INSTO AUSTRALIAN DEBT MARKETS CONFERENCE, SYDNEY
19 MARCH 2002
PRESENTATION BY MR MICHAEL ALLEN, CHIEF EXECUTIVE OFFICER, AUSTRALIAN OFFICE OF FINANCIAL MANAGEMENT
- AOFM background
- Commonwealth financing task
- AOFM funding activities
- Use of swaps
- Liability benchmark issues
The AOFM was established on 1 July 1999 as a prescribed agency within the Treasury portfolio. The AOFM assumed responsibility for the Commonwealth's debt management activities, which were previously undertaken by the Debt Management Branch within the Department of the Treasury.
The key objective of the office is to ensure the execution of the Commonwealth's net debt portfolio management objectives in order to achieve the annual financing requirement and the maintenance of the net debt portfolio risk exposures within approved delegations.
Since formation, the AOFM has focused on two key areas, firstly the development of organisational capabilities and resources in order to achieve its vision of global excellence in sovereign debt management and secondly, in the context of the governments current financial management strategies, a review of the existing liability benchmark framework.
A new organisation structure has been introduced over the past year in conjunction with the implementation of our new human resources framework. The new structure has been created to ensure that organisational accountability can be clearly defined and resource allocation focussed on achieving our output objectives. The structure also seeks to further strengthen our corporate governance framework by maintaining a clear separation of the various aspects of our debt management responsibilities, as well as supporting our compliance and reporting frameworks.
Work has already commenced on a number of significant projects. As has been highlighted in the press recently, the review of our foreign currency benchmark was completed in June 2001. The review of our strategic debt management objectives has also been initiated, and will continue to be undertaken over the course of the current year. This aspect of the review will focus on ensuring that the existing liability benchmark assumptions continue to be consistent with achieving the Commonwealth's desired cost and risk objectives. Given the changing nature of the financing task, opportunities to improve a range of operational issues associated with the impact of the seasonal nature of the Commonwealth's cash flow profile on the existing benchmark framework are now being explored.
The AOFM is hopeful of acquiring a new debt management system shortly. Implementation of this system is expected to provide a more robust risk exposure and performance monitoring platform, along with enabling significant efficiency gains to be achieved in the production of risk management and compliance reports. The platform will also strengthen our existing corporate governance framework.
In conjunction with the implementation of the new debt management system, a review of the existing risk policy framework is being undertaken. Whilst the existing policy framework meets the requirement of our current operating environment, a review is appropriate given the impact of the changes in the Commonwealth's financing task and in the context of the AOFM review of debt management activities.
The AOFM reports, and is accountable to, the Treasurer, through the Secretary to the Treasury.
An Advisory Board was established in December 2000. Its role is to provide advice to the Secretary to the Treasury. Although the Board does not possess executive powers or decision making authority in its own right, the Board advises the Secretary on matters relating to corporate governance, strategic planning, financial risk management strategy, business and planning. The Board also provides advice to the Secretary with respect to monitoring the performance of the AOFM generally.
The six member Board comprises the Secretary to the Treasury, the Executive Director of the Economic Group in the Department of the Treasury, a Senior Executive from the Department of Finance and Administration (representing the Secretary of the Department), the CEO of the AOFM and two representatives from the private sector. The private sector members, appointed for a three year term, are Mr Tony Cole, currently Executive Director at William M Mercer Pty Ltd and Mr Greg Maughan, consultant and formerly a Director of Bankers Trust Australia Ltd.
Three committees have been established for AOFM internal governance. A Liability Management Committee has primary responsibility for establishing policy and programs governing debt management operations and reviewing liability performance; an Audit Committee has responsibility for statutory financial reporting and for monitoring internal financial controls; and a Management Committee has responsibility for oversighting and reviewing the overall strategic management of the organisation.
Commonwealth general government net debt has been in decline since the mid 1990's - government securities on issue for the Commonwealth have fallen from a peak of around $107billion to around $65billion at the end of June 2001.
Current budget forecasts and projections indicate that net debt will decline to zero by June 2005.
However, the government has in recent budget statements outlined a commitment by the Commonwealth to manage the reduction in net debt in line with the objective of maintaining the viability of the Commonwealth Government securities market - an important feature of this strategy is to maintain the liquidity of our benchmark CGS lines.
Over 2001-02 issuance will be in the order of $2.5billion
$2 - $2.5 billion in Treasury Bonds;
New 2015 benchmark line.
