Australian Government Securities: Issuance and Market – CEO presentation at the Australian Government Fixed Income Forum, Tokyo
4 June 2015
The first part of this presentation this afternoon will cover the macro-economic outlook for Australia. I will pause at the end of this part of the segment to allow for any questions, before moving on to a description of the Australian Government Securities market, together with an outlook for our issuance programs. There will be a separate opportunity at the end of that segment for questions on these issues.
The macro-economic outlook can only be high-level as each of the issues I will raise could easily generate a separate presentation. The aim today is to give you a broad picture rather than a detailed analysis. Also, what I cover will be done by way of observations from a national perspective. The different states, and indeed different regions within the states, are all subject to varying degrees of economic opportunity and challenges but it is not my intention to focus on any particular state or region.
There are [five] key observations that I would like to leave you with:
- A decade of rising commodity prices contributed substantially to national income growth, resulting in a follow-up period of very high levels of business investment in the mining sector. This has left Australia heading into 25 consecutive years of real GDP growth, even if the near-term outlook is somewhat subdued.
- Investment in the mining sector peaked two years ago and there is not a strong list of new projects ready to replace projects currently coming to completion. This is largely because of the sharp fall in commodity prices, including oil, and slowing demand for iron ore out of China.
- A relatively strong currency from late 2010 through late 2012, together with a decline in household spending has impacted the trade exposed non-mining sectors of the economy. The present challenge is for the focus of economy growth to move away from what has been a heavy reliance of business investment in the mining sector. But the prospect for increased services remains buoyant. These factors are important in explaining why you hear Australia referred to as an economy in transition.
- Conditions are right for a pick-up in the non-mining economy, but this is happening slowly. However, we already see noticeable improvements in construction (particularly housing), mining output (in volume terms), and household spending. That the Australian economy is diversified will facilitate a return to trend growth.
- Inflation is under control, rising job creation has had a positive effect on the unemployment rate and this together with the re-emergence of wages growth will help to mitigate the downside risk of a sharp correction in property prices.
This chart shows historical annual real GDP growth outcomes with the light bars on the RHS indicting the latest Government forecasts as recently released in the Budget. The dashed line shows trend growth for the period.
We see from this that the Australian economy is entering its 25th consecutive year of growth and is forecast to strengthen further over the next few years. The performance of the Australian economy since 2008-09 has been well below trend but the two decades prior to that show that real GDP growth was consistently above the long-term trend.
Even in the face of the adjustment underway as a peak in mining sector investment continues to unwind, real GDP growth is forecast to increase from 2½ per cent this year to 2¾ per cent next year, before increasing further to 3¼ per cent in 2016-17. This forecast is based on an outlook for non-mining business investment and household consumption to pick up from its current low growth level to something substantially more robust over the coming years.
The peak in mining sector investment is evident from the year in which real GDP growth was last above trend. The fact that it has come off sharply and yet growth overall remains above 2 per cent suggests that other parts of the economy have been contributing to growth, but just not as much as was the case before the global financial crisis. Like most countries, it has taken Australia a long time to recover from this external shock.
This chart shows the terms of trade and the trade weighted index over a period of 40 years. It is clear from the chart that the terms of trade are already weakening appreciably from the recent peak in commodity prices. The peak in prices was largely driven by bulk commodity prices – in particular iron ore and coal. The chart also shows how the Australian dollar gained relative strength over Australia’s trade related currencies.
You can see from the chart that it is only in the last two years that the terms of trade have begun to decline – and with that there has been a depreciation of the Australian dollar on a trade weighted basis. One reason why the currency was thought to have remained relatively strong even after commodity prices began to decline was due to the substantial capital imports supporting the expansion in mining output – this was largely in the iron ore and LNG sectors.
There is little doubt, however, that the strong currency impacted Australia’s export sector and its domestic import competing businesses. This was a period during which nominal GDP growth was very low because it was difficult for business to pass on the effects of rising costs through prices increases. This had a flow-on impact to Government Budget revenue (something I will return to towards the end of this segment of the presentation).
With the terms of trade having now been in retreat for almost two years, this has contributed to a depreciation of the Australian dollar, amongst a number of other factors. A lower Australian dollar has provided relief for the trade exposed sector and we are beginning to see a pick-up in exports consistent with this change.
