Introduction
The Government's fiscal strategy is to maintain budget balance, on average, over the course of the economic cycle. The Government will not consider options that build budget deficits to maintain the Commonwealth Government Securities (CGS) market. (See Box 7.)
Some commentators suggest that the CGS market already is at, or below, the minimum level necessary to perform its key roles. If the market is close to its minimum viable level, the Government would need to increase issuance to maintain market viability. Under the Government's fiscal strategy, this would require the Government to accumulate substantial financial assets.
- For example, in four years time the market would need to be around $12 billion
larger than its current level of around $50 billion, assuming a required growth
rate of 6 per cent per year. The current budget estimates indicate
cumulative underlying cash surplus over the next four years. So, maintaining
the market may require the accumulation of $20 billion to $30 billion
of financial assets over the next four years.
The Government presently holds financial assets in the form of term deposits with the Reserve Bank of Australia (RBA) as part of its cash management operations. This facility helps in managing within-year funding requirements. (See Chapter 2.) Funds on deposit vary over time, depending on differences in the timing of tax revenues and expenditures.
The RBA currently invests funds deposited by the Commonwealth in a portfolio of very low-risk debt assets. These assets are held mainly in the form of domestic and foreign government debt securities. While this facility is appropriate for short-term cash management, it is not considered appropriate to require the RBA to perform the role of funds manager on behalf of the Government for a large and ongoing portfolio of financial assets.
The paper considers three specific options: winding down the CGS market; consolidating Commonwealth and State government debt markets; and maintaining the CGS market and funding the Commonwealth's unfunded superannuation liabilities.
The principal measures of the Commonwealth budget balance position are the underlying cash balance and the fiscal balance. The underlying cash balance is derived from the cash flow statement, while the fiscal balance is derived from the operating statement.
Both measures are calculated as the residual of Commonwealth general government revenues over expenditures. Revenues include income received from all sources including taxation and other fees and charges. Broadly, expenditures include funds expended on current items (such as employee expenses and rent) and non-financial assets (such as the construction of roads, buildings and bridges).
Discussion of these options is based on current budgetary reporting arrangements. However, because the options envisage new arrangements, the Government may need to consider classification issues (and their budget consequences) in greater detail before implementing them.
Option 1: Wind down the Commonwealth Government Securities market
Description
The Government could withdraw from the CGS market. It could do this either by repurchasing all outstanding CGS as headline cash surpluses are realised or by allowing all outstanding debt to mature.
Risk and return issues
Since the Government would be eliminating all outstanding debt over time, this position would effectively eliminate all risks currently associated with the debt portfolio.
Even after repaying all debt, the Government, from time to time, may need to re-enter financial markets due to individual budget surpluses or deficits. This raises the issue of managing the assets acquired during surplus periods and needing to borrow during deficit periods.
This leads to the question of the Government's desired net debt position (positive, negative or zero) over the cycle. The fiscal strategy does not provide definitive guidance on this issue, but implies net debt would oscillate around a fixed nominal level. Budget fluctuations around this level will result in relatively low debt or asset positions, depending on the individual deficit or surplus. If the Government decided to maintain a level of assets on call to ensure deficits never require debt finance, then it would need to consider the assets' nature and governance.
If the Government needed to access significant borrowings at some future time due to an unforseen event, such as a natural disaster, its capacity to access funding is important. This type of risk is known as funding risk.
If the Government needed significant funding, it is reasonable to assume that investors (either domestic or international) would be willing to provide funds. Key investor groups such as superannuation funds and insurers have an ongoing demand for low credit risk investments. Furthermore, passive investors who hold government securities as a proportion of all securities on issue provide a ready group of investors.
Development of market infrastructure would influence the cost of these funds. Market infrastructure is currently highly efficient with sophisticated risk management instruments available. If the Government withdrew from the market and this infrastructure deteriorated, the cost of future borrowings could be higher than if the Government remained in the market.
Market infrastructure is unlikely to deteriorate significantly in the absence of outstanding CGS. Infrastructure would remain and evolve to reflect the prominence of other borrowers, such as States, Territories and corporates. For example, risk management instruments may evolve to reflect increasing debt issuance by corporates. The Government would be able to use this infrastructure to facilitate future borrowings.
The Government's position in the market also influences the level of funding risk. The Government currently has a significant position in the market, with CGS accounting for around one-third of outstanding fixed coupon securities. Several unique characteristics of CGS add to this position including:
- investors will pay a premium for sovereign issued debt above non-sovereign
issued debt with the same high credit rating; - CGS is highly liquid with a broad range of maturities;
- current risk management instruments are directly linked to CGS (for example,
Treasury bond futures); and - CGS is included in global bond indices.
The combination of these factors is demonstrated by the Government's ability to borrow long-term debt around 30 basis points lower than similar rated domestic borrowers. If the Government withdrew from the market and subsequently re-entered, this funding advantage may be weaker.
Any increase in the cost of funding is likely to reflect loss of liquidity in the Government debt market. The Government is unlikely to have to bear significant credit risk premiums as it would re-enter the market with zero outstanding debt. The cost of borrowing may rise by the full 30 basis points. The additional cost of each basis point higher is around $0.1 million per year for every billion dollars of debt. If the Commonwealth borrowed $10 billion (around 1.5 per cent of GDP), the additional cost would be $30 million per year.
This potential increase in the cost of borrowing needs to be balanced against the alternative - the cost (or potential cost) of maintaining the market in the absence of a funding requirement. Potential costs may include adverse returns from asset positions.
