ccsmreview

8/7/2019 CCSMReview

http://slidepdf.com/reader/full/ccsmreview 1/165

8/7/2019 CCSMReview


8/7/2019 CCSMReview


$SSHQGL[ 0DFURHFRQRPLF LPSOLFDWLRQV

3DJH

of interest rates can be thought of as an average of the rates in these twomarkets.

This approach is inconsistent with a p ure expectations interest rate hyp othesisw hich links short and long-term interest rates through arbitrage. If there w eredifferences between the two rates, they would be traded away. This approachacknowledges that the short and long funds markets play d istinct roles and arenot p erfect substitutes. Arbitrage w ill ensure som e relationship between shortand long-term rates, but supply and demand considerations in both marketsw ill affect the d ifference between the two in terest rates.

In the following analysis, the CGS market forms part of the market forlong-term funds.

7KH GHPDQG IRU &RPPRQZHDOWK *RYHUQPHQW 6HFXULWLHV

A number of recent policy papers 10 note the demand for government bondsmay be fragmented into several components, so the bond demand curve maynot have a un iform d own ward slope, as depicted in Chart 25.

A key assumption is that two types of investors will purchase CGS. The firsttype purchases CGS because they play an important role in their portfolio

management. Some investors, notably superannuation funds and insurancecompanies, buy and hold CGS because the revenue streams (couponpayments) from CGS are a very close match to their liability payment streams(see Chapter 3). For example, a life insurance company may sell annuities thatrequire regular annual payments to the beneficiary. For that life company,purchasing CGS provides a safe, regular source of income to match againstpaym ents. Very few substitutes may be available for these investors. CGS pricechanges may n ot have m uch affect on these investors ’ demand for CGS.

The second type of investors actively trade CGS as part of their portfoliomanagement. These investors have many substitutes for CGS, so even smallincreases in CGS prices will encourage these investors to sell CGS andpu rchase other assets.

The balance between the two investor groups will affect the overall marketdemand elasticity. The higher the proportion of active investors, the moreelastic the curve. The d emand curve for CGS will have a mild d own w ard slopein segments where there are sufficient active investors. This assumption is not

Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã Ã

10 For examp le, see Cooper an d Scholtes (2001) and Edey an d Ellis (2002).

8/7/2019 CCSMReview



3DJH

crucial to the results of the analysis, since the demand curve remainsdownw ard sloping wh ether passive or active investors dominate.

A horizontal demand curve, as Cooper and Scholtes (2001) suggest, wouldimply a perfect substitute is available so price increases would lead investorsto substitute the other asset for CGS. As it is unlikely perfect substitutes forCGS exist, a dow nw ard sloping d emand curve seems likely.

&KDUW 'HPDQG IRU &*6

8 r q v Ã v x 6 p v r Ã h q r D y y v v q v

9

7

6

7 Ã h q Ã u y q

R h v

Q v p r

However, at a point (A in Char t 25), the sup ply m ay diminish so mu ch th at the‘buy and hold ’ investors begin to d ominate the m arket. As these investors aremu ch less sensitive to CGS pr ice changes, the d emand curve w ould steepen.

Within this fram ework are two fu rther cases representing the extreme ends of the demand for CGS.

At one extreme (point B in Chart 25), the amou nt of bond s in the m arket maybegin to add a credit risk premium to the price of bonds. In this case, thevolume of CGS on issue may create concerns about whether the Governmentwould default on the debt as the risk characteristics of CGS change. Hence,increases in CGS supply may affect significantly the price, as investors willrequire a larger fall in CGS prices to indu ce them to bu y m ore.

At the other end of this curve, very limited CGS sup ply m ay generate concernsabout liqu idity. In this case, decreased sup ply m ay encourage bond holders to

sell, as they may be concerned that r edu ced liqu idity may redu ce their abilityto sell easily in the futu re. Thu s, decreased CGS sup ply m ay lower the p rice of

8/7/2019 CCSMReview



3DJH

remaining CGS. This illiquidity premium may not be sufficient to invert theslope of the demand curve, particularly if 'buy and hold' investors dominatethis segment, but may simply reduce the downward slope of the demandcurve.

7KH VXSSO\ RI &RPPRQZHDOWK *RYHUQPHQW 6HFXULWLHV

CGS sup ply is assum ed to be exogenou sly determined by governm ent policy.

6XSSO\ DQG GHPDQG RI DOWHUQDWLYH LQYHVWPHQWV

All non-CGS long-term financial investments are grouped together into one set

of ‘private ’ assets, including securities other levels of government issue.Private assets are treated as debt instruments, with the standard inverserelationship between price and interest rate, although the results apply forother asset classes. For equities, the interest rate is the rate of return on theequity.

The demand curve for private assets is downward sloping, and CGS areimp erfect substitu tes for p rivate assets.

The supply of private assets is assumed to be upward sloping. The supply of private assets equates to borrowing to finance the issuer ’s capital spending.The higher the price received, the lower the interest rate, and the moreattractive new capital spend ing w ill be to the issuer.

The combination of the supply and demand for CGS, and the supply anddeman d for private assets determines the average interest rate in the long-termfund s market.

'HWHUPLQDWLRQ RI GRPHVWLF RXWSXW DQG WKH FXUUHQW DFF

To assess the macroeconomic impacts of changes, these markets need to beincorporated into a macroeconomic model with changes in domestic output,interest rates, and the current account balance. The model amalgamates theIS-MP framework for money and goods market equilibrium, adjusting it forthe two different interest rates described earlier, and the BP framework fordetermining the balance of payments. The model is comprised of theIS relationship , the MP relationsh ip and the BP relationship (Char t 26).

8/7/2019 CCSMReview



3DJH

The IS relationship depicts a range of goods market equilibriums for differentcombinations of interest rates and income (see Blanchard 1997). Domesticoutp ut comp rises consump tion, investment, governm ent spend ing and exportsminu s impor ts. The lower the interest rate, the higher the investment, as more

investment projects will be cost effective, and the higher the consumption, asconsu mers redu ce their savings in favour of consum ption. Therefore, the lowerthe interest rates, the h igher the domestic outp ut. Exchan ge rate changes w illshift the IS curve, w ith a dep reciation increasing net exports an d outp ut for agiven interest rate.

The MP relationship depicts the interest rate and output combinationdetermined by the monetary policy stance (see Romer, 2000). 11 The RBA setsthe interest rate in the short-term money market, taking into accoun t the r ate of inflation and domestic output. Generally, higher domestic output leads tohigher inflation, and higher inflation causes the RBA to increase interest rates.As a result, the MP curve is an upward sloping relationship between theinterest rate and outpu t.

The MP relationship is augmented to include the long-term interest rate (seeBaily and Friedman, 1991). While the RBA sets the short-term interest rate,sup ply and demand for long-term financial assets will determine the long-terminterest ra te. Thu s, the interest rate that affects econom ic activity is the averageof the short and long-term interest rates. This is depicted by the AugmentedMP (AMP) curve. This relationship shifts when the difference betweenlong-term and short-term interest rates changes. For example, a fall in thelong-term interest rate relative to the short-term interest rate, shifts the AMPcurve to the right, reducing the interest rate in th e IS-AMP-BP framew ork for agiven level of outp ut. If both shor t and long-term interest rates change by thesame amount (creating a parallel shift in the yield curve), this would bedepicted in a m ove along the AMP curve.

The BP relationship depicts the external sector of the economy, forcombinations of output and interest rates (see Appleyard and Field, 1992). Thebalance of payments comprises the current account (the balance of exports andimports of goods and services and net income flows) and the capital account(the balance of financial capital inflows and outflows). The balance of payments always must balance, so if a deficit on the current account results


11 The MP r elationship is a m odification of th e LM relationship. The key difference is that theMP relationship depicts the central bank implementing monetary policy by setting theshort-term interest rate, whereas the LM curve assumes the central bank implementsmon etary policy by setting the money sup ply.

