The Global Debt Crisis and Australia – Presentation to the Tasmanian Economic Society Forum, Hobart
8 October 2012
Speech delivered by AOFM’s CEO, Rob Nicholl, to the Tasmanian Economic Society Forum
Hobart 8 October 2012
Thank you to the Economic Society for inviting me back to Tasmania.
The problems being dealt with around the world are of as much, if not more, interest to economists than they are to the financial market community and this is why the Economics Society is an appropriate forum for such discussion. The extent to which events are having widespread financial and economic repercussions would have to be unprecedented. At present there simply seems no way forward or out for some countries- with the likelihood that more are set to be dragged into their own vortex of economic decline. The solutions, should they be identifiable, are likely to take decades to gain substantial traction, with a lot of money to be spent and social misery to be endured along the way. I recently read where Governments and central banks across Europe, the US and Japan have pumped something like $12 trillion over the last 6 years into financial support with the end not even in sight, let alone within reach.
Now although I can’t claim the length of association equivalent to that of your next speaker, I did spend a considerable amount of time here. On this basis I appreciate that many in Tasmania may feel remote from the international events shaping financial markets and in turn the uncertainty surrounding highly indebted countries, as well as the drag effect they are creating on ‘global growth’.
It is important however to at least maintain a general understanding of the events that are unfolding, the threats that remain, and what impacts there could be on Australia from further negative changes, as well as the possible fallout from shifting moods and perceptions. I say this to you because Tasmania’s economic fortunes are inextricably linked to the performance of its trading partners and the rest of Australia; its budget revenues are to a large degree dependent on national tax strength (need I mention the GST); and its cost of borrowing moves (albeit not always in tight synchronisation) with the yields of Commonwealth bonds.
However, my discussion of specifics about Tasmania ends there – I wouldn’t want to give the impression that I was either offering policy advice to or meddling in the affairs of another jurisdiction!
But these are things the AOFM maintains an interest in (and hopefully an adequate awareness of) – although for different reasons. As a country, we will not anticipate events or changes, nor understand our limits and opportunities, with our head in the sand – regardless of how remote we may view our position from the aftermath of the GFC. For those who are open to critical assessment, the world is jam packed with valuable lessons – and communities that fail to grasp their strengths and vulnerabilities in a continually changing and highly integrated international setting are at risk of repeating the mistakes of others.
The topic for today is very wide ranging, and we could be here at least all night and through the next covering different aspects of it. Some of the most topical aspects, at least at a high level, are the following:
- what will become of the European Union;
- what will be the outcome of an increasing imbalance in trade between the advanced and emerging economies;
- what are the growth prospects for China in particular, and the Asian region more generally, for the near to medium-term;
- is the US heading for another major setback before finding a pathway to steady economic recovery; and
- can the international banking system be regulated in a manner that will create the required confidence (and safety) that a repeat of the GFC is not forthcoming.
While each of these has relevance in some way to Australia I would like to raise for further thought issues relating to the first three, rather than to analyse them all in detail with the intent of identifying policy considerations, or for that matter looking specifically for answers or solutions. Where you come out on certain issues will have much to do with the perspective from which you approach them – but rest assured because these are discussions that are occurring widely and in great detail, – so someone somewhere is on the case!
I did, however, think it appropriate to offer some insight to and an assessment of how the GFC and the so-called Sovereign Debt Crisis have impacted one prism of the Commonwealth’s considerations, because of my role at the Office of Financial Management. This is the demand for Commonwealth debt in financial markets, given that it has a direct impact on our cost of borrowing. What stems from this gives rise to many considerations and I will cover some of these along the way.
The AOFM role has exposed me to the machinations of financial markets internationally and in particular to the views and outlook of global investors. And regardless of your view on the ability of (or the social justice in) global investors being able to either impact or create events with widespread effect – this collectively they can nonetheless do; and so I think it is important to understand how they may view many of the issues causing widespread angst and uncertainty.
The reason for the AOFM seeking direct contact with global investors interested in or currently exposed to the Australian bond market is pretty straightforward.Â It is to update and discuss with investors topics such as the performance of the Australian economy; the Government’s fiscal position (and related broad policy settings); the Commonwealth bond market more specifically; and the AOFM’S issuance program and how this will impact development of the bond market. Over 75 per cent of Commonwealth debt is now held by a wide range of offshore investors and as such we view close engagement with them to be an important part of maintaining stability in our sovereign bond market.
