Inflation expectations, transient inflation, base effects, lift off, thinking about thinking about hiking – These and a dozen more phrases / words have been dished out in bountiful quantities in financial media in the past few months.
While some emerging markets like South Africa, Turkey, Brazil, Russia might see monetary tightening in response to growing inflationary pressures, these are not ideal comparables, from a monetary policy appropriateness perspective, to either the US or UK or other developed economies. In contrast, developments in the monetary policy space in Australia merit a deeper consideration. During the last global crisis in 2009, Australia was one of the first countries to hike rates in October 2009 in response to faster growth (partly attributable to China’s growing import of commodities) and the prospect of rising inflation then. This time around though Australia has been on par with, if not ahead of, other major economies in deploying its fiscal and monetary firepower.
The RBA is expected to decide in its July 6th meeting if it will extend the “Yield Curve Control” (YCC) target to the Australian Government Bond maturing in November 2024. The RBA is also expected to announce if it plans for even more QE. i.e. more longer-dated bond buying, with the current AUD100 billion tranche likely to expire in September 2021.
For the uninitiated, here is a quick overview of YCC. Yield Curve Control is a rather unconventional monetary tool where the Central Bank targets to maintain yield for a certain tenor (0.1% and 3 years in the case of RBA). In very simple words, it is a blank check with no fixed quantity which promises that the Central Bank will buy as many government bonds of that maturity that it might deem necessary to maintain the yield at a certain level. It is supposed to aid maintaining lower interest rates in the economy, boost borrowing and economic activity and spur growth. Whether that works or not, is not the topic of debate of this article.
First quick recap of Australia’s macro-economic data in recent weeks. The top 4 statistics to follow are –
|1Q 2021 GDP outperformed expectations at 1.8%||The RBA’s central scenario expects GDP to grow 4.75% in 2021 and 3.5% over 2022|
|The unemployment Rate decreased 5.1% in May 2021||The RBA has acknowledged the rapid progress in employment numbers and even acknowledged labor market tightness in some sectors|
|Consumer Price Index grew 1.1% in 1Q 2021||The RBA’s central scenario expects inflation to be around 1.5% in 2021 and 2% in mid-2023|
|Wage Price Index grew 1.5% in 1Q 2021||That is half the rate that the RBA said is needed to generate inflation|
The investing community eagerly awaits the RBA’s preferred path forward. In the context of these Australian Fixed Income space developments, below is a quick primer on Australia’s macro-economic health and key risks, explained in 3 short chapters.
Chapter 1 – Is Australia’s public debt very high and who is lending to the Australian government?
Total outstanding Australian Government Securities (also called AGS) are AUD 881bn as of 31 March 2021. At approximately 38% of GDP, Australia’s general government net debt is still far lesser than other comparable developed economies like the UK, US, France, Italy and Japan. But there are some nuances to consider in Australia’s case which makes it a bit different than the aforementioned countries.
Foreign ownership of AGS stands now at approx. 50%. So roughly AUD443bn out of the total AGS pile of AUD881bn is held by foreign investors. (Source: www.aofm.gov.au). Japanese investors including the large pension funds are one of the largest foreign holders of AGS. This flow has especially increased since 2020 after rates have crashed all around the world. Rolling 12 month net inflows into AGS by Japanese investors have been approx. AUD40-50bn since mid 2020.
First takeaway – Even though Australia’s net debt is significantly lower compared to other developed economies like Japan, the % of foreign ownership is significantly high and that exposes AGSs to the whims of foreign investors.
Chapter 2 – Given that foreign holdings of AGS are high, what is Australia’s net international investment position?
Australia’s success and wealth is significantly attributable to its abundance of resources, primarily iron ore, coal, petroleum and copper. Especially post 2000, as the world and more importantly China notched up industrial activity, Australia found itself in a sweet spot to be able to capitalize on this surge of demand and increase in prices of these commodities. These booming exports aided significant GDP growth. This led to lower unemployment, higher wages, higher government revenue and increased shareholder profits. All in all, it resulted in significant wealth creation domestically. However, this huge demand for commodities also correspondingly meant a higher level of investment into the commodities sector. In other words, this also meant a significant rise in imports of investment goods to boost the capacity of the resources sector. This, together with consumer / final goods imports and a primary income deficit, has kept Australia’s current account in deficit for a large part of the last two decades.