8/7/2019 CCSMReview



3DJH

from higher imports than exports, the capital account must be in surplus; netcapital inflow is requ ired to finan ce the cur rent account deficit.

The BP relationship is a function of the (floating) exchange rate, output andAustralian interest rates compared to foreign interest rates. Changes in theexchange rate affect net exports and the balance of payments, changing ou tpu tfor a given interest rate. Changes in output lead to changes in imports,affecting the balance of payments. Changes in domestic interest rates relativeto foreign interest rates affect the balance of payments through the capitalaccount.

&KDUW ,6 $03 %3 )UDPHZRUN

6 H Q

7 Q

D T

P

D r r Ã

h r

,PSOLFDWLRQV RI D GLPLQLVKLQJ &RPPRQZHDOWK

*RYHUQPHQW 6HFXULWLHV PDUNHWThe following analysis considers a reduced supply of CGS resulting fromgovernment fiscal surpluses. The IS curve describes a given level of government spending and taxation, assuming the level of governmentspen d ing is less than th e level of taxation, so the bu dget is in su rp lus. As this isa static analysis, a bud get surplus does not necessarily imply a contractionaryfiscal policy (which is driven by changes in fiscal policy from one year to thenext). However, if government spending or taxation change, the IS curve

would shift. Budget surpluses provide the government with resources toredu ce CGS sup ply (by repu rchasing).

8/7/2019 CCSMReview



3DJH

Reduced CGS supply would increase the price of remaining CGS. This shiftsthe supply curve left in the CGS market (Chart 27), reducing CGS interestrates. In other word s, investors w ith a h igher demand for CGS w ould accept alower return to hold the scarce CGS.

&KDUW 5HGXFHG VXSSO\ RI &*6

R h v

9 ¶

9

Q v p r

8 B T Ã H h x r

9

9 ¶

T

Q v p r

R h v

Q v h r Ã 6 r Ã H h x r

Private assets are substitutes for CGS for investors. Consequently, higher CGSprices would increase demand for private assets, shifting the private assetdemand curve to the right, increasing the private assets prices and reducingyields on these assets. The net effect of reducing CGS outstanding is to lowerinterest rates on both th e remaining CGS and private assets.

In addition, higher private assets prices would increase the demand for CGS,as the two markets are substitutes. While not depicted in Chart 27, thesechanges in the relative p rices of CGS and pr ivate assets wou ld continue un tilthe m arginal change w as very small. That is, higher CGS prices wou ld lead tohigher demand for private assets, which increases their price, which increasesthe demand for CGS, which increases their price, and so on. As the two assetsare imp erfect substitu tes, each su ccessive increase in dem and would be smallerthan the last, so eventually the system would stabilise at a new, higher pricefor both assets. If price expectations were purely rational, the marketimm ediately would m ove to the new equ ilibrium without iterations.

Three factors w ill influence the magnitud e of price and interest rate chan ges.

Ã First, the size of change in private asset demand induced by a change inCGS prices will influence the magnitude of price changes. For a given

8/7/2019 CCSMReview



3DJH

change in CGS sup ply, the larger the increase in p rivate asset demand , thelarger the fall in interest rates. The closer the two are as substitutes, themore a given increase in the CGS price will lead investors to purchaseprivate assets.

Ã Second, the sensitivity of the demand for CGS for a given change in theprice will influence the magnitude of price changes, so the steeper the slopeof the demand curve for CGS, the larger the change in CGS prices resultingfrom reduced supply. That is, the less sensitive investors are to changes inCGS prices, the more a given change in CGS sup ply will chan ge the p rice.

Ã Third, the sensitivity of the supply of private assets for a given change inprice will influence the magnitude of price changes. The steeper the privateasset supply curve (that is, the larger the price increase or interest ratedecrease required to ind uce fur ther capital spen ding), the larger w ill be thechange in p rivate asset prices.

While average interest rates in the long-term funds market will fall as a resultof reduced CGS supply, the effect may not be the same for all private assets.Assets that are close substitutes for CGS will experience a larger fall in interestrates. Reduced CGS supply will benefit some private asset issuers more thanothers.

Private asset (and CGS) interest rates will fall in relation to short-term moneymarket interest rates. Thu s, the AMP curve shifts to the right and outp ut riseswhile overall interest rates fall. 12 In IS terms, lower interest rates increaseconsump tion an d investment by m oving along the IS curve. The new IS-AMPequilibrium will be at a higher output and lower interest rate (point A inChart 28).


12 The analysis assumes that th e RBA does not increase short-term interest rates in respon se tolower long-term interest rates. If this were the case, the AMP curve w ould shift back to theleft and there w ould be no effect on outp ut.

8/7/2019 CCSMReview



3DJH

&KDUW (IIHFW RI UHGXFHG &*6 VXSSO\ LQ WKH ,6 $03 %3 PRGHO6 H Q

%3

D T

6 H Q ¶

7 Q ¶

D T ¶

6

7

D p r

D r r Ã

h r

Increasing output and falling interest rates create an imbalance in the balanceof payments (the sum of the current account and capital account). Theexchange rate is the mechanism that resolves this imbalance. Higher incomeencourages higher imports and low er interest rates encourages capital outflow.Both factors p ush the exchange rate d own : consu mers sell Australian d ollars to

buy foreign currency to p ay for imports; and investors sell Australian dollarsto buy foreign assets. Thus, the exchange rate depreciates, shifting both theBP curve an d the IS curve to th e right. The IS curve sh ifts due to increasing netexpor ts and the BP curve shifts du e to the d epreciation of the exchange rate.

The new equilibrium occurs at higher income and lower exchange rate thanthe in itial position (point B in Chart 28). The increase in net exports w ill lead toa decrease in the current accoun t deficit.

The size of the reduction in interest rates resulting from the reduced su pp ly of CGS will determine the size of the shift in th e AMP curve, determ ining the sizeof the exchange rate depreciation an d the increase in outp u t.

The more responsive international capital is to changes in interest rates, theflatter the BP curve. For perfectly mobile capital, lowering interest rates leadsto a large volume of capital outflow, inducing a large depreciation of theexchange rate and a large expansion in net exports. The increase in net exportsoffsets the increase in capital outflow. The capital outflow induces a rise in

interest rates back tow ard s the original position. This redu ces the demand for

8/7/2019 CCSMReview



3DJH

CGS and other domestic assets, reducing the price of these assets and soincreases interest rates back to their or iginal levels.

A net decrease in interest rates and net increase in income is consistent withimperfectly mobile capital. Perfect capital mobility requires Australianfinancial assets to be perfect substitutes for foreign financial assets, which isunlikely.

The fiscal position th at p rovides the resources to repu rchase government d ebtreduces domestic interest rates, increasing domestic output. Increaseddomestic output, and a depreciating exchange rate, may generate somepressure to increase prices in the economy generally. These price pressures arelikely to be modest if the economy is operating below full capacity. However,if the economy is operating at full capacity, then price rises may result in littlechange in overall economic output. The increase in investment resulting fromlower interest rates should increase the economy ’s productive capacity insubsequent periods. Expanded economic activity may occur before pricepr essures emerge.

Although changes in interest rates, exchange rates and domestic output arelikely to occur, in reality the impacts are likely to be relatively small. Changesin CGS supply will occur over a relatively long time, so the macroeconomicimpacts are likely be spread ou t.

*OREDO ERQG LQGH[ DUJXPHQW

Some investors may follow a global bond index in their investment strategy.Sovereign global bond ind ices, such as the Salomon Smith Barney Global BondIndex typically rank sovereign bonds by the amoun t on issue in each bond line.For example, $250 million on issue in a given line and US$20 billion overalloutstanding by a government is sufficient to be included the index, and

issuan ce above that wou ld boost the coun try ’s position in the ind ex comp aredto other coun tries (assum ing issuance in other countr ies d id n ot change).

This introduces a discontinuity in CGS demand. CGS demand might not be aun iform down ward sloping function of the p rice, but m ight be affected by th edominance of various types of investors, or at extremes be, affected byperceptions of default risk, or lack of liquidity. A third type of investor couldbe introduced into the market for CGS the foreign investor following aglobal bond index.