Borrowing through the issuance of debt into financial markets is a normal part of government operations and whatever you or I might think of how the borrowed money is used; the fact is that ready access to markets is an important option for governments to maintain. The main reason I say this is because managing expectations and reputations in global financial markets has probably taken on a significance today that was simply not anticipated prior to the events of 2008. This is particularly the case for a country like Australia that even 5-6 years ago was of little note to a large part of the investment community, while today it is the focus of intense and increasing attention and scrutiny. We need look no further than the most obvious examples on display in Europe to understand that the ability of sovereign governments to readily borrow in times of fiscal need, and at reasonable interest rates, can be critical to their management of a domestic banking crisis, or a severe economic downturn.
Rather than just provide a summary the GFC or the sovereign debt crisis, much of which you are probably well acquainted with, I thought I might discuss them by relating their effects back to Australia and particularly how they affected the Commonwealth’s ability to access financial markets in an orderly and cost effective manner. It is useful to bear in mind that the very things that have created highly negative perceptions in international markets about the peripheral Eurozone countries, such as for example Greece, Italy and Spain, have a flipside that highlights attractive characteristics of the circumstances in which Australia currently sits.
Highly unstable banking industries; very high levels of sovereign debt (with unsustainably high and rising costs of servicing that debt); alarmingly prolonged economic contraction (through both a lack of immediate growth prospects and substantial deterioration of international cost competitiveness); what have been described as hopelessly deficient fiscal positions; and highly restricted access to the policy means by which to address these extreme challenges, are plaguing policy makers at the sovereign level and beyond. The mood in financial markets is that these issues will not be dealt with quickly, easily, or without further substantial cost. On the other hand offshore investors see an opportunity for Australia to build on its existing strengths, undertake the transformation necessary to take a new place in a global setting and to use to its best advantage the prospect of continued strong economic growth in the broader Asian region. Let’s hope we can meet their expectations!
In covering some of these global issues and the impact of them on Australia I will along the way provide you a brief summary of what the AOFM does, its activities during the GFC and the Sovereign Debt crisis periods and how this has given us an incentive to follow these events closely and to develop our own perspective about them.
The AOFM’s three principle functions are:
- Funding the Commonwealth budget where required through the issuance of Australian Government debt; and in doing this developing our sovereign bond market;
- Managing the Commonwealth’s daily cash position; and
- Investing in financial assets in accordance with government policy objectives – this including what has turned out to be a fairly significant role in underpinning activity in the market for residential mortgage backed securities.
It is the first of these functions, the issuing of government debt that bears most relevance to what I will cover today and the main conduit for communication with the global financial community.
For most of the decade leading up to the GFC, Australia had been running budget surpluses. Together with a number of asset divestments this had allowed for Australia’s outstanding borrowings to be reduced to the point whereby during 2001-02 a policy debate seemed relevant as to whether the Commonwealth bond (or CGS) market could actually be closed down – i.e. that outstanding Government bonds would be bought back or not replaced on maturity.
Following a broad ranging public review, the decision was taken to retain the CGS market and for a stock outstanding of bonds of about $50-55 billion to be maintained, with an expectation at that time that this would broadly continue on an indefinite basis. Although there was no requirement then to borrow in financial markets to fund budget deficits, under a direction from Government the AOFM continued to issue Treasury Bonds. This practice was maintained through the mid part of the decade in order to maintain a relatively small but constant volume of bonds outstanding.Â At the end of 2002-03 the size of the Commonwealth bond market was about 7.5% of GDP, by the end of 2007-08 it was about 5% of GDP.
The GFC unfolded rapidly in late 2008, creating circumstances that highlighted what appeared to be a newly found appreciation for the downside of risk in financial markets – this revelation an irony given the extent to which leveraging and the underpricing of risk had led to these events in the first place, including the prevalence of but ignorance towards counterparty risk.
