Tag Archives: finance

Park the Debt Truck!

About two months ago, I tried to bring some perspective to concerns about growing government debt in Australia. Last week the opposition has rolled out the “debt truck” to add to the hysteria about growing government debt, so I feel compelled to return to the subject for another attempt.

Last time I looked at net debt data going back to 1970. The data came from a chart in the Treasury paper “A history of public debt in Australia”. The paper also shows a history of gross debt and although I prefer to use net debt, the gross debt data goes back further, all the way to 1911 and so gives a longer historical perspective. As usual, I have posted the data on Swivel.

The alarmists like to trade in dollar figures, pointing to forecasts that gross government debt will peak in 2014 at $315 billion, which will be an all-time record. Of course, that ignores the effects of inflation, so it makes far more sense to look at the debt as a percentage of gross domestic product (GDP). Expressed this way, the 2014 forecast amounts to an expected 21% of GDP (while net debt will be 14%). As is evident in the charts below, this is about the same as in the years following the recession of the early 1990s and it is nowhere near levels in the more distant past. Immediately after World War II, gross debt reached an enormous 125% of GDP.

History of Government Debt

Figure 1 – Australian Government Debt (1911-2008)

If you are wondering about the shaded bands in these charts, they indicate periods of Labor Governments. The opposition is fond of saying that debt falls under Coalition governments and rises under Labor governments. Looking at the data, it is certainly true that government debt fell through both the Menzies and the Howard years (a pairing that would, I am sure, warm the cockles of our previous prime minister’s heart). Beyond that, the link is not so clear cut. What seems more apparent is that government debt fell during good economic times and rose during bad economic times and, moreover, the Coalition have not had a monopoly on good economic times nor Labor on bad. This pattern should not be the least bit surprising. When the economy booms, tax receipts rise and unemployment falls, reducing the cost of welfare payments and when it falters, the opposite occurs. As a result, the government tends to run fiscal surpluses in the good times, paying down their debt, and deficits in the bad times, increasing debt once more.

Recent History of Government Debt Figure 2 – Australian Government Debt (1960-2008)

What the debt demonisers fail to realise is that this counter-cyclical pattern of government spending is a good thing. The increase in welfare spending in troubled economic times helps boost economic activity, softening the impact of a slowdown, which is why welfare spending is often referred to as an “automatic stabiliser”. In more extreme downturns, such as the one we currently face, the government can supplement the automatic stabilisers with additional stimulus spending.

More importantly, government debt is very different from personal or business debt and is not something to be afraid of. In Australia, we have a currency that is not tied to other currencies, nor to gold or any other commodities. It is “fiat money”, effectively under the control of the government. Furthermore, all of the government’s debt is denominated in Australian dollars. This means that the government can, in fact, never run out of money, unlike individuals or businesses. So, any comparison between government debt and household debt is meaningless. Of course, in practice, governments should control their spending. If they kept increasing spending when the economy was strengthening, there would come a point where this spending would become inflationary. But this is a very different kind of constraint than I face on my spending! To dig deeper into the implications of fiat currency, monetary theory Bill Mitchell has a lot of material on the subject on his blog. A good place to start is his post on gold standard myths.

So, there is no substance to the fear that the opposition is trying to excite with their debt truck. Government debt is not what we should be worrying about. What is more concerning is private debt. Since individuals cannot issue new currency to repay their loans, excessive household debt can be a real concern. And, the chart below shows that there is something to be worried about. While the Coalition may be very proud of the record of government debt reduction during the Howard years, they should not be so happy about what happened to household debt under their watch (and you thought I was being easy on Howard before!). Instead of focusing on the possibility that government debt may reach 14% of GDP by 2014, perhaps the opposition’s debt truck should drive around the country alerting everyone to the fact that household debt is already over 100% of GDP.

Govt and Household Debt

Figure 3 – Household and Government Debt (1976-2008)

Of course, there are some commentators, such as Steve Keen, who are rightly concerned about the excessive levels of household debt. It is very likely that Australia and many other developed countries around the world will experience an extended period of private sector “deleveraging” (debt reduction). As long as consumers are saving rather than spending, this will translate to far lower economic growth than we have been used to in recent years.

To this point, I agree with Keen. Where I disagree is the extent to which this deleveraging will result in massive declines in Australian property prices. But that is a topic for another post, the long awaited sequel to my recent post on property prices.

