Memo Coalition: Why our bond yields are falling

LAST week, while our attention was diverted, something amazing happened. In effect, global investors paid the German government to borrow their money and return it in 10 years' time.

Sure, there was a catch. The investors bought inflation-indexed bonds, which means the money they get back in 2022 will have grown to match inflation in the meantime. If inflation in Germany in the next decade is the same as in the previous one, that means if they invest ?10 million ($A12.8 million), they'll get back ?11.675 million. But in 2022, that will buy them only what ?10 million buys them now.

And to park their money like this, investors paid the German government 0.24 per cent of the amount they invested: ?24,000 for every ?10 million. Imagine if the Commonwealth Bank or NAB were to pay us to borrow money from them, and then we eventually pay them back just the amount they lent, plus inflation. Any volunteers?

It shows you how fear has taken over among global investors. They are pulling out of stock markets because they sense they are more likely to lose money there than make it. And they are putting that money in low-risk bonds regardless of how little they pay.

It was not the only coup Germany pulled off last week. It also offered a two-year note, on which it promised to pay no interest at all. Give us ?10 million now, and we'll pay you back ?10 million in 2014; that's the deal. To get investors into this one, the Germans did have to pay a small yield, but just 0.07 per cent. That's value!

Rabobank International strategist Richard McGuire summed it up neatly: "It reflects the now-familiar crisis-induced trend of investors favouring the return of their money over a return on their money."

When confidence is high, investors buy shares or other ventures offering good returns, accepting risk. But in a crisis, as in Europe now, they sell shares and retreat to the safety of the bond market. And there, they lend to governments they know will repay them, not to those offering high returns.

In Europe, pre-crisis bond yields differed little from one country to another. Now the gaps are huge. At last count, 10-year bond yields were 1.37 per cent for Germany and 2.5 per cent for France. But for Italy, they were 5.79 per cent, in Spain 6.32 per cent, Ireland 7.46 per cent, Portugal 12.37 per cent and Greece 29.68 per cent. Countries regarded as safe are issuing debt more cheaply than ever before. Countries in trouble are finding debt either expensive or impossible to issue.

Australia is one of the winners. The Australian Office of Financial Management, which manages the government's debt, has won Risk magazine's global award as sovereign risk manager of the year twice in the past four years. Yields have plunged for Australia's Treasury bonds, inflation-indexed bonds and notes which in turn set benchmarks for yields on bonds issued by Australian companies.

Since 1998, our bond yields have usually ranged between 5 and 6 per cent. But in recent days, the Office of Financial Management issued a new 10-year bond at a yield of just 3.15 per cent, a five-year bond at 2.65 per cent, and a three-year bond at just 2.52 per cent. Yields have fallen by half in a year.

Why? Because global investors have flocked in to buy Australian government debt. Their concern is not that we have too much debt, but too little. IMF figures show that of the 34 advanced economies, Australia has the third smallest ratio of gross debt to GDP: including state and municipal debt, it's just 24 per cent of GDP. By comparison, Germany has a debt-to-GDP ratio of 79 per cent, the United States 110 per cent, and Japan 241 per cent.

The Coalition and its allies are like a broken record warning that Australia is swimming in debt and putting itself in danger. That is simply untrue. Ask yourself: if Labor's borrowing has put us in danger, why is Australia one of only eight countries rated AAA by all three global ratings agencies? Sure, ratings agencies make mistakes, as we all do, but are they that incompetent?

The surge in demand for Australian bonds that has driven yields down has come from overseas buyers. Are these investors incompetent in seeing Australia as a safe bet? No. Rather, the Coalition is using rhetoric to make a dangerous case that doesn't stand up. Australia's debt levels remain very low by world standards. Net debt is expected to peak at less than 10 per cent of GDP here; in Greece, it's about to hit 160 per cent. That's some difference.

The question we should ask is: why aren't our debt yields even lower? Other AAA-rated countries pay far less to borrow than we do. Even the US and Japan, on lower ratings and with critical long-term debt problems, are paying only half to a quarter as much.

The reasons are not clear, but there are several suspects. Because Australia has so little debt, it is less easy to trade, which imposes a premium. Our inflation rate is still a bit higher than in Europe, Japan or the US, which puts a floor under the yield. We are far from the bond traders, and less well known.

And foreign investors are wary of a nation where house prices are so high relative to income, where for 30 years the current account on average has been in deficit by 4 to 5 per cent of GDP, and where banks have a lot of short-term foreign debt, and far fewer foreign assets.

That is what a Coalition government would inherit. It should be thinking about it now.

Read more >>

State's prayer: 'Get us out of debt, but not yet'

IT WAS the young St Augustine who prayed: "Lord, make me chaste but not yet." Last week he was joined in the pews by the young Baillieu government.

