Markets in which government debt securities trade have distinctive elements that may be important for developing sophisticated and well-functioning financial markets.
Government debt securities offer minimal credit risk, high levels of liquidity, a broad range of maturities and well-developed market infrastructure, including active derivative markets.
Therefore, government debt securities may play important roles in financial markets that private sector securities may not fulfil. The roles most commonly identified include providing benchmark interest rates for pricing other fixed coupon securities, managing financial risk, providing a low-risk, long-term, investment vehicle, and acting as a `safe haven' during periods of financial instability.
This chapter outlines and assesses the roles that the Commonwealth Government Securities (CGS) market performs and considers potential private sector substitutes.
Credit risk refers to the possibility that the issuer of a debt security, the Commonwealth Government in the case of CGS, will default on its obligations to repay borrowed funds.
The credit standing of an issuer and the degree of credit risk associated with its debt securities is reflected in the price and yield of the security. Investors require an additional margin in the yield of the security to compensate them for bearing the risk of default. This margin increases as the perceived riskiness of a borrower rises.
The credit risk of a government of a well-developed economy, such as Australia, is generally considered to be small as such countries have the economic and political stability that enables their governments to increase taxation to meet debt-servicing obligations. Therefore, the margin for credit risk is likely to be small. Indeed, CGS often is referred to as a proxy for a risk-free asset.
Government debt securities usually are issued into a limited number of maturities (or benchmark lines). For example, the Commonwealth Government currently has 11 benchmark Treasury bonds with an average of around $5 billion on issue in each line.
The concentration of issuance into a limited number of benchmark lines promotes market liquidity. A market is considered liquid if market participants readily can buy and sell debt securities in large quantities without significantly influencing the market price. Liquidity reduces the possibility that market participants will require a margin to compensate them for the risk that participants moving in and out of the market affect prices (liquidity risk).
Benchmark lines of government debt securities are usually spread over a wide range of maturities. The Commonwealth's 11 benchmark lines are distributed reasonably evenly from less than one year to 13 years to maturity.
Governments issue debt securities over a range of maturities to:
- target high investor demand for a particular maturity. At times when governments issue debt, investors may strongly prefer to invest for a specific period and be willing to provide funds to the government on more advantageous terms.
- reduce the likelihood of exhausting investor demand. Significant issuance of a single maturity over time eventually may lead to investors holding all the debt they are willing to purchase at that maturity. Investors may require a higher yield to encourage them to purchase more debt at that maturity than they otherwise would.
- reduce the risk that maturing debt is refinanced at relatively high interest rates (refinancing risk). For example, if a government issued debt securities in a single benchmark line, it is exposed to the risk that interest rates are high at the time the debt matures. By issuing debt securities into a number of benchmark lines with different maturities, the government can reduce the risk that a significant proportion of its debt is refinanced at relatively high interest rates.
The existence of benchmark lines of government debt securities across a range of maturities provides a source of information on yields at these different maturities. Plotting the yield associated with different CGS benchmark lines shows that at end June 2002, as the time to maturity increased, the yield required by investors also rose (Chart 14). This compilation of yields at different maturities at a particular time for a given issuer is known as the yield curve.
Source: Bloomberg, 2002.
A government debt market is likely to contribute to developing key elements of financial markets, including mechanisms and processes that also are important for the operation of other sectors of the financial markets.
The types of supporting market infrastructures that the presence of a government debt market may contribute to include:
- skilled workforce in the debt market who provide price discovery in securities necessary to promote a liquid market;
- legal and accounting arrangements to govern the issuance, trading and settlement of debt securities which provide certainty in issues such as ownership and payment of debt obligations;
- administrative structures for the clearing, registration of ownership and settlement of debt securities; and
- establishment and development of derivative markets (such as government debt futures markets and repurchase markets) associated with debt securities.
The remaining sections of the Chapter identify several propositions raised in support of the maintenance of a CGS market. These propositions are assessed and possible alternatives identified.
The CGS market provides information about yields at different maturities. This may be important for pricing yields on other debt securities.
The CGS yield often is considered a proxy for the risk-free rate of return in Australia, as yields are unlikely to be affected significantly by credit and liquidity risk. The CGS yield could be interpreted as the base rate of interest that lenders require to provide funds to borrowers before incorporating premiums to compensate for risk. Financial market participants pricing private debt securities in the primary market may use the CGS yield as a starting point, and add margins for credit, liquidity and other risks.
For example, a company with a credit rating below the Commonwealth Government's could issue three-year debt securities priced 50 basis points over the comparable CGS. The additional 50 basis points compensate for the corporate's lower credit standing and lower market liquidity of its debt securities.
The pricing of debt securities is important for the real economy. The efficient pricing of debt securities helps ensure that capital is allocated to the sectors that can achieve the highest investment return. Several problems could arise if the pricing of debt securities is less efficient.
- If the yield on new issues of debt securities is inappropriate there may be income transfers between investors and issuers as the yield adjusts in subsequent market trading.
- Some market participants may withdraw from the segments of the market where problems with pricing debt securities are ongoing. For example, a corporate may restrict issuance to short-dated bonds if longer-dated bonds have ongoing pricing difficulties. This may mean the corporate foregoes lower cost alternatives, potentially increasing the domestic cost of capital.
- A systematic reduction in pricing efficiency may lead to mis-allocation of capital in the economy as some sectors face either too high or too low a cost of capital. For example, if corporate bond yields of an industry were systematically too low, then they would borrow and invest more than would be appropriate, potentially reducing funds available for more productive investment elsewhere in the economy.