8/7/2019 CCSMReview



3DJH

&KDUW &*6 GHPDQG ZLWK JOREDO ERQG LQGH[ LQYHVWRUV8 r q v Ã v x 6 p v r Ã h q r 7 Ã h q Ã C y q

D y y v v q v

9

6

9 ¶

R h v

Q v p r

A minimum amount of CGS on issue will generate an exogenous increase indemand for CGS from global bond index investors, causing the CGS demandfunction to shift to the right, as more investors will want to purchase CGS at agiven p rice. For convenience, this is assum ed to occur at p oint A in Chart 29.

As the CGS supply decreases past point A, the demand for CGS falls as theCGS market falls off the global bond indices. At this point, CGS prices wouldfall and CGS interest rates rise. However, as the su pp ly continu es to d iminishthe p rice wou ld begin to rise from the lower base. This makes the dynamics of the adjustment m ore comp lex.

([WUHPH LOOLTXLGLW\ LQ WKH &RPPRQZHDOWK *RYHUQPHQW6HFXULWLHV PDUNHW

In the case of an u pw ard sloping segment of the dem and curve for CGS due tothe illiquidity of the market, reduced CGS supply leads to an initial increase inCGS pr ices. Then, as the sup ply p asses the peak in th e demand curve, fur therreductions in supply would lead to falls in the price of CGS. Further falls pastthis point w ould lead to increases in CGS interest rates (Char t 30).

8/7/2019 CCSMReview



3DJH

&KDUW ([WUHPH LOOLTXLGLW\ DQG UHGXFHG &*6 VXSSO\

9

T T ¶ T ¶ ¶

8 B T Ã H h x r

R h v

Q v p r

9

9 ¶

T


R h v

Q v p r

The initial rise in CGS prices would increase demand for private assets,causing private asset prices to rise. Lower CGS prices, once supply has passedthe peak, would normally lead to falling private asset prices, as investorswould move from private assets into CGS. However, investors may not seeprivate assets as substitutes once the CGS market is this small. Hence, demandfor private assets may not fall; indeed demand may increase. Thus, reduced

sup ply, past a certain p oint, may generate higher interest rates on CGS but notnecessarily on p rivate assets.

Falling prices and increasing interest rates associated with this effect wouldpartially offset the macroeconomic impacts outlined previously. Final incomelevels would be lower than otherwise and final interest rates higher. Theexchange rate would not fall as much, and the current account contractionw ould be smaller.

,PSOLFDWLRQV RI PDLQWDLQLQJ WKH &RPPRQZHDOWK*RYHUQPHQW 6HFXULWLHV PDUNHW

The previous section assumed that the government had a budget surplus, andtherefore the resources to reduce CGS supply, resulting in lower domesticinterest rates and higher domestic income. However, if the absence of the CGSmarket reduced the efficiency of financial market infrastructure, thegovernm ent could decide to maintain the CGS market. Instead of using bu dgetsurp luses to repu rchase CGS, the governm ent could invest in pr ivate financial

8/7/2019 CCSMReview



3DJH

assets. The macroeconomic implications would depend on whether thegovernm ent invested in domestic or foreign assets.

Also, if the CGS market needed to increase from its current size, thegovernment could consider increasing the supply of CGS and using theproceeds to pu rchase financial assets.

*RYHUQPHQW LQYHVWPHQW LQ GRPHVWLF DVVHWV

In the first case, the government investment activity is restricted to domesticsecurities. The CGS market is maintained in its original form and the budgetsurpluses are used to purchase domestic financial assets. The supply of CGSwould not change but the demand for private assets would increase, so the

price of private asset would rise and interest rates fall. Higher private assetprices would increase the deman d for CGS, so CGS prices also would increase.Hence, both p rivate asset and CGS interest rates w ould fall.

&KDUW ,QYHVWPHQW RI EXGJHW VXUSOXVHVLQ GRPHVWLF ILQDQFLDO DVVHWV

9

9

T

R h v

Q v p r

8 B T Ã H h x r

9

T

9

R h v

Q v p r


The impact would be broadly similar to if the government repurchased CGS.Average interest rates in the economy would be lower than if the governm entdid not have budget surpluses. Income would be higher, the exchange ratelower an d current accoun t d eficit wou ld also be lower (Chart 28).

If the government increased the CGS market from the size depicted in Chart31, additional demand for private assets from Government purchases would

8/7/2019 CCSMReview



3DJH

match increases in CGS supply. Increased CGS supply would decrease CGSprices and increase CGS interest rates. At the same time, governmentpurchases of private assets would increase their prices and reduce theirinterest rates. Further increases in CGS supply would not increase interest

rates.Any government investment in private financial assets, while reducingaverage interest rates on those assets, would affect some assets more thanothers. The government is unlikely to invest in all private financial assets.Governm ent pu rchases of some assets and not others m ay create distortions inthe private asset market. If the Government purchased equities in onecomp any, that wou ld increase their market p rice and redu ce the future cost of capital raising for that company. However, any companies whose equitiesw ere not purchased by the governm ent wou ld not get the same benefit.

To summarise, government purchases of private assets with budget surplusesw ould reduce dom estic interest rates, but at the risk of creating distortions inthe private finan cial asset market.

*RYHUQPHQW LQYHVWPHQW LQ IRUHLJQ DVVHWV

In the second case, the government investment portfolio is restricted to foreign

assets. The CGS market remains unchanged, and as the government ’s budgetsurp luses are invested in foreign assets, demand for dom estic private assets isunchanged. Domestic average interest rates do not change so there is nochange in consump tion and investment.

However, the government ’s investment of budget surpluses in foreign assetscould push the exchange rate down. At the margin, this would stimulateexports, improving the current account deficit.

If the government decides to increase CGS supply above the existing level, theprice of CGS would fall and CGS interest rates would rise (Chart 32). Thiswould cause lower demand for private assets, as they would be relativelymore expensive than CGS. In this case, no offsetting increase in demand forpr ivate assets would result from Government investment of issuance proceeds.The overall imp act is that average interest rates wou ld increase.

8/7/2019 CCSMReview



3DJH

&KDUW ,QFUHDVHG &*6 VXSSO\ DQGIRUHLJQ LQYHVWPHQW RI SURFHHGV

9

T

R h v

Q v p r

8 B T Ã H h x r

T

9

T

9

R h v

Q v p r


The AMP curve will shift to the left as long-term interest rates increase,redu cing consum ption, investment and domestic outp ut (Chart 33). This shiftcreates an imbalance in the balance of payments, due to lower imports andcapital inflow associated with higher interest rates. However, capital outflow

w ould occur as the governm ent invested bond proceeds in foreign assets.

Higher interest rates and lower imports would put upward pressure on theexchange rate, but the governm ent investing overseas wou ld par tly offset this.The BP curve would shift to the left due to the exchange rate appreciation andIS cur ve w ould shift to the left as the exchange rate ap preciation redu ced netexports. The new equilibrium would be reached at a lower level domesticoutp ut an d higher current accoun t deficit.

8/7/2019 CCSMReview



3DJH

&KDUW (IIHFW RI LQFUHDVHG &*6 VXSSO\ LQ WKH ,6 $03 %3 PRGHOZKHQ JRYHUQPHQW LQYHVWV LQ IRUHLJQ DVVHWV

6 H Q ¶

7 Q ¶

D T ¶

6 H Q

P

D T

D r r Ã

h r

7 Q

(IIHFW RI KHGJLQJ IRUHLJQ H[FKDQJH H[SRVXUH

When the government invests in foreign assets, it creates an exposure toexchange rate risk. The government could hed ge to remove this risk. To agreeto entering a hedging arrangement with the government, the counterpartywould have an opposite risk exposure to the government. For example, aUS investor buys Australian dollar-denom inated assets, but w ants certainty inthe US dollar value of the investment, while the government buys US dollarinvestments but w ants certainty in Australian d ollar returns.