UPDATE: for a Nobel Prize-winning perspective, here is Paul Krugman arguing that government deficits saved the world.

Pinching Debt Data

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Regular readers of the Mule will know that I am a bit of a data-mining junkie. Whenever I come across an interesting chart I start Googling for the underlying data. But, even with well-honed Google skills, it’s not always possible to find the data. Sometimes it is simply not publically available. I ran into just this problem recently. The recent Australian Federal budget triggered countless alarmist opinion pieces despairing that Australia would be “mired in debt” and this prompted me to do some research of my own. In the process, I came across a handy primer on the subject entitled “A history of public debt in Australia”. Written by a number of Australian Treasury employees in the Budget Policy Division, it included the chart below which shows the history of net Government debt (combining Commonwealth and State debt) over almost 40 years. The chart also includes forecasts for the next few years.

Debt History - Original (v2)

Australian Government Net Debt to Gross Domestic Product

While the paper is clearly quite recent (it has no publication date), the forecasts pre-date those included in the May budget, so I was interested in updating the chart with the latest Treasury forecasts. The underlying data does not appear to be published online and, since I do not work with the authors in the Budget Policy Division, I had to resort to special measures. I turned to a handy (and free, open source) little piece of software I have used a number of times to pinch data from charts. The software is called Engauge Digitizer and it allows you to import an image of a chart and extract the underlying data.

Engauge Digitizer Screenshot

For charts with points or curve segments, Engauge generally does a great job of automatically finding the data. For a column chart like the one I had found, the process is a little bit more manual, but with a bit of clicking on the tips of each of the columns in the image, I had my data. The chart below shows the data I obtained. One indication of the accuracy of the results is that the authors of the history paper noted that net debt had averaged 5.7% of gross domestic product (GDP) since 1970. Satisfyingly, the average of my extracted data over this period was also 5.7%.

Australian Government Net Debt to GDP (imported data)

Having obtained the data, I was then able to replace the forecasts with the more recent Treasury figures included in Budget Paper No. 1.

Debt History - New Forecasts (v2)

Australian Government Net Debt to GDP (updated forecasts)

For the alarmists who are worried about this growing debt, it is useful to put these forecasts in a global perspective. The chart below puts these Treasury forecasts alongside IMF forecasts for a number of other developed countries.

World Debt Forecasts

Global Debt to GDP Forecasts

Compared to the rest of the developed world, the global financial crisis is still not looking quite so scary for Australia. When it comes to the United Kingdom, rating agency Standard and Poor’s is even more pessimistic than the IMF and is concerned that their net debt could reach 100% of GDP and have accordingly changed the credit rating outlook for the UK to negative.

UPDATE: For anyone interested in getting hold of the data without resorting to scraping it from the images, I have uploaded it to Swivel. This dataset includes the most recent Treasury forecasts.

Dubai Perspectives

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dubai-small I’m hoping to try something a little bit different here on the Stubborn Mule: a guest post.

But first some background. Recently I came across this article in the Independent exploring the “dark side” of Dubai. It paints a very grim picture of massive crumbling developments, environmental degredation, Western ex-pats who either revel in luxury or are thrown into debtors prison and a society built on the backs of an immigrant sub-class of near slaves. I know very little about Dubai, or the rest of the United Arab Emirates (UAE) for that matter, but found the article a compelling read. So, as usual, I shared the link with my social networks on twitter* and Facebook. This drew an immediate response from a friend who has lived in the UAE who thought it painted a very distorted picture of Dubai. So, I have offered her a guest spot here on the Mule to present an alternative perspective.

So, with any luck you’ll be reading the first guest post here very soon.

UPDATE: the article is written, but waiting on clearance. Fingers crossed!

FURTHER UPDATE: sad to say it looks as though the piece is not going to see the light of day. My guest poster’s employer has ruled out any scope for publishing the piece, even if it is done anonymously. It was to have given a more positive picture of Dubai, but the experience suggests to me that on the score of openness at least, Dubai does not do well!

* In fact, I suspect that I came across the article on twitter in the first place.

Who is to Blame for BrisConnections?

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Bolton as The Dude In the latest instalment of the ongoing debacle that is BrisConnections, Nicholas Bolton shrugged off the mantle of hero to mum and dad shareholders in exchange for a secretly arranged $4.5 million dollars. I have to admit I would have enjoyed the Schadenfreude of seeing Bolton continue to stick it to Macquarie Bank, but whatever his shortcomings (which include a striking resemblance to the One.Tel dude—thanks to the friend who pointed this out to me and to Crikey!), and however tempting it is to blame him for not finishing the job, it was never his job to protect shareholders.