Therefore the transition to broader growth in the Australian economy is already underway. Exports are expanding as resource investment projects reach completion and the lower exchange rate is supporting a pick-up in the export of services.
Housing construction is responding positively to lower interest rates, but there are signs that this is now being driven appreciably more by investor demand than owner/occupier demand. This presents some concern for policy makers, particularly if the supply of new properties continues to lag demand and there is continuing upward pressure on prices of the existing housing stock – something we currently observe in the Melbourne and Sydney markets.
The upper left chart shows the main contributors to real GDP growth in the decade prior to the peak in mining sector investment. We can see from this that household consumption has been consistently prominent but began to decline immediately after the onset of the global financial crisis. The slowdown in dwelling investment during this period is also evident from the chart. The role of public spending throughout the period is also apparent although we have recently entered into a phase of fiscal consolidation by the Australian and state governments. In this regard Governments face the challenge of balancing the aim of consolidating their fiscal positions from an extended period of deficits, with the prospect of prolonging a return to stronger economic growth through reducing public expenditure.
The lower right hand chart shows the forecast contributors to GDP growth. Household consumption is expected to regain momentum (and we already see signs of this), as will dwellings investment and net exports.
The pick-up in net exports will largely be the result of increased output in iron ore that has been made possible by the large capacity expansion that has been underway for several years. Australia is a relatively low cost producer of iron ore and this is one reason we see rising output even in the face of declining prices.
LNG exports will also begin to come ‘on-line’ from this year as a number of new large processing facilities are completed. However, the income effect from this uplift in exports will be lesser than previously thought because of the declines in commodity prices over the last 6-8 months in particular.
The trade and investment generated through Australia’s recently completed free trade agreements with China, Japan and Korea will also help to boost net exports. These countries represent Australia’s three largest export markets – accounting for 55 per cent of total goods and services exports. To build on this momentum, the Government is also working to conclude other key trade negotiations, such as the Trans-Pacific Partnership and a Comprehensive Economic Cooperation Agreement with India.
An element of exports easily overlooked in relation to Australia is the services sector. Australia has developed very strong export capability around a number of services – in particular tourism, education and business services. Following depreciation of the currency over the last 12-18 months, together with continued household growth and a steady expansion of the number of middle-high income households in our main trading partners, the prospect for increasing service exports is not only potential but already being realised.
Taking tourism for example, tourists from China accounted for over one quarter of the growth in travel services spending in 2013-14. There were over 760,000 Chinese visitor arrivals in that year alone spending around $6.5 billion or $8,600 per visitor, providing support for businesses in sectors such as retail and accommodation and food services.
Furthermore, education exports will be boosted by changes to student visa policy arrangements. The Government is forecasting net international student migration to increase from 88,200 in 2014 to 139,300 in 2017-18, following the introduction of new visa streamlining measures and post-study work arrangements.
This slide highlights the extent to which business investment in the mining sector will have dominated GDP outcomes over the past 6-8 years. What the left-hand chart doesn’t show is the extent to which a decline in mining sector investment will act as a drag on GDP growth. It is possible that it could (at least in the near to middle-term) return to pre-2006 levels. This will shift a lot of emphasis and focus onto business investment in other parts of the economy. However, as we can see from the right-hand side of the chart, the levels of business investment in non-mining sectors is already at a reasonable level – but it will need to increase appreciably to offset the fall expected from the mining sector.
I won’t spend much time on this chart because it covers comments I have already made – but it does make clear from where the pick-up in commodity export volumes will derive.
The top two panels refer to coking and thermal coal exports and both show the forecast for a steady increase in output.
The lower right-hand panel is for iron ore and it shows the forecast for a continuation of rising export volumes. Whether or not the fall in iron ore prices will reduce the growth in tonnage of output growth as some of the higher-cost producers defer output or even pull-back production, is yet to be determined.
The lower left panel is the one that shows the greatest impact and that will come from commissioning a number of very large LNG facilities – beginning this year through to 2017. When in full production these facilities will have the capacity to export substantial volumes of gas – with the prospect of large untapped reserves to be developed into the future as the outlook for demand and energy prices once again create suitable conditions suitable for further investment in this sector.