$200 million inflation linked bonds; and
in order to manage mismatches in the Commonwealth's cash flow, Treasury Note issuance sufficient to maintain outstandings within the range of $3-$6 billion.
- It should be noted that we are undertaking a review of our activities in the Treasury Note market and have been holding discussions with major market participants in order to ensure that our issuance arrangements remain in line with investor requirements. Following the finalisation of this review process, any changes to existing arrangements will be announced well in advance of being implemented.
The AOFM had $13.4 billion of term deposits with the Reserve Bank at 30 June 2001.
the potential for the AOFM to engage in direct financial asset acquisition is often the subject of some speculation. At this stage we intend to continue the existing practice of taking term deposits with the Bank. Any changes to these arrangements will be signalled to the market well in advance of any potential new arrangement being announced.
Last year the AOFM introduced bond conversion tenders. These tenders provide holders of nominated bonds the opportunity to convert their holdings into one of our more liquid lines. This enables the AOFM to:
increase the amount of benchmark bonds outstanding more quickly than can be achieved in the current low gross issuance environment; and
smooth the profile of outstanding bonds in a manner that improves the overall efficiency of the CGS market.
The use of a public tender process to undertake consolidations is consistent with our objective with respect to activities being conducted in a transparent fashion. We are pleased with the results of this strategy to date, and intend to conduct further such tenders next financial year.
The government's debt reduction strategy has a significant impact on AOFM funding sources. In particular, the domestic bond market is now accounts for around 80 per cent of funding. This has been at the expense of reduced dependence on the Treasury Note and term floating rate note markets (TABS). The change in funding source has also had a significant impact on the overall portfolio risk exposures, particularly with respect to the generation of portfolio floating rate exposures. This is a point that I will return to later with respect to our activities in the interest rate swaps market.
Debt portfolios by necessity have some element of exposure to movements in market prices that will, in turn, carry varying implications for portfolio cost and risk. With the benefit of hindsight it will always be possible to look back at the universe of potential portfolio structures and assess which structure offered the best overall performance.
A well accepted approach to addressing this management challenge is to specify a hypothetical portfolio structure - a portfolio benchmark - with financial risk exposure characteristics that, ex-ante, can be expected to be consistent with a cost and risk performance acceptable to stakeholders.
It is against this background that a benchmark was developed and implemented by the Commonwealth over the period since 1989. Independent consultants developed this benchmark framework. In 1989 JP Morgan was appointed to the position of independent advisor. In 1996 this arrangement was reviewed and following a public tender, UBS was appointed to this role.
Broadly the AOFM's benchmark is defined in terms of exposures to interest rate and exchange rate risks, measured by target ranges for portfolio currency shares and the modified duration of each currency exposure in the portfolio. The duration range for Australian dollar denominated debt is 3 to 3.5. The benchmark target for foreign currency exposure is 10 to 15 per cent of the AOFM's net debt portfolio. Both JP Morgan (in 1989) and UBS (in 1996 and 1998) concluded that a small foreign currency exposure in the portfolio could assist in meeting portfolio cost and risk objectives.
The Commonwealth has used swaps to assist with meeting the benchmark targets. I will first outline the use of interest rate swaps in achieving the targeted modified duration of the portfolio.
INTEREST RATE SWAPS
As I have noted already, the Commonwealth is subject to interest rate risk in respect of the debt portfolio. At least some part of this risk will always remain and cannot feasibly be eliminated.
The Commonwealth enters into interest rate swaps in order to reduce the overall risk of the portfolio - that is, to reduce the extent to which the value of the portfolio changes in response to changes in interest rates and/or to reposition portfolio risk profiles. The use by the AOFM of interest rate swaps is consistent with the practice of a number of other sovereigns as well as those used by a broad range of non-speculative private sector liability managers.
The Commonwealth entered into its first interest rate swap for the purpose of managing the duration of the AUD denominated debt portfolio in August 1997. Some swaps were entered into in 1992-93 and 1994-95 as part of the foreign currency swap programme.
The use of interest rate swaps over recent years reflects the need to manage the impact of increasing duration of the portfolio as debt has been paid down, and the fact that other means by which duration could have been reduced were considered to be less attractive. Over the period from 1997, the use of swaps has provided the AOFM with the flexibility to manage the required reduction in liabilities on an orderly basis along with providing a mechanism to hedge the impact of increased duration associated with the maintenance of the issuance of long dated CGS.