However, the onset of the GFC came with a massive impact and with it a repricing of risk that resulted in new appetite for triple-A rated sovereign credit. Â Although the group of triple-A rated sovereigns was quite large at the time, the beginning of uplift in demand for Commonwealth bonds did emerge quite quickly.Â There was likely to have been a number of reasons for this including:
- the economic growth phase of Asia (and in particular China) that investors had been tracking for some time;
- comparative risk assessments in the immediate aftermath of the financial turmoil and the onset of and prospect for economic malaise in Europe and the US in particular;
- an ongoing accumulation of sovereign reserves to unprecedented levels, heightening the need to explore the means by which to diversify the management of them – a process that had begun at this point but would take on increasingly greater importance for reserve managers over the years ahead;
- the further rise of commodity influences, including the view that the $AUD was a commodity currency and that this provided a positive link to Asian region growth; and
- the emergence of several minor currencies with growing reserve status – the $AUD being one of these.
Although with only a small but steady supply being issued, Treasury bonds became more tightly held, liquidity in our bond market began to disappear rapidly and our yields (that is the interest rate demanded by investors for lending to us) began what has turned out to be a long march downwards. And true to any part of this story – you will find a ‘heads’ you win ‘tails’ you lose element. In this case the increase in demand for Commonwealth bonds has driven down our costs of borrowing, this no doubt being more so the case because the market interest is broader than just domestic investors. However, you may be aware of commentary in recent months about the upward pressure that this offshore demand for Commonwealth bonds is having on the value of the $AUD (an issue also with its own ‘heads’ you win – ‘tails’ you lose perspectives).
As the GFC unfolded one thing quickly led to another, and the Commonwealth announced revised budget projections for 2008-09 due to a significant write-down in budget revenues and the rapid implementation of a fiscal stimulus program. The Australian economy was to benefit from two sovereign fiscal stimulus programs – directly from the Commonwealth and indirectly from the large program introduced shortly thereafter in China. The nature of the global slowdown and the need for extended stimulus related expenditure programs, together with the impact on the Commonwealth budget of fiscal stabilisers, suggested that the budget would remain in deficit for several years, and in fact this has turned out to be the case.
The increased issuance of Commonwealth bonds resulted in the outstanding stock of CGS increasing at a commensurate rate. From June 2008 to June 2012 the size of Commonwealth bond market grew by just over fourfold. Annual issuance of bonds went from around $5 billion per year in 2007-08 to just under $57 billion in 2010-11 and then just over $60 billion the following year – at the end of this financial year (i.e. 2012-13) the bond market in size will be about 16% of GDP. Growth in the size of the Commonwealth bond market was no doubt in itself instrumental in attracting substantial attention from offshore investors, who are still looking for places to invest with more than just the feint hope that they will be paid back – or that they can trade these securities openly in the market without the fear of moving prices against themselves.
Also, convincing investors that the market would remain at least around its current size was an important development because this will impact liquidity for many investors, a highly important market characteristic to them. The decisions to either begin investing in the market, or increase existing holdings of Commonwealth bonds, are decisions now based largely on medium to long-term considerations – not opportunistic trades driven by speculation in Australian interest rates or changes in the value of the $AUD. This is an important factor in judging the evolution of our domestic financial market because it gives it a status of maturity and stability, with which investors become familiar, in turn raising the profile of and opportunities for other sectors of the Australian fixed income market, such as for state governments and the large corporate borrowers who increasingly rely directly on financial markets for raising capital rather than through the banks. It is therefore difficult to get past the proposition that in order for a domestic financial market to develop in a functional manner, a robust sovereign bond market is the best foundation on which investors can readily price the risks they are taking on.
Prior to the 2011-12 Budget the Government had Treasury chair a review panel to understand the impact from the GFC on its ability to access financial markets when a need arose suddenly. There seems little doubt that maintaining the mechanisms that allow ready access to financial markets has proven to be valuable – even if this requires issuing bonds in times when the budget financing task is minimal, and putting aside the broader benefit to which I just highlighted regarding domestic financial market development generally. A strong resilient sovereign bond market is now taken to be a key indicator of the underlying fiscal and economic performance of any country. Australia has somewhat fallen on its feet in this regard and we should not take for granted the vote of confidence in our circumstances from international investors that is reflected in the heavy demand for our bonds and the triple-A stable outlook credit rating we continue to enjoy. This is not of course to say Australians can sit back and relax – as the saying goes “the road to hell is paved with good intentions” – therefore we need to be clear about what it is we seek to achieve, but at the same time anticipate the risks that surround us.