So, in summary, mining exports will assist growth and our more traditional bulk commodity sectors of the mining industry will continue to play an important role, but from here on it will be through increased output (which is a capital rather than labour intensive part of the process).
The important thing to note from this next chart is that it is easy to think about Australia as an economy largely based on mining – in fact it is not.
The economy is actually quite diversified, and mining contributes less than 10 per cent directly to economic output. In reality the Australian economy is heavily based on services with the combined services sector comprising around 45 per cent in terms of value-added. Sustained activity in these sectors, with many looking to the prospect for appreciable growth, will be an important underpinning of business activity during the transition period.
The key point is that the transition is occurring, but just at a slower pace than had originally been forecast. That the pace of change has been slower than expected is most likely due to the fact that what is occurring in Australia is a combination of structural and cyclical adjustments. That is to say, Australia’s below trend growth is not just related to changes in the business cycle, but as a result of it having to respond to external changes that are impacting its trade flows and opportunities.
The strong currency impact; falling commodity prices from a combination of slowing global demand and increased supply from other country producers; the need for an internal reallocation of labour away from industry sectors either stagnant or in decline; and the emergence of new opportunities that will require a different type of investment and skills, together present a combined challenge for business and policy makers. Australia does not lack the capacity to invest, nor the labour market capability to respond to new opportunities. However, the adjustments required to face into the changing circumstances will take some time implement.
One thing that continues to differentiate Australia from other advanced countries is steady population growth. This chart shows that the current rate of growth is about 1.6 per cent – comprising around 60 per cent net migration.
There are several reasons why this will play an important role over the forecast period. One is because it will continue to support spending growth from the household sector. The second reason is that immigration continues to be an important policy mechanism to assist with building the labour market; particularly where there are specific skills shortages and these can be targeted through Government initiated programs. Further to the use of targeted skill immigration programs the Government remains aware of the need for creating labour market arrangements that provide for sensible flexibility and do not inhibit business investment, while at the same time facilitating re-training and promoting the benefits of broad workforce planning. However, these are policy aspirations that will take some time to implement and the time required to achieve such changes will also contribute to a more prolonged transition period for the economy.
This chart shows year-on-year changes to household consumption and wages growth. It is important to bear in mind that these measures are really only broad indicators, as household spending patterns can and do vary markedly across regions, and wage outcomes are not the same across all industry sectors. That said, they do give a good feel for present circumstances and the near-term outlook.
The impact of the global financial crisis is obvious from this chart and we can say with confidence that both household consumption and wages growth are yet to return to pre-2008 levels.
You can also note from this chart the impact of the strong commodity price growth during the 7-8 years prior to 2008. This was a period during which strong wages growth centred on the mining sector, in turn generating the flow-on effects of high consumer confidence, high levels of household consumption and high wages growth in other parts of the economy – particularly for industry sectors that were either directly or indirectly servicing the mining sector.
Lower commodity prices are now flowing through to lower income growth throughout the economy, including wages. However, lower wage growth is allowing firms to retain staff at a time when profit growth is modest.
Buoyant conditions in the housing market are also supporting household consumption, increasing both household wealth and spending on household related goods and services. Lower oil prices have also improved household spending capacity, with recent retail fuel prices down by over 14 per cent since last year. These factors, along with rising equity prices and limited increases in electricity prices, have helped household consumption to grow at its fastest rate in nearly three years – this being in the most recent December quarter outcome.
It is possible that conditions could improve even more rapidly than expected if household spending begins to pick up at a greater rate, with businesses responding by increasing planned levels of investment, or bringing existing investment plans forward. With interest rates at historic low levels and rising capacity utilisation, there is upside to the forecasts, particularly in 2016-17 if stronger spending conditions were to prevail. However, if demand and confidence fail to lift, there is a risk that the recovery in non-mining business investment could be further delayed.
Household consumption has also been supported by a modest fall in the household saving ratio. This chart compares historical household savings rates for Australia, Japan, the US and the UK. Australia and Japan had by far the lowest savings rates going into the financial crisis, but in the years immediately following the crisis Australia had a very sharp increase to be the highest rate.
However, there are now signs that households are smoothing consumption as the terms of trade decline. The household saving ratio is forecast to continue to fall but only by a modest amount, and is expected to remain well above pre-crisis lows.