When it comes to assigning blame, it should fall fair and square on the ASX. If they were doing their job properly, they should never have allowed BrisConnections to be listed in the first place.

To explain why requires a (relatively) brief explanation of instalment receipts. Also known as partly paid shares, they are a means a of issuing shares in a company in stages. If a company was estimated to be worth around $200 million, rather than issuing 100 million shares at $2 each, this approach involves selling 100 million “instalment receipts” (rather than fully paid shares) at $1 each. At some point in the future, holders of these receipts would pay a further $1 and their receipts convert into ordinary shares. This means of raising capital is very well suited to construction projects where the company does not require all of the capital upfront and was, for example, used to finance the construction of the Sydney Olypmic Stadium prior to the 2000 Olympics.

So, using instalment receipts was a natural approach to raising capital for the construction of Brisbane’s Airport Link. However, there is a crucial difference between the approach Macquarie Bank used with BrisConnections and most previous projects such as the Olympic Stadium and the Telstra privatisation. In the earlier examples, payment of later instalments was optional. Holders of instalment receipts had the choice of paying the next instalment and converting their holdings to fully paid shares or simply walking away with nothing. However, in the case of BrisConnections, paying the instalment is not optional and this makes a big difference.

To see why, I’ll go back to the hypothetical example of the $200 million company. Imagine that, for some reason (project problems, global financial crisis, or whatever), the value of the company fell to $150 million and then to $100 million and finally to $60 million. If they had originally raised capital by issuing 100 million $2 shares, then the share price would fall to $1.50, then to $1 and finally to $0.60. Obviously investors would be disappointed to see their investment fall in value, but these things happen on the share market.

Now imagine that they had issued 100 million $1 instalment receipts with a compulsory instalment payment of $1 in the future. So, even though the original investors had only invested $1, they had effectively committed $2. Initially worth $1, these instalment receipts would fall in value to around $0.50 when the company fell to $150 million. This is because the overall value of a fully paid share is $1.50 and instalment receipt holders have committed to paying the final $1, so the balance is $0.50. It gets messier as the value of the company continues to fall. When the company is worth $100 million, the instalment receipts are essentially worth $0 and with the company worth $60 million they should be worth negative $0.40! What this means is that a holder of one of these receipts should be prepared to pay someone $0.40 per receipt to take them off their hands. Since a “buyer” of the receipts considers the company to be worth $0.60 per share but knows there is a commitment to pay $1, they would want to be compensated $0.40 per share to take on the commitment of paying the instalment.

This is where is gets problematic for the ASX. The way the stock exchange system is set up, it is impossible to trade on the exchange with negative prices. So, even though these hypothetical receipts have a negative value, they would have to trade at a positive price. And they are not worth that! This is exactly what happened with BrisConnections. It got to the point where it was trading at price of a fraction of a cent when the value of the instalments were in fact negative. As a result, investors unaware of the future instalment obligation thought they were snapping up large numbers of shares at a bargain price and instead are now faced with enormous liabilities that many will simply be unable to pay.

The ASX has responded by announcing new rules requiring better disclosure from brokers. This misses the point. No amount of disclosure will change the fact that BrisConnections instalments could not be traded at real, negative prices. Even if everyone had full disclosure and (assuming no-one was trying anything tricky like Bolton) so no-one bought any units at near zero prices, this would leave the problem that existing investors would be unable to sell their holdings at all.

When the BrisConnections receipts were first listed, everyone might have expected the value of the company to go up not down, but the possibility that it could have gone down was always there and this should have raised alarm bells with the ASX right from the start.

Put simply, if the ASX cannot cope with negative prices, they should never allow anything to be listed on the exchange that has the slightest chance of having a negative value.

Since instalment receipts are hardly new, why has this only come up now? The secret lies in the fact that the instalments for Telstra, the Olympic Stadium and so many others were optional. Since there would never be a committed liability for instalment holders, the prices of the receipts could certainly go down to very close to zero, but they could never be negative. Of course, if no-one paid the instalment this would create some difficulties for the company and they would have to raise fresh capital, but a debacle like BrisConnections could never happen. Why was BrisConnections structured with a committed instalment? I can only guess the certainty of future cashflows for BrisConnections made it much easier for Macquarie Bank to pull out fatter fees for structuring the deal in the first place, which is why I would not have been sorry to see it all collapse for them (and it still might). Even if I am right in my suspicions, this would hardly be surprising news about Macquarie. So, I don’t really blame them, I blame the ASX.

