RBA Blames Everyone But The RBA

RBA’s Christopher Kent really laid it on the line today in a speech where he discussed the like between US Monetary Policy and Australia – “US Monetary Policy and Australian Financial Conditions”.

He concludes that “Global developments undoubtedly influence Australian financial conditions. In particular, developments abroad can influence the value of the Australian dollar and affect global risk premia. But changes in monetary policy settings elsewhere need not, and do not, mechanically feed through to the funding costs of Australian banks, and hence their borrowers are insulated from such changes”.

But the higher bank funding rate spreads which see here are perhaps more of a reflection of the risks the markets are pricing in, than anything else. Yet this was not discussed. Too low rates here for several years are the root cause (and guess where the buck for that stops?). This led to overheated lending, and home prices, which are now reversing, with obvious pressures on the banks. This leaves the economy open to higher rates, from overseas ahead.

This is the speech:

Australia is a small open economy that is influenced by developments in the rest of the world. Financial conditions here can be affected by changes in monetary policy settings elsewhere, most particularly in the United States given its importance for global capital markets. However, Australia retains a substantial degree of monetary policy autonomy by virtue of its floating exchange rate. In other words, a change in policy rates elsewhere need not mechanically feed through to Australian interest rates. While Australian banks raise significant amounts of funding in offshore markets, they are able to insulate themselves – and by extension Australian borrowers – from changes in interest rates in other jurisdictions.

Just before delving into the details, some context is in order. First, Australian banks have long borrowed in wholesale markets, including those offshore. However, they do so much less than used to be the case (Graph 1).[1] For a number of reasons, domestically sourced deposits have become an increasingly large share of overall funding for banks.[2]

Graph 1: Net Foreign Debt Liabilities
Graph 1

Second, to the extent that Australian banks have continued to tap offshore wholesale markets, it is worth reflecting on some of the characteristics of this borrowing. For instance, some banking sectors around the world borrow in US dollars in order to fund their portfolios of US dollar assets.[3] This can leave them vulnerable to intermittent spikes in US interest rates. However, this is generally not the case for Australian banks. Rather, a good deal of the borrowing by Australian banks in US dollars reflects the choice of the banks to diversify their funding base in what are deep, liquid capital markets. By implication, if the costs in the offshore US dollar funding market increased noticeably relative to the home market, then Australian banks can pursue other options. They might opt to issue a little less in the US market for a time, switching to other markets or even issuing less offshore. They are not ‘forced’ to acquire US dollars at any price, as some other banks may be. Another important feature of this offshore funding, as I will address in detail in a moment, is that the banks are not exposed to exchange rate risks as they hedge their borrowings denominated in foreign currencies.

Independence – It’s an Australian Dollar Thing

As you are well aware, the US Federal Reserve has been raising its policy rate in recent years, and interest rates in the United States are now higher than in Australia. These developments reflect differences in spare capacity and inflation: unemployment in the United States is at very low levels, inflation is at the Fed’s target and inflationary pressures appear to be building. Since August 2016 – the last time the Reserve Bank changed its cash rate target – the Federal Reserve has raised its policy rate seven times, by 175 basis points in total (Graph 2). Yet while Australian banks raise around 15 per cent of their funding in US dollars, interest rates paid by Australian borrowers since then have been little changed.

Graph 2: Australian and US Interest Rates
Graph 2

How is it that interest rates for Australian borrowers have been so stable, despite Australian banks having borrowed some US$500 billion in the US capital markets, in US dollars, paying US dollar interest rates? The answer lies in the hedging practices of the Australian financial sector. As I’ll demonstrate, Australian banks use hedging markets to convert their US interest rate obligations into Australian ones.

The Australian banks fund their Australian dollar assets via a number of different sources. Some of their funds are obtained in US dollars from US wholesale markets. In order to extend these USD funds to Australian residents, they convert the US dollars they have borrowed into Australian dollars soon after the securities are issued in the US. On the surface it would appear that such transactions could give rise to substantial foreign exchange and interest rate risks for Australian banks given that:

  1. the banks must repay the principal amount of the security at maturity in US dollars. So an appreciation of the US dollar increases the cost of repaying the loan in Australian dollar terms; and
  2. the banks must meet their periodic coupon (interest) payments in US dollars, which are tied to US interest rates (either immediately if the security has a floating interest rate, or when the security matures and is re-financed). So a rise in US interest rates (or an appreciation of the US dollar) would increase interest costs for Australian banks that extend loans to Australian borrowers.