Household consumption is forecast to rise by 3 per cent in 2015-16 and 3¼ per cent in 2016-17. The extent to which the household saving ratio will fall to support consumption growth is a key risk surrounding this outlook.
This chart shows both the unemployment rate and the participation rate. There was a marked change in each during 2008 that has set a recent trend yet to be reversed. As I said earlier, a combination of factors following the global financial crisis led to an extended period of low nominal GDP growth, especially since outside the mining sector manufacturing and services in particular were under significant pressure. This was also a period during which expectations of rising unemployment were elevated, household consumption was low, the savings rate was high and business investment has been low to steady – but definitely not growing appreciably.
Over the last few years the unemployment rate has been gradually rising because the number of new jobs being created each month has not been sufficient to offset job losses throughout the economy (and more recently particularly in the mining construction sector). This is the case even though the size of the labour force has been in decline due to a falling participation rate. Part of the reason the participation rate has been in decline is because the number of underemployed has also been increasing –this acts as a disincentive for those sitting just outside the margin of the active labour force to actively seek work.
However, low wages growth, spare capacity in the labour market and the scope for increased business investment together provide the prospect for a declining unemployment rate over the forecast period out to 2018-19.
The unemployment rate is still expected to peak at 6½ per cent in 2016 (that is next year) with lower forecast wage growth moderating the impact of lower forecast real GDP growth.
The near-term outlook for inflation is somewhat benign. This is because of the present low wages growth; the fact that there is appreciable spare capacity across many industry sectors (including the labour market), regulated and unregulated price increases for the non-traded sector continue to be modest, and overall the level of household demand while rising remains somewhat subdued when compared with past experience.
The potential for upward pressure on inflation will most likely derive from any retracing of oil prices to recent highs (to the extent this is likely in the current circumstances) further depreciation of the Australian dollar, the mergence of strong upward pressure on house prices more broadly than the Sydney and Melbourne property markets and an accelerated pick-up in household consumption.
The Reserve Bank of Australia has set a target range for inflation if 2-3 per cent on average and has been very active in its monetary policy role in the past when it comes to managing this. There is no reason to believe that it will not respond to sharp inflationary pressure if it believes future levels are drifting appreciably beyond its target range.
This chart shows the Australian Government fiscal performance back to 1980, together with current forecasts and projections for the next decade.
There are several things worthy of note.
- 1st– Australia has been through several periods of fiscal deficit, with each of the last two periods followed by relatively short and effective fiscal consolidation. The difference between those and the present circumstances was the reliance on reasonably strong revenue growth, together with expenditure policies, to return the Budget to surplus. In the current circumstances nominal GDP growth remains very low by historical standards, which in turn is impacting revenue growth.
- 2nd – Australia was running strong Budget surpluses prior to the global financial crisis, but as we know this was in no small part supported by commodity price growth.
- 3rd – The Government is currently faced with the challenge of managing the impacts of a cyclical downturn with the realisation that there are emerging structural Budget issues to address. These structural issues derive largely from the following trends – an ageing population demographic that will negatively impact the revenue raising dependency ratio, and overtime increase pressure on health and pension support expenditures; and a tax system that is heavily reliant on income tax.
At this stage Australia is forecasting an underlying cash deficit of about 2 per cent of GDP for this year. This compares to a deficit of closer to 3 per cent of GDP last year. On present estimates, the budget is projected to return to surplus in four years from now.
Recent deteriorations in the fiscal position are largely due to weaker than expected tax receipts – a result of slower than expected economic growth and lower nominal GDP outcomes than previously forecast.
The outlook is for further consolidation that will be based on a combination of revenue growth and expenditure policy – some of which is aimed at near-term Budget support, while other expenditure measures will not have any planned appreciable effect for a year or two and then grow in importance overtime. It is the medium to long-term planning that the ratings agencies are focused on in terms of how Australia’s fiscal position relates to its triple-A stable outlook sovereign rating.
What this means for the outlook of supply for Australian bonds is that we can expect current elevated levels of supply to continue for the next few years at least – but I will cover our issuance programs in the next part of the presentation.
In the meantime let me summarise by making the following comments:
- The transition to broader-based growth is underway, but the pace and timing of the pick-up in economic growth is subject to some uncertainty. A lower exchange rate, historically low interest rates and lower oil prices should stimulate faster growth. However, the short-term impacts from the sharp reduction in mining investment are significant and a pick-up in non-mining investment may not be as strong as anticipated. There is also a risk that momentum in consumer spending could slow again.