AIG and DZ Bank: Dumb and Dumber

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To date, in their efforts to make the Global Financial Crisis (GFC) even more disastrous than it already is, the US Government has pumped an extraordinary $170 billion into the American International Group (AIG), the humbled and humiliated insurance giant. AIG’s biggest problems arose from entering into enormous credit default swap (CDS) transactions. The reason this creates systemic risk is that CDS are bilateral transactions between two counterparties and so if AIG is in trouble, so are the counterparties on the other side of the transaction. CDS are a little like insurance contracts (albeit with far less regulation), which is perhaps why AIG was attracted to the business, and with AIG selling protection, the buyers of protection are nervous.

Dumb and Dumber Given the amount of money that the US Government has provided to AIG, it is reasonable for US taxpayers to expect some transparency from the recipient of their hard earned dollars. Today AIG has begun taking steps in that direction with the release of a number of documents under the heading “AIG Moving Forward”. Among these documents was a list of collateral postings made to AIG’s CDS counterparties. While this does not give the full picture of the vast CDS transactions volumes AIG built up over recent years, it gives an interesting glimpse of some of the larger participants in this dangerous game. The collateral postings are similar to margin payments made on margin loans when share prices fall: as AIG loses money on its CDS, it makes collateral payments to the counterparty to mitigate the risk that AIG may not be able to pay up in the future.

The counterparty list includes many of the usual suspects: Deutsche Bank, Goldman Sachs, UBS, etc. There are, however, a few interesting names. The one that struck me was DZ Bank,. Never having heard of DZ Bank, I had to look them up. It turns out, that Deutsche Zentral-Genossenschaftsbank is the fifth-largest bank in Germany and operates as a central bank for small German co-operative banks. It is not a listed company as it is collectively owned by the 1,000 or so cooperative banks it serves. It seems that providing services to these banks was not enough for DZ and so they branched out into the exotic world of CDS. Based on AIG’s disclosure, DZ have received a total of $1.7 billion in collateral (split between direct payments from AIG up to December 2008, and payments from the Maiden Lane III vehicle established as part of the Government bail-out) and so they ventured into CDS in scale. I can’t help thinking that in doing so, they didn’t know much more about what they were taking on than Waverly Council. It also helps to explain how they managed to lose €1 billion in 2008.

One last point on the subject of AIG. Despite managing to destroy such large amounts of value, it seems that they still want to pay bonuses of $165 million to senior executives. Timothy Geithner, Obama’s new Treasury Secretary, described this as “unacceptable”. I think he was politely trying to say “wake up and see what’s going on around you!”.

How Big Are Australian Banks?

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There is no doubt that the big four Australian banks have navigated the global financial crisis better than many banks around the world, particularly in the US and UK. However, there seems to be a pervasive tendency in Australia to overstate the success of the Australian banks.

A couple of weeks ago, Michael Duffy wrote in the Sydney Morning Herald that

There are only 15 banks in the world which now have a AAA credit rating. The four major Australian banks are among them.

It would be nice if it was true. However, no Australian bank has a AAA rating, they are all in the AA band. There are a few Government-owned or guaranteed banks around the world with a AAA and the only privately-owned bank with a AAA rating these days is the Dutch Rabobank.

More recently, Kerry O’Brien was interviewing the astute Morgan Stanley analyst Gerard Minack when he made the comment

Given that the big four banks in Australia are now in the top 12 around the world, what risk still applies to Australian banks as this scenario that you’ve described unfolds?

Gerard blinked for a moment before moving on, so I suspect he knew that Kerry did not have his facts straight here. By my reckoning (with a bit of assistance from Bloomberg),now that Westpac has taken over St George, it just scrapes in at number 12. ANZ, however, is all the way down at number 33 and the other two are somewhere in between. If I have missed any of the major world banks in my calculations, that would only push Australian banks further down.

