“The whole sea is storming” is apparently the Swedish name for the children’s game of musical chairs, at least according to Wikipedia. “Literally fighting for chairs,” though, is what it’s apparently called in Cantonese and Mandarin. And we think that sets the stage for this week in the markets better than anything: fighting for capital. Sovereign governments want it. Tangible assets are getting it.
The context for this week’s action was a strange day on Wall Street on Friday. The U.S. dollar, at long last, rallied a bit. It scared the daylights out of everyone. The Dow and oil fell. Bond yields rose. But gold went up on Friday and finished the week up 2.7% to $1,146.80. That’s right. Gold rallied with the dollar. Hmmn.
Days like Friday make investors question their conviction. They start to convince themselves that after a near 60% rally in stocks since the March lows, some kind of correction is coming. But they wonder if it’s just a run-of-the-mill correction. Or is it phase two of the Depression that began in 2008?
Our focus today, though, is on the bond scam being perpetrated by money-grubbing governments. That is, our focus is on the counter-attack by national governments against rising bond yields. Between the GFC and ageing populations, the Western Welfare States know that they must increase deficit spending in the coming years. But already the gold market is telling them what global savers think of this (not much).
So how does a government fund its spending programs if global creditors begin to turn to other assets? Well, it can have its own central bank “monetise the debt.” But having the central bank buy government bonds with new money is a sure-fire path to currency depreciation and higher interest rates. It simply highlights what we’ve been saying for five years now: the funding model for the fiscal welfare states is broken.
But lately we see that we’ve underestimated just how clever governments can be at squeezing new revenues out of people and forcing the market to choke down government bonds. Last month, the FT’s Alphaville blog reported that the U.K.’s Financial Services Authority (FSA) is essentially guaranteeing a bond bubble by forcing banks to own sovereign bonds.
The FSA is doing this for the banks’ own good, of course. With liquid government bonds on the balance sheet, the banks would have a “liquidity buffer.” This should, the FSA reckons, inspire faith by market participants in the fundamental health of the banks, and prevent another collapse of public faith. Ahem.
But did you know in a September discussion paper called “APRA’s prudential approach to ADI liquidity risk” that the regulator of Aussie banks is considering imposing a similar liquidity requirement on Aussie banks? It would force the banks to own assets of a certain credit calibre. And you can guess which assets would qualify.
Go on. Guess. We dare you.
Really, you can’t make this stuff up. Western governments are starting to tell Western banks that the only way for banks to be sure they have sufficient liquid assets is to buy more government bonds!
And it won’t be a choice. The banks should have known better than to take government money and government guarantees. It was only a matter of time before governments came up with a way to tap bank deposits to pay for massive borrowing programs.
APRA says its current policy regarding liquidity at banks, “provides little guidance as to what constitutes a liquid asset for stress-testing purposes.” However, the Big Con begins, “there is an emerging international consensus amongst prudential supervisors that liquid assets should be high quality assets that can be readily sold or used as collateral in private markets, even when those markets may be under stress; as a backstop, liquid assets should also be eligible central bank collateral for normal market operations.”
Here’s where the intentions are laid bare. “APRA proposes to adopt this definition of liquid assets in APS 210. In most currencies, sovereign bonds will be the assets that most clearly satisfy these criteria.”
APRA then expressed some mock concern that because Australia’s Federal government had consistently run surpluses for the last ten years or so, it would have to work with the Reserve Bank to find some other “safe” asset like a sovereign government bond for banks to involuntarily load up on. But that was a bit rich.
After all, the Australian Federal government is piling up the debt! The Australian Office of Financial Management is selling $2.4 billion in bonds and notes this week alone. Choke on that, the Big Four. Granted, the AOFM says Australia’s 2010 borrowing program of $50 billion is slightly less than Treasury expected, given Australia’s improved GDP picture. But it’s still a lot of debt to sell.
Of course if you’re forcing banks to buy it, the sale is not as hard. Maybe we are getting ahead of ourselves, though. APRA says it won’t impose the new liquidity requirements until next year, after it’s had time to review responses to the idea from market participants. Right.
Incidentally, did you see that both the Commonwealth Bank and Westpac fell back on the government guarantee to raise money in the wholesale funds market last week? CBA tapped the guarantee to raise $1.36 billion in the U.S. market. Westpac, on the other hand, tapped the guarantee to raise money right here in Australia. It sold $1.1 billion worth of bonds, and apparently the local market was a little tepid without the government guarantee.
Unless the banks are using the government guarantee to borrow money which they can invest in some higher-yielding asset, you know it’s not something they want to do. It costs them more to “rent” the Aussie government’s AAA credit rating. And it’s not something they’ve had to do in three months. What does that tell you?
It tells us that when you’re a net capital importer, your banking system is not nearly as healthy and robust as you think. Borrowed booms are fickle.