Possible alternatives for pricing debt securities in the Australian market could be based on the price of existing debt securities of organisations with similar risk characteristics or the interest rate swap curve (Box 1).
Market participants could price debt securities using information on the yields of debt securities issued by organisations with similar risk characteristics. Alternatively, a company with an existing presence in the debt market could price new debt securities based on the yield on its existing debt securities. The premiums for risks, such as credit and liquidity risk, incorporated in the price would reflect the current financial market view of these risks.
The continued development of the corporate debt market in Australia will be important for ensuring that pricing with respect to existing securities is viable. The level of corporate bonds outstanding has grown steadily over recent years. This growth also is reflected in market turnover (Chart 15). Corporate bonds on issue increased from less than $15 billion at June 1997, to over $60 billion at June 2001.1 Companies with AAA credit ratings issue around one-third of the current outstandings of corporate bonds, companies with A credit ratings issue a further one-third and companies with AA credit ratings issue around one-quarter. Lower rated companies issue the remainder. The continued improvement in the depth of the corporate debt market across the various credit ratings will improve the usefulness of the corporate debt market for pricing new issuance of debt securities.
Note: Includes floating rate bonds but excludes asset-back securities.
Source: Reserve Bank of Australia, 2002; and Australian Financial Markets Association, 2001a.
Another alternative is to price debt securities against the price of interest rate swaps. The interest rate swap market is liquid, incorporates an element of credit risk and encompasses a broad range of maturities.
- The liquidity of the swaps market is high. The annual turnover in the domestic interest rate swap market (fixed to floating swaps) was around $650 billion in 2000-01. This compared to annual turnover in the CGS market of around $600 billion.
- Financial institutions account for a large part of the market and have high credit ratings.
- The interest rate swap curve currently extends to a similar maturity as the CGS yield curve. This should allow pricing at the same range of maturities.
An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another. The most common interest rate swap involves the exchange of fixed rate interest payments for floating rate interest payments based on a given principal amount for a defined time.
In Australia, the floating rate for interest rate swaps is the Bank Bill Swap Reference Rate (BBSW), which is the interest rate at which financial institutions are willing to lend each other money. The fixed interest rate is determined by the supply and demand in the market for paying and receiving fixed interest payments. Expectations about the path of interest rates over the swap period also will influence the fixed interest rate. The compilation of the fixed interest rate on interest rate swaps of different maturities forms the interest rate swap curve (Chart 16).
Source: Bloomberg, 2002.
The credit risk of undertaking an interest rate swap is relatively low compared to transactions in physical instruments such as corporate bonds. In an interest rate swap, only the interest payments are swapped, not the principal. The credit risk that counterparties bear is limited to any outstanding payments for the difference between the fixed rate and the BBSW.
For example, assume Company A has borrowed $100 million for 3 years at the three-month BBSW from Bank C. The company is exposed to the risk that interest rates may rise over the period of the loan which would increase Company A's debt-servicing costs. To hedge this risk, the company could enter into an interest rate swap with Bank B. This would entail the company agreeing to make interest payments based on an agreed fixed interest rate, in return for receiving the three-month BBSW. If interest rates rise, the company will be able to meet the higher borrowing costs from the increase in payments it receives under the interest rate swap. The net effect is that Company A pays the fixed rate that is agreed in the interest rate swap.
The CGS yield is not the sole benchmark for pricing other debt securities in the Australian financial markets. The price investors paid for some recent issues of corporate debt securities was based on the rate for an interest rate swap at that maturity, plus an additional margin for risks such as credit risk. While some of these issuances also note the price as a margin over the CGS yield, increasingly the interest rate swap curve is used as the primary pricing benchmark.
The International Monetary Fund (International Monetary Fund, 2001), the Bank for International Settlements (Bank for International Settlements, 2001) and the Organisation for Economic Cooperation and Development (Organisation for Economic Cooperation and Development, 2002a) report these benchmarks are commonly used overseas for pricing new issues of debt securities implying that, internationally, government securities also are becoming less important for pricing.
The Government would appreciate views from stakeholders on:
- whether CGS is used extensively as the primary benchmark for pricing the debt securities of other issuers;
- whether the interest rate swap curve is used widely for pricing debt securities. If not, are there obstacles to using the swap curve in the future? and
- what other options are available for pricing debt securities? How effective are they?
Some financial market participants may use the CGS yield as a reference benchmark for comparing the yields on different debt securities of a similar maturity.
Benchmarking the yields of different securities against the yield on CGS with a similar maturity may allow market participants to gauge the premiums added for risks such as credit risk. Participants can determine whether they consider these premiums appropriate and trade accordingly.
For example, assume that debt securities from Company A are trading 50 basis points above CGS, and Company B's debt securities are trading 75 basis points above CGS. If financial market participants considered both companies' debt securities entailed similar risk, they would purchase Company B's securities and earn higher returns. Benchmarks may hasten the identification of arbitrage opportunities (higher profits for a given level of risk) and improve the efficiency of pricing in the financial markets. However, this argument does not appear compelling. Market participants could compare directly yields rather than relying on an arbitrary reference point.
CGS yields do not represent the only viable reference benchmark for assessing the yield on other debt securities. Possible alternatives for pricing new issues of debt securities - corporate debt securities or the interest rate swap curve - may substitute for CGS yields as a referencing benchmark. Because the interest rate swap curve more closely approximates the cost of funds for several financial market participants, it could be a more appropriate reference benchmark than the CGS yield curve.
