Statement 7: Asset and Liability Management (Continued)
During the global financial crisis, the stresses confronting financial markets around the world were unprecedented. The crisis led to significant disruption to capital flows, difficulties in pricing and hedging risk, and a general flight of investors to high‑quality, safe‑haven assets.
The repercussions of the crisis continue to play out in many ways, including through a heightened focus on the sustainability of other developed countries' sovereign debt positions and the introduction of new regulatory regimes for financial institutions.
In Australia, the continued functioning of a liquid, AAA‑rated Commonwealth Government Securities (CGS) market through this period was critical to managing risk and retaining confidence in Australian financial markets.
In light of the crisis, the anticipated return to surplus, the new global bank liquidity requirements and the changing nature of the CGS investor base, it is timely that the Government consider the future of the CGS market.
In 2002‑03, the Review of the Commonwealth Government Securities Market was undertaken in response to concerns about the future viability of the declining CGS market. Since this review, successive governments have committed to retaining a liquid and efficient CGS market to support the three‑ and ten‑year Treasury Bond futures market, even in the absence of a budget financing requirement.
During the global financial crisis, liquidity became severely constrained in key financial markets that had previously been considered alternatives to the CGS market for managing financial risk, such as the interest rate swaps market. In the absence of a fully functional interest rate swaps market, the continued functioning of a liquid, AAA‑rated CGS market, and its associated futures market, was at times the only option available for managing interest rate risk and supporting the pricing and hedging of other financial instruments. The capacity of financial market participants to price and manage interest rate risk contributes to a lower cost of capital in Australia.
The presence of a liquid, AAA‑rated fixed income market also provided a safe investment vehicle for investors and supported confidence in Australian financial markets more generally.
As investors around the world moved to safe haven assets, such as sovereign bonds, markets came under increasing pressure and liquidity became constrained. In Australia, the existence of an active, albeit small, government bond market, with an investor pool familiar with the government's debt instruments and well‑established infrastructure and procedures, enabled the AOFM to increase the volume of issuance quickly as the need arose in the context of dramatically reduced government revenues.
The crisis affirmed the value in maintaining a CGS market of sufficient size to support the long‑term stability of the financial markets and to ensure the Government is well placed, in a practical sense, to respond to sudden events with large fiscal impacts.
Recent developments impacting on the CGS market
The CGS investor base has changed significantly in recent years, with a number of new passive investors entering the CGS market. Passive investors form a stable and important investor base for CGS. However, they do not tend to trade their CGS holdings actively and therefore do not contribute to liquidity in secondary markets.
There has also been an increased allocation into Australian denominated securities in the foreign exchange portfolios of some investors, because of the strength of the Australian economy.
The new global capital and liquidity standards for banks, agreed by the Basel Committee for Banking Supervision in December 2010, will impact further on the investor base for CGS. The standards are expected to mean that Australian banks will generally hold larger amounts of government bonds on their balance sheets than has previously been the case.
The CGS holdings of passive investors and Australian banks in coming years will have important implications for liquidity in the CGS market.
In light of the changing CGS investor base, the fiscal outlook for a return to surplus and the peak in CGS, the Government considered it timely to review the future of the CGS market.
As part of these deliberations, and in addition to the ongoing dialogue between the AOFM and the financial markets, the Government consulted a panel of financial market participants and financial regulators on the future of the CGS market.1
The panel underlined the crucial role of a liquid, AAA‑rated CGS market and associated futures market during the crisis and supported retaining liquidity in these markets as the primary objective for the CGS market in the future. The panel considered there was also significant value in maintaining a diversified investor base, including passive investors, to absorb any unexpected increase in issuance.
To maintain a liquid and efficient bond market that supports the three‑ and ten‑year futures market and the requirements of the new global bank liquidity standards, the panel agreed that the CGS market should be maintained around its current size — that is, around 12 to 14 per cent of GDP over time.
Drawing on this advice, the Government is clarifying its objectives with regard to the future of the CGS market.
Maintaining liquidity in the CGS market to support the three‑ and ten‑year bond futures market will continue to be the Government's primary objective, in particular as Australian banks prepare for the 2015 commencement of the Basel III liquidity requirements.
In addition, the Government will: support liquidity in the Treasury Indexed Bond market by maintaining around 10 to 15 per cent of the size of the total CGS market in indexed securities; and continue to lengthen the CGS yield curve incrementally, in a manner consistent with prudent sovereign debt management and market demand.
The Government will continue to monitor the CGS market, and consider the advice of the panel, to ensure the market remains of a sufficient size to support these objectives as the budget returns to surplus and headline cash surpluses are used to reduce the level of gross CGS on issue.
These objectives will mean that at some stage after the budget has returned to surplus, the Government will need to transition from reducing the level of CGS on issue to maintaining an appropriately sized CGS market, while continuing to reduce the level of net debt outstanding.
This will see the Government once again begin to accumulate financial assets. These assets will initially be held as highly liquid assets to provide the Commonwealth with flexibility in managing its financing requirements in the short term. The Government will consider the use of accumulated financial assets in conjunction with future consideration of the size of the CGS market.
To ensure flexibility in implementing the Government's objectives for maintaining a deep and liquid CGS market, and to meet the Government's financing needs over the forward estimates, the Government will seek an amendment to the Commonwealth Inscribed Stock Act 1911 to increase the legislative limit on CGS issuance.
1 The panel consisted of representatives from the Treasury, the AOFM, the Reserve Bank of Australia, the Australian Prudential Regulation Authority, the NSW Treasury Corporation, the Treasury Corporation of Victoria, and a number of private sector market participants.
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