Economic impact
The following section outlines the direct impact of reducing the supply of CGS on related financial markets and the broader macroeconomy. It assumes that winding down the CGS market does not create systemic effects such as Australian businesses facing a higher cost of capital due to a reduced capacity to manage interest rate risk. (See Chapter 3 for these potential effects.)
The relationship between the price of CGS and the quantity of CGS investors will want to hold is likely to be inverse. As the price rises, investors will want less CGS as they seek other alternative investments. If the price falls, investors will want to hold more CGS.
The Government's fiscal strategy has provided the resources to repurchase outstanding CGS. Reduced CGS on issue is likely to increase the price of the remaining CGS outstanding. This is associated with a fall in interest rates on CGS. Investors who value CGS very highly are prepared to accept a lower return to hold the now more scarce CGS.
A very diverse range of other financial assets exists in the economy. The market considers many other financial assets substitutes for CGS. When the price of CGS increases, investors will look to buy other assets. This will increase the price of other assets and reduce their interest rates. The net effect of reducing CGS outstanding is to lower interest rates on both the remaining CGS and other assets. The magnitude of the changes in prices and interest rates will depend on a range of factors. (See Appendix 3.)
The direct market effects are likely to lead to a decrease in average interest rates. This has broader macroeconomic implications. The reduction in average interest rates may increase consumption and capital investment, increasing overall domestic output immediately and also increasing future productive capacity.
Lower Australian interest rates are likely to cause some investors to rebalance their portfolios in favour of relatively higher yielding foreign investments. This may lead to a depreciation of the Australian dollar. This depreciation would increase the competitiveness of Australia's exports, improving the balance of trade and current account.
The increase in domestic output resulting from higher investment and net exports and depreciation of the exchange rate may generate some pressure for increased prices in the economy generally. These price pressures are likely to be modest if the economy is operating below full capacity. However, if the economy is operating at full capacity, then price rises initially may result in little change in overall economic output. Economic output is likely to rise in subsequent periods, as higher investment boosts productive capacity.
The role of global bond indices complicates this analysis. Some investors follow a global bond index in maintaining their portfolio of investments. Sovereign global bond indices generally weight sovereign bonds by the amount on issue.
The presence of global bond index investors may complicate the dynamics of adjustment following a reduction in the CGS market. We assume that as the amount of CGS on issue falls, the price will rise. However, once CGS outstanding falls to a point that would remove the CGS market from global bond indices, there may be a large downward step in the amount of CGS sought by investors due to the withdrawal of global bond index investors. Consequently, there may be a step down in the price of CGS, which could cause interest rates to rise. Further reducing the amount of CGS on issue then would cause the price to rise again, eventually rising above the level applying before the global bond index investors withdrew.
Given the size of Australia's financial markets, any changes in broader interest rates associated with changes in the supply of CGS are likely to be small. Consequently, the broader macroeconomic impacts are likely to be extremely modest. Given other changes in economic activity occurring at any time, the impact of changes in the CGS market would not necessarily be discernible.
Governance issues
The Government would maintain existing governance arrangements surrounding the Commonwealth's debt portfolio while debt was outstanding.
Budget impacts
The budgetary impact of winding down the CGS market would depend on the Government's approach to withdrawing from the market.
If the Government repurchased all outstanding CGS as budget proceeds become available, this would generate repurchase premiums. A repurchase premium is calculated as the difference between the value of the CGS instrument on the Government's balance sheet and the price at which the CGS is repurchased. These repurchase premiums have two components.
First, repurchasing outstanding debt ahead of maturity may bid up the price of that debt. Second, much of the outstanding CGS was issued at higher interest rates (and therefore lower bond prices) than currently prevail, so repurchasing before maturity would result in substantial repurchase premiums.
Repurchase premiums will reduce the underlying cash balance in the year the debt is cancelled or matures.
Allowing outstanding CGS to mature will mean that the Commonwealth continues to pay interest on the debt. However, given projected budget surpluses and asset sales proceeds, the Government would build up financial assets over the period. It is reasonable to expect the return on these assets would approximately offset the additional interest cost from paying coupons until the bonds mature, leaving the underlying cash balance broadly unchanged.
Transition issues
The Government could choose to withdraw from the market in line with budget surpluses and asset sales proceeds. However, this would result in the Government bearing repurchase premiums.
This approach also may unsettle financial markets. Other chapters discuss the need for private sector financial instruments to develop and fill some roles played by CGS. Repurchasing all outstanding CGS over the next few years would put additional pressure on the private sector to quickly develop new instruments.
An alternative to a quick withdrawal from the market would be to allow all outstanding CGS to mature. Allowing the current outstanding CGS to mature would mean that the Commonwealth maintained the Treasury bond portfolio until at least 2015. This approach would ensure that the Government does not pay repurchase premiums on CGS.
This approach also would provide more time for financial markets to adjust to the withdrawal of CGS from the market, although they would need to adjust well before the maturity of the longest dated bonds.
Key questions
The Government would appreciate views from stakeholders on:
- potential implications of winding down the CGS market;
- the likely impact on the cost of capital;
- the most appropriate approach and timeframe to implement a decision to
wind down the market, if this decision is made; and - the likely re-entry costs (in the form of additional borrowing costs) if
the Commonwealth withdraws from the market.