If the government used budget surpluses to purchase foreign assets andhedged the exchange rate risk, the effect would be similar to the governmentinvesting in domestic securities. The government ’s foreign investment wouldmatch a domestic investment in private assets (the US investor buyingAustralian dollar-denominated assets). Hence, domestic private assets pricesrise and interest rates fall. The macroeconomic effects of lower interest rateswould app ly.

If CGS supply increases and the proceeds are invested in foreign assets withexchange rate hedging arrangements, domestic average interest rates wouldnot change. Increase CGS supply would raise interest rates, while increaseddemand for domestic private assets due to the hedge counterparty ’s domesticinvestment would reduce interest rates. No broader macroeconomicimplications w ould arise.

8/7/2019 CCSMReview



3DJH

If no hedge counterparty has an opposite risk exposure to the government,another counterparty could be willing to bear the risk in exchange for somecompensation. This would create the same net economic impacts as theunhedged case, but would involve a transaction cost. The hedging

arrangement may be a mix of ‘natural ’ counterparties and counterparties thatrequire compensation, so the net interest rate effect may be somewhere inbetween the two cases.

/RQJHU WHUP VWDELOLW\ LVVXHV

The above analysis considers the short-term implications of the governm ent ’sfiscal position. This section ou tlines som e longer-term imp lications for th e path

of interest rates, governm ent finances and economic outp ut.

The IS curve in the analysis is based on a govern ment fiscal surp lus. This fiscalsurplus provides the government with resources to repurchase CGS orpurchase private financial assets, pushing domestic interest rates down andincreasing domestic output. With no policy change, higher domestic outputleads to a higher su rp lus, through the income tax and social w elfare systems.

The higher surp lus provides the government w ith m ore capacity to repurchase

CGS or purchase private financial assets in the next period, further reducinginterest rates and further increasing d omestic outp ut.

If everything else were equal, this wou ld imply that m aintaining ongoing fiscalsurp luses would lead to ongoing redu ctions in interest rates. In the model, theopposite also would be true. Ongoing fiscal deficits would lead to ongoingincreases in interest rates. This may appear to produce an unstable result.However, a number of factors may mitigate the likelihood or extent of thisinstability. The constraining factors will be different for budget surpluses and

deficits.

In the case of budget surpluses, Chart 34 indicates how ongoing budgetsurpluses would lead to reductions in the supply of CGS (or increases in thedemand for private financial assets), reducing interest rates.

As discussed previously, when CGS supply diminishes, the degree of substitutability of CGS for p rivate assets d iminishes, so increases in CGS priceswill not have as large an impact on demand for private assets. In addition,

when the Government begins investing budget surpluses in private financialassets, it will initially only purchase small volumes of private assets, so theinitial impacts on private asset prices will be small. However, growth in

8/7/2019 CCSMReview



3DJH

pr ivate asset markets due to econom ic grow th w ill increase CGS demand andso m itigate the p rice imp acts of Government p urchases of private assets.

&KDUW 2QJRLQJ EXGJHW VXUSOXVHV

9

T

R h v

Q v p r

8 B T Ã H h x r

T T Å

9

9 Å

There are several factors that w ould redu ce or p revent the instability imp liedin the model.

Ã First, Australia is a small open economy with a close relationship betweendomestic interest rates and interest rates in international markets. The moreresponsive international capital flows are to changes in interest rates, thesmaller the net change in d omestic interest rates for a given bu dget surp lus.International capital mobility would constrain downward pressure oninterest rates, constraining the investment, consumption and outp ut effects.

Ã Second, as mentioned previously, increased domestic output due to lowerinterest rates may lead to price pressures as the economy approachespotential output. Higher prices would offset the increased output, leadingto a diminished feedback to the budget. The economy ’s potential outputwould constrain a budget surplus from leading to perpetual decreases ininterest rates.

That said, budget surpluses that lead to lower interest rates (either byrepurchasing CGS or by directly purchasing private assets) would

increase investment, increasing productive capacity in subsequentperiods. Through this channel, budget surpluses can contribute to

8/7/2019 CCSMReview



3DJH

growth in potential output. This allows greater increases in domesticoutput to accumulate before the potential output constraint begins tooffset the effects of bud get surp luses.

Ã Third, a budget surplus may have less impact on domestic output if theprivate sector d oes not expect the policy to be sustained . If the pr ivate sectorviews the surplus as temporary with deficits to follow, then they may notincrease their spending as much. Then decreases in interest rates associatedwith current budget surpluses may not generate as large an increase indomestic output, reducing the future surpluses and mitigating against theongoing decline in interest rates.

In the case of bu dget deficits, the analysis need s to be considered in the contextof a growing economy. Ongoing deficits would increase the supply of CGS ineach p eriod , pushing interest rates up . How ever, this ignores changes to CGSdemand. Growth in the economy would lead to increased demand for allassets, includ ing CGS. This would shift the dem and curve for CGS, to the right,pushing interest rates down. The net effect on interest rates depends on thebalance of these two considerations. If the deficit in each period causes CGSsupply to grow faster than increased CGS demand, then interest rates willincrease on an ongoing basis. In contrast, if CGS supply grows more slowlythan CGS demand, then interest rates will fall. If the growth in CGS supply ismatched by growth in demand for CGS, interest rates will be unchanged(Chart 35).

&KDUW 2QJRLQJ EXGJHW GHILFLWV

9

T Å

R h v

Q v p r

8 B T Ã H h x r

T T

9

9 Å

8/7/2019 CCSMReview



3DJH

Empirical evidence on the change in CGS demand for a change in domesticoutp ut is unclear. How ever, one assum ption m ay be u seful. If the elasticity of demand of the CGS market with respect to GDP were one, then changes in th edebt to GDP ratio would lead to changes in interest rates. If a one per cent

increase in GDP led to a one per cent increase in CGS demand, then a rise inthe d ebt to GDP ratio would increase interest rates. An elasticity of one may bea reasonable starting point as th e d emand for assets increases w ith income.

Ã To illustrate, if the debt to GDP ratio were 10 per cent, and the nominalGDP growth rate were 6 per cent, then a deficit of 0.6 per cent would notchange the d ebt to GDP ratio or in terest rates. The 0.6 per cent d eficit w ouldmean that CGS sup ply w ould be 10.6 per cent of period one GDP in p eriodtwo. How ever, CGS demand also w ould increase to 10.6 per cent of periodone GDP. The new equilibrium would be at the same interest rate.

The sensitivity of interest rates to th e income elasticity of dem and for CGS alsow ould depend on the pr ice elasticity of dem and for CGS. The m ore elastic thedemand, the less sensitive interest rates would be to the income elasticity of demand.

In summary, the model outlined implies budget surpluses lead to lowerinterest rates, which lead to higher output, which leads to higher surplusesproviding greater capacity to retire debt or purchase assets. This result mayapp ear to be a p otentially u nstable result. How ever, a number of factors affectthe likely magnitude of the interest rate changes. Further, the unstable resultassumes that fiscal policy does not change and budget surpluses continue toincrease. This is unlikely to be a relevant case in practice.

&RQFOXVLRQ

The analysis is highly stylised and somewh at abstractly represents Au stralia ’sfinancial markets and domestic output determination. It clearly does notcapture th e full breadth and soph istication of Australia ’s finan cial markets, nordoes it fully encapsulate the interaction between financial markets and othereconomic activity. However, it does provide a useful economic framework forassessing the likely effects of changes in th e size of the CGS market.

Given the size of Australia ’s financial markets, any changes in broader interestrates associated with changes in CGS supply are likely to be small.

Consequently, the broader macroeconomic impacts are likely to be modest.

8/7/2019 CCSMReview



3DJH

With other changes in economic activity occurring at any time, the impacts of changes in the CGS market m ay not be d iscernible at a p articular p oint.