However, it is standard practice for Australian banks to eliminate, or at least substantially reduce, these risks. They can do this using a derivative instrument known as a cross-currency basis swap. Such instruments are – when used appropriately – a relatively cost effective way of transferring risks to parties with the appetite and capacity to bear them.

Simply put, cross-currency basis swaps allow parties to ‘swap’ interest rate streams in one currency for another. They consist of three components (Figure 1):

  1. first, the Australian bank raises US dollars in the US wholesale markets. Next, the Australian bank and its swap counterparty exchange principal amounts at current spot exchange rates; that is, the Australian bank ‘swaps’ the US dollars it has just borrowed and receives Australian dollars in return. It can then extend Australian dollar loans to Australian borrowers;
  2. over the life of the swap, the Australian bank and its swap counterparty exchange a stream of interest payments in one currency for a stream of interest receipts in the other. In this case, the Australian bank pays an Australian dollar interest rate to the swap counterparty and receives a US dollar interest rate in return. The Australian bank can use the interest payments from Australian borrowers to meet the interest payments to the swap counterparty, and it can pass the interest received from the swap counterparty onto its bondholders;
  3. At maturity of the swap, the Australian bank and its swap counterparty re-exchange principal amounts at the original exchange rate. The Australian bank can then repay its bond holders.[4]

In effect, the Australian bank has converted its US dollar, US interest rate obligations into Australian dollar, Australian interest rate obligations.

Figure 1: Cash flows of foreign borrowings hedged using a cross-currency basis swap; described in the paragraphs preceding this image.
Figure 1

An analogy related to housing can help to further the intuition here. Imagine a Bloomberg employee who owns an apartment in New York but has accepted a temporary job in Sydney. She fully expects to return to New York and wishes to keep her property, and she does not wish to purchase a property in Sydney. The obvious solution here is for her to receive rent on her New York property and use it to pay her US dollar mortgage. Meanwhile, she can rent an apartment in Sydney using her Australian dollar income. In other words, our relocating worker can temporarily swap one asset for another. As a result, she can reduce the risks associated with servicing a US mortgage with an Australian dollar income.

As I mentioned earlier, it is common practice for Australian banks to hedge their foreign currency borrowings with derivatives to insulate themselves and their Australian borrowers from fluctuations in foreign exchange rates and interest rates. The most recent survey of hedging practices showed that around 85 per cent of banks’ foreign currency liabilities were hedged (Graph 3). Also, the maturities of the derivatives used were well matched to the maturities of the underlying debt securities.[5] This means that banks were not exposed to foreign currency or foreign interest rate risk for the life of their underlying exposures. By matching maturities, banks also avoided the risk that they might not be able to obtain replacement derivatives at some point in the future (so called roll-over risk).

Graph 3: Banks' Hedging of Foreign Currency Debt Security Liabilities
Graph 3

For the very small share of liabilities that are not hedged with derivatives, there is almost always an offsetting high quality liquid asset denominated in the same foreign currency of a similar maturity, such as US Treasury Securities or deposits at the US Federal Reserve. Taken together, these derivative hedges and natural hedges mean than Australian banks have only a very small net foreign currency and foreign interest rate exposure overall (Graph 4).

Graph 4: Composition of Foreign Currency Exposures
Graph 4

So who is bearing the risk?

Despite Australia’s external net debt position, in net terms Australian residents have passed on – for a cost, as we shall see – key risks associated with their foreign currency liabilities to foreign residents. Australian residents have found enough non-residents willing to lend them Australian dollars and to receive an Australian interest rate to extinguish their foreign currency liabilities. As a result, Australians are net owners of foreign currency assets, not borrowers.[6] Collectively, Australians have used hedging markets and natural hedges to (more than) eliminate their exchange-rate exposures associated with raising funds in offshore markets.