Option 2: Consolidate Commonwealth and State government debt markets
Description
Australian governments could consolidate Commonwealth, State and Territory debt issuance into one issuance programme. It could achieve this in one of two ways. First, the Commonwealth could issue CGS and use the proceeds to buy existing State and Territory government debt. This would increase significantly the size of the CGS market, but eliminate the semi-government debt market. Second, State and Territory governments could cease issuing debt in their own right, and the Commonwealth could issue CGS to meet State and Territory government funding needs. This also would eliminate the semi-government market, but over a longer period.
The Commonwealth, States and Territories considered and rejected this option in August 2001. (See Appendix 5.)
Risk and return issues
Consolidation may reduce public sector borrowing costs by up to $150 million per year if States' and Territories' borrowing costs fall to the Commonwealth's level. However, savings of this magnitude could take 10 to 15 years to be realised fully as debt matures and is refinanced.
The magnitude of savings resulting from consolidation depends on factors including continuation of the current spread between yields on Commonwealth and State and Territory debt, maintenance of current general government debt levels and no change in the Commonwealth's cost of funds. This final point is crucial if consolidation is pursued. Arrangements would need to maintain financial markets' confidence in the integrity of all governments' financial management, as a small increase in the Commonwealth's cost of funds would significantly reduce the savings.
Spreads are likely to reduce, so the cost to the Commonwealth is likely to increase, while the cost to the States and Territories is likely to decrease. However, the Commonwealth could require the States and Territories to pay the Commonwealth an additional amount to reflect the cost imposed on it.
Savings also may accrue from relative improvements in the efficiency of the Australian government securities market but these are very difficult to estimate. These could arise through more competitive tendering on debt issuance.
Economic impact
The option is based on CGS trading at lower interest rates than semi-government debt. This may be due to the CGS market's relatively higher liquidity, or a perceived difference in credit risk between the Commonwealth and State and Territory governments. However, absorbing the semi-government market into the CGS market would change the interest rates in the two markets. Reduced supply (or outright repurchase by the Commonwealth) of semi-government bonds is likely to drive up their price, reducing their interest rates. At the same time, the supply of CGS will increase, pushing down CGS prices and increasing CGS interest rates. Consequently, average interest rates in the economy are not likely to change significantly with this option.
The principal role this option may benefit is interest rate risk management. As the size of the CGS market would increase, current interest rate risk management activities based on the CGS market would continue.
The option will not increase the size of government debt markets, and therefore will not enhance the market's role as a safe haven during episodes of financial instability, or increase long-term investment vehicles.
If the fiscal discipline of all Australian governments continues as it has in recent years, this option would only provide a temporary solution to the future of the CGS market. Continuing budget surpluses at all levels of government eventually would diminish this combined market, so the option may assist the transition to a smaller market, but may not be a long-term solution.
Any economic impacts are likely to be modest and occur over considerable time.
Governance issues
The key problem with this consolidation is significantly reduced transparency and incentives for jurisdictions to maintain sound and sustainable financial positions. This reflects the removal of the direct link between a jurisdiction's financial position and the financial market's determination of its cost of funds. This is a key strength of current arrangements and has contributed to most jurisdictions' improved fiscal performance over the last several years. While the governments could introduce a number of mechanisms to reduce fiscal lassitude, they are not likely to be as effective as the current arrangements. Moreover, such arrangements may reduce the States' fiscal autonomy.
Mechanisms providing some incentives for fiscal discipline include:
- retaining separate credit ratings for all jurisdictions and using these
ratings to determine borrowing costs. This would involve the Commonwealth
levying States and Territories additional charges based on their credit ratings,
with credit rating agencies providing ratings as if the States and Territories
were accessing the capital market directly. - limiting the amount that a jurisdiction could borrow through the consolidated
entity; and - putting in place secured creditor arrangements in the event of default.
However, the governments would need to overcome significant design issues to implement these arrangements. The effectiveness of these mechanisms would be less certain than current arrangements and they would be complex to administer.
Budget impacts
Budget presentation and accounting issues would arise if consolidating debt issuance involved restructuring existing debt the Commonwealth and the States and Territories have issued. For example, options to repurchase existing debt would trigger revaluation of that debt on the relevant government's balance sheet. Where jurisdictions currently recognise debt at book value, this could generate significant accounting losses by way of premiums and increases in the value of debt liabilities, for debt issued at past high interest rates. Portfolio management responses could avoid recognising any revaluation, but this approach would carry considerable transaction and management costs.
A restructure could cause a balance sheet adjustment affecting net worth.5 Revaluations do not affect the operating statement, so the measures of operating balance, net lending and cash balance would be unaffected.
Transition issues
Any move to a consolidated market for debt issuance would involve transitional issues. Two options to manage the existing stock of Commonwealth and State and Territory debt would be to:
- leave the existing debt in place and gradually refinance maturities over
time with CGS; and - undertake an open market repurchase of the existing debt, financed by the
issuance of CGS.
The first option would take considerable time to achieve the full benefits (and savings) of a consolidated debt market. The second option has various uncertainties, including the possible success of any repurchase programme and determination of the parameters of such an exercise.
Key questions
The Government would appreciate views from stakeholders on:
- whether there is merit in reconsidering the idea of consolidating Commonwealth,
State and Territory government debt into one market; and - whether this option would assist with the transition to reducing the supply
of Government debt.
