Bond traders take on Costello

Australia heads to zero public debt
Philip Baker

The federal government's promise to pay off all government debt - using the proceeds of the sale of Telstra - is creating alarm in the heart of Australia's financial markets.

The Sydney Futures Exchange - which has up to 60 per cent of its business at risk if the $50 billion Commonwealth bond market is shut down - and big bond market operators are lobbying Treasurer Peter Costello to keep the market alive. Bond market heavyweights Macquarie Bank, Salomon Smith Barney, ABN Amro, AMP, Merrill Lynch and UBS Warburg, the Australian Financial Markets Association and International Banks and Securities Association claim that Australia's ability to withstand the next global economic crisis could be jeopardised if the bond market shrinks into insignificance.

Commonwealth bonds, which the government issues when it borrows money, are the safest of all securities. For many individuals who are labouring to pay off credit cards and mortgages, zero government debt may sound like a good thing. But it could also create a dilemma for big and small investors because it would result in a real shortage of risk-free, safe-haven assets for superannuation savings. The remaining government bonds on issue would be scarcer and more expensive for investors. Fund managers would be forced to invest in riskier corporate bonds or send the money offshore - at the very time the government has increased to 9 per cent the amount of an individual's salary that must be invested in superannuation.

At the end of one of the worst years for global stockmarkets, this isn't a scenario that most investors will want to hear. "It's crunch time," says Stephen Halmarick, director of economic research at Salomon Smith Barney. "If the amount of bonds on issue falls much further, global fund managers will stop investing in Australia and local fund managers will be forced to increase the amount of money they send offshore each year simply because there are no assets domestically to buy. "This has negative implications for the Australian dollar, but it could also force fund managers to purchase lower rated and riskier corporate bonds. Superannuation funds will be denied a risk-free investment."

It could also be another step towards Australia becoming a branch-office economy, one of Costello's big fears. Says Ken Farrow, chief executive of AFMA: "We run the risk of not being the financial headquarters for the region if we don't have a bond market. There will be further centralisation of financial services, and Australia should be in the thick of it."

One concern is that the Treasurer will dismiss the bond market's case as special-interest pleadings from desk jockeys on big salaries driving flash cars. But the bond market "support group" says much more is at stake than the jobs of bond traders. Farrow says the implications are enormous. He says that if the bond market no longer existed the job security of 3,000 AFMA-licensed dealers and the 5,000 operations people who support them could be in jeopardy. "On top of that the investment industry employs in excess of 10,000 and that doesn't include the service providers, lawyers, accountants and IT people. Hypothetically they all could be at risk, and do we really want that?"

The federal government has not yet decided whether to let the bond market wither as it repays its debt. A Treasury paper, to be released soon, will canvass the options available to the Treasurer. One idea would be to issue more bonds and use the proceeds to fund a $50 billion asset portfolio, or the government could decide to use the bonds to fund its $84 billion superannuation liability for Commonwealth employees. The paper will discuss the risks and outcomes of not having a bond market. The Australian Office of Financial Management, set up in 1999 to manage the Commonwealth's debt portfolio, will also enter discussions.

The bond market has been shrinking because of the run of budget surpluses since the Howard government came into office in 1996. The volume of tradeable bonds on issue has halved from $114 billion in 1997 to $50 billion as government debt has been repaid. A further $12 billion is held in portfolios and not actively traded.

The lobby group argues that risk-free bonds are the lynchpin of the domestic financial markets. According to Halmarick, the recent volatility in financial markets highlights the importance of having a sound financial system. "A major financial centre needs a government bond market, and the growth of the corporate bond market will rely on having a solid benchmark to price other deals," he says.

Others say government bonds play an even broader role. "Government bonds gives you a risk-free asset to determine value in all other assets," says Kevin Talbot, head of fixed income and currency at AMP Henderson Global Investors. "The whole asset allocation is very difficult without it. Without government bonds it makes it very difficult to price other assets, not just corporate bonds but property and infrastructure assets - the whole lot. The market will lose its transparency and it will be more expensive for companies to borrow in Australia, so they will head offshore for funding."

