CEO’s presentation to the Finance and Treasury Association
17 April 2002
- 1 FINANCE AND TREASURY ASSOCIATION PUBLIC SECTOR FINANCE AND TREASURY MANAGEMENT CONFERENCE, CANBERRA, 17 APRIL 2002
- 2 PRESENTATION BY MR MICHAEL ALLEN, CHIEF EXECUTIVE OFFICER, AUSTRALIAN OFFICE OF FINANCIAL MANAGEMENT
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FINANCE AND TREASURY ASSOCIATION
PUBLIC SECTOR FINANCE AND TREASURY MANAGEMENT
CONFERENCE, CANBERRA, 17 APRIL 2002
PRESENTATION BY MR MICHAEL ALLEN, CHIEF EXECUTIVE OFFICER, AUSTRALIAN OFFICE OF FINANCIAL MANAGEMENT
In my presentation today I intend to cover a number of issues associated with my allocated subject – `Benchmarking and Performance Measures’. Please forgive me if I do not spend a lot of time talking about some of the more detailed issues with respect to benchmarking. Given the opportunity to participate in this public sector finance focused conference, and in the context of the recent media attention on certain aspects of the AOFM’s operations I thought that I might take the liberty of addressing three key topics:
- recent initiatives at the AOFM;
- overview of the Commonwealth financing task and associated AOFM funding activities; and
- the more specific issue of the AOFM’s liability portfolio benchmark approach, and in particular focusing on our experience with respect to our foreign currency benchmark.
The AOFM was established on 1 July 1999 as a prescribed agency within the Treasury portfolio. The AOFM assumed responsibility for the Commonwealth’s debt management activities, which were previously undertaken by the Debt Management Branch within the Department of the Treasury.
The AOFM’s primary mandate is to manage the Commonwealth’s net debt portfolio in order to achieve the annual financing requirement and the maintenance of the net debt portfolio risk exposures consistent with the Government’s desired cost and risk objectives.
Since formation, the AOFM has focused on two key areas, firstly the development of organisational capabilities and resources in order to achieve its vision of global excellence in sovereign debt management and secondly, in the context of the Government’s current financial management strategies, reviewing a range of our debt management practices, particularly with respect to the existing liability benchmark framework.
A new organisation structure has been introduced over the past year in conjunction with the implementation of our new human resources framework. The new structure has been created to ensure that organisational accountability can be clearly defined and resource allocation focussed on achieving our output objectives. The structure also seeks to further strengthen our corporate governance framework by maintaining a clear separation of the various aspects of our debt management responsibilities, as well as supporting our compliance and reporting frameworks.
Work has already been commenced on a number of significant projects. As has been highlighted in the press recently, the review of our foreign currency benchmark was completed in June 2001. The review of our strategic debt management objectives has also been initiated, and will continue to be undertaken over the course of the current year. This aspect of the review will focus on ensuring that the existing liability benchmark assumptions continue to be consistent with achieving the Commonwealth’s desired cost and risk objectives. Given the changing nature of the financing task, opportunities to improve a range of operational issues associated with the impact of the seasonal nature of the Commonwealth’s cash flow profile on the existing benchmark framework are also being explored.
The AOFM is hopeful of finalising the acquisition of acquiring a new debt management system shortly. Implementation of this system is expected to provide a more robust risk exposure and performance monitoring platform, along with enabling significant efficiency gains to be achieved in the production of risk management and compliance reports. The platform will also strengthen our existing corporate governance framework.
In conjunction with the implementation of the new debt management system, a review of the existing risk policy framework is being undertaken. Whilst the existing policy framework meets the requirement of our current operating environment, a review is appropriate given the impact of changes in the Commonwealth’s financing task and in the context of the AOFM review of debt management activities.
The AOFM reports, and is accountable to, the Treasurer, through the Secretary to the Treasury.
An Advisory Board was established in December 2000. Its role is to provide advice to the Secretary to the Treasury. Although the Board does not possess executive powers or decision making authority in its own right, the Board advises the Secretary on matters relating to corporate governance, strategic planning, financial risk management strategy, and business planning. The Board also provides advice to the Secretary with respect to monitoring the performance of the AOFM generally.
The six member Board comprises the Secretary to the Treasury, the Executive Director of the Economic Group in the Department of the Treasury, a Senior Executive from the Department of Finance and Administration (representing the Secretary of the Department), the CEO of the AOFM and three representatives from the private sector. The private sector members, appointed for a three year term, are Mr Tony Cole, currently Executive Director at William M Mercer Pty Ltd, Mr Greg Maughan, a consultant with a background in funds management and Mr Peter Warne, formerly a Director of Bankers Trust Australia Ltd.