Option 3: Maintain the Commonwealth Government Securities market and fund the Commonwealth's unfunded superannuation liabilities
Description
The Government could issue CGS to maintain the market and apply the proceeds to funding the Commonwealth's unfunded superannuation liability. This could be achieved either by creating an asset fund hypothecated against the Commonwealth's superannuation liability, or by directly transferring CGS issuance proceeds into a superannuation fund. (See Box 8 for a discussion of State government experience with funding unfunded superannuation liabilities.)
The principal difference between the hypothecated asset fund and the superannuation fund is the governance arrangements. However, there also may be different risk and return implications and economic impacts if the asset fund adopts a different investment strategy to the superannuation fund (possibly due to different mandates). The budget treatment of the two approaches also may differ if the superannuation fund were considered to be outside the general government sector.
Most State and Territory governments have implemented policies of funding part or all of their superannuation liabilities. The combined liability of State and Territory governments is currently around $80 billion, $40 billion of which is unfunded. While each jurisdiction has established its own timeframe for funding these liabilities, most States will have fully funded their superannuation liabilities by 2035.
Most States have decided to fund their superannuation liabilities by allocating an asset portfolio to a superannuation fund. Western Australia, for example, has established an external superannuation fund to which assets are allocated. The fund lies outside the public sector, as the assets of the fund are not controlled by, or available for, the benefit of the State.
In contrast, the Queensland Government holds a diversified asset portfolio dedicated to meeting superannuation liabilities rather than establishing a specific superannuation fund. The New South Wales Government also recently adopted this approach.
The Queensland Government is the only jurisdiction to fully fund its employee entitlements. The Government has accumulated a large pool of assets, which are sufficient to meet assessed superannuation liabilities. The provisions in the Charter of Social and Fiscal Responsibility require that the State's financial assets cover all accruing and expected future liabilities of the general government sector. Financial assets are managed by the Queensland Investment Corporation which is a wholly-owned statutory authority of the Queensland Government. As the financial assets are held on the general government balance sheet, the budget operating result can be affected significantly by the volatility of returns generated on investment earnings.
The New South Wales Government has allocated financial assets to a superannuation fund to meet its superannuation liabilities. It has also recently announced the establishment of a new non-superannuation investment fund - the General Government Liability Management Fund. No contributions have yet been made to this Fund. It will hold financial assets against the State's superannuation liability. When the superannuation liability is fully funded (expected to be around 2030), the legislation establishing the Fund provides that the Government can use excess funds, but only to reduce debt. The Fund is established under legislation as a general government, non-budget dependent, entity. The operational management of the Fund is expected to be outsourced.
Risk and return issues
Hypothecated asset fund
If the Government were to create a hypothecated asset fund against its superannuation liabilities, it would have to consider an investment strategy. Investment activity involves a trade off between risk and return. Investments that have a higher risk generally have a higher return. The relationship between risk and return has implications for government investment. CGS are the lowest risk financial assets available in the domestic market. As the lowest risk financial asset available, Government bonds also have the lowest expected returns to investors.
The risk-return relationship implies that the Government could borrow at low cost through the CGS market and, on average, expect to obtain a higher return on investment in any other class of Australian dollar denominated financial asset. The exact returns depend on the financial asset classes in which the Government invests. These could range from high-risk assets, such as equities, through to low-risk assets, such as State government bonds. Adopting a high-risk strategy may lead to above average long-term returns, but returns could be lower for significant periods and negative returns could also occur.
The level of returns exceeding the interest cost of CGS would closely relate to the additional risk and any additional operational costs.
Two broad classes of financial assets may be relevant to the Government's investment strategy: debt and equity securities.
Debt securities
Three broad categories of debt securities are Commonwealth, semi-government (State and Territory) and private sector (corporate bonds). The Commonwealth and State bonds are the lowest risk class; corporate bonds are the highest risk. Corporate bond issuers have a range of credit ratings.
Risks associated with a debt portfolio are not limited to credit risk. This is the risk that the bond issuer will alter the term of payments to the detriment of the bond holder. Other risks include interest rate risk and re-investment risk. (See Appendix 2.)
The type of returns (interest payments or capital gain) will depend on the types of securities in the portfolio. This would affect budget reporting.
Equity securities
Equity differs from debt since it involves actual ownership, not simply the loan of capital. Investors share in the profits of companies in which they own equity.
Equities tend to carry higher risk than debt securities for two main reasons.
- First, equity holders have the lowest priority if a company liquidates,
as they only have a residual claim on the company's assets after creditors
claims have been met. When a company is insolvent when liquidated, equity
holders receive nothing. - Second, coupon payments on debt instruments are non-discretionary and specified
in advance. In contrast, dividends are paid at the directors' discretion.
The level of dividends depends primarily on the company's profitability.
Equity returns are as dividends (a flow) and capital gains (stock accumulation).
Investment options
Three broad considerations would frame the Government's approach to investment.
First, the Government has a low tolerance for risk. This will limit government investment to low-risk assets. In addition, to reduce non-systemic risks associated with individual stocks, it would need to diversify investments to limit exposure to any individual issuer.
Second, to limit the Government's impact on the prices of particular markets or assets in which it invests, its holdings of particular assets may need to be limited to not unduly distort prices.
Third, the Government needs to consider any public policy considerations associated with having substantial ownership or influence over private or public sector entities. Public policy considerations can arise due to potential conflicts of interest associated with the Government's role as policy maker, regulator and owner.
This may apply to both equity and debt. Equity involves direct ownership of an entity. A controlling (or even significant) interest in any individual stock may not be appropriate for public policy reasons. Debt does not involve direct ownership. However, if the Government holds a significant proportion of an individual entity's debt, then the entity may perceive that acting against the wishes of the Government may lead to capital withdrawal.
