Pete Wargent blogspot

CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Monday, 11 July 2016


The dreaded deficit!

A bit of minor excitement last week when the rating agency Standard & Poor's (S&P) - yes, one of  'them lot' that awarded triple-A ratings to toxic pools of debt in 2008 - put Australia's AAA-rating on a negative outlook.

This means that Australia's AAA-rating may come under threat in due course.

S&P is perhaps unsurprisingly not all that happy with Australia's delayed expected route back to surplus by 2021, some eight years than had originally been planned.

A deficit is where a government has expenses that are greater than its revenues, and this is reported as the underlying cash balance. 

So either commodity prices will have to rebound quick-sharp, or the government will need to tighten its belt if the AAA-rating is to be maintained. 

In reality this may well mean that the cash rate will be cut further some time in the not too distant future, perhaps even next month, in order to pump prime the economy some more.

The news of a potential rating downgrade naturally prompted some arousal in the media.

Although Australia's budget deficits appear larger than we have seen historically - and indeed they are in dollar value terms - as a percentage of GDP they have not been quite so dramatic, following a splurge of spending which helped to get us through the financial crisis relatively unscathed. 

Some people have noted a concern that if Australia loses its AAA-rating then the interest rate we have to pay to borrow may increase.

The dreaded debt pile!

Government debt, as the name implies, is a measure of borrowing.

When a government runs deficits, over time this tends to be reflected in increasing government debt.

It's becoming quite popular to have a whinge about Australia's national debt - such as here for example ("I look at our national debt and I despair for our generation"). 

There is some national debt, no doubt.

There are government bonds on issue totaling a bit more than $400 billion in Australia, up from around $100 billion in the late 1990s, and not a lot before the financial crisis. 

A couple of points here. 

Firstly, Australia's government net debt as a share of GDP is actually not that high.

Secondly, take a look at the red lines below denoting the coupon rate on Australia's Treasury Bonds (the coupon is the rate of interest payable on the bond, in this case paid semi-annually in arrears on the face value of the bonds).

Of the 22 Treasury Bonds on issue with maturity dates out to 2039, towards the left of the chart you will see a coupon of 6 per cent. 

Yet maturing in November 2020 you may notice a Treasury Bond first issued last year paying a coupon of just 1.75 per cent. 

What's happening here? Government debt is getting remarkably cheap to service, that's what! 

According to this year's budget since late 2010, the Australian Office of Financial Management (AOFM) has incrementally lengthened the yield curve while the cost of borrowing has been so incredibly low by historical standards. 

What this does is to increase the average maturity and duration profile of the debt portfolio, "thereby lowering variability in future debt servicing costs, and reducing refinancing risk".

In other words, we're borrowing for long periods of time at very cheap rates. 

Yields at record lows

Last week, Australia's 10 year government bond yield fell to its lowest ever level last week at under 1.85 per cent.

As you can see below, as recently as 1995, the 10 year bond yield was in double digit territory. Amazing. 

AOFM tender results last week showed that we borrowed $700 million for 12 years at an average bid of 2.0281 per cent, while we also borrowed $800 million for four years at an average bid of 1.5769 per cent. 

I don't know about you, but this chart and these numbers aren't screaming to me that Australia needs to be having panic attacks about fiscal deficits, government borrowing, or for that matter whether or not S&P deems us worthy of a AAA-rating.

Infrastructure boom

While I'm not necessarily a fan of household debt analogies, I think we'd all agree that borrowing for recurrent spending is not really that good an idea.

However, borrowing to invest for the future can be beneficial, if it is done sensibly. 

It's true for households, and it's definitely true for governments.

After all, what's the point of a AAA-rating if you're never going to use it?

Sure, in an ideal world there would be very low government net debt, the economy would be humming along, we'd be running surpluses, and when the next downturn comes we'd have more ammunition in the bank.

But is a world without debt necessarily a better place? It certainly didn't seem it when liquidity dried up through the financial crisis. 

Australia's capital cities have an infrastructure deficit, and some borrowing to fund infrastructure investment is a good idea.

The detail of the 2016-17 budget papers show a capital expenditure budget of more than $45 billion, which creates jobs and helps the economy through the slowdown in the economy post-mining boom.

Source: Budget

And it's the younger generations that will benefit most from the new infrastructure. 

Will the government spend the money in the most efficient manner? Nope, probably not. 

Sure, some government expenditure ends up leaking overseas - including to other governments - but most of it either ends up in the hands of corporations and institutions, or in the hands of the people. And they in turn spend the money again...and again. 

And the interest on government debt has never been so cheap to service.