The Government would appreciate views from stakeholders on:
- whether the yield on CGS is commonly used as a reference benchmark for comparing the yields on other debt securities; and
- whether any major obstacle hampers the interest rate swap curve or some other benchmark being used as a reference benchmark.
The CGS market underpins a number of important derivative markets that play a crucial role in managing financial risk. Winding down the CGS market could result in significant changes to a number of these markets. This may reduce the capacity for financial market participants, and businesses more generally, to manage their exposure to financial risk. This also may affect the cost of capital in Australia. If businesses face a higher cost of capital, then this would reduce investment, consumption and economic output.
Financial market participants, and Australian businesses more generally, are exposed to a broad range of financial risks during their daily operations. A key financial risk many businesses manage is that interest rates may change (interest rate risk). For example, a business may borrow funds at a floating rate of interest and be concerned that interest rates may rise in the near future. The business may eliminate this risk by locking-in the interest rate on the borrowing.
The ability to manage interest rate risk cost-effectively is important for participants trading in financial markets. It is crucial for participants playing a `market-making' role. These participants will enter into transactions that transfer interest rate risks from clients to themselves for a payment (usually a margin on the interest rate charged) regardless of the existence of an offsetting exposure on their books. These market-makers promote market liquidity. Changes in the scope or cost of managing financial risks may reduce incentives to play a market-making role, with the consequent impact on financial market liquidity.
The existence of efficient derivative markets for managing interest rate risks may lower the cost of borrowing for corporates. Potential investors in corporate debt can reduce the risk they face by using derivatives. Without derivatives, bonds would be less attractive.
The CGS market, and its associated derivative markets, are the primary vehicles in Australia for managing interest rate risk. The principal derivative markets related to the CGS market are the three-year and ten-year Treasury bond futures markets (Box 2). Possible approaches to managing interest rate risk using these instruments are outlined in Box 3.
The Treasury bond futures market has developed into the primary vehicle for managing interest rate risk in Australia for several reasons. First, correlation between changes in the yields on CGS and changes in yields on other debt securities is high. Second, the underlying price of the futures contract cannot be significantly manipulated. Third, the Treasury bond futures market is very liquid and financial market participants can move in and out of the market without affecting the market price of the contracts.
A futures contract is a legally binding agreement to buy or sell something in the future. The buyer and seller of a futures contract agree on a price today for a product to be delivered and paid for in the future. In most cases, actual delivery of the underlying security does not take place. Instead, the contract is settled by a cash payment calculated as the difference between the market price of the underlying product and the price agreed in the futures contract.
In Australia, the three-year and ten-year Treasury bond futures contracts are the principal mechanisms for managing interest rate risk. Trading in futures contracts takes place on a futures exchange - the Sydney Futures Exchange in Australia (SFE). These contracts are standardised and are based on a Commonwealth Government Treasury bond with a face value of $100,000, a coupon rate of 6 per cent and term to maturity of either three years or ten years. The contracts are cash settled against values determined by average yields for baskets of Commonwealth Government Treasury bonds selected by the SFE. Bonds are selected on the basis of their liquidity, amount outstanding and term to maturity. For the three-year contract, the SFE seeks to have a basket of bonds with an average remaining period to maturity of around 3 years. Similarly, for the ten-year contract the SFE seeks to have a basket of bonds with an average remaining period to maturity of around 10 years.
The relationship between bond yields and the value of a futures contract is inverse. For example, assume Company A purchases a ten-year Treasury bond futures contract. If the average yield for the bonds included in the basket for the ten-year contract falls, the settlement value of the futures contract will increase. On expiry, the difference between the settlement value of the contract and the value of the contract at the time of purchase would be cash settled by a payment to Company A.
Borrowers can use Treasury bond futures contracts to manage interest rate risk. For example, Company A has borrowed $100 million at a fixed interest rate to purchase capital equipment. The company is exposed to the risk of interest rates falling. Company A could hedge its interest rate risk by buying Treasury bond futures contracts at the same time as it enters into its loan. If interest rates subsequently fall (the price of bonds rise), the profit Company A makes on the futures contract will offset the relatively higher interest cost that it was required to pay on its loan over the period.
Similarly, investors also can use the Treasury bond futures market to manage interest rate risk. For example, Bank B has purchased $100 million of three-year fixed rate debt securities from Company A and is exposed to the risk that interest rates may rise (and bond prices fall). To manage this risk, Bank B could sell $100 million of three-year Treasury bond futures contracts. If interest rates subsequently rise (the price of bonds fall), Bank B will make a profit on the Treasury bond futures contract. The profit Bank B makes on the futures contract will offset the decline in the value of Company A's three-year fixed rate debt securities.
The high level of correlation between changes in CGS yields and other debt securities reflects the absence of risk premiums from the CGS yield. In the absence of premiums for risks such as credit and liquidity, changes in the CGS yields are likely to reflect changes to market interest rates flowing from shifts in the demand and supply of funds. All other debt securities should reflect these changes in the average yield.
A high level of correlation between changes in CGS yields and those on other debt securities means that holders of debt securities can hedge their interest rate risk by taking the opposite position in the Treasury bond futures market. Holders of debt securities can hedge their interest rate risk by selling a Treasury bond futures contract. If the price of the debt security subsequently falls, any loss made on the security should be largely offset by the profit made on the Treasury bond futures contract (see Box 3).
These relationships are likely to be strong in normal times. However, significant financial turbulence may undermine the strength of the relationship between changes in CGS yields and changes in the yields on other debt securities. Given the essentially risk-free status of CGS, investors may shift funds from other debt securities during times of uncertainty in the financial markets (flight to quality). In some cases, widespread simultaneous selling of non-government debt securities and purchasing of CGS may move the yields on the two types of debt in the opposite direction. This situation would limit the usefulness of Treasury bond futures for hedging interest rate risk on other debt securities and could amplify losses.