All these factors point to the Government limiting holdings of individual securities. The exact limitation cannot be determined precisely but it is likely that a lower limit would be appropriate for equity than debt. Chart 23 indicates the current size of the segments of the Australian debt and equity markets in which the Government could consider investing. Adopting limits for the Government's potential level of investment will have significant implications (Box 9), even if the limits are arbitrary.
[caption id="attachment_40159" align="aligncenter" width="492"]
Chart 23: Australian financial asset market size (June 2002)[/caption]
Note: Investment grade bonds refer to debt securities with a credit rating
of BBB or higher.
Source: Salomon Smith Barney, 2002; and Bloomberg, 2002.
For indicative purposes, this box uses a 5 per cent limit for equities. The Corporations Act 2001 deems 5 per cent to be a significant interest (requiring disclosure) and at 20 per cent, effective control can occur (requiring a takeover announcement).
For indicative purposes, the box uses a 15 per cent limit for debt.
The Government could invest in only State government bonds and AAA-rated corporate bonds. Restricting investment to 15 per cent of each issue would allow around $10 billion of investment (Chart 24).
The Government could invest in all investment grade debt securities.6 Restricting investment to 15 per cent of each issue would allow around $15 billion of investment.
The Government could invest in all investment grade debt securities and ASX 300 equities. A combination of 5 per cent of the ASX 300 and 15 per cent of investment grade debt securities would allow around $45 billion of investment.
[caption id="attachment_40160" align="aligncenter" width="463"]
Chart 24: Size of Government investment possible with investment limits[/caption]
Source: Salomon Smith Barney, 2002; and Bloomberg, 2002.
The analysis in Box 9 indicates that, with limits for policy reasons, the Government could not currently invest more than around $45 billion in the domestic market. If this was insufficient to accommodate the Government's investment needs, then it would need to invest offshore. These limits may be too high, as they would require the Government to hold equity in every ASX300 company. However, the possible size of domestic investment will change over time as Australian financial markets grow.
International investment carries additional risks to those incurred through domestic investment. Two additional risks relate to international investment: country risk and exchange rate risk. (See Appendix 2.)
In investing in international assets, the Government also must take into account any tax implications. The Australian Government may be subject to foreign taxation, depending on the overseas jurisdictions of its investment. This could reduce the returns on foreign investment. In particular, interest and dividends received from international investments may be subject to withholding taxes overseas jurisdictions levy, with no deduction for the cost of the Government debt used to fund the investment. However, a tax treaty between Australia and a relevant country, or as a consequence of the doctrine of sovereign immunity, may reduce or eliminate withholding taxes.
In all cases, the exact details and level of taxation would depend on the relevant overseas jurisdictions and other factors.
Superannuation fund
A superannuation fund would usually take an investment strategy that delivered returns closely matching its payment profile. In practice, most superannuation funds achieve this by investing in a diversified portfolio of financial assets. The average superannuation fund portfolio comprises of 45 per cent equities in units and trusts, 19 per cent overseas, 16 per cent securities, 7 per cent cash and deposits, 5 per cent direct property, 4 per cent loans and placements and 3 per cent other investments (Australian Prudential Regulation Authority, 2002).
Due to the governance arrangements surrounding superannuation funds, the Government would not necessarily be able to set limits on investment in particular classes of assets.
Economic impact
Superannuation liabilities are the largest unfunded liability on the Commonwealth Government's balance sheet.7 The lack of a dedicated asset reserve to offset these liabilities makes them unfunded. The total unfunded superannuation liability of the Commonwealth, estimated at around $84 billion for 2002-03, is expected to increase to around $89 billion by 2005-06. This nominal increase averages around 2 per cent per year, over the forward estimates period.
Proponents of this option argue it would be beneficial on intergenerational equity grounds. This argument reflects concerns that the current approach may impose an unfair burden on future generations by asking them to pay for a liability that arose due to the current generation employing public servants.
Intergenerational equity relates to the distribution of the cost of providing government goods and services between generations of taxpayers. Liabilities passed onto future generations determine the distribution of this cost. For example, issuing debt to fund recurrent expenditure would transfer the cost of providing services from the current generation to future taxpayers. Altering the liabilities passed onto future generations requires the current generation to adjust the proportion of its consumption that it is willing to fund. That is, the current generation would need to adjust the level of its saving.
Applying proceeds from issuing CGS to fund the Commonwealth's superannuation liability is unlikely to change the intergenerational distribution of the costs of government goods and services. While purchasing financial assets with the proceeds may provide future generations with a means of meeting the Commonwealth's superannuation liability, future generations would bear the cost of the debt issued to purchase these assets.
The Commonwealth's fiscal strategy is the main driver of the intergenerational distribution of the costs of government goods and services. The Government does not intend to alter the fiscal strategy given its significant benefits.
Any macroeconomic impacts associated with changes in CGS supply are likely to be small given the size of Australia's financial markets. Indeed, effects of CGS market changes may not be discernible, given other changes in economic activity occurring at the same time. While any effects will be small, the following outlines the likely direction of changes in interest rates and output from maintaining or increasing the CGS market's size.
The Government's fiscal strategy provides the resources to reduce CGS supply, resulting in lower domestic interest rates and higher domestic income (Option 1). However, if the Government decides to maintain the CGS market, and invests in financial assets, two key factors determine the macroeconomic implications. First, whether the Government invests in domestic or foreign assets. Second, whether the Government maintains the CGS market at a particular nominal level or alternatively grows the market over time. The macroeconomic impacts will be broadly similar whether the investment is undertaken directly by the Government or by a Government funded superannuation fund.