For those who are not aware of our swap execution process, we aim to conduct activities on an orderly basis over the course of each financial year and in a way which minimises any market impact, whilst at the same time ensuring that tenders are conducted in a competitive fashion. In normal circumstance we endeavour to seek quotes from between two and four eligible counterparties.
On 19 February 2002 the AOFM issued a press release announcing that there is no intention to enter into further interest rate swaps for the remainder of the current financial year. This reflects our assessment of current portfolio requirements over the period to June 2002.
It is expected that interest rate swaps will continue to be used to meet portfolio benchmark targets. We will provide an update of our intentions for next financial year when we release details of our funding programme towards the middle of the year.
CROSS CURRENCY SWAPS
I will now turn to the AOFM's use of cross currency swaps, and given recent attention of this area of the AOFM's activity in the media, I am hopeful that these comments may provide you with an insight into some of the key background issues.
I will provide some history first. The Commonwealth has had a foreign currency exposure for many decades. This foreign currency exposure reflected the relative ease of raising debt finance in foreign currency rather than in domestic currency.
Through the period in which the Commonwealth issued foreign currency denominated debt the value of the portfolio was significantly affected by changes in the value of the Australian dollar. For example, in 1984-85 the depreciation of the dollar resulted in an increase in the value of foreign currency debt of around $3.6 billion expressed in current dollars. In 1985-86 the depreciation of the Australian dollar increased the value of the debt portfolio by around $5.1 billion in current dollars.
In 1987 a decision was taken by the then Treasurer not to undertake any further physical foreign currency debt borrowings. In 1988, the Loan Securities Amendment Act provided the Department of the Treasury with the authority to engage in a broader range of financial instruments, including foreign currency swaps.
The maintenance of a discretionary foreign currency exposure in the Commonwealth debt portfolio was recommended by JP Morgan in the late 1980's. The strategy was based on analysis that suggested that some foreign currency exposure would provide long term cost savings relative to a portfolio wholly comprised of Australian dollars. Over a period of years, JP Morgan continued to advise the Commonwealth that the optimal debt portfolio structure should include a foreign currency exposure, to a maximum of 15 per cent. They also advised that there were some risk reduction properties associated with the strategy.
The foreign currency swap programme was commenced in 1988, with the stock of outstandings increasing gradually over the early years. In the early 1990's, in line with the significant increase in the Commonwealth's funding requirement, the stock of foreign currency outstandings was also increased in order to maintain the exposure in line with the benchmark target.
In 1996, a review by UBS supported the maintenance of the benchmark framework and the foreign currency exposure target. New swap transactions were entered into over the next two years. No new net foreign currency swaps were entered into after February 1999.
Over the period from 1989 to mid 2000 the cumulative economic return of the foreign currency exposure strategy was positive. However, it should also be noted that at times over the period, there was volatility in performance.
As I have already mentioned the Commonwealth has maintained a currency exposure in the debt portfolio since at least the 1930's. Over the 1980's the exposure level had been reduced from around 30 per cent to around 15 per cent. From 1989 the foreign currency exposure was successfully maintained within the benchmark target range of between 10 and 15 percent. The impact of the significant decline in net debt over the second half of the 1990's was handled by maturing foreign currency swaps. However, the combined impact of the reduction in the AOFM's net debt portfolio and the and the impact of the depreciation of the AUD in mid 2000 placed the AOFM in the position of having to undertake US dollar purchases in excess of maturities in order to maintain the exposure within the 15 per cent target range.
In mid September 2000, the AOFM advised the Secretary to the Treasury that, in the absence of US dollar purchases in advance of existing maturities, it was likely that the benchmark target would be exceeded over the remainder of 2000-2001. This then led to a temporary suspension of the benchmark. On December 6 the Treasurer agreed to suspend the benchmark and requested that the AOFM conduct a review of the need for foreign currency debt, and the level of any benchmark that might be adopted.
Over the period to June 2001 the AOFM undertook the review. The review concluded that a long-term position of zero foreign currency exposure in the portfolio was now preferred in light of changes in a number of factors that underpinned the original analysis. These factors included the significant reduction in debt levels achieved over recent years and the narrowing of the historical spreads between Australian and US government interest rates.
Following the Treasurer's approval of the AOFM's recommendation, the rundown of the existing stock of FX contracts was resumed in September 2001. The rundown will be conducted on a phased approach over a medium to long-term horizon. This gradual approach reflects the long time horizon over which the exposure was accumulated.
The policy was always entered into with a long-term focus.