- Low interest rates are supporting the Australian economy’s transition to broader-based growth at a time when household demand is strengthening. The construction of new dwellings has contributed strongly to recent growth, but there are concerns about the potential for inflated asset prices in certain parts of the property market. In short, the housing sector has responded quickly to accommodative monetary policy, strong growth in house prices and continued population growth. Risk in the market is more focused on the ability for new supply to meet demand.
- The outlook for improved unemployment outcomes and the prospect of moderate wages growth in a diversified economy will help to soften any near-term price adjustment in the property market. In addition, this is an issue that has the full attention of policy makers and regulatory authorities. Inflation looks to be contained and so the RBA is to able to maintain a low cash date for now to support the transition, although of course it remains aware that the low cost of capital can over-stimulate the property market while seeking to encourage business investment.
I am going to cover four aspects of the Australian market in this part of the session;
- an overview of the key fiscal ties between the Commonwealth and the States – this will give some context for the last panel session today;
- an outlook for the Australian Government’s issuance programs;
- an overview of the key features of the Australian Government Securities market; and
- a few high-level reasons as to why we think the Australian market is attractive to offshore investors in particular.
Australia has 6 States and two Territories. The bulk of the population and around 85 per cent of GDP centre on the four largest States – New South Wales, Queensland, Victoria and Western Australia.
This chart shows the proportion of total public sector revenue raised by the Commonwealth and the States. Overtime the role of the Commonwealth has grown substantially in terms of raising tax revenue – this being in large part a result of successive legal interpretations about the Constitutional powers of the Commonwealth over the States in its ability to exercise tax powers. It is also in large part a residual impact of the States handing their income tax power to the Commonwealth during the Second World War – something the Commonwealth has not relinquished.
The Commonwealth currently raises about three quarters of total public sector revenues, the greatest proportion of this being through personal and corporate income taxes.
Because the States raise only 25 per cent of total public sector revenue, but have responsibility for around 40 per cent of expenditure – a system of fiscal transfers is required between the Commonwealth and the States to rebalance this situation. This is the result of a long standing policy choice by the Commonwealth.
The chart shows that on average the states therefore rely on the Commonwealth for about 45 per cent of their budget revenues.
This chart shows the relative importance of their own tax bases for each of the States, and in turn their reliance on the fiscal transfer system. The two top-shaded areas of each bar show this.
The most significant of the fiscal transfers involves a formal fiscal agreement between the Commonwealth and the States to transfer in full the collection of a national Goods and Services Tax (GST). This way of redressing the fiscal imbalance between the Commonwealth and the States is referred to in Australia as Vertical Fiscal Equalisation. This is a very longstanding policy and goes to the heart of the fiscal relations between the two levels of government. The Agreement that underpins these arrangements provides for the states to use these monies for any purpose. The importance of these arrangements as a source of budget revenue varies for each State. This is the middle grey part of each bar.
Total GST revenue is distributed between the states on an adjusted per capita basis that aims to take account of the inherent revenue raising and expenditure challenges of each relative to their combined average experience. Therefore, those States with relatively stronger economic performances and lower costs of providing services receive a lower per capita adjusted share of the GST fiscal transfer than other jurisdictions.
Also by way of Intergovernmental Agreement the Commonwealth makes a number of specific purpose fiscal transfers to the States (the light blue sections at the top of each bar). While fairly broad in nature most of the total amount goes to supporting the States in key service delivery areas such as health and education. As can be seen from the chart, these tied payments can provide up to about 25 per cent of a State’s revenue base, but on average it is closer to 20 per cent.
A third source of Commonwealth direct fiscal support comes in the form of assistance in managing the impacts of a large natural disaster. This covers amongst other things fires, floods and cyclones. The National Disaster Relief & Recovery Arrangements allows for direct financial support of up to 75 per cent of the cost for re-provisioning essential services and infrastructure. These arrangements are only triggered in the event of circumstances on a scale that is beyond the reasonable capacity of a state to manage in the short-to-medium term.
