Budget 2020 takes Australia towards a trillion-dollar debt, but most experts say it isn’t a problem. Here’s why
On debt and deficits, let’s start with the obvious thing.
When the Federal Coalition was last in opposition, during the global financial crisis, its political strategy was to demonise the Rudd Labor government’s deficit spending.
It told voters Labor’s spending had created a “debt and deficit disaster”.
The strategy was effective and it romped home in the 2013 election.
But now the Coalition is facing its own, far deeper, economic crisis, and it has embraced deficit spending on a vastly bigger scale.
Treasury expects the total level of Commonwealth debt under the Morrison Government will soon surpass $1 trillion.
So what does all this debt mean? Who is holding it? And what will happen if interest rates rise?
How is the Australian Government funding its deficit spending?
When the Federal Government is in “deficit”, that means it is spending more money into the community than it’s collecting in revenue (from taxes and other receipts).
Deficit spending is necessary during an economic downturn to support the incomes of households and businesses.
Think of the JobKeeper and JobSeeker payments. They wouldn’t be possible without deficit spending.
Officially, Australia’s Government is funding its emergency spending with money it is “raising” from selling bonds.
That means it’s being funded by debt.
Why would a government that issues its own currency, and so has the power to create money to pay for things, want to fund its deficit spending with borrowed money?
Authorities prefer to do it that way because they believe it imposes spending restraint on governments.
The theory is if governments feel accountable for a growing pile of debt, they will think more carefully about the money they’re spending.
There’s currently an argument among economists, driven by proponents of a body of thought called Modern Monetary Theory, that says the Federal Government should be creating all the money it needs without adding to its accumulated debt, within limits.
But that’s an argument for another day.
How does the funding work?
The Government is “raising” the emergency money it needs via the Australian Office of Financial Management (which is an arm of Treasury), which is selling Australian Government bonds on the Government’s behalf.
The bonds are being sold to institutional investors (large foreign and local banks) with the promise of regular interest payments and a repayment of the principal at a set future date.
Those institutional investors are then creating their own markets for the bonds (called “secondary markets”), by on-selling them to other investors such as pension and superannuation funds, hedge funds, insurance companies, private banks and central banks, which want to hold interest-bearing assets in their portfolios.
This year, the Reserve Bank of Australia has been a major buyer of Australian Government bonds from those secondary markets.
It has been purchasing as many Australian Government bonds as needed to keep the interest rate, the “yield”, on three-year Government bonds down around 0.25 per cent, as part of its stimulus plan for our economy.
Keeping the interest rates low on Government bonds feeds through into lower interest rates for households and business borrowers, which the RBA hopes will stimulate more economic growth and inflation.
The RBA has been buying bonds from the secondary market, rather than directly from Treasury, because it wants to keep some separation between Treasury’s issuance of bonds and the RBA’s funding of government spending.
Paul Keating, the former prime minister, recently criticised the RBA for that practice, accusing RBA officials of lacking the courage to break with economic orthodoxy and allow themselves to buy bonds directly from Treasury.
How much debt are we talking?
This process of raising money for deficit spending has led to an explosion of Commonwealth Government debt which will take years, and possibly decades, to pay off.
For context, the Rudd Government’s stimulus packages across 2008-10 were worth $67 billion.
In the final months of the Rudd Government in mid-2013, Australia’s net debt position was $159.6 billion.
The net debt-to-GDP ratio was 10.4 per cent.
In December last year, after six years of Coalition government, Australia’s net debt position had more than doubled and was estimated to be peaking at $392.3 billion in 2019-20, before slowly reducing in size.
But this week’s Budget shows that figure will explode in coming years.
Treasury is forecasting Australia’s net debt position will be $703.2 billion for 2020-21 (meaning a net debt-to-GDP ratio of 36.1 per cent).
And that debt will increase to $966.2 billion in 2023-24 (to a net debt-to-GDP ratio of 43.8 per cent).
Alongside that rapid accumulation in debt is the rapid growth in the value of Commonwealth Government bonds on issue.
According to Treasury, at the start of July this year, the face value of total Australian Government bonds on issue was $684.3 billion (equivalent to 34.5 per cent of GDP).
That’s forecast to grow to $872 billion in 2020-21 (44.8 per cent of GDP).
Then it will hit $1 trillion in 2021-22 (50.5 per cent of GDP).
Then $1.1 trillion in 2022-23 (51.6 per cent of GDP).
And $1.14 trillion in 2023-24 (still 51.6 per cent of GDP).
Who owns Australian Government debt?
The AOFM does not target specific types of investors when it sells Australian Government Securities (AGS), also known as bonds.
It is not in control of where its bonds get sold in secondary markets.
However, it still keeps an eye on them to know who’s demanding them and why.
And there’s always high demand from foreign investors.
Why? Because Australia is considered a prosperous country with trustworthy institutions and strong legal and regulatory frameworks.
If you park your money here, you’re virtually certain of getting it back.
These overseas investors include pension funds, insurers, sovereign wealth funds, hedge funds, banks and other countries’ central banks.
Since 2016, around 60 per cent of AGS on issue have been held by foreign investors.
However, in June this year, that number had fallen to 53.1 per cent, largely due to the Reserve Bank’s decision to dramatically increase its purchases of AGS this year.
As at September 25, the RBA had purchased $52.3 billion of AGS this year, and $11.1 billion of state and territory government bonds.
Who are some of the biggest foreign investors?
Some of the biggest non-resident investors include:
Japanese investors: In modern times, Japan has been the single largest investor in Australian fixed income by country, with its large pool of savings (including pension funds and life insurance assets).