The high level of liquidity in the Treasury bond futures market has helped make Treasury bond futures more efficient in hedging interest rate risk. Daily turnover last year in the three-year Treasury bond futures market averaged around $6 billion and around $2 billion in the ten-year Treasury bond futures market. Market liquidity ensures market participants can quickly move in and out of the market, and undertake large transactions without significantly affecting prices in the market.
Alternatives for managing interest rate risk other than using the Treasury bond futures market may exist. The principal alternative could be based on the interest rate swap market. In addition, derivative markets based on the interest rate swap or corporate debt markets, such as swap or corporate bond futures, could be established to manage interest rate risk.
Australia's interest rate swap market is well established and highly liquid. The correlation between changes in the yield on interest rate swaps with yields on other debt securities is high (Table 2). For example, the correlation between swaps and corporate debt securities with AA credit rating is 0.969, compared to 0.974 between CGS and AA-rated corporate debt. This suggests interest rate swaps may be an effective hedging tool for managing interest rate risk on other debt securities.
Note: Correlation calculations based on monthly yield data for three-year fixed
coupon bonds over the period August 1997 to June 2002.
Source: Treasury calculations based on data from Bloomberg, 2002.
The yield on interest rate swaps contains an element of credit risk which also is present in yields on other debt securities. This may improve the overall correlation of swap yields with other yields during financial uncertainty when flight to quality may occur. The credit risk element may assist swap yields to more closely track other yields in these situations, while yields on CGS diverge as investors shift funds into the lower risk CGS.
The interest rate swap market may not assume the primary role for managing interest rate risk in Australia due to limits on improving market liquidity. Interest rate swaps are bi-lateral agreements tailored to suit the needs of counterparties and traded in the over-the-counter derivative market rather than on an exchange.2 They also are subject to credit risk. This is a positive factor from a pricing perspective, but a negative from the perspective of bearing direct risk on the hedge activity. A participant wishing to unwind an interest rate swap must:
1. get the agreement of the counterparty to unwind the swap; or
2. find a third party with a creditworthiness acceptable to the counterparty to take over its side of the swap; or
3. enter into an exactly offsetting swap.
This process reduces the participant's ability to move quickly in and out of the interest rate swap market. In principle, development of a standardised interest rate swap contract could overcome this problem. This would facilitate the use of supporting market infrastructure, such as a central clearinghouse and exchange trading. The central clearinghouse effectively becomes the counterparty to the two parties in the swap. The clearinghouse actively monitors each party's ability to meet their obligations under the swap through daily margin calls. Either party could pass the swap on to a third party without needing the agreement of their counterparty.
A second possibility could be to develop an interest rate swap futures market with standardised contracts traded on an exchange. Businesses could use these contracts to manage risk, provided the underlying price (the swap yield) is highly correlated with yields on other securities and the underlying price cannot be manipulated. Evidence indicates that the swap yield is highly correlated with corporate bond yields and that the swap market is highly liquid suggesting market manipulation is unlikely. Consequently, an interest rate swap futures market may be a viable alternative.
A third possibility could be to establish corporate debt derivative markets. However, the corporate debt market would need to be sufficiently large and liquid to reduce the likelihood of market manipulation of prices that form the basis of futures contracts. This would require continued improvements in corporate debt market turnover and liquidity, and may take time to develop.
Some alternatives would require considerable development to be viable. However, the absence of the CGS market would encourage innovation and provide incentives to develop alternative instruments. Alternative instruments would have a ready investor base, given the current high usage of CGS-based risk management instruments.
Financial market participants would also need time to adjust to using alternative instruments that may be developed to manage interest rate risk. For example, some funds managers may need to update existing management mandates to allow them to gain access to new derivative instruments.
The Government would appreciate views from stakeholders on:
- whether there is scope for the Treasury bond futures market to be replaced by a futures market based on alternative instruments. What could hamper an alternative futures market from developing?
- whether the interest rate swap market is sufficiently liquid at maturities longer than five years to facilitate interest rate risk management;
- whether the viability of the interest rate swap market would be affected significantly by winding down the CGS market; and
- if alternate risk management tools were not available, what would be the likely impact of this on the cost of capital for corporate bond issuers?
The low credit risks and long time to maturity of CGS make them a relatively attractive investment option for investors such as superannuation funds and insurance companies. If investors could not invest in CGS, then they may face more difficulties matching their relatively long-dated liabilities with their financial asset holdings.
Investors such as superannuation funds find CGS provide a long-dated financial asset that can assist portfolio management by closely matching long-dated liabilities. Low-risk long-dated securities also provide investors with greater diversification options.
Historically, CGS have been the principal source of long-dated financial assets. The absence of CGS may limit long-dated investment options and complicate portfolio management. Some long-dated options, such as long-dated corporate bonds, still will provide investment diversification opportunities. However, their supply is relatively small and they are riskier than government debt, particularly for very long maturities, as it is difficult to have complete confidence in the existence and viability of a single company over very long periods.
Lower CGS supply may require portfolio managers to deal with the risk associated with a growing gap between the maturity structure of their financial assets and liabilities. For example, if factors influencing the rate of growth on the long-dated liabilities of a superannuation fund also are not reflected in the rate of return achieved on shorter dated assets, over time the superannuation fund may risk having difficulty meeting its obligations.