Three main operational committees have been established for AOFM internal governance. A Liability Management Committee has primary responsibility for establishing policy and programs governing debt management operations and reviewing liability performance; an Audit Committee has responsibility for statutory financial reporting and for monitoring internal financial controls; and a Management Committee has responsibility for oversighting and reviewing the overall strategic management of the organisation.
Commonwealth general government net debt has been in decline since the mid 1990’s – government securities on issue for the Commonwealth have fallen from a peak of around $107 billion to around $65 billion at the end of June 2001.
Budget forecasts and projections indicate that net debt will decline to zero by June 2005. Figures in the chart are based on 2001-02 Budget data produced in May 2001. Updated data will be available in May 2002 with the release of the 2002-03 Budget.
In terms of OECD experience Australia continues to lead the way.
Notwithstanding the decline in Commonwealth net debt, the government has in recent budget statements outlined a commitment to manage the reduction in net debt in line with the objective of maintaining the viability of the Commonwealth Government Securities (CGS) market – an important feature of this strategy is to maintain the liquidity of our longer dated benchmark CGS lines.
I note that there have been some comments recently with respect to the consolidation of the Commonwealth and State government bond markets. I thought that it might be opportune to note that it was unanimously agreed by the States that this proposal should not proceed. This position was supported by the Treasurer. As noted by the Treasurer in his press release in August last year, the proposal was rejected on a number of grounds, including a reluctance to change existing arrangements and the absence of identifiable longer term cost savings.
Over 2001-02 bond market issuance will be in the order of $2.5 billion. This issuance reflects the broad strategy of maintaining critical mass outstandings in 8 to 12 maturities across the yield curve.
Consistent with maintaining a commitment to maintaining the length of our existing benchmark curve, a new line is planned to be introduced prior to the end of the current financial year. This new stock is expected to be a 2015 maturity.
In October last year the AOFM introduced bond conversion tenders. These tenders provide holders of nominated bonds the opportunity to convert their holdings into one of our more liquid lines. This enables the AOFM to:
- increase the amount of benchmark bonds outstanding more quickly than can be achieved in the current low gross issuance environment; and
- smooth the profile of outstanding bonds in a manner that improves the overall efficiency of the CGS market.
The use of a public tender process to undertake consolidations is consistent with our objective to conduct debt management activities in a transparent fashion. We are pleased with the results of this strategy to date. The market also appears to value the liquidity provided by these transactions. At our conversion tender held yesterday, around 80 per cent of the bonds available in the market were offered. This indicates strong market support and accordingly we intend to conduct further such tenders next financial year.
Now turning to our activities in the Treasury Note market. In order to manage mismatches in the Commonwealth’s cash flows, Treasury Note issuance sufficient to maintain outstandings within the range of $3-$6 billion have been maintained over the 2001-02 financial year.
- It should be noted that we are undertaking a review of our activities in the Treasury Note market and have been holding discussions with major market participants in order to ensure that our issuance arrangements remain in line with investor requirements. Following the finalisation of this review process, any changes to existing arrangements will be announced well in advance of being implemented.
- Without pre-empting the outcome of this review process it is difficult to imagine a scenario whereby T-Notes will not continue to be used to supplement seasonal funding requirements and continue to play an important role within the AOFM’s overall funding strategy.
The AOFM had $13.4 billion of term deposits with the Reserve Bank at 30 June 2001.
- the potential for the AOFM to engage in direct financial asset acquisition is often the subject of some speculation. At this stage we intend to continue the existing practice of taking term deposits with the Bank. Any changes to these arrangements will be signalled to the market well in advance of any potential new arrangement being announced.
The government’s debt reduction strategy has had a significant impact on AOFM funding sources. In particular, the domestic fixed rate bond market now accounts for around 80 per cent of total funding. This has been at the expense of reduced dependence on the Treasury Note and term floating rate (i.e. Treasury Adjustable Rate Bonds) markets. The change in funding source has also had a significant impact on the overall portfolio risk exposures, particularly with respect to the generation of portfolio floating rate exposures in order to achieve our benchmark portfolio duration targets. This is a point that I will return to later with respect to our portfolio management activities.
I would now like to address the third issue – our portfolio benchmark approach.
Debt portfolios by necessity have some element of exposure to movements in market prices that will, in turn, carry varying implications for portfolio cost and risk. With the benefit of hindsight it will always be possible to look back at the universe of potential portfolio structures and assess which structure offered the best overall performance.