Japanese Government bonds have had persistently low interest rates over many years, so Japanese investors have sought higher returns and diversity outside Japan, including in Australia.
According to the Bank of Japan, as of December 2018, total Japanese holdings in Australian dollar-denominated bonds were around $250 billion, representing roughly 7 per cent of their overall fixed-income allocation.
Central bank foreign currency reserves managers: According to the AOFM, around two-thirds of the world’s 50 largest reserves managers hold Australian Government bonds, with our bonds forming a core part of foreign central banks’ holdings of Australian dollar-denominated assets.
As of June 2019, reserves managers held around $US11.5 trillion in foreign currency, of which $US188 billion was allocated to Australian dollars.
Hedge funds: The AOFM says hedge funds have been active participants in the AGS market for years.
“Some are opportunistic and trade in and out of positions rapidly, while others hold positions for longer periods,” the AOFM website says.
What about domestic investors?
Domestic investors currently hold over 40 per cent of AGS on issue.
The balance sheets of domestic banks account for roughly half of those holdings, driven by regulations that require them to maintain a certain quantity of high-quality liquid (easy and quick to sell) assets.
Local fund managers, super funds and insurers hold AGS too. As does the RBA.
Does it matter that Commonwealth debt will surpass $1 trillion?
Economists say the thing that’s important is the size of the debt compared to the size of Australia’s economy.
Australia’s net debt-to-GDP ratio is forecast to jump above 43 per cent by 2023-24, but that’s relatively low compared to other advanced economies.
In 2019, before this year’s COVID-19 recession, the government debt-to-GDP ratio of Germany was already 41.3 per cent, while the UK’s was over 75 per cent, France’s was nearly 90 per cent and Japan’s was over 150 per cent.
Even when Australia’s net debt-to-GDP ratio hits 43.8 per cent (its forecast peak at this stage), it will still be low by historical standards.
Between 1939 and 1946, Australia’s debt-to-GDP ratio jumped from 40 per cent to over 120 per cent when the government borrowed huge sums to pay for the war.
What’s the risk of interest rates rising?
Economists say it’s highly unlikely that interest rates will be rising for many years.
And that’s a good thing, from a debt perspective.
In April, the economist Chris Richardson from Deloitte Access Economics reminded voters that borrowing costs had never been lower.
“Never in the 2,000 years of recorded history of interest rates has it been cheaper for governments to borrow,” he said.
“The current [stimulus] spend is comfortably more than twice as big as a share of national income than [during the global financial crisis]. But we’re also paying interest rates that are just one-fifth as high as they were back then.”
That was six months ago.
Interest rates have remained at 0.25 per cent since then, and there’s speculation the RBA may want to cut rates again this year.
Okay. But what if rates do start rising?
When rates do eventually rise again, it won’t make it much harder for the government to service its existing debt.
Higher rates only make “new” money raised in debt markets more expensive.
Because when the AOFM issues a bond, the government is guaranteeing regular fixed interest payments to the bond’s owner for the length of the bond’s life.
And those fixed interest payments don’t change.
For example, let’s say the AOFM issues a bond with a 10-year term with an annual interest payment of 2 per cent.
If the face value of the bond is $100, the government must pay $100 to the bond’s owner when the bond’s term ends in 10 years.
Over those 10 years, the bond’s owner will also receive an annual interest payment of 2 per cent of the face value (i.e. $2 each year).
Regardless of what happens to official interest rates in that decade, those fixed interest payments of 2 per cent won’t change for that bond.
That’s why economists say the government should be borrowing as much as possible now to lock in the lowest possible debt servicing costs.
However, when an economy’s interest rates do change — and they always change over time — it will affect the fixed interest payments of new bonds the AOFM issues.
That means if interest rates increase, new bonds will offer slightly higher interest payments than bonds already in existence, and that means it will become slightly more expensive for the government to raise new money.
But consider this.
The AOFM has issued a suite of bonds this year with different maturities and fixed interest payments.
Last month, it sold $16.4 billion worth of Treasury bonds that mature in December 2021 and promise an annual interest payment of 2 per cent.
It also sold $24.7 billion that mature in December 2030 and promise an annual interest payment of 1 per cent.
It even sold $15 billion that mature in June 2051 – over 30 years away – that promise an annual interest payment of 1.75 per cent.
And that’s just a fraction of the bonds it issued last month.
But how effective will the deficit spending be?
Mark Todd, the head of fixed income at Bank of China, said we needn’t be concerned about the Australian Government’s ability to service its debt.
He said in 2018-19, the Government’s net interest payments on $373.5 billion worth of debt (representing a net debt-to-GDP ratio of 19.2 per cent) were $15.1 billion.
But in 2022-23, the Government’s net interest payments on $900 billion worth of net debt (representing a debt-to-GDP ratio of 42.8 per cent) will be $2 billion less than that, at just $13.1 billion (according to the budget papers).
Mr Todd said that indicated how cheap it would be to borrow huge sums of money in coming years.
“The Government should be channelling Fleetwood Mac’s Don’t Stop, you know, just keep on going, borrow as much money as you possibly can,” he told the ABC.
But he warned the key to everything would be how “effective” the Government’s deficit spending was going to be.
“They should borrow as much money as humanly possible and be effective with the spend, meaning speed of delivery, broadness of delivery, and with a national plan,” he said.
“But giving people tax cuts and all this traditional trickle-down stuff, is unfortunately a reprisal of policy by dogma.
“There needs to be far more vision.”