If the CGS market shrinks, interest rates in the economy are likely to fall,leading to higher consumption and investment activity and, therefore, higherdomestic outp ut. At the same time, lower interest rates w ould likely lead to adepreciation of the exchange rate. This would reduce the current accountdeficit and red uce net foreign investm ent in Au stralia. These effects most likelyw ould be mod est and occur over a relatively long time.

If the governm ent were to maintain or increase the CGS market and invest indomestic securities, average interest rates would again fall, and the broadermacroeconomic implications w ould be the same as if the CGS market sh rank.However, as the Government most likely would only buy a subset of alldomestic private assets, relative price changes may create distortions in thedomestic pr ivate asset market.

If the government were to maintain the CGS market and invest in foreignassets, domestic average interest rates would not change. If it hedged theforeign exchan ge exposure, domestic interest rates wou ld fall.

If the government increased the supply of CGS and invested the proceeds inforeign assets, domestic average interest rates would increase and domesticoutput would fall. If the government hedged this foreign exchange position,domestic average interest rates wou ld not change.

8/7/2019 CCSMReview


3DJH

$ 33(1',; 6(/(&7(' ,17(51$7,21$/ (;3(5,(1&(

*RYHUQPHQW GHEW PDUNHWV

6LQJDSRUH

6L]H RI PDUNHW

The Government initiated the Singapore Government Securities (SGS)programme in 1987. Prior to this there was very little issuance of government

securities, and no active secondary market for government securities existed.The Government primarily issued securities to meet the investment needs of Singapore ’s national pension scheme, and commercial banking sector liquidityrequiremen ts. As a result there was very little turn over in the market.

Over the first decade of the programme, the government bond marketdeveloped slowly with minimal increase in issuance size and turnover.However, in 1998 the Government implemented a number of reforms toenhance the bond market ’s efficiency and liquidity. This included increasing

the issuance of SGS, especially longer-dated bonds. Since 1998, the SGS markethas grow n by an average rate of around 23 per cent p er year. Outstanding SGSat Jun e 2002 totalled S$53 billion (US$30 billion) (Char t 36).

&KDUW 6LQJDSRUH *RYHUQPHQW VHFXULWLHV RQ LVVXH

!

"

#

( ' " ( ' $ ( ' & ( ' ( ( ( ( ( " ( ( $ ( ( & ( ( ( !

!

"

#

Q r Ã p r Ã s Ã B 9 Q Q r Ã p r Ã s Ã B 9 Q

T p r ) Ã Ã 8 @ D 8 Ã 6 v h Ã 9 h h i h r Ã ! !

8/7/2019 CCSMReview


$SSHQGL[ 6HOHFWHG LQWHUQDWLRQDO H[SHULHQFH

3DJH

0RWLYDWLRQ

The Singapore Government does not need to issue government bonds tofinance its expenditures. The Government has operated substantial fiscalsurp luses for m any years and accumu lated sizeable reserves. The govern ment

debt market therefore is maintained for reasons other than meeting thefund ing requirements of the government.

The principal objectives of developing the SGS market, as outlined by theGovernm ent, are to:

Ã provide a liquid investment alternative, with little or no risk of default, forind ividual and institutional investors;

Ã

establish a liquid government bond mar ket wh ich serves as a benchm ark forthe corporate debt secur ities market; and

Ã encourage the development of skills relating to fixed income securities andbroad en the spectrum of finan cial services available in Singapore.

,QVWLWXWLRQDO DUUDQJHPHQWV

Singapore ’s central bank, the Monetary Authority of Singapore, issuesgovernm ent secur ities on behalf of the Government.

All proceeds from the issuance of government securities are placed in theGovernment Securities Fund established by the Government Securities Act .The Fun d is managed by th e central bank.

The Government Securities Act and the Financial Procedure Act outline theinstruments in which funds held in the Government Securities Fund can beinvested. Funds can be invested in any stocks, funds or securities authorisedfor the investment of trust funds, or in securities issued or guaranteed by any

government or international financial institution except those issued by theGovernment of Singapore. Funds also may be invested in gold and otherbullion, or held on d eposit in any bank.

8/7/2019 CCSMReview



3DJH

+RQJ .RQJ

6L]H RI PDUNHW

The Hong Kong Government began issuing debt in 1990, w ith the introd uctionof the Exchange Fund Bills and Notes programme. Exchange Fund Bills andNotes are Hong Kong dollar debt securities issued by the central bank. Theyconstitute d irect obligations of the Hon g Kong Governm ent.

After the programme was introduced, the total size of the governmentsecur ities market in H ong Kong increased by an average of around 30 per centper year . At June 2002, H K$115.7 billion (US$15 billion) of governmentsecur ities were on issue (Chart 37).

&KDUW +RQJ .RQJ *RYHUQPHQW VHFXULWLHV RQ LVVXH

!

#

%

'

( ( ( ( ( ( ! ( ( " ( ( # ( ( $ ( ( % ( ( & ( ( ' ( ( ( ! !

!

#

%

'


T p r ) Ã Ã 8 @ D 8 Ã 6 v h Ã 9 h h i h r Ã ! !

0RWLYDWLRQ

The Hong Kong Government established the Exchange Fund Bills and Notesprogramme with the objective of maintaining monetary and financial systemstability. The programme is also aimed at promoting the development of thedomestic bond market more generally. The Government considers thedevelopment of the domestic bond market to be an important factor in thecontinu ed promotion of H ong Kong as an international financial centre.

The Government does not need to issue government securities to finance itsexpenditures. Prior to the onset of the Asian financial crisis, the Government

8/7/2019 CCSMReview


8/7/2019 CCSMReview



3DJH

8QLWHG 6WDWHV

6L]H RI PDUNHW

Prior to the recent turnaround in the US fiscal position, there had beensignificant reductions in the amount of publicly held Treasury securities.Projections indicated that the market could be virtually eliminated by 2013.The large reductions in publicly held debt were made possible by largeconsecutive fiscal surpluses. Debt held by the public fell from around50 per cent of GDP in 1993 to 33 per cent in 2001. Current projections nowind icate th at publicly h eld debt w ill fall to aroun d 15 per cent by 2012(Congressional Budget Office, 2002).

While the size of the US Treasury market has declined, private sector debt

markets have expanded. Total debt outstanding in the corporate and agencydebt markets totalled almost US$6,000 billion or around 60 per cent of GDP atthe end of 2001.

The corporate debt market grew considerably from 1996 to 2001, with debtoutstanding increasing by 10 per cent of GDP (Chart 38). This compares torelatively slow growth between 1990 and 1995. The agency debt market hasgrown by an average of 20 per cent per year since 1998. Agency securitiesconstitute obligations of government-sponsored enterprises, which operate

un der federal charter.

8/7/2019 CCSMReview



3DJH

&KDUW 86 JRYHUQPHQW FRUSRUDWH DQGDJHQF\ VHFXULWLHV RQ LVVXHD

!

"

#

$

%

( ( ( ( ( ( ! ( ( " ( ( # ( ( $ ( ( % ( ( & ( ( ' ( ( ( ! !

!

"

#

$

%

6 t r p Ã 9 r i 8 h r Ã 9 r i B r r Ã 9 r i


h B r r Ã q r i Ã r s r Ã Ã t r r Ã q r i Ã u r y q Ã i Ã u r Ã i y v p

T p r ) Ã Ã U u r Ã 7 q Ã H h x r Ã 6 p v h v Ã ! ! 0 Ã P t h v h v Ã s Ã @ p v p Ã 8 r h v Ã h q

9 r r y r Ã ! ! i

0RWLYDWLRQ

The Government issues Treasury securities to meet its fiscal fundingrequirements, and has adopted a policy of retiring debt, as budget proceedsbecome available.

The redu ction in p ublicly held Treasury secur ities, has raised concerns amongsome market participants, because of the traditional role these securities haveplayed in financial markets. The Treasury securities market has served as apricing and hedging benchmark for financial markets, reflecting the minimalcred it risk and high liquidity of the Treasury m arket.