The Commonwealth has pursed the well accepted approach to addressing this management challenge is to specify a hypothetical portfolio structure – a portfolio benchmark – with financial risk exposure characteristics that, ex-ante, can be expected to be consistent with a cost and risk performance acceptable to stakeholders.
It is against this background that a benchmark was developed and implemented by the Commonwealth over the period since 1989. Independent consultants developed this benchmark framework. In 1989 JP Morgan was appointed to the position of independent advisor. In 1996 this arrangement was reviewed and following a public tender, UBS was appointed to this role.
Broadly the AOFM’s benchmark is defined in terms of exposures to interest rate and exchange rate risks, measured by target ranges for portfolio currency shares and the modified duration of each currency exposure in the portfolio. The duration range for Australian dollar denominated debt is 3 to 3.5. The benchmark target for foreign currency exposure was 10 to 15 per cent of the AOFM’s net debt portfolio. The notion of maintaining a foreign currency exposure was recommended by both JP Morgan (in 1989) and UBS (in 1996 and 1998). Both consultants advised that a small foreign currency exposure in the portfolio could assist in meeting portfolio cost and risk objectives.
The Commonwealth has used swaps to assist with meeting the benchmark targets. I will first outline the use of interest rate swaps in achieving the targeted modified duration of the portfolio.
INTEREST RATE SWAPS
The Commonwealth enters into interest rate swaps in order to reduce the overall risk of the portfolio – that is, to reduce the extent to which the value of the portfolio changes in response to changes in interest rates and/or to reposition portfolio risk profiles. The use by the AOFM of interest rate swaps is consistent with the practices of a number of other sovereigns as well as a broad range of non-speculative private sector liability managers.
The Commonwealth entered into its first interest rate swap for the purpose of managing the duration of the AUD denominated debt portfolio in August 1997. Some swaps were entered into in 1992-93 and 1994-95 as part of the foreign currency swap programme.
The use of interest rate swaps over recent years reflects the need to manage the impact of increasing duration of the portfolio as debt has been paid down, and the fact that other means by which duration could have been reduced were considered to be less attractive. Over the period from 1997, the use of swaps has provided the AOFM with the flexibility to manage the required reduction in liabilities on an orderly basis along with providing a mechanism to hedge the impact of increased duration associated with the maintenance of the issuance of long dated CGS.
On 19 February 2002 the AOFM issued a press release announcing that there is no intention to enter into further interest rate swaps for the remainder of the current financial year. This reflects our assessment of current portfolio requirements over the period to June 2002.
It is expected that interest rate swaps will continue to be used to meet portfolio benchmark targets. We will provide an update of our intentions around the commencement of the next financial year.
CROSS CURRENCY SWAPS
I will now turn to the AOFM’s use of cross currency swaps, and given the recent media attention in respect of this area of AOFM activity, I am hopeful that these comments may provide you with an insight into some of the key background issues.
I will provide some history first. The Commonwealth has had a foreign currency exposure for many decades. Prior to the development of the domestic capital markets the build-up in foreign currency exposure reflected the relative ease of raising debt finance in foreign currency rather than in domestic currency.
Through the period in which the Commonwealth issued foreign currency denominated debt the value of the portfolio was significantly affected by changes in the value of the Australian dollar.
The maintenance of a discretionary foreign currency exposure in the Commonwealth debt portfolio was recommended by JP Morgan in the late 1980’s. The strategy was based on analysis that suggested that some foreign currency exposure would provide long-term cost savings relative to a portfolio wholly comprised of Australian dollars. Over a period of years, JP Morgan continued to advise the Commonwealth that the optimal debt portfolio structure should include a foreign currency exposure, to a maximum of 15 per cent. They also advised that there were some risk reduction properties associated with the strategy.
The foreign currency swap programme was commenced in 1988, with the stock of outstandings increasing gradually over the early years. In the early 1990’s, in line with the significant increase in the Commonwealth’s funding requirement, the stock of foreign currency outstandings was also increased in order to maintain the exposure in line with the benchmark target.
No new net foreign currency swaps were entered into after February 1999.
Over the period from 1989 to mid 2000 the cumulative economic return of the foreign currency exposure strategy was positive. However, it should also be noted that at times over the period, there was volatility in performance. More recently the cumulative economic performance has been negative.