This chart shows the composition of total Commonwealth tax revenue over the last decade. One thing to note from the chart is that the GST collections, which are transferred in full to the States, represent about one-seventh of total Commonwealth tax revenue.
Also of note is that personal income and corporation’s tax provide up to two thirds of the total tax collected by the Commonwealth, with transaction taxes in the form of excises and levies playing a very small part in the Commonwealth taxing effort.
This diagram highlights that the States are the main providers of a number of key and important areas of expenditure through the direct provision of a range of public services. While the Commonwealth is primarily responsible for matters such as income redistribution, welfare support, defence, security and immigration, the states carry most responsibility for expenditure on infrastructure, and the core services of health, law enforcement and education.
I will now turn to the second broad issue I want to cover and that is the outlook for our issuance programs and some specifics of the sovereign bond market. Details about each of the state (or semi-government) markets and programs will be brought up in the panel session, as will something of how the domestic banks issuance intentions are planned.
We (the AOFM) issue three forms of government securities. These are: Treasury Bonds (our nominal bonds); Treasury Indexed Bonds (which are just under 10 per cent of our total outstandings); and Treasury Notes.
Treasury Bonds and Treasury Indexed Bonds are used to meet the Government’s Budget financing task and because of this our term issuance programs have an annual focus. Treasury Notes have maturities of up to one year (but are typically 3-6 months) and as a cash instrument we use these to help us manage the Commonwealth’s cash portfolio throughout the year.
We do not announce a Treasury Notes issuance program for the year because it is difficult for us to determine what amount of short-term funding will be needed throughout the year. At present there are $7 billion of Treasury Notes outstanding.
For the coming fiscal year (which commences on 1 July) our total Treasury Bond issuance is planned to be $74 billion – of that just under half will be used to fund maturities and the remaining $38 billion will represent net new issuance to finance the Budget deficit.
Our Treasury Indexed Bond program is planned to be $4 billion, with about one-quarter of that to fund a maturity and the remaining $2.8 billion is net new issuance, which will also contribute to financing the Budget deficit.
Most of our issuance is conducted through weekly auctions – the price makers in our market are registered to bid for stock at these auctions. There are two auctions for Treasury Bonds (currently around $700 million per auction) and one for Treasury Notes (usually $0.5-1.0 billion). Treasury Indexed Bond auctions are held twice per month (usually at around $200 million per auction).
Sometimes new maturities are established using the syndication method – these are typically long dated yield curve extensions. We have used the syndication method regularly in the last 4 or 5 years. The aim is to place as much stock in the hands of end investors as possible while balancing considerations such as an appropriate price at which to issue and leaving some stock with the intermediaries for post transaction trading.
This chart shows three things – (1) the size of the market and how it is projected to grow; (2) gross sovereign debt as a proportion of GDP (the yellow line read off the RHS); and (3) the proportion of Australian sovereign bonds held by offshore investors (the dark bars). Due to forecast budget deficits over the next few years, the volume of annual issuance will remain relatively high and accordingly the size of the Australia Government bond market will continue to grow. Under current expectations, Australian Government Bonds as a per cent of GDP is expected to peak in January 2018 and then decline thereafter – although in outright terms the overall size of the market will continue to grow over the forecast period as shown. This brings me to the third broad issue I wish to cover – some key features of the Australian Government Securities market.
Since 2008 the market has grown six times larger and is projected to almost double in size again by June 2019. At this point it will reflect about 27 per cent of GDP. What this means for investors is that the Australian Government bond market will remain a medium sized market in global terms and there will be an availability of issuance supply over the period. In comparison with other sovereign bond markets – at 27 per cent this will still see Australia with a relatively low exposure to sovereign debt (something that underpins its triple-A stable credit rating).
Although offshore ownership has been as high as 80 per cent in recent years, it is currently just under 70 per cent. Much of the net new issuance over the past 4-5 years has been absorbed by central banks and sovereign wealth funds that have been looking to diversify investment into new currencies. As an advanced economy currency building in liquidity, the Australian dollar has been of growing international interest.
Many of you would be aware that for an advanced country sovereign bond market the Australian market stands out for its high level of ownership relative to other markets. We as the issuer do not take a view as to whether the level of offshore participation in our market is too high or too low. This is simply the result of market outcomes because there are no regulations or requirements of the Australian Government that either favour or disfavour foreign ownership. In fact we believe that the risks and benefits are balanced.