Since mid 2008, the appetite for Commonwealth bonds from offshore has continued to grow steadily. This demand can be traced to many of the major changes that have occurred and trends that have developed in the global macro economy during this period. I have mentioned the increased supply of bonds to fund budget deficits. While there are arguments to suggest that the added supply of Commonwealth bonds has stimulated and created its own demand, it is mainly the external global changes that have driven the circumstances for a smooth and steady take up of this increased supply and I will now turn to these for some moment.
With the onset of the GFC, global growth began to slow. Many countries quickly entered into recessions, causing investors to move their investment focus from equities into traditional safe haven investments, such as sovereign debt. This has led to lower yields from traditional sovereign fixed income markets such as US Treasuries, UK Gilts and German Bunds.
Many countries also undertook expansionary fiscal programs and began to aggressively ease monetary policy, resulting in lower official cash rates, which in turn led to the sovereign yield curves of the core global bond market countries such as the US, Japan, Germany, and the UK in particular falling even further. In other words, as the world looked an increasingly risky place to invest, money came out of equity markets and into fixed income, and within that the countries offering the safest bet in terms of bond investments were those attracting lower and lower returns for the privilege of providing a safe haven investment destination.
Australia has ridden the edge of this effect because its relatively small size on an international scale is simply not able to accommodate the demand for global investor placement that has been searching for the safe haven opportunity. The relatively small size of our market, together with the strong underlying fundamentals of Australia’s current circumstances and outlook are just some of the reasons we are seeing such a high proportion of our bonds being held by offshore investors – offshore investors are willing to and capable of outbidding our domestic investor base, who have an inherently higher tolerance for risk and are chasing higher returns than the sovereign bond markets are offering.
To put the size of our bond market into perspective, if you compare Australia with the other triple-A bond markets our closest comparison in Canada has a market more than double our market size; Germany’s is about six times our size in dollar terms; and the UK’s is just over seven times our market size. The US Treasury bond market – although it no longer attracts a triple-A rating – is still considered the cornerstone of sovereign bond markets if for no other reason than its sheer size; it is just under 60% of the US economy (and almost 40 times larger than ours). To put it another way, the Commonwealth bond market represents less than 2% of the combined size of these four markets.
Going into the GFC many advanced economies had been consistently running government budget deficits. The additional expenditure of their new fiscal programs resulted in these countries accumulating increasingly large amounts of debt; so much so that the average gross sovereign debt across OECD countries is now at 100% of GDP – that’s the average, not the highest. Many of these economies (including Australia) had also been funding current account deficits for some time. The current account deficits of advanced economies were offset by the growing surpluses of many of the emerging economies; those in the Asian region of particular note. Consistent current account surpluses have led to a steady accumulation of foreign exchange reserves for emerging countries. The global accumulation in foreign reserves, particularly during the last decade, has played a major role in the offshore demand for Commonwealth bonds because reserve managers are finding it increasingly difficult to meet their investment mandates without seeking out smaller sovereign bond markets in which to invest. As I mentioned earlier, Australia has benefited from this to the extent that a high demand for our paper is driving down our cost of borrowing. It is also enjoys the relative benefit of these reserve managers being conservative investors (unlike what are referred to as ‘fast money’ investors) and the increasing focus of Australia for them as a medium to long-term investment allocation helps to provide for stability in our bond market.
To give some idea of the growth and development in this enormous pool of reserves, we can look to the IMF Currency Composition of Official Foreign Exchange Reserves (or what is known as the COFER data). The COFER data derives from a quarterly survey of central bank foreign exchange allocations for 34 advanced and 110 emerging countries. Central banks indicate how they allocate reserves to the four main reserve currencies (being the $US, the Euro, the Yen and the Pound Stirling) the Swiss Franc, and then a category which includes a basket of ‘Other’ currencies. This includes the AUD, CAD, HKD as well as some increasingly important currencies such as RMB and the INR.
The Cofer data shows that in 2005, total FX reserves for the emerging and advanced economies were about equal at around $2 trillion. By 2008 emerging economy reserves were at $4.7 trillion while the advanced economy reserves totalled $2.5 trillion. The most recent data shows total foreign reserves now over 2.5 times greater than they were in 2005, with emerging economies holding $7.0 trillion and advanced countries $3.4 trillion.