While the International Monetary Fund and the US Federal Reserve haveacknowledged the role US Treasury securities play in the financial market,they consider private sector alternatives exist that could fill this role. Indeed,several markets already have assumed a limited benchmark role for risk management, monitoring and analytical purposes. These markets include thecorporate debt, the agency debt and interest rate swap mar kets.

The corporate debt market has respon ded to the d eclining m arket for Treasurysecurities by increasing issuance sizes and regularity to appeal to investordemand. Some large corporate borrowers have moved to position themselvesas benchmark issuers. In 1998, Ford Motor Credit and the General Motors

8/7/2019 CCSMReview



3DJH

Acceptance Corporation, two US finance companies with single-A creditratings, announced billion dollar issues with an expressed intention to createinternational benchm arks.

Despite sound growth in the corporate debt market, some commentatorssuggest its potential as a benchmark m ay be limited by its fragmented n ature,lack of infrastructure and supporting markets, and potential credit risk andfirm-specific factors. Currently, corporate debt primarily is used as abenchmark to monitor the performance of the market, evaluate otheroutstanding corporate debt securities and assist in pricing of new corporatedebt issues. Hedging activity using corp orate issues is limited .

The agency debt market also serves a benchmark role for hed ging and pr icingpurposes. In response to the declining supply of Treasury securities, someagencies have introduced their own benchmark debt issuance programs,mod elled on the issuance practices of Treasury secur ities.

The US interest rate swap market serves a benchmark role for hedgingpositions taken in other markets. The high level of correlation betw een changesin the interest rate on swaps and other debt instruments makes swaps a usefulhedging instrument. Swaps also have been used to price new issues of debtsecurities.

The recent turnaround in the US fiscal position and subsequent increase indebt issuance over the medium-term, means that the Government may nothave to decide on the futu re of the Treasury secur ities market for some time.

8/7/2019 CCSMReview



3DJH

5HSXEOLF RI .RUHD

6L]H RI PDUNHW

The Korean Government bond market has undergone significanttransformation since the Asian financial crisis. Before 1997, the governmentbond market was relatively underdeveloped, with outstanding governmentbonds on issue comprising around 6 ½ per cent of GDP, significantly lowerthan that of most other ind ustrialised countries.

The small government bond market reflected the Government ’s strong fiscalposition. How ever, in 1998, the fiscal position chan ged significantly as a resu ltof the financial crisis. The emergence of large budget d eficits, financed largelythrough the issuance of Treasury bonds, has increased substantially the

amount of bonds on issue. By 2001, the government bond market hadexpan ded to around 15 per cent of GDP (Chart 39).

&KDUW .RUHDQ JRYHUQPHQW DQG FRUSRUDWH VHFXULWLHV RQ LVVD

$

$

!

! $

"

( ' & ( ' ( ( ( ( ( " ( ( $ ( ( & ( ( ( !

$

$

!

! $

"

U r h Ã 7 q U h y Ã B r r Ã 7 q 8 h r Ã 7 q


h U h y Ã B r r Ã i q Ã p v r Ã s Ã U r h Ã 7 q Ã A r v t Ã @ p u h t r Ã T h i v y v h v Ã 7 q

I h v h y Ã C v t Ã 7 q Ã h q Ã B h v Ã T r p v v r

T p r ) Ã Ã F r h Ã I h v h y Ã T h v v p Ã P s s v p r Ã ! !

The limited supp ly of governm ent bonds has meant that corporate bonds havedominated the Korean bond market. Prior to the financial crisis governmentbond s did not serve a benchm ark role du e mainly to limited issuance. Insteadmarket participants used three-year corporate bonds as benchmark

instruments of debt, reflecting the relative size and liquidity of the bondmarkets.

8/7/2019 CCSMReview



3DJH

0RWLYDWLRQ

Some market participants have considered the lack of a well-established debtmarket to be a major contributing cause of the financial crisis. It was believedthat the lack of development in the domestic bond market may have resulted

in heavy reliance on bank borrow ing, and redu ced capacity to evaluate creditrisk.

The Government has stated that the development of the government bondmarket is an important factor in developing the domestic bond market as awhole. Consequently, the Government has adopted several measures to makegovernment bonds a reliable benchmark. The Government has promotedthree-year Treasury bonds as the benchmark debt instrument. In particular, ithas allocated over half the total issuing volume to the three-year bond in ord er

to raise liquidity of the issue. Furthermore, it plans to extend benchmarks to alonger matu rity and establish a benchm ark yield cur ve over a reasonable rangeof maturities.

8/7/2019 CCSMReview



3DJH

0DQDJLQJ *RYHUQPHQW DVVHW SRUWIROLRV

1HZ =HDODQG

6L]H RI DVVHW SRUWIROLR

The New Zealand Government maintains a number of financial assetportfolios. These p ortfolios are expected to total around NZ$25 billion(US$12 billion) at end June 2002, an d increase to around NZ$40 billion(US$20 billion) by 2006.

The expected growth in the Government ’s total financial assets is primarilydue to the recent establishment of the New Zealand Superannuation (NZS)

Fund . Assets in the N ZS Fund are expected to increase from their current sizeof $600 million (US$260 million), to arou nd $9 billion (US$4 billion) by 2006.

Chart 40 shows the growth in the NZS Fund and other Government financialasset funds, established for the purposes of meeting specific governmentobligations.

&KDUW 1HZ =HDODQG *RYHUQPHQW DVVHW SRUWIROLRV WRD

!

#

%

'

B r r

T r h h v Ã A q Ã

@ h u h x r

8 v v

6 p p v q r

8 r h v

8 v v

I r Ã a r h y h q

T r h h v Ã A q Ã

!

#

%

'

Ç i v y y v Ç i v y y v

h 6 Ã i r Ã s Ã u r Ã i h v h y Ã h r Ã s y v Ã h r Ã u r y q Ã i Ã u r Ã B r r Ã v p y q v t Ã h r

u r y q Ã i Ã u r Ã S r r r Ã 7 h x Ã s Ã I r Ã a r h y h q Ã h q Ã u r Ã I r Ã a r h y h q Ã 9 r i Ã H h h t r r Ã P s s v p r

T p r ) Ã Ã I r Ã a r h y h q Ã U r h Ã ! !

8/7/2019 CCSMReview



3DJH

0RWLYDWLRQ

The NZS Fund was established to smooth the rising fiscal costs of theGovernment ’s universal pension system stemming from the ageing of thepopulation. Under current pension arrangements, annual pension payments

are expected to rise from their current levels of about 4 per cent of GDP toarou nd 9 per cent of GDP over the n ext fifty years. Although exacerbatedslightly by the ‘baby boomer ’ generation, this increase is primarily due to thepermanen t effects of increasing longevity an d declining fertility.

The Government ’s intention to pre-fund its future pension liabilities willrequire it to make capital contributions to the fund starting at around2 per cent of GDP each year and steadily winding down to zero by the mid2020s as the annual cost of NZS rises. To ensure the Government meets these

obligations, it has pu t in p lace a long-term fiscal strategy aimed at achieving anoperating balance, on average over the economic cycle, sufficient to meet therequirements for contributions to the N ZS Fun d .

Other NZ government funds have been established to meet specificgovernment obligations. The Accident Compensation Corporation and theEarthquake Commission have been established to meet insurance liabilitiesassociated with national insurance schemes. The Govern ment Sup erannu ationFund is a defined benefit superannuation scheme for public servants, which

w as closed to new members in th e early 1990s.


The NZS Fund will operate independently of the Government and is to bemanaged by a Crown entity board, appointed through an independentnom inating comm ittee process. The New Zealand Sup erannu ation Act sets outthe investment objectives of the NZS Fund. The Act stipulates that the Fundmust be invested on a prudent commercial basis, in a manner consistent withbest-practice portfolio management, and aim for maximum returns withouttaking undue risk. Moreover, the fun d m ust not operate or invest in a w ay thatis damaging to the nation ’s repu tation.