After denouncing the Brumby government for taking on new debt to build infrastructure, Team Ted's first budget did just the same. It increased spending, cut taxes, and paid for it by almost trebling the state's debt from $8 billion in mid-2010 to a projected $23 billion in mid-2015.

At the same time, like its predecessor, it pledged to stabilise the debt in a few years' time but now at $23 billion, rather than the $16 billion Labor promised last year.

Both sides are united in the same prayer: "Lord, make me stop living off debt but not yet."

Last Tuesday's budget focused justifiably on keeping Ted Baillieu's campaign promises. Most were humane, targeted programs to benefit pensioners, low-income earners and first-home buyers, and to boost services such as public transport and mental health.

Treasurer Kim Wells argued that the government could not tackle the debt while implementing these promises.

That it chose to keep its promises tells us something about Baillieu. But that it put off tackling the debt indeed, allowed it to treble also tells us that his rhetoric about the "ruinous" fiscal position left by Labor is just rhetoric.

The Brumby government had serious flaws, but its handling of state finances was responsible, as the state's AAA credit rating testifies.

But now the focus switches to what comes next. And that could be very different.

The day after the budget, Wells foreshadowed that next year's budget will be tough. By then, the government will have received the final report of the Vertigan review of state finances that will examine how and where spending can be cut.

The panel's first report last month claimed the state's finances were already in underlying deficit, and on an "unsustainable" course. It urged spending cuts of $2 billion a year to put things back on track and finance future investment in infrastructure.

Rather than using debt to help finance infrastructure spending, as governments have done for centuries, the Vertigan panel called on the government to:

Pay off all infrastructure spending within 10 years claiming the main benefits of new infrastructure projects are to the generation that builds them, not future generations.

Pay off its existing debt as soon as possible.

Ensure that net infrastructure investment, as defined by the Bureau of Statistics, is around 0.5 per cent of gross state product each year. By contrast, Tuesday's budget envisaged it will be just 0.02 per cent of GSP in 2013-14, and 0.12 per cent in 2014-15.

These are very challenging goals particularly for a government that has begun its term by increasing spending and debt. The government has yet to respond, and Wells declined to do so last week. But he agreed in principle that infrastructure spending should be financed by taxes, not debt.

"Over the long term, we want to be able to generate enough cash in the operating surplus to be able to fund our infrastructure works," he said. "I find it difficult to believe we are going to fund infrastructure projects with debt in the long term."

But to finance them with cash, you need either more cash (a.k.a. higher taxes) or big cuts in spending. And if Baillieu is to meet voters' expectations of better infrastructure, he will have to spend even more on it. His government, like Brumby's, could promise to stabilise the debt only because it plans to turn down the flow of infrastructure spending to a level that, on the Vertigan panel's definition, would barely keep assets at current levels.

The issues the panel raised are real, so it's a pity its report was so flawed. It began by falsely claiming the government's April statement on state finances "suggested the current level of debt may be significantly larger than previously reported". It didn't, and they weren't.

Its claim that government spending has jumped sharply to an unsustainable trend ignores the reason why: the federal stimulus that staved off the global financial crisis was paid through the states and that spending is deflating already. The state's share of Victoria's spending including infrastructure was 12 per cent at the end of the Kennett government, and rose to 12.5 per cent in the three years to 2008. That was needed, and it was sustainable.

The panel's argument that infrastructure investment should be paid for by the current generation because its main benefits flow to them is just nonsense. The railway network built in Melbourne in the late 19th century benefited the millions of people who have lived in Melbourne since far more than it benefited the relative few living in Melbourne at the time. The same is true of roads, schools, hospitals, parks, dams even desal plants.

Baillieu has an alternative: to rely on future growth and sustained fiscal discipline, with some spending cuts, to allow him to build more infrastructure without increasing debt faster than the state's output.

After all, he needs a solution that is compatible with winning re-election.

Read more >>

Tackle the debt - IMF tells US

THE International Monetary Fund has called on the US to take "decisive policy action" to bring its government debt under control, warning that it is on track to be almost 100 per cent of GDP by 2020.

In its annual report on the US, released last night, the IMF said the Obama administration and Congress needed to go further to tackle the budget deficit which IMF staff estimate will be between 5 and 8 per cent every year over the next decade.

The IMF's board of directors made it clear that both tax rises a taboo for Republicans and spending cuts would be needed to bring the US budget back anywhere near balance, let alone into surplus.

"A larger than budgeted adjustment would be required to stabilise debt to GDP under the staff's economic assumption, requiring revenue and expenditure measures," it said.

It urged reform of entitlements, such as farm subsidies, pensions and benefits. It also urged the US to aim to cut its debt-to-GDP ratio over the longer term. The US has run just one budget surplus in the past 50 years.