This trend has had a profound effect on the demand for what are perceived as safe haven currencies and safe haven bond markets as many Asian investors are allocating away from European markets in particular. While the $USD remains the world’s reserve currency, the proportional allocation of reserves from both advanced and emerging country portfolios has been declining over the last decade. For most of the prior decade the Euro had looked to some investors as if it could replace the $USD as the reserve currency but for a number of reasons, not the least of which was the onset of the European sovereign credit and banking crises, the relative demand for it (particularly outside of the Eurozone) is also subject to steady decline. While the Pound Stirling appears to have attracted some emerging country reserves since 2005, both it and the Yen as a proportion of total reserves have stayed pretty much unchanged.
This leaves only one place for the focus of increasing foreign currency demand – the ‘Other’ currencies category. This category has increased its share of allocations from about 4% in 2005 to over 10%. If we turn to Bank of England FX data we know that amongst this basket of ‘Other’ currencies the $AUD is a major (if not the major) currency and it is now the fifth most traded currency in the world. And even if 10% sounds a relatively small proportion, we are still talking about over $1 trillion.
While we are having a debate here in Australia about a two-speed economy, a similar phenomenon is obviously apparent on a global scale, with the differences in economic performance across the advanced and emerging economies probably at the greatest it has been for many decades.
A stand out performer for many years and one of significance for Australia is the continued expansion of the Chinese economy. While real annual GDP growth for China over the last decade averaged around 10-12%, it is only in the last few years that the Chinese economy has become the world’s second largest economy, with some predictions that it will eclipse the US economy in size within the next two decades. China is now Australia’s single largest trading partner; its quick growing and relative importance to Australia reflected by it having taken 6% by value of our exports a decade ago but 33% now. It is also our single largest import market source providing around 17% of total merchandised imports into Australia. This puts Australia in the rather unusual position of having a trade surplus with China; a picture not reproduced between China and its other trading partners.
There are risks however to the performance of the Chinese economy over coming years and they could come from both within and beyond its borders. I am sure Saul Eslake will be talking to this in more detail, with specific reference as to what this might mean for Australia, and so I will make only a brief reference to an obvious external threat to Chinese economic growth.
The EU and the US remain the two most important trading destinations for Chinese exports and both present growth risks – more so probably the EU. If we look only at the so-called crisis countries (also known as the PIGS – in Portugal, Ireland, Italy, Greece and Spain) RBA and UN data indicate that China’s export exposure to them is equivalent to about 1.5% of its GDP, about half the exposure of Russia and about a third for the exposure of the Eurozone countries collectively. On the other hand the composition of those exports is also an important factor because China’s exports to them are proportionately higher in the form of durable goods; with the nature of the economic downturn in these crisis countries reflected in a steep decline for such goods. Russia and the Middle East on the other hand largely export mineral fuels and related products, which has tended to mitigate (at least to some extent) the risks of a downturn being transferred from peripheral Europe into these countries.
There can be no doubting that Chinese’s economic growth has had a major effect on the resilience and growth of the Australia economy through the aftermath of the GFC. Despite concerns around possible Chinese sharp economic slowdowns, our close trade and business connections with it have indeed helped insulate us against the global slowdown.
Offshore investors are often keen to discuss Australia’s exposure to a marked slowdown in China, but we point out to them that while there are risks to the China growth story, our export prospects are not concentrated on China alone – with Japan and other ASEAN region countries playing an important trading role with Australia. And although the current wave of business investment in Australia is leveraging off the mining sector, mining operations per se at present contributes less than 10% directly to GDP. I often also point out that if a country could choose its trade exposure, it would probably want to choose the Asian region over anywhere else. Given that our direct exposure to the US and the Eurozone is very limited, this leaves Australia in a relatively strong position. I was very recently in Canada and they are thinking of what will happen if there is a massive fiscal consolidation in the US, which would in turn create the prospect of a further recession in the world’s largest economy – the US takes about 75% of Canada’s exports, which in relative terms offers a picture of much greater export vulnerability than is the case for Australia.
While there will be ongoing debate as to the volatility in China’s economic performance (and indeed for the Asian region as a whole this could also be the case), it is difficult to look past the prospect that ongoing Chinese economic growth will continue to contribute to the general robustness of the Australian economy. Together with the other fundamentals favourable to Australia, many offshore investors see this as a strong positive for us, reinforcing their view of Australia’s ability to adequately manage its finances and the other factors that contribute to its triple-A credit status.