Note: Amount outstanding at the end of the June quarter. Estimates for 2001-02
are for the end of the March quarter.
Source: Australian Bureau of Statistics, 2002a.
The extent of this potential problem depends on the importance of CGS as a long-term investment for investors, such as superannuation funds. The estimates suggest that overseas investor holdings of CGS on issue have averaged around 35 per cent, pension funds (superannuation funds) holdings have averaged around 17 per cent, and life insurance corporations holdings have averaged around 13 per cent (Table 3).
The superannuation sector's holdings of CGS need to be considered in the context of the total assets the sector manages. At the end of the March quarter 2001-02, superannuation funds reported total assets of around $500 billion, with CGS accounting for less than 5 per cent of these assets. The very small contribution of CGS to total assets suggests CGS may not be a crucial instrument in the investment strategy of the superannuation sector at the moment.
However, the superannuation sector may wish to hold more CGS, but the current size of the market may constrain this. Furthermore, as the superannuation system matures, the superannuation balances of Australians will increase. Then people will be more likely to take an income stream on retirement rather than a lump sum. In the future, superannuation funds will tend to have a larger proportion of their assets backing pensions (rather than in the accumulation phase) than currently. The particular type of retirement products people take up will heavily influence the extent of this increased demand.
The continued development of the corporate bond market and derivative markets may provide an alternative source of relatively low risk, long-term, debt securities. If corporates continue to issue more into the corporate debt market, a wider range of investment options should become available, both in credit quality and maturities. Furthermore, the development of credit derivatives (Box 4) such as default swaps may allow investors to achieve a synthetic, low credit risk, debt security. This could involve the packaging of longer-dated corporate debt with a default swap to achieve a relatively low credit risk, long-dated debt security.
Credit derivatives are contracts between two parties. They isolate a specific aspect of credit risk in an underlying instrument and transfer that risk from one party to another.
A credit default swap entails one party guaranteeing (for a fee) the performance of a third party in honouring their debt securities. If the debt issuer defaults, the party that provided the guarantee will step in and meet the issuer's obligations.
For example, an investor could invest in debt securities of a corporate with a credit rating of A and simultaneously execute a credit default swap to hedge against the risk that the corporate does not meet its obligations. The net profit from the interest income on the debt security and the cost of purchasing the credit default swap should be comparable to the return on instruments with a higher credit rating.
The market for credit derivatives such as credit default swaps is relatively new in Australia. However, market turnover has increased markedly. In 2000-01, turnover in credit default swaps was around $23 billion, more than double the turnover in 1999-2000. The market is expected to continue to expand as more participants enter and familiarity with the possible application of these credit derivatives increases.
The Government would appreciate views from stakeholders on:
- the significance of CGS as a long-term investment vehicle, particularly for institutional investors such as superannuation funds and life offices;
- whether there is currently an unmet demand for CGS within the superannuation sector; and
- the potential to develop alternative long-term investment instruments.
In the past, the CGS market has played a central role in the Reserve Bank of Australia's (RBA) implementation of monetary policy. A key issue is whether a decision to wind down the CGS market would affect adversely the RBA's ability to implement monetary policy.
The RBA announces the desired stance of monetary policy in terms of a target for the interest rate on overnight funds borrowed and lent between banks. This interest rate is the cash rate and it forms the base of the structure of interest rates in the economy. Changes in the cash rate feed through to these other rates and ultimately affect the level of economic activity.
The cash rate is determined by the supply of, and demand for, exchange settlement (ES) funds, balances held in banks' ES accounts at the RBA. Banks use these balances to meet their settlement obligations to each other and to the RBA. At any time, the sum of all balances in banks' ES accounts represents the aggregate supply of ES funds available to the banking system. Only transactions between the banking sector and the RBA affect the aggregate supply of ES.
Every day, flows go both out of and into the banking system. These flows arise because RBA clients are active (including making government payments or collecting taxes) or because the RBA itself is active. If, on a given day, the net of these flows results in the pool of ES balances available to the banking system being less than demanded by banks, the cash rate would tend to rise and move away from the target the RBA sets. The reverse also holds.
The RBA undertakes transactions with financial institutions each day to ensure it supplies sufficient ES funds to the banking system to meet demand at or close to the cash rate target. In other words, it transacts to offset the impact of flows into and out of the banking system. These transactions are open market operations.
The RBA's open market operations involve it purchasing securities to inject funds into the banking system or selling securities to withdraw excess funds from the banking system. These transactions once were carried out exclusively through outright purchases and sales, but now are conducted almost entirely through repurchase agreements. Repurchase agreements involve the sale of a security with an agreement to repurchase it on an agreed future date at an agreed price. They expose the RBA to little market risk and are efficient because the RBA can set the maturity (unwind) dates to meet expected future flows of funds.
The RBA's daily operations typically involve large values. In 2001-02, the average daily value of RBA transactions was $1.8 billion. On some days, turnover exceeded $4 billion. Given the scale of these operations, the RBA - like most central banks - has opted to hold and deal in securities that are liquid, have a high level of price transparency and carry minimal credit risk. In Australia, as in most other countries, this traditionally meant central government debt securities.
In recent years, the RBA has responded to the decline in the amount of CGS on issue by broadening the range of securities that it will accept as collateral on repurchase agreements in open market operations. The RBA will now accept:
- Australian dollar securities issued in Australia by central borrowing authorities of State and Territory governments (since June 1997);
- Australian dollar securities issued offshore by central borrowing authorities of State and Territory governments but traded in the Australian Austraclear System as euroentitlements (since June 2001); and
- Australian dollar securities issued in Australia by a range of AAA/Aaa rated supranational organisations (since October 2000/June 2001).