Government investment in domestic assets
Maintain the market at a nominal level
Budget surpluses could be solely used to purchase domestic financial assets. This would not change CGS supply but would increase the demand for private assets, increasing the price of private assets and reducing their interest rates. Increased private asset prices would increase investors' demand for CGS, as they are now relatively more attractive, leading to higher CGS prices and lower CGS interest rates.
The net effect will be broadly similar to the Government repurchasing CGS. Average interest rates will be lower than they would have been in the absence of budget surpluses. Lower interest rates lead to higher investment, consumption and economic output, and a lower exchange rate and current account deficit.
Grow the market
The Government could grow the CGS market over time by increasing CGS issuance. The Government then could invest budget surpluses and the proceeds of new issuance in financial assets. Increased CGS supply decreases CGS prices and increases CGS interest rates. At the same time, Government investment in private assets increases their prices reducing their interest rates. The net effect is that further increases in CGS supply would not change average interest rates from the lower level resulting from the Government's fiscal position, but will change relative rates between CGS and private asset markets.
Furthermore, government investment in private assets also would change relative prices within the private asset market, assuming the Government does not equally invest across all domestic financial assets. This may create distortions in the financial markets. For example, government purchases of one company's equity will increase their market price, reducing their cost of capital raising. In contrast, companies whose equities are not purchased by the Government will not benefit.
Unhedged Government investment in foreign assets
Maintain the market
If the Government invested budget surpluses in foreign assets, then Australian financial markets would be broadly unchanged as there would be no change in CGS supply or domestic private asset demand. Government purchases of foreign assets may put some downward pressure on the exchange rate.
Grow the market
If the Government decided to increase CGS supply, CGS prices would decrease, increasing CGS interest rates. This would decrease demand for other domestic assets as they would be relatively more expensive than CGS, decreasing their prices and increasing their interest rates. As such, the overall impact is that average domestic interest rates would increase.
An increase in domestic interest rates would reduce consumption, investment, and domestic output. It would also put upward pressure on the exchange rate, as foreign investors would be attracted to higher Australian interest rates. Government foreign investment would provide partial offsetting pressure. The exchange rate appreciation would reduce net exports, increasing the current account deficit.
Hedged Government investment in foreign assets
If the Government invested in foreign assets, it would be exposed to exchange rate risk. The Government could consider hedging to remove this risk. A counterparty entering a hedge arrangement with the Government often will have an opposite risk exposure to the Government. For example, a US investor may buy Australian dollar-denominated assets, but want certainty in US dollars, while the Government may buy US dollar investments but want certainty in Australian dollars.
Maintain the market
When budget surpluses are used to purchase foreign assets and the exchange rate risk is hedged, the effect would be broadly equivalent to the Government investing in domestic securities as the Government's foreign investment is likely to be matched by the counterparty's domestic investment. Hence, the price of domestic assets would rise, reducing interest rates.
Grow the market
If CGS supply is increased and proceeds invested in foreign assets with exchange rate hedging arrangements, domestic average interest rates would be broadly unchanged. Increased CGS supply increases CGS interest rates, but the hedge counterparty's domestic investment increases demand for other domestic assets, reducing interest rates. As such, there should be no broader macroeconomic implications.
This analysis assumes that hedge counterparties would reduce their risks by purchasing domestic assets. If this is not the case, then the economic effects would be the same as presented for unhedged foreign investment.
Governance issues
Hypothecated asset fund
If the Government issued additional CGS and invested in a hypothecated asset fund, it would need to decide whether to outsource funds management activity. If the Government directly undertook investment activity, this would raise two major governance issues.
- First, costs would be associated with diverting scarce senior management
resources, possibly reducing the focus on other activities of government. - Second, costs may be associated with the potential dilution of accountability
associated with taking on a new task that the Government has not traditionally
undertaken. For example, investment returns may receive a high profile deflecting
an appropriate level of public scrutiny from core government functions.
If the investment activity were outsourced, then the Government would bear the additional operational costs through management fees. However, this would not remove the need for the Government to directly invest resources in the regulation and oversight of the investment activities. This would involve direct staffing costs, possibly diverting senior public service management and diluting accountability. That is, the Government would still bear the costs associated with designing and managing the contracts associated with the outsourced functions.
The Government would need to establish a set of rules for the fund's operation. It would need to decide on the extent of limits on fund activity and the extent to which it could directly control investments on a day-to-day basis. The existence of a large pool of assets raises a number of issues.
- First, the Government's access to the assets in the fund may need to be
limited. If the Government had ready access to the fund, low-priority projects
may be undertaken outside the scrutiny of the budget process. These projects
may not be as worthwhile as other projects. This arrangement contrasts with
superannuation fund assets which, once placed in the fund, the Government
is unlikely to access. - Second, pressures would exist to apply the funds to specific policy objectives
that would be achieved more appropriately through legislative or budgetary
action. The fund's goals and objectives should be specified in advance. - Third, if the Government invests in private sector assets, then other investors
may perceive an implicit guarantee for these investments. This may distort
the markets and pressure the Government to provide assistance if assets perform
poorly. - Fourth, if the Government decides to invest in equities, then it would
need to decide whether to exercise voting rights attached to ordinary shares.