A separate report by IMF staff estimates the deficit this year will be 11 per cent of GDP (compared with 3 to 4 per cent in Australia). That is forecast to halve by 2012, but then rise as the ageing population and soaring health and debt costs inflate spending.

The report tips the 10-year bond rate to average 3.6 per cent this year, but then jump to 5.9 per cent by 2012, and to 6.5 per cent thereafter.

The staff estimate that gross government debt will be larger than the US GDP by 2012.

"The mission saw a key macro-economic challenge as ensuring that public debt is put and is seen to be put on a sustainable path, without jeopardising the recovery," the staff report said.

"Under current policies, federal debt held by the public could rise from 64 per cent to 95 per cent of GDP by 2020."

It suggests most of this will need to be bought by domestic investors, with foreign investors likely to unwind their holdings.

"Over the medium term, higher real interest rates will be needed to encourage the implied portfolio shifts," the report said.

The report lays bare clear disagreements between the IMF team and the US authorities over prospects for the US economy, and hence for returning the budget to some form of sustainability.

In Melbourne yesterday, Harvard historian Niall Ferguson warned that competition between a rising China and a fiscally weakened US could lead to conflict.

Read more >>

Fiscal time bomb yet to explode

PAUL Krugman has a Nobel Prize in economics, and we don't. He is also a columnist with The New York Times, where he writes with insight, deep knowledge, and the courage of his convictions. But he's not infallible. Martin Wolf is chief economics commentator for London's Financial Times, and the most respected of all our tribe worldwide. His columns are rich in detailed grasp of the facts, and in wisdom to judge what weight to give them. But he too is not infallible.

It is because Krugman and Wolf have earned such respect and trust that their crusades, if misdirected, become very dangerous. In my view, that is happening now.

Both disagree sharply with the change in economic tack by Western policymakers in the wake of the Greek fiscal crisis, the subsequent panic in financial markets, and the Tories' victory in the British election.

Last year's consensus was that governments and central banks should remain focused on fighting the legacy of the global recession, and be wary of withdrawing their fiscal and monetary stimulus too soon.

But this year the world has focused on the flipside of that stimulus: debt.

And the more policymakers have focused on debt, the more alarmed they have become: not only by the debt run up to end the recession, but the accumulated debt that has financed three decades of deficits in the G7 economies.

In the 1930s, Keynes taught us that, rather than governments aiming to run balanced budgets, they should adopt a counter-cyclical role: borrow and spend in bad times, when private sector demand has collapsed, then save and repay the debt in good times, when the economy needs no support.

But outside Australia, the first of these goals has proved far more popular with governments than the second. The United States has run a budget surplus just once in the past 50 years. Japan, France and Italy have not run a surplus in the past 30 years, while Britain has had just five years of surplus amid 25 years of deficits. This year, the International Monetary Fund forecast in April, G7 deficits would range from 11.4 per cent of GDP in Britain and 11 per cent in the US, to 5 per cent in Canada, Italy and Germany.

Most alarmingly, by 2015, when their economies are forecast to be back to normal, they would still be running deficits of 7.3 per cent of GDP in Japan, 6.5 per cent in the US, and 4 to 5 per cent in Britain, France and Italy.

Is this sustainable? Take a look at the table below, which shows the IMF's projections of net debt in 2015. Since the Reagan era began, the net debt of the US has soared from 25 per cent of GDP to 66 per cent, and on current settings, the IMF projects it will reach 86 per cent by 2015, and 107 per cent (roughly Greek levels) by 2020.

Japan and Italy already have net debts above 100 per cent of GDP, and by 2015 the IMF projects debt ratios of 75 to 85 per cent of GDP for Britain, France and Germany.

(And Australia? See how low our debt will be? There is no debt problem here. Our problem is having a Liberal Party so clueless on economics that it doesn't know what our real problems are.)

Worse, those G7 debts were run up in good years. Yet the real fiscal time bomb is yet to go off. The West is now in a demographic "sweet spot": many people of working age, relatively few children and retirees. But over the next 20 years, the baby boomers will retire, shrinking the number of workers who pay taxes, while doubling the number of retirees governments will have to support in healthcare, pensions and aged care.

During the Greek crisis, I recalled one of the Reserve Bank's rules of thumb: decide which risk has the most serious consequences if you get it wrong, then lean against it.

The worst risk to the global financial system is not that of investors losing confidence in the Greek government's ability to pay its debts. It is the risk of investors losing confidence in the US government's ability to pay its debts.

Rubbish, Krugman and Wolf interject. The US has deep, sophisticated financial markets. It borrows only in its own currency, and could meet any crisis by raising taxes. Where did the investors fleeing Europe put their money? In US government bonds. It is, Wolf says, "the world's most credible reserve asset".