Consequently, this effectively doubled the pool of collateral available to the RBA at the end of June 2002.
In addition, the RBA has increased its use of foreign exchange swaps to supplement its operations in domestic securities. Foreign exchange swaps work like repurchase agreements. Australian dollars are exchanged for foreign currency rather than domestic securities. Moreover, the foreign currency can be invested in foreign debt securities. As the swap involves agreement to unwind the transaction at a future date at an agreed exchange rate, neither party to the swap is exposed to exchange rate risk. In 2001-02, foreign exchange swaps undertaken for liquidity purposes amounted to about $90 billion.
The RBA should be able to respond to further reductions in the CGS supply to maintain its capacity to implement monetary policy (Box 5). This is likely to involve further broadening of the range of domestic securities in which the RBA transacts and greater use of foreign exchange swaps.
United States Federal Reserve Board of Governors Chairman Alan Greenspan commented to the Bond Market Association in April 2001:
`While the prospective paydown of [US] Treasury debt presents us with challenges, I am confident that... the Federal Reserve can make the needed adjustments and will be able to continue to implement monetary policy in the national interest.' (Greenspan, 2001)
The Governor of the Reserve Bank of Australia commented to the Commonwealth House of Representatives Standing Committee on Economics, Finance and Public Administration in May 2002:
`I think our view is that, if we were ever to reach the point where there was not enough Commonwealth or State authority debt around, we could probably find a way of conducting our market operations using private sector instruments.' (Hansard, 2002)
The Government would appreciate views from stakeholders on the declining importance of CGS in the operation of monetary policy.
CGS can provide a safe haven during times of financial instability. In times of financial instability, investors may become concerned about the risk of maintaining investments in certain sectors of an economy, or indeed the whole economy. As a result, they may transfer funds into assets they perceive to be low risk. A substantial CGS market may allow risk-averse investors a viable investment alternative. In the absence of CGS, the risk of substantial capital flight may affect the exchange rate, interest rates and domestic market confidence.
During times of financial instability, investors may seek safe assets to avoid the potential of a capital loss on their investment. For example, investors may hold shares in a company in a particular market segment when they hear about an adverse shock to that segment (such as airline stocks affected by the September 11 terrorist attacks). To avoid losing their capital altogether if the company collapses, investors can sell their shares and instead purchase low credit risk assets.
In many cases where a shock affects only one market segment or industry, investors may simply move into similar assets in other market segments or industries. However, when shocks affect the market more broadly, many investors may seek lower risk assets, creating a flight to quality.
In many cases, investors go to government bonds. They also seek other safe financial assets. An example of flight to quality was the change in relative yields on low risk corporate, high risk corporate and government bonds following September 11. The spreads between corporate bond yields and equivalent maturity Treasury bonds rose immediately after the terrorist attacks (Chart 17). However, the spread widened most for lower credit rated corporate bonds and least for the highest rated bonds as investors sold relatively risky assets and purchased relatively safe assets.
Note: Bonds with three years to maturity.
Source: Reserve Bank of Australia, 2002.
In Australia, events such as the 1997-98 Asian financial crisis, have had a greater impact on the Australian corporate bond spread.
A similar reaction occurred after US company Enron collapsed earlier this year. The spread between BAA rated corporate bonds and US Treasury bonds rose significantly following the disturbance in the equity market (Chart 18).
Note: Credit spread = ten-year BAA minus ten-year US Treasuries.
Source: Datastream, 2002.
Clearly, government bonds can act as safe haven assets. However, the circumstances in which CGS would be necessary or effective in insulating the real economy are unclear.
At one extreme, a small shock, say resulting from the collapse of a single large corporation, might see some investors seeking safe havens in CGS or other highly rated issuers. In this case, highly rated bonds could provide the safe haven, and some large, low risk equities also may suffice.
At the other extreme, a severe financial crisis, such as a systemic banking crisis, the presence of the CGS market may not make a substantive difference. Investors may take their funds out of the country to more stable markets, or simply hold cash.
A range of cases occur between these extremes. In the intermediate case of a relatively large, financial system-wide disturbance, the presence of very low risk government securities may be beneficial.
While the CGS market exists, it is likely to be used as a safe haven. Then the size of the CGS market may be important with the larger the market, the better. In a very small CGS market, the additional demand for CGS generated by financial instability may very quickly increase the price of CGS. This would reduce its attractiveness. In a very large liquid market, an additional demand generated by financial instability would have less impact on CGS prices, and therefore have a smaller impact on the market's attractiveness as a safe haven.
The reduction in CGS in recent years has been directly linked to the Government's sound fiscal strategy. This fiscal strategy has also contributed to strong economic performance and prospects. This, in turn, contributes to reducing the impact of financial instability on the Australian economy.
To the extent that financial instability still occurs, a key issue in determining the future of the CGS market is whether other assets can act as a safe haven or mitigate against financial instability.
If no alternative safe haven assets exist in Australia, then financial instability may lead to capital flight. This may push down the exchange rate and further disturb unsettled financial markets. The International Monetary Fund has identified this safe haven role as a key uncertainty in assessing the need for a government debt market (Box 6).
However, investors can hold alternative investment vehicles such as AAA/Aaa rated corporate bonds, mortgage-backed securities, or cash at commercial banks during financial distress. Cash could involve lower returns than alternative investments, but provide a suitable low risk substitute for CGS. Australia's sound prudential regulation of the banking sector ensures investors are likely to view bank assets as relatively low risk. Cash would be a less acceptable substitute when inflation is very high but this is less likely to be relevant in Australia with its well entrenched monetary policy framework and low inflation environment.