If the Government uses its voting powers, then it may be pressured to exercise
its influence potentially to the detriment of the business' commercial interests.
However, not exercising voting rights may diminish control and governance
of private sector bodies. - Fifth, the Government's investment activities may lead to conflicts of
interest as the policy maker, regulator and owner.
These issues may favour offshore investment where many of these concerns do not arise. For example, the Norwegian investment fund is restricted to investing outside Norway. (See Appendix 4.) Box 10 outlines the governance arrangements for financial asset portfolios that have been adopted in a number of other countries. Many countries have adopted `arms length' management arrangements in governing legislation.
Countries that have established government financial
asset portfolios include Norway, New Zealand, Canada and Ireland. (See
Appendix 4.) These portfolios range in size, with Norway maintaining
a significant level of financial assets of around US$80 billion (42
per cent of GDP). The rationale for investing in financial assets generally
has been to address intergenerational concerns such as meeting future
spending pressures associated with the ageing of the population or managing
revenue variations associated with resource exhaustion.
While the precise governance arrangements for the financial asset portfolios vary, the frameworks to manage the portfolios have common elements.
- The management of the financial asset portfolios generally is outsourced to external fund managers, except in Norway, where the central bank currently manages around half of the assets in the portfolio.
- The investment decisions are taken on a prudent commercial basis, with the aim of maximising returns to the government subject to an acceptable level of risk.
- Funds generally are invested in both domestic and foreign financial markets. In the case of Norway, the entire asset fund is invested in foreign financial markets. This reduces the risk of government investment distorting domestic financial markets.
- Funds may be invested in both equities and debt securities. In some countries regulations govern the broad composition of the financial asset portfolio. For example, both Ireland and Norway have defined asset allocations and distributions within which fund managers must operate.
- Some governments restrict equity holdings to avoid some governance issues that arise when governments hold equity in private companies. For example, in Norway, the equity investments are limited to 3 per cent of the share capital in any one company. In addition, the central bank may only exercise voting rights associated with its shareholdings if it is necessary to secure the financial interests of the fund. New Zealand also has legislated to prevent the government fund from taking a controlling interest in any other entity.
;
Superannuation fund
Many of the issues around deciding whether to outsource funds management, or deciding on fund operating rules, are removed if the Government funded its superannuation liabilities through a superannuation fund.
Currently, most Commonwealth Government superannuation liabilities are in schemes regulated under the Superannuation Industry (Supervision) Act 1993. The trustee of the fund has sole responsibility for prudent fund management. Section 58 of the Superannuation Industry (Supervision) Act 1993 provides that the fund rules must not, except in very limited circumstances, permit trustees to be subject to direction by another party. Furthermore, various provisions ensure that the trustee's powers and duties are unfettered, including requiring the trustee to consent to changes in the governing rules.
These requirements would ensure that the Government could not direct superannuation fund trustees to invest in particular projects, industries or regions. Rather, trustees of complying superannuation funds are required to formulate an investment strategy that has regard to the risk and return of the fund's investments, expected cash-flow requirements, diversification and liquidity of investments, and the ability of the fund to discharge its liabilities.
Once the Government makes payments to a superannuation fund, it cannot access those funds unless there is a surplus of assets over liabilities. Even if surplus funds exist, the Government as an employer sponsor may face considerable difficulties in extracting a surplus from the superannuation fund.8
A trustee may pay a surplus to an employer sponsor, subject to a number of pre-conditions. When surplus exists in the fund, the governing rules of the fund must allow for this surplus to be paid to an employer. Furthermore, the trustees must agree to the payment of surplus funds to the employer. That said, it may be unclear whether a surplus exists.
If the Government or future governments cannot access surplus funds, they could suspend temporarily annual payments to the fund and rely on the existing fund assets.
The Government would always carry a residual liability to the fund because of the uncertainty of Commonwealth superannuation liabilities. Commonwealth superannuation schemes are principally defined benefits schemes that guarantee employees pre-determined retirement incomes based on established formulas. As such, Government liabilities would depend on variables including growth of public sector employment and remuneration. The uncertainty of these variables makes it difficult to provision perfectly for liabilities, so mismatches between government asset reserves and superannuation liabilities can occur. In the event of a shortfall, the Government would need to make top-up payments.
Complying superannuation funds must prepare statements of financial positions, operating statements and cash flow statements. The superannuation fund also must appoint an approved auditor to provide a report of the fund's operations for each financial year.
The creation of a superannuation fund would involve both management fee costs and resource costs. Outsourcing the investment management to a superannuation funds manager would incur investment management fees. In addition, costs would be associated with regulation and oversight of the fund's activities. In particular, scarce public sector senior management resources would be diverted from their core functions to oversee the activities of the fund. Moreover, the Government's accountability may be diluted as public scrutiny may be focussed away from core government functions.
Budget impacts
The impact on budget reporting of holding financial assets complicates the assessment of this option. For example, if issuing CGS and purchasing financial assets leads to a deterioration in the reported budget position, then the Government would need to take this into account in assessing the stance of fiscal policy. The Government would need to communicate clearly the underlying economic effects of the policy where the budget measures that receive greatest market focus may present an incomplete picture.
The principal measures of the Commonwealth's financial position that may be affected are the Commonwealth budget balance (the underlying cash balance and the fiscal balance), and Commonwealth general government net debt. 9
The precise impact on the budget would depend on the composition of the financial assets purchased and the strategy the Commonwealth adopts for managing the portfolio. The impact on the Commonwealth budget of issuing CGS and purchasing financial assets would depend on the net effect of the:
- cost of servicing the additional CGS on issue, known as public debt interest
expenses; - income earned on financial assets, such as coupon payments on debt securities;
and - capital gains/losses on the sale of financial assets.