I humbly disagree. The only sense in which the US is a credible safe haven is that markets now view it as such. But in their modern classic on asset booms and busts, This Time is Different (Princeton), Carmen Reinhart and Kenneth Rogoff show that markets normally view the build-up of dangerous debt overload as safe until the moment the truth dawns, when suddenly everyone wants out.

As long as Washington has a political culture in which one side will veto any tax rise and is indifferent to debt, no one can guarantee that future US governments will honour their commitments. A recent survey of US investors found 46 per cent thought it likely that Uncle Sam would default within a decade; only 33 per cent thought it unlikely.

If this global financial crisis seemed bad, just wait for the one we'll see when investors no longer trust the US government.

That is the risk we must avoid at all costs.


THE G7, AND A SMALL PROBLEM

Net debt as a percentage of GDP: 1990, 2015

USA 46%, 86%
Japan 13%, 154%
Germany 29%*, 75%
Britain 27%, 84%
France 25%, 95%
Italy 89%, 122%
Canada 44%, 30%
Australia 6%, 4%**

*1991 ** Treasury estimates, 2015-16

SOURCE: INTERNATIONAL MONETARY FUND

Read more >>

Greek lesson in the perils of overspending

THE fatal riots in Athens reflect the vast gulf in how the Greek financial crisis is seen at home, and in the world. Greeks, by and large, are outraged by the cuts and reforms thrust on them by their government, the European Community and the International Monetary Fund. "It's not fair!" they insist. "Why are they doing this to us?"

To outsiders, it's all too clear. Greece has been living beyond its means for years, borrowing heavily from the rest of the world and, until recently, fudging its books to hide the reality. The financial markets no longer trust it, and will not lend to it or roll over debt, except at prohibitive prices. That's what happens when you push your luck too far.

The facts are simple. Last year, Greece ran a budget deficit equivalent to 13.5 per cent of its gross domestic product (compared with 4.1 per cent in Australia). Its gross public debt was 115 per cent of GDP (as against 16 per cent in Australia), and rising rapidly. And the banks would not lend more.

How did it get there? Take its pension system. Greeks can retire early on a lifetime pension equivalent to 80 per cent of their final salary, and indexed to match wage growth. They receive 14 months a year of pension payments, with bonuses at Christmas and Easter. The OECD estimates that some Greeks actually receive more on the pension than they did when they were working.

In Germany, which underwent bruising pension reforms in the mid-2000s and now finds itself unwillingly funding 30 per cent of the EU's bailout for Greece, top-selling tabloid Bild went to town. "Why do we have to pay Greece's luxury pensions?" its front-page headline demanded last week, alongside a photo of an elderly Greek pensioner it said was paid $A5000 a month.

Greece, it told readers, is "the land of bankrupts and luxury pensions, tax dodgers and rip-offs. It's a country where the authorities use satellites to search for houses with swimming pools, in order to send the owners a tax bill." It reported that Greeks on average paid almost $A2000 a year in bribes, and shops routinely refused to provide tax receipts for purchases.

And that is part of the story. Greece joined the European Union, joined the euro, but never became part of that northern European culture in which officials, taxpayers and citizens obey the law because they see the state as theirs. In Greece, tax evasion and corruption are rife. Transparency International's annual index finds investors rate it the most corrupt country in the developed world, worse even than Saudi Arabia and Ghana.

And change is not coming easy. American-born Prime Minister George Papandreou, elected last October, has taken a series of courageous decisions to admit the true state of Greece's finances, and impose cuts and reforms across the board to reduce the deficit from 13.5 per cent of GDP to 3 per cent within three years.

Pensions have been frozen, and in some cases cut. Early retirement has been abolished. The public sector will hire no new staff in 2010, except for essential positions. Some 10,000 qualified applicants have been turned away. From 2011, hiring will resume, but only at the rate of one public servant hired for every five who leave. Contract employees will be terminated, overtime payments have been cut by 30 per cent, bonus payments and salaries have been cut, and public sector wages reduced overall by 10 per cent in the government itself and by 13 per cent in its enterprises.

But Greeks have rebelled, with a poll finding 51 per cent vowing to fight the cuts. At one end of society, the Athens rioters demand that the rich should pay, not them. At the other, London real estate agents Knight Frank report that 6 per cent of all purchases of London properties for more than £2 million ($A3.2 million) in recent months have been by Greeks shipping their money out of the country.

The biggest risk is that nervous markets are now losing confidence in the other heavily indebted, high-deficit countries of western Europe. Spain, Portugal and Ireland form the new frontline of countries that could be forced to replay the Greek tragedy.

It's a great case study for fiscal prudence.

Read more >>