Plans by Howard and co to scrap government bonds have been rethought. Susan Campbell looks at the implications of their debt-free dream and the benefits provided by the current market.
Bitter debate on the appropriate level of government debt has raged for years.
Is it really too high? Do governments need to carry it round their necks like a millstone? Generally, the anti-debt factions have appeared to have the upper hand for a while now. But in an interesting turn of events some financial market experts are now saying that public sector debt is too small and that our elected representatives must take an active role to keep the government bonds market alive.
Last year prime minister John Howard and his fellow parliamentarians seriously considered winding down the government debt market. Treasurer Peter Costello had indicated he was inclined to allow the market to continue to contract by using assets sales to repay debt. With that backdrop, in late October 2002, treasury's debt management review team released Review of the Commonwealth Government Securities Market, a 160-page paper. The market responded with 40 written submissions and 120 consultative meetings with most interested parties arguing that eliminating government bonds would impede efficient risk management measures for fund managers and traders.
The bond market was genuinely concerned that its market was being threatened by Costello's ambition to be the world's first treasurer overseeing a debt-free government. These fears were allayed, however, when he committed to retaining the Commonwealth government bond market.
In May 2003, the then head of the debt review team, Blair Comley, in a presentation to the finance and treasury association's Adding Value to Government Financing conference, indicated that the commonwealth had accepted the view that the CGS market assists efficient interest rate risk management, and that diversity within the financial system helped reduce vulnerability to shocks. Comley, now acting head of the Australian office of financial management, added: 'That the decision is not specifically targeted at meeting investor demand for risk-free financial assets.'
The government has now accepted the argument that the market should be kept alive and indicated it would structure issuance of bonds to underpin liquidity for the key three-year and 10-year bond futures contracts used by many financial market players to manage risk exposures. The government will aim to have about $5 billion in stock for each of the eight or so maturity lines of debt needed for effective liquidity which means just over $40B of outstanding debt.
Paul Bide, head of debt markets division, Macquarie Bank considers that last year's review was a useful exercise. 'The proposition that financial markets, the banking system and proper risk management and identification were inextricably linked was allowed to be tested by the process treasury undertook and the government bond market is better off for that having taken place as its role is better understood by a broader group of people.'
To put this in to perspective it is worth considering the total size of the Australian bond market currently. According to ANZ Investment Bank head of credit research, Kate Birchall, there was a total pool of $154B of bonds on issue as at May this year. The largest sector is actually the semi-government bond market at 35 per cent, followed by the Commonwealth government bond market at 31 per cent. The corporate bond market, which has seen rapid growth in the 1990s, comes in at 27 per cent.
Birchall does not believe that the changes indicated in the 2003-2004 budget will have any material impact on the financial markets and ANZ believe that the CGB market will retain its traditional role of proving a risk-free alternative for investors.
Estimates suggest that CGS outstandings will increase marginally from $60.4B to $63.4B.
Macquarie Bank's Bide sees the treasurer's statement in the recent budget (Budget Paper No. 7) as endorsing the CGS market as having a central, unique and important role to play as facilitating risk management in the economy.
He says: 'That bodes well for the future of the market.
'The right size of the market is a hard issue to be explicit about. Where this issue has rested is that the government has committed to maintain the CGS market to the point where the Sydney futures exchange can offer and administer its two bond futures contracts.
'It is generally understood that to run these two contracts, the CGS market needs to be at least large enough to have $15B of stock in at least three lines for each contract plus $15B of stock in lines 'outside' the stock that would be included in each contract.'
Toby Johnston, investment strategist, Alliance Capital Management Australia Ltd says that the projected Budget surpluses are actually quite small due to tax cuts, extra spending on defence and the delayed sale of the remainder of Telstra. 'These surpluses are highly dependent on the government's economic growth forecasts,' he points out. 'If growth is weaker than forecast, the surpluses will be smaller and in fact the Budget may go into deficit. This uncertainty underscores the importance of maintaining a viable bond market.'
In addition, some aspects of government spending benefit both the current and future generations. An example is increased defence spending. Why should today's taxpayers share the whole burden of paying for a service that is critical to the security of current and future generations? In other words, issuing long-dated debt to pay for projects that benefit future generations is an equitable and efficient way to fund such projects. 'Maintaining an active and viable bond market makes both economic and social sense,' adds Johnston.
James Wright, head of fixed interest at ING Investment Management believes that the volume of government debt on issue has huge implications for Australian fixed interest investors. 'Over the past few years,' he says, 'the fall in government bonds on issue has been offset by the increase in corporate borrowers raising funds in the public capital markets [shifting from traditional bank funding].
'However, the growing demands from Australian superannuation funds for investment grade fixed interest assets is overwhelming the potential supply.'
A shortage of conventional fixed income assets will force Australians to invest in foreign bonds and by doing so they will have to take on foreign currency, sovereign and credit risks.
With the equity market continuing to look risky, bonds are becoming increasingly popular for superannuation and other fund managers.
Under most circumstances envisaged, and despite the government's commitment to maintain the current level of liquid benchmark bonds (around $45B), it is likely that there will be greater flows offshore to international sovereign and credit portfolios. 'Domestic credit markets will continue to be well supported, although they are likely to fall in percentage terms as the international component of fixed interest assets held by superannuation funds increases,' adds Wright.
And what about the semi-government debt securities? Though this is still an active market it is unlikely we are going to see any state government increase the size of its debt in the near term. This restriction on supply will ensure that yields remain low for investors. Super funds and private investors have been pushing up the demand for secure good credit investments such as Commonwealth and semi-government bonds which will keep the price continually bid.
But another big question arises now that the government is committed to keeping the bond market alive, what will it do with the proceeds? This is also a question that should concern all taxpayers in Australia. What will the government do with the surplus? Any government must be accountable for the surplus funds. The most talked about usage of a surplus is to apply the cash balances as a sinking fund to the unfunded superannuation liabilities. The unfunded superannuation liability is already beginning to bite at state and local government levels. Some local councils already have to put up rates to meet the shortfall in their funding.
Overall, Bide from Macquarie Bank feels that the final impact on the financial markets of the governments decision is very positive. 'It allows those who are currently managing financial risks in the CGS framework to feel comfortable that key infrastructure will remain. Systemic stability is not threatened and the ability to raise debt capital and ability to identify and trade financial risks is assured, or is at least as good as we can do as a financial market.'