China’s demand as a consumer of raw materials particularly Australia’s is well known. However its position as a global investor is less well known (but is becoming more apparent). As is the case for many emerging economies, Chinese Foreign Reserves have also had a swift uplift. In 2005 China’s reserves were around $500 billion. They are now well in excess of $3 trillion. This makes China the largest Reserve Manager in the world with around $2 trillion more than the reserves of Japan, the second largest reserve holder. Together China and Japan are very large holders of foreign debt, a situation that is not likely to change in the near future.
While there are many things to learn from the GFC a few of note are as follows.
First, the Icelandic banking collapse was a sobering illustration of debt leveraging gone mad, combined with the exposure it had to foreign exchange risk.
Second, the way forward for many European countries will be extremely difficult – they have very limited policy measures within reach. Furthermore there seems little possibility for an easing in the competitive pressures they face, this manifested in depressed labour markets and higher unemployment being because of the lack of an exchange rate adjustment mechanism. In the absence of economic growth prospects this presents a very challenging task to manage. Whether this leads to a partial or complete breakdown of the EU remains an unanswered question, but much of the effort to date looks more to have bought time rather than directly solved problems. In the event of sovereign exits from the EU, without doubt this will create another round of global financial volatility. Whether this would be short-lived or prolonged would depend on factors too numerous and complex to raise here today.
Third, the stock market crash of 1929 led to the US introducing laws to separate the highly speculative activity of investment banking from more run-of-the-mill retail banking.Â Moves are afoot once again in the US to tighten controls and take back a lot of the light handed flexibility its financial sector has managed to win over the past few decades. A debate along similar lines is also underway in Europe. Whether this will adequately address core concerns regarding the spread of unmanaged risk, or create new complexities that add costs and stifle productive innovation is a question that also remains wide open. Unfortunately, the best regulatory intentions are often only properly understood with the benefit of hindsight.
The Sovereign debt crisis has probably been the single and largest, external ongoing event that has affected how Australia’s sovereign debt market is viewed. Concerns first began to arise around sovereigns when pressure was placed on them via their respective financial sectors. Aside from the sub-prime crisis that emerged in the US, the issue first gathered global prominence when the Irish government was required to bailout major Irish investment banks in early 2009, although Dubai’s issues around its property market also triggered alarm amongst investors.
However things began to change more dramatically when Greece announced in late 2009, that its budget deficit was going to be 12.7 % of GDP – almost double the market expectation – and in an extremely short period of time. This was different from the Irish situation as Greece did not have a banking sector problem per se at the time, rather it had accumulated through the banks a substantial public debt level (around 130-140% of GDP). This resulted in immediate pressure on Greek bond spreads over German bunds and most other European bond markets, including other triple-A rated sovereigns.
The financial sector and public debt issues that were eating away at Ireland and Greece began to cause concerns for other countries with similar problems. Focus quickly turned to Portugal and Spain but even supposedly stronger Eurozone countries began to feel the heat. So-called contagion risk became an issue of increasing concerns as the rating agencies started downgrading the poorer sovereign credits but also began to focus on the credit status and outlook of the stronger ones.
If we look at the fundamentals of how these countries can best be expected to deal with their circumstances, many have high debt and because they appear as a credit risk their costs of borrowing is unsustainably high (putting pressure on and creating short-term concern about their ability to refinance). Add to this the fact that their banks are being assessed as under-capitalised and in many cases they are exposed to the default of write down on the debt they hold from their sovereign neighbours. Business and consumer confidence is extremely low and therefore investment for growth is lacking; with very high unemployment rates domestic household demand has been pushed extremely low in some countries. If they have been relatively high spending, governments may find the possibility of reducing this to create some relief on onerous fiscal positions, but this will likely come at the risk of exacerbating depressed economic circumstances. And while labour market and welfare support reforms may be highly desirable (and in some case critical), reducing these is going to prove increasingly difficult to achieve politically. At the same time demographic changes will only work to reinforce growing pension liabilities, and limit opportunities to expand tax revenues. These are extremely challenging circumstances to manage.