A key issue in an episode of financial instability is liquidity - that is, the ability to convert assets to cash or another safe asset when required. The RBA can provide emergency liquidity to the financial system by making funds available to the market as a whole through its open market operations. The RBA also can lend directly to an institution (governed under the Corporations Act 2001) in cases of liquidity difficulties, if the failure of the institution to make its payments could seriously affect the financial system. This would help calm unsettled markets, and therefore reduce the need for investors to seek safer assets.
The strength of the United States' (US) fiscal position through the late 1990s and early 2000s resulted in significantly reduced US Treasury securities on issue. This reduction raised concerns about the continuing role of the US Treasury securities market in the US financial markets - similar to the current situation in Australia. The International Monetary Fund (International Monetary Fund, 2001) examined the implications of the decline in the US Treasury securities market and the prospects for private sector instruments to fulfil the roles currently played by US Treasury securities. (See Appendix 4.)
The International Monetary Fund analysis concluded that uncertainty surrounded the ability of the private sector to provide an adequate substitute for US Treasury securities as a safe haven during periods of instability. US Treasury securities were not only an important safe haven product in US domestic markets, but also a significant international safe haven. The International Monetary Fund acknowledged that determining the risk associated with the absence of US Treasury securities is very difficult, given little is known about the links between market dynamics and safe haven assets.
The International Monetary Fund also recognised that longer-dated US Treasury securities may enhance the ability of investors such as pension funds and insurance companies to achieve desired portfolio risk-return targets. In the absence of US Treasury securities, the limited supply of high quality, long maturity fixed interest instruments in the private sector may complicate portfolio management. This would require a greater focus on managing the risk generated by the mismatch between the long-dated liabilities and shorter-dated assets.
The International Monetary Fund found that participants in US financial markets increasingly used private sector alternatives for pricing and referencing other debt securities and managing financial risk. Indeed, several markets already assume a limited benchmark role in these areas. These markets include the corporate debt, agency debt and interest rate swap market.3
In an example of this, central banks around the world acted after the September 11 terrorist attacks to boost liquidity in their financial systems to ensure markets did not experience systemic failures resulting from disruptions in payment and settlement systems or the increased risk aversion. This was designed to ensure the continued smooth operation of markets rather than to change monetary conditions (Reserve Bank of Australia, 2001a).
Other approaches also may be available to the Government. For example, the Government could issue shorter term instruments to provide safe haven assets when required. The Government is likely to continue to issue Treasury Notes given the volatility of cash flows throughout the year. The Government could consider issuing large quantities of additional Treasury Notes at times of financial instability to increase the supply of safe haven assets. This approach need not detract from system-wide liquidity. It could involve offsetting cash injections or being prepared to accept non-cash assets in return for Treasury Notes.
However, very important practical issues may be associated with the use of Treasury Notes at times of financial instability. First, it may be difficult to identify the onset of a crisis in time for Treasury Note issuance to be an effective safe haven. Second, large-scale issuance of Treasury Notes during an episode of financial instability may diminish confidence. This is particularly important as market confidence is critical at such times.
The Government would appreciate views from stakeholders on:
- the importance of the CGS market in providing a safe haven during periods of financial instability;
- what evidence there is of the role of CGS as a safe haven? and
- what possible alternative safe havens exist and how appropriate they are?
The CGS market may attract foreign capital into the Australian economy.
Need for foreign investment in Australia
The need for foreign investment in Australia depends on the gap between domestic savings and investment, which translates into the current account balance (Chart 19). If domestic savings meet domestic investment, then net foreign investment is not needed (gross foreign investment may occur but it will be matched by Australians investing overseas).
The Government's fiscal strategy is to maintain budget balance, on average, over the course of the economic cycle. Higher Commonwealth general government saving can contribute to improved national saving and reduce pressure on the current account deficit.
Source: Australian Bureau of Statistics, 2002b.
Since the Government is not investing more than it is saving (and therefore not borrowing by issuing CGS), it does not require additional foreign capital inflow. Instead, private sector savings and investment decisions will determine whether additional foreign capital inflow is required.
Impact on foreign capital flow of reducing the supply of Commonwealth Government Securities
Foreign investors will invest in Australia if the rate of return encourages them to invest here, rather than elsewhere. The savings-investment imbalance may enter investors' calculations if they believe that it signals future exchange rate movements that will influence foreign currency returns.
Reduced CGS supply would increase the price of the remaining CGS outstanding, causing interest rates on CGS to fall. Investors who value CGS very highly would accept a lower return to hold the scarcer CGS.
All other financial assets are considered substitutes (although imperfect) for CGS, so the increase in the CGS price would cause investors to buy other financial assets. This would increase the price of these assets and reduce their interest rates. While a very diverse range of other financial assets exists and this change in demand would affect some more than others, in broad terms, the average interest rate on all other assets would fall.
As such, the net effect of reducing CGS outstanding would lower average interest rates in the domestic economy, which should stimulate physical investment and therefore national income.
Assuming foreign interest rates do not change, lower Australian interest rates are likely to cause some foreign investors to reduce their holdings of Australian assets, to buy higher yielding foreign investments. However, some foreign investors will be more sensitive to interest rate changes than others. Some foreign investors strongly interested in maintaining a portfolio of Australian assets, partly due to their confidence in Australia's sound macroeconomic and policy framework, will not necessarily withdraw their capital. In this case, reduced supply of CGS may see these investors replace some of the CGS in their portfolio with other domestic assets.