The chart below shows data I have uploaded to Swivel giving the market capitalization for 40 of the biggest banks in the world in billions of US dollars. Figures are in thousands of millions (i.e. billions) of US dollars. While management of the big four Australian banks should be pleased with how they are faring, there is no need to blow their trumpets to the point of ignoring the facts.

One final point: it is interesting to note that the three biggest banks in the world today are Chinese banks.

For those who read my earlier Amazing Shrinking Banks post, you may notice that I have added a few more banks, including the large Chinese banks.

The Amazing Shrinking Banks

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Last year, I wrote quite a few posts on the subject of the credit crunch, aka the GFC (“Global Financial Crisis”) or GD2 (“Great Depression 2”). Whatever you want to call it, it has been unfolding for almost two years, and does not show any signs of letting up yet. The hardest hit to date have been banks. Many, including Northern Rock, Bear Stearns, Lehman Brothers, Wachovia, Washington Mutual and every Icelandic bank have fallen along the way, via bankruptcy, merger or Government bailout. Others limp along with the odd adrenaline shot from Government to shake a little more life back into the patient.

Just one of these terminal patients is the Royal Bank of Scotland, whose market capitalization has fallen by 90% over the last two years, despite large injections of capital by the UK Government. The bank’s chief executive, Sir Fred Goodwin, has just resigned and was described by the Telegraph as “the most reviled man in Britain”. The once gargantuan Citigroup has shrunk even more and is now 92% smaller than it was in January 2007. In contrast, whether by good luck or good management, Australian banks have held up well. Nab has been the worst affected, thanks in part to some pesky CDO write-downs, shrinking by 55%. Westpac has weathered the storm better than any major bank in the world, with a fall of only 17% in its market capitalisation. (Quick note to shareholders: your investment will have fallen by more than this since market capitalization equals share price times number of shares and like all banks, Westpac have raised additional capital during the course of the crisis and of course they have also bought St George).

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Volkswagen: The Biggest Company in the World?

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One of the more peculiar stories of late in these times of turbulent financial markets is how, briefly, Volkswagen became the biggest company in the world. In the process, hedge funds around the world suffered losses estimated at over US$35 billion.

Over the last few years, Porsche has been building a stake in Volkswagen. By November 2007, the size of their stake had reached 31%, much of which was achieved by means of share options* rather than direct share purchases. Significant increases in the Volkwagen share price meant that these options delivered large profits for Porsche, prompting criticism that the company was acting more like a hedge fund than a car manufacturer.

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Australia and the Global Financial Crisis

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Over the last few months I have written a lot about the global financial crisis. My posts have focused on specific events as news has broken, ranging from a programming bug by Moody’s to the enormous US bailout plan and Government guarantees from Ireland to Australia. Here I will instead take a broader perspective and provide an overview of how the crisis has unfolded and, more specifically, how Australia came to be caught up in the mess.

A year ago, many commentators were extolling the idea that Australia’s economy had “de-coupled” from the United States and Europe, and would continue to be powered by the rapid growth of China and other developing nations. Concerns about inflation meant that interest rates were rising and many felt Australia would escape the incipient economic slowdown in the developing world. Events have instead unfolded differently. The Federal Government has taken the extraordinary step of guaranteeing deposits held in all Australian banks, building societies and credit unions and the Reserve Bank of Australia has delivered an unexpected 1% cut in interest rates, citing heightened instability in financial markets and deteriorating prospects for global growth. This was an extraordinary turnaround. It is, of course, the result of Australia becoming ensnared in the global financial crisis that began in mid-2007 and has intensified ever since. But how and why did Australia get caught up in a mess that started with falling property prices in the US?

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Australian Bank Guarantee on Wholesale Debt

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In a post earlier this week, I wrote

The Government was right to step in with the guarantee and it has doubtless provided some stability for a financial system that remains jittery, but the sooner the details are sorted out, the better.

The main outstanding question I was referring to was how the guarantee would apply to wholesale debt. Uncertainty on this point has been creating significant concern for investors in cash management trust and other managed funds. The amount of money moved from these funds to bank deposits may be over $1 billion.

Finally today, the Government announced the wholesale guarantee fee, which will also apply to retail deposits over $1 million. While there had been speculation that the fee would vary based on the time to maturity of each security, the Government has instead opted for a fixed fee. The fee varies with the credit rating of the bank taking up the guarantee.

Credit Rating	Debt Issues Up to 60 Months
AA	0.70%
A	1.00%
BBB and Unrated	1.50%

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