I would also make the following points:
1st – The peak of offshore holdings at around 80 per cent in the March quarter of 2012 started to decline as the rate of new foreign entrants, particularly the offshore public sector slowed. The fall was exacerbated further by active Japanese selling through late 2012 and 2013. In the last 18 months we have seen increasing interest from a wider group of offshore investors, which has tended to support the level of foreign ownership around its current level, with the benefit of further broadening the investor base;
2nd – When the rate of buying in face value terms by offshore investors slows relative to the amount of bonds the AOFM issues, there will tend to be a pick-up in domestic buying – particularly as yield adjustments serve to ‘clear’ the market; and
3rd – There is often a focus on the potential for offshore ownership to decline in the face of a weakening Australian dollar. But the picture is not usually as straightforward as that because for those investors who hold our paper without currency hedging in place, a depreciating Australian dollar can be a signal for them to top-up their portfolio.
Prior to 2008 (the yellow bars) the Government was running fiscal Budget surpluses and the debt management task for the AOFM was to maintain a minimum level of stock on issue and small annual issuance programs were used to support the three and 10-year futures contracts. During this period there were 10 Treasury Bond lines (with an average size of $5 billion) and the longest maturity was around 12 years – there was no Treasury Indexed Bond or Treasury Notes issuance.
Today (the blue bars) there are 21 Treasury Bond lines with an average size of $16 billion, with the longest maturity being 2037 (or around 22 years). We have made clear that it is our intention to consolidate a benchmark at around 20 years and we have three maturities in that region together comprising over $21 billion in outstanding bonds. As we look ahead we see that the opportunity could also exist to extend the yield curve further – possibly to 30 years. We will do this if we think there is sufficient demand and stable market conditions to support this.
This chart shows the amounts outstanding for each of our 21 Treasury Bond lines. The light shaded areas show where we have directed our issuance so far this fiscal year. While we have concentrated a lot of issuance effort into 10-year maturities and longer, we have also issued right across the curve. To date we have established four new maturities – two shorter stocks around the 5-year mark and two very long stocks to help consolidate the 20 year part of the curve.
Our issuance decisions are based on a number of considerations: (1) is our strategy to increase the average term to maturity of the total stock of outstanding debt; (2) another is to support the three and 10 year futures contracts (and from the chart you can see the issuance that has been directed to the Oct 18, Oct 19 and Nov 20 lines, together with the issuance directed into the Apr 24, 25 & 26 lines); and (3) is to meet demand each week –we are able to do this by consulting the intermediaries on a weekly basis to determine what maturities are most in demand.
Another consideration is to ensure that we build new lines to a level at which they begin to generate liquidity – and the dashed orange line on the chart shows our expectation of the point at which our Treasury Bond lines begin to experience good liquidity (ie around $12 billion).
We have recently announced to the market that for the year commencing 1 July we will be establishing three new maturities – a 2021 maturity to provide issuance support for the 3-years futures contract; a 2028 maturity to provide issuance support for the 10-year futures contact; and a 2039 to further consolidate the 20-year benchmark and to offer issuance support for what will be a third futures contract available in the Australian market – a 20 year futures contract is expected to launch shortly.
The liquidity of Australian Treasury Bonds continues to increase, and in terms of outright bond trading volume, the annual market turnover is now multiples of the outright size of the Treasury bond market. The increase in liquidity will in part be due to the increasing size of our issuance programs, but it is also reflective of the growing number of investors and participants in our market and the very competitive pricing that often occurs out of Sydney and London.
Although our inflation indexed bonds comprise a relatively small part of our overall market, this is a segment that we have devoted a lot of development attention towards over the past 4-5 years. In 2009 we had about $6 billion outstanding across three lines. We now have 7 Treasury Indexed Bond lines (although one is about to mature). Since re-commencing the issuance of inflation linked bonds we have established new long-end maturities that have helped with yield curve extensions of the Treasury Bond market. The successive launch of the 2030 and 2035 lines have been used to achieve this. We have recently announced to the market that we will establish another new long-end maturity for the coming year – this will be either a 2040 or 2045 maturity.
This is a market that has a strong following by our domestic investor base, but there has been growing offshore interest.