But the Reserve Bank is not convinced that such alarm is warranted. The RBA acknowledges a fall in turnover of bonds, but cites the sharp rise in activity in swaps and forward-rate agreements as reasons why the debt market is in good shape. Turnover in Australian debt markets averaged more than $90 billion a day in 2000-01 compared with $65 billion in 1997-98. It said this was due to an increase in the turnover of futures contracts, repurchase agreements and the AOFM's liquidity management.

According to the RBA, the number of active market makers in government bonds has dropped to 15 in 2001 from 20 in 1996, although market sources suggest 75 per cent of turnover is transacted by only four or five players. Reserve Bank assistant governor Ric Battellino laid it on the line for the bond market when he highlighted the lack of issuance by both state and federal governments. "The extent you want to promote a bond market in Australia, it is going to have to come from ... corporate bonds," he said.

RBA statistics released in June seem to be at odds with market participants' assessments of the shrinking Commonwealth government bond market. In 1992-93, the government conducted 20 bond tenders and issued bonds worth $18.4 billion. In sharp contrast, in the last fiscal year there were four tenders totalling $2 billion and in the next fiscal year between $2 billion and $3 billion are expected to be issued.

Australia has enjoyed liquid markets in debt and derivative products for many years and international evidence suggests a liquid government benchmark in bonds is needed for healthy capital markets. No other country has abandoned its government bond market.

If the bond market withered away to nothing, what would it cost taxpayers to bring it back to life when capital did need to be raised? ABN Amro's chief economist, Kieron Davies, says: "That's difficult to answer because what you save now on interest payments can be chewed up by start-up costs and markets reward regular borrowers with cheaper funding, but Canada, Ireland, Norway and Singapore all have the same problem as Australia and they are still raising debt and investing the money."

Economic commentators argue that the zero-debt pledge is nothing but a political mantra and there is no economic benefit to having no debt. According to Rick Shepherd, director of public finance at Standard & Poor's, Commonwealth debt under a Labor government peaked at 19.10 per cent of gross domestic product in 1995-96, from 4.2 per cent of GDP in 1989-90, because of government borrowing during the recession of the early 1990s. "This was considered high by historical standards in Australia but still extremely low when compared to countries in the OECD," says Shepherd. "The level of debt is now so low that from an economic angle there is not a great deal to be gained by pushing it lower. It's just a political argument now."

For example, to become a member of the European Monetary Union a country only has to bring its public debt below 60 per cent of GDP.

But the zero-debt line is misleading at best. The federal government will still have enormous debts on its balance sheet. There is still an outstanding liability of $84 billion in unfunded Commonwealth employees' superannuation. Added to that is the cost of the old-age pension and health-care costs which are expected to balloon.

The shift of assets from the public to the private sector has occurred at the same time as a sharp rise in personal debt and foreign debt levels, reflecting that companies are already heading offshore for funding. Since 1996 foreign debt has soared from $194 billion to $329.80 billion and, says Shepherd, this is one reason why Australia's commonwealth foreign currency rating has not been upgraded from its current AA+ level.

Investors are already channelling money into offshore securities. Rainmaker, a financial services information company, claims the flow of Australian funds siphoned off into international bonds has surged to $32 billion, from $9 billion in 1997. According to Rainmaker's head of research, Alex Dunnin, that number will hit $60 billion in another five years.

The trend is already being fuelled by asset consultants, who recommend clients have exposure to foreign corporate and government bonds to achieve greater diversity and higher returns. "Mercer have had clients with offshore fixed-income assets for quite some time," says Mercer Investment Consulting's head of fixed income, Simon Romijn. "In the past four years, however, we have actively recommended that a substantial portion of fixed-interest assets be switched offshore."

Philip Baker writes for the Australian Financial Review, where this article first appeared on 13 August 2002. Republished with kind permission.

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Suggested citation
Baker, Philip, 'Bond traders take on Costello', Evatt Journal, Vol. 2, No. 7, November 2002.<>