The budget impacts of a hypothecated asset fund and a superannuation fund are likely to be broadly similar if they are both classified in the same way. However, the classification treatment of the two alternatives would be different if one was classified inside the general government sector and the other outside the general government sector. Considerable uncertainty about this classification issue is due to the precise arrangements that are put in place. The following discussion assumes that a hypothecated asset fund would operate within the general government sector, while a superannuation fund would be outside the general government sector.
Hypothecated asset fund
The immediate impact on the budget balance would be the difference between investment income and the interest cost of the additional CGS. However, the total return on a financial asset often includes an element of capital gain made on the asset sale. The capital gain/loss made on the sale of financial assets does not affect the budget balance.
This implies the total return on financial assets the Commonwealth acquires would need to be well above the interest rate on the CGS, if a financial asset acquisition strategy is to improve the underlying cash balance and the fiscal balance.
For example, if the Commonwealth issues $1 billion of CGS with a coupon of 10 per cent and purchases $1 billion of financial assets, the financial assets must provide an income stream of at least $100 million each year to offset the cost of servicing the CGS each year. However, if the return on the financial assets incorporates an element of capital gain, say 50 per cent, then the total return on the financial asset would need to be $200 million per year to avoid an adverse effect on the budget balance.
The impact on net debt of issuing CGS and purchasing financial assets would depend on the composition of financial assets the Commonwealth acquires. Issuing CGS would increase selected financial liabilities by the value of the CGS issued. If the proceeds of the issuance were used exclusively to purchase financial assets in the form of other debt securities or deposits, then this would not alter net debt. However, if financial assets such as equity were purchased, then net debt would rise by the amount of these purchases.
For example, if the Commonwealth purchases $1 billion of debt securities with the proceeds from the $1 billion issuance of CGS, these transactions would not alter net debt. However, if the Commonwealth purchased $500 million of debt securities and $500 million of equities, this would increase net debt by $500 million.
Net worth would remain unchanged if equity were purchased.
Superannuation fund
If the superannuation fund were created outside the general government sector, the financial assets of the superannuation fund would be held outside the Commonwealth general government balance sheet and income payments would not be included in the budget. However, the debt issued to fund the superannuation liability still would be included in the general government balance sheet.
Initially, issuing debt and transferring the proceeds to a superannuation fund would increase general government net debt. However, net worth would not be changed - as superannuation liabilities move off the general government balance sheet, debt liabilities would increase. On an ongoing basis, net debt and net worth would only be affected by the extent the superannuation fund's return on investment changed Commonwealth payments to the superannuation fund. Any change in the budget balance resulting from the fund's investment activities would flow through to net debt and net worth.
Payments to the superannuation fund and ongoing debt servicing costs would affect directly the underlying cash balance. Indirect effects may be due to changes in the rate of return through the level of payments the Commonwealth is required to make to meet the accrued superannuation liability. For example, if the superannuation fund's investments performed poorly, the Commonwealth might need to make additional payments to meet employees' superannuation entitlements.
Transition issues
If the Government chose to maintain the CGS market and fund the Commonwealth's unfunded superannuation liability, it might do this by building up a financial asset portfolio at a rate dictated by budget surpluses, asset sale proceeds and the rate of CGS issuance required to increase the size of the CGS market over time.
An unlikely alternative would be for the Government to issue a large amount of new debt in a short time and pay the proceeds into the superannuation fund. The current Commonwealth superannuation liability is around $85 billion. The Government would need to issue $85 billion in new debt to purchase financial assets to offset fully this liability. Given there is currently around $50 billion of CGS on issue, total CGS would need to rise to around $135 billion. As the stock of debt currently on issue matures, total CGS would fall back in line with, and eventually grow at the same rate as, the superannuation liability.
Key questions
The Government would appreciate views from stakeholders on:
- governance arrangements for a hypothecated asset fund that stakeholders
suggest would insulate investment decisions from direct Government control; - whether funding the unfunded superannuation liability through a superannuation
fund is a good way of dealing with the governance issues associated with substantial
Government asset holdings; - the appropriate limits on holdings of any single instrument if the Government
were to invest in debt securities; - the appropriate limits for equity holdings in any one company if the Government
were to invest in equities; - the likelihood of Government investment distorting asset prices;
- the impact of restricting Government investment to foreign securities;
and - the increased uncertainty for fiscal policy arising from variations in
investment returns.
5 Net worth is defined as total assets less total liabilities. Net worth provides a more comprehensive picture of a government's overall financial position than net debt. Net worth incorporates a government's non-financial assets, such as land and other fixed assets, as well as certain financial assets and liabilities not captured by the net debt measure.
6 Investment grade debt securities are those with a credit rating of BBB or higher.
7 Liabilities that are recorded on the balance sheet are a matter of accounting practice. The balance sheet does not include factors such as future age pension liabilities or the assets of future taxing capacity.
8 Employer sponsored funds such as the current Commonwealth Government superannuation schemes, are subject to equal representation rules. This means the fund has an equal number of employer and member representatives.
9 Net debt is the sum of selected financial liabilities (deposits held, advances received, government securities, loans, and other borrowing) minus the sum of selected financial assets (cash and deposits, advances paid, and investments, loans and placements).