Unsurprisingly then, given the current account deficit and the attractive investment opportunities in Australia which incentivize the flow of capital into the country, Australia has built a negative Net International Investment Position (“NIIP”) over the years. Australia’s NIIP is a negative AUD875bn as of March 2021. In summary, Australia owes foreigners more than it owns in foreign assets. And quite substantially! In contrast Japan’s NIIP is a positive US$3.7Tn.
Here is a further breakdown of Australia’s net liability position. Australia’s net foreign debt was approx. AUD1,140bn as of 31 Mar 2021. This is the net position of debt securities from Australia’s perspective. In other words, the amount by which foreign residents’ ownership of Australian debt securities exceeds Australian residents’ ownership of foreign debt securities is AUD1,140bn. As I explained before, a significant portion of this number includes the AGS held by foreign residents, (approx. AUD443bn), which has grown substantially in recent years. This also includes the debt securities within the financial and corporate sectors in Australia. However, on the other hand, Australia also has a positive position in Net Foreign Equity. In other words, Australian residents owns more foreign equity than foreign residents own equity in Australia. As of Mar 31, 2021, net foreign equity was a positive AUD264bn. This can be largely attributed to the successful superannuation funds in Australia which have channeled domestic savings into foreign equities, especially during the last 7-8 years.
Second takeaway – Australia has a large negative NIIP. i.e. a net liability position vs. the rest of the world. Traditional economics deems this to be a risk. While Australia has been a beneficiary of a commodities led export boom, the current account balance has generally been in deficit resulting in this large negative NIIP. Overseas ownership of Australian government debt has increased with more investments from overseas central banks and Japanese pension funds. Superannuation funds are building a large foreign asset portfolio.
Chapter 3 – Is Australia’s International Investment Position Liability really a risk?
However, the headline NIIP numbers hide another interesting underlying story. Firstly, the net foreign debt that Australia has built over the past years is more long term in nature. This reduces the risk of short-term outflow shocks. The mix between long-term and short-term debt has been changing favorably in the past years attributable to the fact that a large part of these Australian liabilities are the long term Australian Government Bonds as opposed to the Australian financial sector borrowing from overseas. Second and more importantly the bulk of the liabilities (both debt and equity instruments) are denominated in AUD. Hence the country is not significantly exposed to foreign currency risks. All of the Australian government bonds are denominated in AUD and a large portion of the borrowings of the banks and corporates tends to be either denominated in AUD or denominated in a foreign currency and hedged back to AUD. On the contrary, Australia’s foreign assets (both debt and equity instruments) are mostly denominated in foreign currency. Hence as a whole, Australia has a net foreign currency asset position. In summary, in the event of AUD deprecation, Australia’s foreign asset position improves further since the AUD value of the foreign currency denominated asset increases and likewise, the dollar value of Australia’s AUD denominated liabilities decreases.
Third takeaway – While Australia’s NIIP is a large liability, the mix of exposure is mostly long term in nature, eliminating the risk of short-term outflow shocks. Also, Australia’s has a net asset position in foreign currency denomination and hence generally stands to benefit from an AUD depreciation event.
Australia is said to be the lucky country and prior to this pandemic induced recession, Australia had gone recession-free for a record 30 years. A large part of that record performance was attributable to external factors (like China’s colossal growth) and Australia was just in the right place at the right time. Circumstances are a bit different now. Even though commodity prices have rallied in the past 6 months or so, another large, extended, externally induced mining boom is unlikely. The government is ramping up fiscal incentives to spur domestic growth. Other services led export opportunities like tourism and education are more center-stage from a longer term perspective. How the lucky country performs from here on will be a thrill to watch. And so will be investors view of the Australian Fixed Income Securities.
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