The Board will establish the Fund ’s investment strategy independently of Ministers. While Ministers are free to make their expectations as to the Fund ’sperforman ce known to the Board , and the Board m ust have regard to that, theBoard ’s over-riding responsibility is to invest the Fund on a prudent,comm ercial basis.

To further address some of the governance issues associated with themanagement of government owned asset portfolios, the New Zealand

8/7/2019 CCSMReview



3DJH

Sup erannu ation Act requires that the Fun d avoid taking a controlling interestin any other entity. In addition, there are reasonably extensive accountabilityand reporting requirements, including publication of the Fund ’s statement of investment policies, stand ards and procedu res.

The Board of the Fund has only recently met for the first time and has yet toestablish its investment strategy. As a result it is not yet clear what assetcomposition and management strategy the NZS Fund will adopt. However, itis reasonable to expect that it will pursue a diversified portfolio acrossinternational capital markets.

The Government ’s asset portfolios may be managed actively or passively.However, the choice of active or passive equity management is heavilyinfluenced by the taxation status of the fund. A passive investment strategycan have advantages under the New Zealand taxation system. The NZS Fundwill be subject to domestic taxation arrangements and therefore might faceincentives to imp lement a p assive equity investment strategy.

8/7/2019 CCSMReview



3DJH

1RUZD\


The Norwegian Government Petroleum Fund was established in 1990 tomanage the large government surpluses that resulted from petroleumrevenues. The Petroleum Fund ’s income consists of the central Government ’snet cash flow from p etroleum activities and return on the Fund ’s capital. At th eend of 2001, the Fund held assets totalling NOK 613 billion (aroundUS$80 billion) or 42 per cent of GDP (Chart 41).

&KDUW $FFXPXODWHG DVVHWV LQ WKH *RYHUQPHQW 3HWUROHXP )XD

!

"

#

$

%

&

( ( % ( ( & ( ( ' ( ( ( ! ! ! ! ! "

!

"

#

$

%

&


h 9 h h Ã s Ã ! ! Ã h q Ã ! " Ã h r Ã w r p v

T p r ) Ã Ã I t r Ã 7 h x Ã ! 0 Ã H v v Ã s Ã A v h p r Ã r v h r

0RWLYDWLRQ

The Petroleum Fund provides a mechanism to assist with long-term fiscalchallenges. Norway faces increased pension expenditure as its populationages, at a time when petroleum revenues are expected to decline. These twotrend s may place significant p ressure on governm ent finances in the long-run.The Petroleum Fund seeks to address both these concerns, by smoothing theuse of petroleum revenues over time, and providing an instrum ent for meetingthe long-term increases in pension expend iture.

The Petroleum Fund is an integrated part of the Government ’s finances.

Government guidelines for its fiscal strategy state that the structural, non-oilbud get deficit should correspond to the expected real return on the PetroleumFund at the beginning of the fiscal year. This strategy implies a gradual

8/7/2019 CCSMReview



3DJH

increase in the use of Petroleum Fund revenues to finance the budget deficitover the medium -term, without depleting the Fun d ’s assets.

Further, the Government can draw on petroleum revenues during periods of slower economic activity. During a recession in the early 1990s, largegovernment budget deficits were funded from petroleum revenues, and theGovernm ent did not make any transfers to the Petroleum Fun d .


The responsibility for op eration of the Government Petroleum Fun d has beendelegated to the central bank of Norway. The investment strategy of the Fund ,is to invest capital in a w ay that maximises the Fun d ’s international purchasingpow er, taking into account an acceptable level of risk.

The Fund is invested entirely in foreign financial assets as regulations prohibitit from investing in th e dom estic market. This is intend ed to preven t the Fundfrom becoming a supplementary source of financing governmentexpen ditu res, and to avoid d istorting the d omestic economy.

The Fun d ’s asset allocation is set at 60 per cent bond s and 40 per cent equ ities.To avoid some of the governance issues that arise when governments holdequity in p rivate comp anies, regulations stipu late that the Fund ’s investments

must not exceed 3 per cent of the voting shares or share capital in any onecompany. In addition, the central bank may only exercise the voting rights,associated with its shareholdings, if it is necessary to secure the financialinterests of the fund .

Initially, the Fund ’s equity management was almost entirely conducted byexternal fund managers. These funds were passively managed, that is fundswere invested with reference to stock exchange indices. In 1998, theGovernment allowed external fund managers to actively invest the Fund ’s

assets.The composition of Fund management has changed significantly since theFund ’s inception. In 2001, the central bank took over the management of alarge number of external index managed portfolios, and now manages57 per cent of total Fun d assets both actively and passively.

In 2001, an Environmental Fund was established with NOK 2 billion of capitalholdings to invest in shares of companies wh ich satisfy certain environm entalcriteria, or which have little negative influence on the environment. ThisFund ’s performance will be evaluated after three years to determine whetherthe ethical investments affect overall Fun d p erforman ce.

8/7/2019 CCSMReview



3DJH

&DQDGD


The Canadian Government established the Canadian Pension Plan (CPP) in1966, to provide all working Canadians with retirement income. The Federaland Provincial Governments jointly manage the CPP, however, it does notform part of general government revenue or expenditure and therefore doesnot d irectly affect government bud get p ositions.

In June 2002 the CPP held assets to talling C$56 billion (US$35 billion). Of th eseassets, around 31 per cent w ere managed by an investment board and investedin equities with a view to securing maximum returns without undue risk of loss. The CPP holds the remaining assets in fixed-income securities consisting

of federal and provincial bond s and an interest-bearing cash reserve (Char t 42).

&KDUW &DQDGLDQ 3HQVLRQ 3ODQ DVVHW KROGLQJV

!

"

#

$

%

( ( ( ! ! ! !

!

"

#

$

%

8 Q Q Ã D r r Ã 7 h q 8 h h q v h Ã Q r v Ã Q y h Ã 8 Q Q U h y

Ç i v y y v Ç i v y y v

T p r ) Ã Ã 8 h h q v h Ã Q r v Ã Q y h Ã h v Ã r h 0 Ã 8 h h q v h Ã Q r v Ã Q y h Ã D r r Ã 7 h q Ã h v

r h

0RWLYDWLRQ

The CPP was initially established as a pay-as-you-go plan, where benefits paidto each generation of cur rent retirees were financed from th e contributions of

the following generation. However, in 1996 the Government realised that theCPP had insufficient assets to meet its long-term obligations. Consequently,the Government agreed to increase contribution rates to levels that would

8/7/2019 CCSMReview



3DJH

generate funds in excess of those required to pay current entitlements. That is,the system moved to partial funding. It is anticipated that the CPP will be20 per cent fund ed by 2017.


The Government established the Canadian Pension Plan Investment Board toinvest excess funds in the CPP which are not currently required to meetpension payments. The Board is an independent investment corporation,operating at arms length from governm ents.

The Canad ian Pension Plan Investment Board Act requires the Board to investin assets with a view to achieving a maximum rate of return without unduerisk of loss. The Board can invest in any asset they think is appropriate,

includ ing equ ities, bond s and real estate. So far, it has invested almost entirelyin equ ites, to balance the large fixed-income p ortfolio held by the CPP.

The CPP Investment Board may invest in both domestic and internationalassets, however, its foreign asset holdings are restricted to 30 per cent of thetotal portfolio. This restriction applies to most retirement saving or pensionplans in Canada.

Initially, investments in Canadian equities could only be conducted passively,

that is through stock index funds that replicated established stock exchangeindices. This restriction was removed in 2001. The Investment Board now hasfull discretion over its investment policy.

The Government tabled legislation in Parliament in June 2002 that proposesthe transfer of the CPP assets currently managed by the Government to theCPP Investment Board, consolidating the investment management of all CPPassets in the one organ isation. The tran sfer will be phased-in over three years.

8/7/2019 CCSMReview



3DJH

,UHODQG

6L]H RI PDUNHW

The National Pensions Reserve Fund was established in 2001, and held assetstotalling Euro 7.7 billion (US$7.5 billion) at December 2001 (Chart 43). It isexpected that the Fun d will grow to Euro 40 billion by 2025.