Looking forward, we do not yet know, and in fact will not know for some years to come, whether the policy of maintaining a portion of net debt in $US will end up saving the Commonwealth money compared with a policy that involved no foreign currency exposure. This will be dependent upon the path of exchange rates and interest rates over the relevant period.
At the time the policy commenced the expected long term savings were considered sufficient to offset the possibility of higher short-term volatility. In contrast, when the policy was terminated last year, greater weight was given to the importance of short term volatility, particularly in the context of declining debt that increased the risk of the portfolio being "out of the money" at the time it was unwound.
BACKGROUND TO FX BENCHMARK SUSPENSION
Perhaps it is now appropriate that I now address another aspect with respect to the benchmark suspension and review process.
As the Treasurer outlined in his press release on March 4, 2002 the decision to suspend the benchmark was made on the basis of broader macroeconomic considerations. The background being that over the 2000-01 financial year the AOFM's task of managing the foreign currency benchmark was challenged by:
an unsettled exchange rate market, where over the course of the year to mid 2000 the currency had depreciated in the order of fifteen per cent; and
the projected reduction in net AOFM liabilities over 2000-2001 reflecting the application of fiscal surpluses to net debt repayment.
As I have already mentioned the combined effect of these two factors would have required the AOFM to undertake significant purchases of US dollars, well in excess of the 2000-01 schedule of US dollar maturities.
History now tells us that "macroeconomic policy considerations will always be more important than portfolio allocation rules".
Decisions of this nature reflect the complexities associated with sovereign debt management. On one hand governments have the same set of financial risk exposures as any large private sector corporation. In the liability management area these exposures and risks need to be managed in order to minimise long-term costs. This necessitates the sovereign debt manager to engage in a range of market sectors in order to ensure portfolio funding and risk management objective are achieved. Given the size of the sovereign's liability management exposures, either with respect to physical funding or the requirement for other risk management products, it is generally the case that the sovereign debt managers activity has the potential to significantly impact on prevailing market pricing.
This leads to the further challenge for sovereign debt managers - being that in some circumstances narrow liability management objectives may have to be compromised in order to ensure that broader public policy objectives can be achieved. For example, minimising the short term impacts on markets of large shifts in funding requirements often requires the sovereign debt manager to be exposed to medium term movements in interest rates. This necessitates a trade-off to be made. Accordingly, broader public policy considerations may require sovereign debt managers to adjust risk management strategies in order to ensure consistency with macro economic objectives.
The decision to suspend the AOFM benchmark over the second half of 2000 is an example of the type of constraint that can be placed on a sovereign debt manager.
FORWARD FX CONTRACTS
I would now like to make mention of the AOFM's use of FX forward contacts with the Reserve Bank (represented as the green bars on the slide). Over the period in which the benchmark was suspended (October 2000 to September 2001) the AOFM transacted forward foreign exchange contracts with the Reserve Bank in order maintain the existing stock of foreign currency liabilities. Since the decision to move towards zero foreign currency exposure was agreed by the Treasurer in September 2001, forward foreign exchange contracts have also been entered into to manage the rundown of the foreign currency exposure in accordance with a schedule agreed with the RBA. Let me emphasize: these forward contracts have not resulted in any additional foreign currency exposure. Indeed, the entire strategy involves a rundown in exposure and the forward contracts are simply a way of managing what would otherwise be a lumpy maturity profile. When appropriate, we will continue to engage in these transactions over the course of the rundown.
For those not familiar with the AOFM it would not be unreasonable to assume that the range of issues highlighted in the press over recent weeks is either new information or difficult to locate. Whilst the interest in Commonwealth debt management activities is not usually at the levels experienced recently, information on the AOFM's debt management activities can easily be accessed by way of our annual report and website. For example, foreign currency portfolio exposures are reported in substantial detail and in line with prescribed government accounting standards. Our annual report also provides a comprehensive overview of our debt management activities.
It should also be noted that the impact of the gradual unwinding of the foreign currency exposure on the budget would be restricted to the financing impact of any realised gains or losses over the period.
The AOFM was established with a brief to enhance the capacity of the Commonwealth's debt management function. To date much of our focus has been on internal issues - enhancing the existing corporate governance framework, establishing new organisational infrastructure, increasing resources, implementing new debt management systems, reviewing debt management strategies and liability portfolio benchmarks. The completion of the foreign currency review in June last year was the first of a number of important steps. Other tangible achievements have also been delivered. Work continues on a number of very challenging issues.
We look forward to being able to provide you with further updates over the course of the calendar year.