returns is not generally likely to be in Australias longer-term interests. Such deficits pass higher debt servicing costs on to future taxpayers without increasing future incomes. They may also put upward pressure on interest rates and reduce business confidence, thereby crowding out private investment. This detracts from future output growth. The experience in Australia and many other countries since the mid-1970s suggests that running budget deficits on an ongoing basis has not been effective in delivering a sustainable lowering of unemployment, due to adverse effects on confidence and interest rates and insufficient attention to structural facto
    rs affecting unemployment.

  11. While the concerns of financial markets broadly accord with the requirements for maximising sustainable growth, market views may on occasion be misguided or over-simplistic. Policy needs to be based on sound and appropriately nuanced economic analysis, rather than simply validating market views. Governments may not be able to directly control the reactions of financial markets, but there are strategies they can adopt to minimise the risk of policy being hostage to capricious or arbitrary reactions. Macroeconomic policy can still be effective, but its effectiveness is likely to be compromised unless it is soundly based (recognising the limits of what macroeconomic policy alone can achieve), credible and conducted in a transparent manner.

  12. Transparency is particularly important in this regard. Governments need to communicate clearly their policy objectives and the rationale for policy approaches, particularly in terms of how they contribute to sustainable long-term growth. Markets also need to be able to have sufficient information to assess performance. Another important element is that governments relations with the private sector be conducted on a sound and transparent basis. Transparency can bring significant benefits in terms of educating markets and promoting confidence in the policy framework.

  13. Australia has been able to sustain strong economic performance notwithstanding the financial crisis that spread through much of East Asia. Paul Krugman went as far as to suggest that Australias performance makes it the miracle economy of the region. Australias ability to sustain strong growth has been due, in no small part, to the institution of sound macroeconomic policy frameworks and, in particular, the restoration of the budget to surplus.

  14. Transparency has also been important in helping Australia maintain credibility in the eyes of the market. One example is the Charter of Budget Honesty, backed by legislation, which came into operation in 1998 and aims to improve fiscal outcomes by enhancing the transparency of and accountability for fiscal policy. In particular, the Government is required to set out its fiscal objectives and strategy, and provide full economic and fiscal outlook reports at the time of the budget, at mid-year and prior to elections.

  15. More detail on the transparency of Australian government policies and the policy framework was provided in the report Making Transparency Transparent: An Australian Assessment.

  16. The benefits to Australia of greater transparency are illustrated when considering the recent widening in Australias current account deficit (CAD). With the public sector in surplus, the CAD reflects an excess of private sector investment over private sector saving ¾ financed by private sector lending from abroad. A similar moderate growth/high CAD scenario also existed in the East Asian economies before the onset of the financial crisis. However, the greater transparency of Australias institutions and policy framework has provided investors with greater certainty as to the economic and legal environment in which they operate. The ability to make such an informed assessment of commercial risk has helped investors to differentiate between conditions in Australia and other economies.

  17. In marked contrast to the East Asian economies, Australia has had a well-regulated financial sector, and sound and transparent corporate governance. Financial markets have not been distorted by explicit or implicit government guarantees on corporate borrowing. This has allowed foreign lenders the confidence to assess commercial risks and continue lending to the private sector.

  18. It is sometimes argued that financial markets do not adequately distinguish between bad budget deficits and good budget deficits, used to fund sound public investment or to support inadequate demand growth. There may be an element of truth in this, but the main problem is more likely to be that governments may be viewed as lacking credibility, because in the past they have tended to resile from running surpluses when demand was strong, or to fund poor quality public investments. The solution for governments is to build credibility by establishing a track record of consistent fiscal soundness, and to conduct policy on a transparent basis with clearly articulated policy objectives.

  19. Governments can also take steps to ensure a sound framework for public investment provision: including through privatisation of functions that are better performed by the private sector; contracting out of service delivery; corporatisation of government business and the introduction of competition.

  20. Credibility and transparency together are likely to provide governments with more scope for flexibility in conducting policy. In the absence of credibility and transparency, markets are much more likely to react disproportionately to short-term developments or to apply rigid strictures as to what constitutes appropriate policy.

30 For example, see Argy (1995) and Edey and Hviding (1995).

31 For example, see discussion in Argy (1996).

32 See Edey and Hviding (1995).

33 Kortian and O'Regan (1996). The authors also find that the $US/$A and the TWI rates had the lowest volatility over that period of the five currencies examined. The others were the JPY/USD, DEM/USD and GBP/USD.

34 Kortian and O'Regan (1996).

35 See, for example, Mathews (1995) and Manning (1995).

36 For example, see Lux (1995) or Kortian (1995) for discussion of this phenomenon.

37 For example, Argy (1996), Dooley (1996) and Eichengreen and Wyplosz (1996).

38 See The Economist, 16 March 1996.

39 See, for example, Gruen (1995) or, for a more theoretical approach, Harvie and Lee (1996).

40 Paul Krugman writing in Forbes Magazine, December 1998.