&KDUW $FFXPXODWHG DVVHWV LQ 1DWLRQDO 3HQVLRQV 5HVHUYH

!

#

%

'

! !

!

#

%

'

6 p p y h r q Ã B r r Ã p v i v U h y Ã h r

¼ Ã i v y y v ¼ Ã i v y y v

T p r ) Ã Ã I h v h y Ã Q r v Ã S r r r Ã A q Ã 8 v v Ã !

0RWLYDWLRQ

The National Pensions Reserve Fund was established to meet part of theincreasing costs of government social welfare pensions and public service

pen sions arising from the p rojected ageing of the p opu lation. The Governmentestimates the annual cost of public pensions will increase by around 8 per centof gross national product (GNP) by 2056.

In order to pre-fund part of the future cost of pension expenditures, theGovernm ent is requ ired to m ake contributions to the Fund equal to 1 per centof GNP each year u p to 2055.

The Government is restricted from withdrawing any assets from the Fund

before 2025. Thereafter, withdrawals must be for the specific purpose of meeting social welfare or public service pension expenditures. Further,

8/7/2019 CCSMReview


8/7/2019 CCSMReview


3DJH

$ 33(1',; '(&,6,21 21 &2162/,'$7,1*

&20021:($/7+ $1' 67$7( '(%7 0$5.(76

12

Debt Issuance By Australian Governments

At the request of the Ministerial Council for Commonwealth State FinancialRelations in March 2001, State, Territory and Commonwealth Heads of Treasuries considered the benefits of moving to a consolidated system of issuing State and Commonwealth debt. The States, after receiving thisconsideration, have unanimously agreed not to proceed with such a proposal.The Common wealth concurs with this view.

This assessment reflects the following issues:

Ã The current arrangements, where each jurisdiction has responsibility for itsown debt issuance, provide a d irect link between th e jur isd ictions ’ financialposition and its cost of funds in the financial markets. Substantial benefitshave accrued from these arrangements, which promote greater fiscald iscipline and sup erior financial management ou tcomes;

Ã The savings attributed to the consolidation proposal are un certain, likely tobe small in the short term and difficult to qu antify in the longer term ; and

Ã Consolidation is unlikely to have any material impact on the investmentdecisions of international portfolio managers.

While Treasurers have agreed that the consolidation of debt issuance is notappropriate, they consider it important to continue to promote the effectiveoperation of the governm ent bond market within the existing framework.

CANBERRA2 August 2001

8/7/2019 CCSMReview


8/7/2019 CCSMReview


3DJH

%,%/,2*5$3+<

Appleyard, D.R., and Field, A.J. (1992) International Economics, Irwin, United

States.

Australian Bureau Statistics (2002a) Financial Accounts, Cat. No. 5232, Marchqu arter, ABS, Canberra .

Australian Bureau Statistics (2002b) Australian System of National Accounts,Cat. No. 5204, Au sStats Time Series Spread sheets, ABS, Canber ra.

Australian Financial Markets Association (2001a) Australian Financial Market

Report , AFMA-SIRCA, Au stralia.

Australian Financial Markets Association (2001b) Debt Specialist Handbook ,second edition, AFMA, Australia.

Australian Prudential Regulation Authority (2002) Superannuation Trends,March qu arter, APRA, Syd ney.

Australian Office of Financial Management (2002) Borrowing Programme:Commonwealth Government Securities, viewed on 10 August 2002<http:/ / www.aofm.gov.au/ borrowing_programme/ CommonwealthGovernmentSecurities.htm>.

Baily, M.N., and Friedman, P. (1991) Macroeconomics, Financial Markets, and theInternational Sector, Irwin, United States.

Bank for International Settlements (2001) ‘The changing shape of fixed incomemarkets ’, BIS Working Papers , No. 104, September.

Blanchard , O. (1997) Macroeconomics , Prentice-Hall, United States.

Canad ian Pension Plan Annual Report, various years, Government of Canad a,view ed on 16 July 2002:<http :/ / w ww.hrd c-drhc.gc.ca/ isp/ p ub / cpp pu b_e.shtml#annu al>.

Canadian Pension Plan Investment Board, Annual Report, various years,viewed on 16 July 2002 <http :/ / w ww .cppib.ca/ info/ ann ual/ index.htm l>.

Chalk, N. and Hemming, R. (1998) ‘What should be done with a fiscalsurplus? ’, IMF Paper on Policy A nalysis and A ssessment , No. 10.

8/7/2019 CCSMReview


%LEOLRJUDSK\

3DJH

Commonwealth of Australia (2002a) Budget Strategy and Outlook 2002-03,Bud get Paper N o. 1, Commonwealth of Australia, Canberra.

Commonwealth of Australia (2002b) Final Budget Outcome 2001-02,Comm onw ealth of Australia, Canberra.

Congressional Budget Office (2002) The Budget and Economic Outlook: An update,August, CBO, United States Government, viewed on 12 September<http:/ / w ww .cbo.gov/ sh owd oc.cfm?ind ex=3735&sequence=0>.

Cooper, N., and Scholtes, C. (2001) ‘Government bond market valuations in anera of dwindling supply ’, in The Changing Shape of Fixed Income Markets: ACollection of Studies by Cent ral Bank Economists , BIS Pap ers , No. 5.

Edey, M., and Ellis, L. (2002) ‘Implications of declining government debt forfinancial markets and monetary operations in Au stralia ’, in Market Functioningand Central Bank Policy , BIS Pap ers , No 12.

Fabozzi, F.J. (1997) The Handbook of Fixed Income Securities, fifth edition,McGraw -Hill, United States.

Fleming, M.J. (2000) ‘Financial market implications of the Federal debtpaydown ’, Brookings Papers on Economic Activity, Issue 2.

Fleming, M.J. (2000) ‘The benchmark U.S. Treasury m arket: recent p erforman ceand possible alternatives ’, Federal Reserve Bank of New Y ork Economic PolicyReview, April.

Greenspan, A. (2001) ‘The paydown of federal debt ’, speech before the BondMarket Association, Wh ite Sulphur Springs, West Virginia, Ap ril 27, 2001.

Hansard (2002) Official Committee Hansard, House of Representatives

Standing Committee on Economics Finance and Public Administration, Friday31 May 2002.

International Monetary Fund and World Bank (2001) Developing Government Bond Markets: A Handbook, The World Bank and International Monetary Fund,United States.

International Monetary Fund (2001) ‘International capital marketsdevelopm ents, prospects and key policy issues ’, August.

Korea National Statistics Office (2002) Statistical Database, viewed on5 Augu st 2002 <http :/ / www.nso.go.kr/ eng/ esub/ esub2.htm >.

8/7/2019 CCSMReview


%LEOLRJUDSK\

McGrath, M., and Viney, C. (1997) Financial Institutions, Instruments and Markets, second edition, McGraw Hill, Australia.

Mylonas, P., Schich, S., Thorgeirsson, T., and Wehinger, G. (2000) ‘New issuesin pu blic debt management: governm ent surpluses in several OECD coun tries,the common currency in Europe and rapidly rising debt in Japan ’, OECDW orking Paper, No. 12.

National Pensions Reserve Fund Commission (2001) Annual Report, viewed on9 August 2002 <http:/ / www.ntma.ie/ SectionIntros/ PensionsFundintro.htm>.

New Zealand Treasury (2002) Budget Economic and Fiscal Update , viewed on20 Au gust 2002 <http :/ / w w w.treasury .gov.nz/ forecasts/ befu/ 2002>.

Norges Bank (2001) The Government Petroleum Fund: Annual Report, viewed on18 July 2002 <http :/ / w ww.norges-bank.no/ english/ petroleum _fund / rep orts/ 2001/ ind ex.htm l>.

Organisation of Economic Cooperation and Development (2002a) Debt M anagement and Government Securities M arkets in the 21 st Century , OECD, Paris.

Organisation of Economic Cooperation and Development (2002b) Economic

ccsmreview

Documents