Australians’ ability to find non-residents willing to assume Australian dollar and Australian interest rate risks is a reflection of the willingness of non-residents to invest in Australian dollar assets. This in turn reflects Australia’s status as a country that has long had strong and credible institutions, a high credit rating and mature and liquid capital markets. The willingness of these non-resident counterparties to assume these risks via a direct exposure to Australia’s banking system – sometimes for as long as thirty years – reflects the fact that Australia’s banks are well-capitalised and maintain high credit ratings. In short, Australians have found a source of finance unavailable domestically (at as reasonable a price), and non-residents have found an asset that suits their portfolio needs.

Since there are no free lunches in financial markets, there is the question of the cost for Australian banks to cover these arrangements. One part of this cost is known as the basis.

An imperfect world

Some swap counterparties have an inherent reason to enter into swap transactions with Australian banks. In other words, such exposures actually help them to manage their own risks. Non-residents that issue Australian dollar debt – in the so called Kangaroo bond market – are a case in point. These issuers raise Australian dollars to fund foreign currency assets they hold outside of Australia. This makes them natural counterparts to Australian banks wanting to hedge their foreign currency exposures. Similarly, Australian residents invest in offshore assets. To the extent that they want to hedge the associated exchange rate exposures, they too would be natural counterparties for the Australian banks.

However, it turns out that these natural counterparties do not have sufficient hedging needs to meet all of the Australian dollar demands of the Australian banks. So in order to induce a sufficient supply of Australian dollars into the foreign exchange swap market, Australian banks pay an additional premium to their swap counterparts on top of the Australian dollar interest rate. This premium, or hedging cost, is known as the basis. Simply put, the basis is the price that induces sufficient supply to clear the foreign exchange swap market.[7]

Since the start of the decade, the basis has oscillated around 20 basis points per annum (Graph 5). Typically, though not always, the longer a bank wishes to borrow Australian dollars, the higher the premium it must pay over the Australian dollar interest rate.

Graph 5: AUD and USD Cross-Currency Swap Basis
Graph 5

You may be wondering why Australian banks are willing to pay this premium; why don’t they instead only borrow Australian dollars in the Australian capital markets to meet their financing needs? In addition to the prudent desire to have a diversified funding base as I mentioned earlier, the short answer is that it may not be cost-effective to raise all their funding at home. What tends to happen is that banks – to the extent possible – seek to equalise the marginal cost of each unit of funding from different sources. If they were to obtain all of their funding at home, that would be likely to increase the cost of those funds relative to funds sourced from offshore. So the all-in-cost of the marginal Australian dollar from domestic sources will tend to be about the same as the marginal dollar obtained from offshore.

Astute students of finance will also wonder why the basis is not arbitraged away.[8] The answer is that structural changes in financial markets have widened the scope for market prices to deviate from values that might prevail in a world of no ‘frictions’. This is consistent with the concept of ‘limits to arbitrage’ (which the academic community only started to re-engage with in the past couple of decades). Arbitrage typically requires the arbitrageur to enlarge their balance sheet and incur credit, mark-to-market and/or liquidity risk. As Claudio Borio of the BIS has noted: balance sheet space is rented, not free. And the cost of that rent has gone up.[9]

What about financial conditions more generally?

None of this is to suggest that monetary policy settings in the United States (and elsewhere for that matter) have no impact on financial conditions here in Australia. But the link is neither direct nor mechanical.

The primary channel through which foreign interest rates influence Australian conditions is through the exchange rate. An increase is policy rates elsewhere will, all else equal, tend to put downward pressure on the Australian dollar, because capital is likely to be attracted to the higher rates of return available abroad. A depreciation of the Australian dollar in turn will tend to enhance the competitiveness of our exporters, including those services priced in Australian dollars like tourism and education. Through various channels, exchange rate depreciation can also loosen financial conditions in Australia, which is not always the case in other countries, particularly those for which inflation expectations are not well anchored and where there are substantial foreign currency borrowings that are unhedged.[10]

Foreign monetary policy settings, particularly those in the United States, can also affect global risk premia. We are now approaching a period when US monetary policy is moving to a neutral stance. This follows a lengthy period of very easy monetary conditions, which may have encouraged investors to ‘search for yield’ to maintain nominal portfolio returns in an environment of low interest rates. The expectation of low and stable policy rates and inflation outcomes in turn compressed risk premia across a range of asset classes. In the period ahead, it seems plausible that term and credit risk premia will rise, which will increase costs for all borrowers, Australian banks included.