In contrast, an investor solely investing in Australia to gain exposure to sovereign debt, will invest in alternative sovereign debt, if the CGS supply is reduced.
Some investors follow a global bond index in establishing their investment portfolio. Sovereign global bond indices rank sovereign bonds by the amount on issue in each bond line. For example, the Salomon Smith Barney Global Bond Index includes governments with $250 million on issue in a given line and US$20 billion overall outstanding. Greater issuance would raise the country's position in the index (if other countries did not change their issuance). Consequently, reducing the supply of CGS would reduce foreign investment from those investors who passively follow a global bond index.
The International Monetary Fund and World Bank (International Monetary Fund and World Bank, 2001) recently noted that government debt markets can play a role in developing private financial markets. Both private and public sector debt markets provide a potential destination for foreign capital. This is likely to be most relevant for countries trying to establish financial markets. However, it is less likely that removing a government debt market from an already sophisticated financial market would have adverse consequences.
Issuing CGS to attract capital inflow, on balance, may not be a sensible policy. The level of capital inflow is not a policy goal in itself. A more desirable policy goal is to keep the cost of capital in Australia as low as possible. If the reason for the additional capital inflow is that additional CGS issuance drives up Australian interest rates, then issuance would be undesirable as higher interest rates will reduce investment, consumption and domestic output.
Putting aside passive global bond index investors, the Government's fiscal strategy should mean private savings and investment decisions drive the need for foreign capital inflow. To the extent that foreign capital is required to finance domestic investment, then generally sound economic, political and social environment should attract foreign investors into Australia. Australia has a very strong record of building and maintaining a stable macroeconomic framework and undertaking ongoing structural reform.
The Government would appreciate views from stakeholders on:
- whether the absence of a CGS market would affect Australia's attractiveness to foreign investors; and
- how important global bond indices are for foreign investment in Australia.
The CGS market may play a role in promoting Australia as a global financial centre.
Australia's attractions as a global financial centre
In recent years, the Commonwealth Government has taken steps to promote Australia internationally as a global financial centre. Axiss Australia has outlined the following benefits that Australia offers: 4
- a strong economy;
- liquid and innovative financial markets;
- a secure business environment;
- low cost property;
- world class information and communications technology;
- people skills to service the region;
- competitive salaries and other business infrastructure costs;
- excellent quality of life; and
- time zone advantages.
The deregulation of Australia's financial markets has ensured that highly developed markets exist for equities, debt, foreign exchange and derivatives. Total turnover in these markets is around $43,000 billion per year. Turnover in the debt market accounts for over half of turnover across the financial markets.
In recent years, the volume of non-government debt outstanding has risen while the volume of Commonwealth debt has fallen. New domestic issues of bonds by non-government borrowers now are at record levels.
Increased issuance has led to higher volumes being traded in the secondary market. Turnover in fixed coupon non-government debt securities was around $150 billion for the year ending June 2001, around 20 per cent higher than the previous year. Most turnover within the non-government debt market is in corporate securities, bank securities and mortgage-backed bonds. Most securities traded are rated A+ or above.
Issuance by offshore borrowers, both through domestic issues (Kangaroo bonds) and global structures, has picked up significantly. Kangaroo bonds outstanding now are around $18 billion. (See Chapter 2.)
Development of private capital markets
The International Monetary Fund and World Bank have recently noted that government debt markets can play a role in the development of private financial markets. Often, the development of government bond markets facilitates the necessary exchange mechanisms and institutional frameworks to develop private markets - for example, settlement systems, trading systems, and central security depositories.
One argument used to promote Australia's role as an international financial centre is the highly skilled, well-educated and multilingual finance sector workforce. Whether having employees skilled in the operations of the CGS market provides positive benefits for other segments of the financial markets is unclear. If it does, then the CGS market may indirectly reduce transaction costs.
In Australia, market infrastructure is highly efficient with sophisticated risk management instruments available. If the Government withdrew from the market and this infrastructure deteriorated, then transaction costs, and therefore the cost of capital in Australia, may be higher than if the Government remained in the market.
Market infrastructure is unlikely to deteriorate significantly in the absence of outstanding CGS. More likely, the infrastructure would 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.
Australia is the leading regional market in interest rate derivatives. If derivatives markets continue to develop, particularly in interest swaps and corporate bond derivatives, then they would maintain Australia's role as a flexible and dynamic financial centre.
Whilst the CGS market has clearly assisted with financial market development, it is less clear whether removal of the market would hamper further financial market development. Indeed, withdrawal of the CGS market may encourage further innovation and development.
Innovation in Australia's financial markets
Given the growth in private markets in recent years, the absence of the CGS market may not affect Australian financial market liquidity or innovation. Australia's financial markets may become more innovative as new products are developed to fill the roles played by CGS. For example, the absence of CGS may generate new derivative products for risk management.
Australia already offers a broad range of benefits as a centre for global financial services. Further development of private financial markets and products should strengthen Australia's benefits from deep and liquid financial markets.
The Government would appreciate views from stakeholders on:
- whether the CGS market plays a significant role in promoting Australia as a global financial centre; and
- whether the absence of a CGS market would affect transaction costs and Australia's attractions as a centre for global financial services.
2 The over-the-counter derivative market refers to customised derivatives that suit the individual needs of the counterparties. The individualised nature of these derivatives means it is not feasible to trade them on an exchange. Derivatives traded on exchanges have pre-determined and commonly understood parameters, such as principal and settlement dates.