But it’s not like the Aussie Federal government or the State governments are a picture of financial health either. In today’s Australian Scott Murdoch reports that, “The debt of Australia’s six state governments could soon outrank the $136 billion owed by the commonwealth as the state administrations fund an ambitious infrastructure program in a bid to boost the economy.
Murdoch says state governments will float $28 billion in new debt in the next seven months, prompting us to wonder which Aussie state is the most like California, fiscally speaking of course. Queensland appears to take the cake, with a $57 billion annual deficit and projections for eight more years of deficits. New South Wales comes in second.
Yet the Keynesians, if we ever gave them breathing room in this space, might tell you that funding long-term infrastructure projects with government debt is exactly the right thing to do in a recession. The government spending makes up for shortfalls in private sector spending. And when the recession passes by, the entire state (and nation) are left with shiny new infrastructure that increases export capacity and productivity. A win win!
Maybe it will work that way. And maybe it won’t. The really interesting scenario is whether state government borrowing needs begin to compete with Federal borrowing needs. The Feds can compel Aussie banks to buy government bonds, if the APRA rule passes. What can the States do to make sure their debt is purchased? Hmm. A government guarantee? Chocolates and flowers to creditors? A pretty please?
A government’s inability to pay for the promises it’s made is no laughing matter, especially when those promises involve an ageing population. But, “The commonwealth budget is in danger of going directly from the deficit caused by the financial crisis to one caused by ageing of the population without ever seeing a surplus,” writes David Uren in today’s Australian.
It would be a bitter pill to swallow. After all, Kevin Rudd has promised that strict government spending limits will put the Federal budget back into surplus sometime around 2015-2016. Ahem. But it’s now looking like the deficit that was born under the GFC will grow and flourish as Australia faces the same demographic crisis as other Western nations: paying for the retirement and healthcare of the Boomers.
But wait! The IMF says that by 2014, Australia’s public sector debt as a percentage of GDP will be just 27.8%. That’s not worrying at all, is it? Especially when you compare it to projected levels of 108% in the U.S., 98% in Britain, 128% in Italy, and a whopping 245% in Japan.
Those countries have real problems. American and Britain have broken financial systems and massive public sector debts that are still growing. Japan and Italy are getting old, with fewer workers to support retirees. Will those governments be able to borrow what they need? Or will the bond market rebel?
You’d think Australia wouldn’t have much to worry about, compared to that quartet. But remember: the country is a new importer of capital. The government, like the private sector, has to borrow from foreign creditors. And foreign creditors have to want to lend Australia money. So will they?
They might, perhaps at higher interest rates. But then again, maybe they’ll just come for Australia’s oil and gas and its oil and gas companies. A recent report by Deloitte previewed a coming contest between independent oil companies (IOCs) and national oil companies (NOCs) owned by governments. “Over the next couple of years, IOCs will start to be faced with the dilemma of constrained access due to ongoing resource nationalisation and the growing sophistication of the NOCs.”
The NOCs believe in free markets, except when it comes to maximising the value of strategic resources like oil. They do, however, like to use free markets to pursue acquisitions in foreign equity markets. “National Oil Companies (NOCs) are on the hunt,” the report says.
“The are aggressively looking for corporate M&A opportunities to accomplish their three goals: bolster their market strategies; expand their reserve portfolios; and develop strategic alliances…From an economic standpoint, net consuming NOCs are seeking to gain access to sufficient reserves to fuel their countries’ economic engines over the long haul.”
The other method the NOCs might take is to pursue listed independent oil and gas juniors who are rich on exploration projects but capital poor. There are a few of them here in Australia. It’s not a bad trade.
Deloitte writes that, “Independent oil and gas junior companies have struggled in recent months due to their higher sensitivity to oil prices and tax regime changes. After the oil price collapse of 2008, many leapt into survival mode.
“Those that succeeded in freeing up cash are now poised to implement M&A strategies designed to enhance their reserve portfolios while those that remain cash strapped, which is still the fast majority, are likely to be M&A targets.”
There’s an idea for investors. Don’t go after the cash-rich juniors. Go after the cash-poor ones that are likely to be M&A targets and might get a bit of a premium bid from potential NOC acquirers. Hmm. We’ll ask Diggers and Drillers editor Alex Cowie what he thinks of the idea and get back to you.
In the meantime, if you want a more comic perspective on China’s choices in the coming years, have a look at this skit. And then ask yourself how easy it’s going to be for borrowing nations to get what they ask for with no strings in the future. For Australia, you have to wonder what the strings are going to be. It depends on who’s doing the lending.
If it’s European and U.S. banks, the “strings” will be higher interest rates. If it’s China, the “strings” might be a friendlier and more transparent policy from the Foreign Investment Review Board concerning Chinese acquisitions of Aussie companies. And if the Reserve Bank has to eventually monetise Aussie debt, the “strings” will be much higher inflation.
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