Capital Markets 201 – Part 1

Welcome to the first in a new series of videos and posts in which we discuss the capital markets. It’s important to understand how these markets work because they are such a large element in the financial system, with bonds and other funding instruments, and the mix of derivatives together dominating the markets – and by the way, the risks in the system too. As you will know from our earlier posts, the total value of derivatives in the system globally dwarfs the value of the real economy.

You might like to know that I spent a number of years working in a major bank where I taught capital markets to their senior executives, because they had been subject to a major financial crash during which it became clear that the senior executives in the company had NO idea about how the markets really worked, and the inherent risks which they were taking. Some would say little has changed.

In this introduction I will discuss what we are going to explore in the series, over the weeks ahead.  I am not assuming any prior knowledge of the topic in these shows, so we will start out quite simply, but by the end of the series we will be touching on some really complex, yet interesting concepts.  So do come along for the ride. And I should explain that I called the series “Capital Markets 201” because this is going to be more, much more than a simple 101 overview.

So today, to start, I am going to outline the structure of the series and offer a definition of “Capital Markets”.

The capital markets are simply a market place where buyers and sellers engage in the trade of financial securities like bonds, stocks, and other instruments. This buying/selling may be undertaken by participants as diverse as banks, other financial institutions, companies, government entities and even individuals. The market may exist within a country, and internationally, with the bulk of the transactions relating to Australia for example, being off-shore.

These markets help to channel surplus funds from savers to institutions which then invest them, and many of these trades are in longer-term securities, though as we will see later sort-term funding and also a complex set of derivatives are also important in the sector.

Finally, capital market consists of primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and bonds, and other securities, whereas secondary markets deals with the exchange of existing or previously-issued securities. Another important division in the capital market is made on the basis of the nature of security traded, i.e. stock market and bond market.

Finally, as well as trading in the underlying securities there are many flavours of derivative. A derivative is a contract between two parties which derives its value/price from an underlying asset. The most common types of derivatives are futures, options, forwards and swaps. Generally stocks, bonds, currency, commodities and interest rates form the underlying asset.

So to the structure of our series of programmes.

We are going to start in the next video with the concept of the time value of money. It’s essential to understand that capital markets are essentially all about manipulating cash flows. So we need to know about how to assess cash flows, and develop some basic language to describe them. We will also touch on concepts such as compound interest, current and future value, and internal rates of return.

Next we will look at the treasury operations in banks and other large corporations, and discuss the concept of disintermediation, where companies behave like banks in their own right. We will also meet archetypical “Belgium Dentists” and where they put their money.

After that, we will start looking at the individual instruments which make up the Capital Markets armoury. So we will look at bonds and other funding instruments, and how they work, and the different flavours which are out there. These instruments are the bedrock of the capital markets, so we will look at who might buy and sell such instruments.

Once we understand how bonds work, we can then start to explore the more complex derivatives areas of the capital markets.

We will look at futures and options contracts and how they work. This is a big area and we will look at both contracts relating to physical commodities like corn and pork bellies as well as financial contracts.

We will take a deep dive into interest rate and currency swaps and options, an area which I find really interesting.  And there are a number of other variants which we will also touch on.

Then towards the end of the series we will start looking at financial engineering, where these various products are put to work. I will look for example at securitisation (I was involved in some of the early transactions in the 1990’s).

And as we bring the series to a close we will look at the risks in the system, the way the markets are regulated, or not, and some of the gaps in reporting and disclosure.

So buckle up, and enjoy the ride.  And by the way, I will run a couple of live Q&A events as we progress through the series, and I will also try and answer questions as we go though, so do post any you may have.

Watch out for the next episode – The Time Value of Money – coming soon.

And by the way, if you value the content we produce please do consider joining our Patreon programme, where you can support our ability to continue to make great content. Here is the link, and it’s in the comments below.