From the commencement of the foreign currency programme, exposure was successfully maintained within the benchmark target range of between 10 and 15 per cent. The impact of the significant decline in net debt over the second half of the 1990’s was handled by maturing foreign currency swaps. However, the combined impact of the reduction in the AOFM’s net debt portfolio and the and the impact of the depreciation of the AUD in mid 2000 placed the AOFM in the position of having to undertake US dollar purchases in excess of maturities in order to maintain the exposure within the 15 per cent target range.
In mid September 2000, the AOFM advised the Secretary to the Treasury that, in the absence of US dollar purchases in advance of existing maturities, it was likely that the benchmark target would be exceeded over the remainder of 2000-2001. This then led to a temporary suspension of the benchmark which was formally confirmed by the Treasurer on December 6, 2001.
Over the period to June 2001 the AOFM then undertook a formal review of the foreign currency benchmark. The review concluded that a long-term position of zero foreign currency exposure in the portfolio was now preferred in light of changes in a number of factors that underpinned the original analysis. These factors included the significant reduction in debt levels achieved over recent years, a desire to remove the potential impact of currency volatility and the narrowing of the historical spreads between Australian and US interest rates.
Following the Treasurer’s approval of the AOFM’s recommendation, the rundown of the existing stock of foreign currency exposure was resumed in October 2001. The rundown will be conducted on a phased approach over a medium to long-term horizon. This gradual approach reflects the long time horizon over which the exposure was accumulated.
The policy was always entered into with a long-term focus.
BACKGROUND TO FOREIGN CURRENCY BENCHMARK SUSPENSION
Perhaps it is now appropriate that I now address another aspect with respect to the benchmark suspension and review process, to highlight one of the major challenges faced by sovereign debt managers, particularly in the context of managing to a liability benchmark.
As the Treasurer outlined in his press release on March 4, 2002 the decision to suspend the benchmark was made on the basis of broader macroeconomic considerations. The background being that over the 2000-01 financial year the AOFM’s task of managing the foreign currency benchmark was challenged by:
- an unsettled currency market, where over the course of the year to mid 2000 the currency had depreciated in the order of fifteen per cent; and
- the projected reduction in net AOFM liabilities over 2000-2001 reflecting the application of fiscal surpluses to net debt repayment.
As I have already mentioned the combined effect of these two factors would have required the AOFM to undertake significant purchases of US dollars, well in excess of the 2000-01 schedule of US dollar maturities.
History now tells us that “macroeconomic policy considerations will always be more important than portfolio allocation rules”.
Decisions of this nature reflect the complexities associated with sovereign debt management. On one hand governments have the same set of financial risk exposures as any large private sector corporation. In the liability management area these exposures and risks need to be managed in order to minimise long-term costs. This necessitates the sovereign debt manager to engage in a range of market sectors in order to ensure portfolio funding and risk management objectives are achieved. Given the size of the sovereign’s liability management exposures, either with respect to physical funding or the requirement for other risk management products, it is generally the case that the sovereign debt manager’s activity has the potential to significantly impact on prevailing market pricing.
This leads to the further challenge for sovereign debt managers – being that in some circumstances narrow liability management objectives may have to be compromised in order to ensure that broader public policy objectives can be achieved. For example, minimising the short-term impacts on markets of large shifts in funding requirements often requires the sovereign debt manager to be exposed to medium term movements in interest rates. This necessitates a trade-off to be made. Accordingly, broader public policy considerations may require sovereign debt managers to adjust risk management strategies in order to ensure consistency with macroeconomic objectives.
TRANSPARENCY AND CERTAINITY
With respect to the ongoing development of our liability benchmark, I would just like to make a quick comment about the impact of greater transparency of Commonwealth finances. Over recent years, the move to an accrual accounting framework, and greater disclosure as a consequence of initiatives such as the Charter of Budget Honesty has led to a greater level of transparency. Enhanced transparency, along with the use of forecasts, has had the impact of increasing the focus on looking at budget outcomes over a longer term horizon. Accordingly there is now a greater emphasis by our stakeholders on certainty, particularly with respect to the impact of future debt serving costs and the performance of debt portfolio. We expect this trend to continue over time.
The AOFM was established with a brief to enhance the capacity of the Commonwealth’s debt management function. To date much of our focus has been on internal issues – enhancing the existing corporate governance framework, establishing new organisational infrastructure, increasing resources, implementing new debt management systems, reviewing debt management strategies and liability portfolio benchmarks. The completion of the foreign currency review in June last year was the first of a number of important steps. Other tangible achievements have also been delivered. Looking forward work continues on a number of very challenging issues.
Last updated: 7 November 2013