This chart shows our reliance on short-term funding over the last few years. As I said earlier, we issue Treasury Notes to assist us with managing the Government’s cash portfolio. Because estimates of revenue inflows and the timing and exact size of outlays throughout the year can and do change frequently, we are unable to identify a firm Treasury Note issuance program one year ahead. You can also see that our reliance at any point in time can vary quite markedly depending on other factors – such as the asset balance of the portfolio as it varies throughout the year.
We took a decision in 2013 to reduce our reliance on the Treasury Notes market in order to reduce our exposure to re-financing risk, but we did not in practice think this was an appreciable risk.
However, as our issuance of Treasury Notes began to decline it had the unanticipated effect of depriving some investors in our market of an instrument useful for them in managing their Treasury Bond portfolios. In response to the feedback we received from a number of investors we began to re-issue Treasury Notes again last year – and our issuance for the year ahead will look similar to what we are currently issuing – that is around $1 billion per week with around $7-10 billion outstanding on average across the year.
This market attracts a specific type of investor and is dominated by buy-and-hold strategies, in turn impacting liquidity.
Moving on to the last of the four broad issues I wanted to cover – this is some of the reasons why we think the Australian Government Securities market is attractive, particularly to offshore investors.
Our market has experienced a period during which we have seen a large number of reserve managers enter it. This has happened during a time where there have been periods of significant volatility in global financial markets. Volatility, or the potential for it, has derived from uncertainty in global economic and fiscal performance. Reserve managers (and here I am referring to central banks and sovereign wealth funds), being quite conservative in regards to their asset management tasks, have tended to look for foreign currency diversification opportunities that fit together with high sovereign credit quality and liquid markets.
With a triple-A stable rating from the world’s largest three rating agencies the Australian sovereign bond market easily meets that criterion. Add to that regularity of issuance supply and transparency and predictability of the issuer and this creates an attractive option for reserve managers. Liquidity in individual bonds lines due to their relatively large size (i.e. compared to the overall size of our market), and competitive price making that allows for active trading opportunities for most time zones around the world (with trading mostly out of Sydney and London) are also important factors. On top of that there is liquidity in the currency and a yield pick up over other advanced country sovereign markets – an issue I will touch on further in a moment.
Of the 50 largest reserve managers in the world almost two-thirds are now investors in our market. Whereas prior to 2009 the central bank participants were largely tactical investors, they have now all made strategic portfolio allocations into the Australian market. Of the 30 largest ¾ are participants in the market.
In addition, we have a strong domestic investor base that includes some very large fund managers and the domestic bank treasuries. Our offshore investor base comprises substantial real money representation including pension and insurance funds. The geographic diversity of the investor base is very broad and covers all of Europe, North and South America, right throughout the Asian region, Japan of course of which Tokyo is by far our largest single concentration of investors, and the Middle East.
Despite Australia’s AAA (stable) rating, strong net debt position, steady economic growth, and stabilising fiscal position, Australian Treasury Bonds still provide an attractive return when compared to yields on other advanced economy securities. Our short-end yields provide a substantial pick up over the short-end yields of other curves, while the Australian-US 10 year spread this year has traded between 35 and 100 basis points, but in recent times has been trading around the 70 basis point mark.
Interestingly the Australian-Japanese 10-year spread has been tightening steadily for almost 2 years. Currently it is around 250 bps, compared to nearly 400bps at its widest back in 2013. You can get a greater pickup into the long end of Australian curve from JGBs than you do in the short end. In comparing Australia to most other advanced economies yield curves, such as the US, the greater pick up is in the short end.
Australian Government bond yields still stand out strikingly against all other Triple-A economies, and against almost all other advanced economies (New Zealand being the exception) even in some cases against the fast growing emerging economies.
Finally I would like to mention the growing liquidity of the Australian dollar. Although not in the same category as one of the big four reserves currencies like the YEN, the US dollar, the Pound Sterling, or the Euro, when compared to comparable currencies like the Canadian dollar and Swiss Franc its liquidity is growing at least as fast as turnover is concerned – something that is evident from this chart. This growing liquidity (which continues to build) will only continue to benefit offshore investors by reducing transactional costs through narrower spreads, attracting a greater number participants including market makers and allowing a greater number of issuers and products to be originated in our currency.
Last updated: 11 June 2015