Add to this that over time a number of countries have had their sovereign ratings fall into Junk Bond territory, while a number of triple-A countries were also downgraded or placed on negative outlook. The most notable of these of course was the US – a scenario that five or more years ago would probably have been laughed at. Negative ratings activity in turn created a sharp rise in the sovereign bond yields of many countries and thus their financing costs – with an increased widening in yield spreads over more stable sovereigns a further “beware” signal to investors. Unfortunately these negatives have self-reinforcing effects.
These impacts were largely brought on in the first instance by hot money exiting particular sovereign markets with declining credit status, often taking bets on the way out that amplified the sell-off. However the downgrades and falling prices reduced the group of potential buyers available to step back in, with investors in many cases obliged by law or by their mandates to hold only high quality levels of credit.
Throughout 2010 and 2011, the European Union, the ECB, individual Central Banks and supranational agencies have undertaken a number of actions to attempt to arrest a deteriorating situation. This has included setting up new institutions like the Economic Financial Stability Facility, quantitative easing in the form of buying or offering to buy European sovereign bonds, and conducting Long Term Refinancing Operations, which have now occurred on two occasions.
I have traversed quite about of ground, but barely scratched the surface of the many issues about which we should be thinking. Fortuitously, the take-out for Australia from much of what has happened over the last four or more years has been positive. While we can look to the specifics of our domestic circumstances to get a better understanding of the things that matter to us on a daily basis, I have tended to spend most of my time looking at Australia’s circumstances from a relative perspective at the international level. The absolute perspective from a national standpoint raises a range of different issues, a lot of which can be traced back to the volatility and uncertainty in international markets, but there are also many that don’t necessarily have a close direct link.
Before I finish I will bring you back to some AOFM perspectives by way of a broad summary.
It was during the period of the Sovereign debt crisis, of late 2009 through to present, that Australia’s sovereign bond market position came heavily in to focus for the rest of the world. With the deterioration of sovereign credit quality around the world but particularly within Europe, Australia’s relative position was a stand-out. Since then the poor underlying fundamentals for many countries (most of them close to or within the broader Eurozone) have continued to percolate, creating more rather than less pressure on already vulnerable finances and economic performance. To give some light to this, around two years ago there were 19 triple-A stable nations (rated by all 3 major global agencies). The number has now shrunk to just seven of which Australia remains one of these. Of the seven, Australia has the highest yielding and second largest bond market. And as I mentioned earlier, at the same time the $AUD has been growing in liquidity and acceptance, now very actively traded with appears gradually less volatility (something to which commodity currencies remain vulnerable). This is in a global investment world where return and liquidity (provided by larger bond markets) have become increasingly important, if not in some cases, essential.
The events and developments during and following the initial impact of the GFC and the Sovereign Debt Crisis have certainly had a major effect on the demand for Commonwealth bonds, and the yields that we pay are now at or around historic lows. This in itself has triggered a debate not unlike the debate that occurred in the US about whether we should be seizing the opportunity to borrow long in order to fund significant infrastructure.
Most sovereign yields have fallen during the period but Australia’s have fallen further. In the last two years our short bond yields (the AU/US 2 year spread) have narrowed against US Treasury yields by close to 200 bps, while our long 10yr spread has narrowed by 100 bps. This reflects an impressive relative performance against the rest of the world on the art of Australia.
With the fall in yields on Commonwealth bonds, this in turn has reduced the funding costs of most other Australian borrowers including the states and the banks (although the funding costs of the domestic banks is a topic I will stay clear of – but there are some good RBA papers on its website in recent times covering this). Again it could be argued that credit spreads have generally widened against the sovereign in this period. However there is no doubting that when all Australian credit is priced off the Commonwealth bond curve, their outright levels of funding have been dragged down overtime with our yields.
The GFC and Sovereign debt crisis have had a seismic impact on the global economy. Australia has been fortunate enough to have avoided or to have been only marginally impacted by many of the worst developments. However within the area of government funding costs, and the ability to smoothly and readily issue government securities into global markets, Australia has also clearly benefitted. The international investment community looks at us with envy and we should not disregard the fact that while we live day-to-day in domestic circumstances, we have in many respects been shielded from what could arguably have been far worse impacts. We need only look to Europe to see that hardship is set to be the ‘norm’ for quite some time to come.
In this context at least Australia looks a great place to be.
Last updated: 6 November 2013