For the first time we have been given an inkling of just how close the Australian financial system and economy came to freezing or imploding in the last quarter of 2008.

For all the confident talk from the government, the Opposition and others about how well we have done, we would not have been able to claim that if the economy had ground to a halt as credit froze over.

Prime Minister Kevin Rudd was the most accurate when he told the Queensland ALP conference earlier this year that Australia came very close to a serious crisis.

Overseas credit was cut off for everyone, including the federal government, the banks and companies, Australians panicked (there is no other word for it) and withdrew billions of dollars of cash from their banks to hide (presumably under the bed); banks could not raise money domestically from the markets so scared were they of one another, so they turned to the Reserve Bank in desperation.

So large was the demand for cash that the RBA ran out of $20, $50 and $100 bills and had to order more than $11 billion worth be printed to fill orders from the banks.

In fact everyone turned to the Reserve Bank in desperation for the three months to December, 2008 and into the early months of 2009.

All up the RBA boosted liquidity day-to-day in the markets by about $100 billion as the crisis intensified from October into early 2009. It was unprecedented.

Many of the moves, such as currency swaps with the Fed and rule changes to allow more and different types of securities to be dealt to the bank in liquidity management operations, were revealed during the year, but not the extent of activity as the RBA’s balance sheet blew out to $165 billion at the height of the crisis in the last months of 2008 and early this year (now about $100 billion as conditions improved), still above normal.

The central bank’s actions saved Australia (with help from treasury, the federal government and the US Fed) from joining other economies in deep freeze: The bank’s senior executives were worth the pay rises they received during the year that some ignorant financial writers bagged this morning because they failed to comprehend the story that RBA laid out for them in its 2009 annual report.

Just how serious was it then?

Well, Australians were so worried about the financial crunch in the last three months of 2008 that they forced the Reserve Bank to boost supplies of cash to the economy by a massive $10 billion or 19% as they demanded cash.

The run on cash was part of a period of intense nervous crisis as the Reserve Bank found ways to boost the supply of liquid funds to the banks, individuals, businesses and even the government.

Financial institutions from credit unions to the biggest banks “self-securitised” their highest quality home-loan mortgages and sold $45 billion in the December quarter (now down to $20 billion) of them to the RBA in short-term deals called repos or repurchase agreements to raise cash to maintain liquidity during the worst months of the crisis. The RBA changed its rules to allow the exchange account balances the banks hold at the RBA to rise to a peak of $11 billion late in 2008 because financial institutions demanded instant availability of cash.

Term deposits held by the bank from financial groups peaked at $18 billion in late 2008 (now nil) as the RBA attempted to manage the demand for cash from banks and other institutions, and not flood the system, or print money.

Because US dollars were hard to get hold of, the RBA auctioned the currency from its swap with the Fed and by last November nearly $28 billion was outstanding (now nil)

The RBA provided $6.9 billion in forex to the federal government from its reserves on 2008-09, the peak of the crisis because it couldn’t buy the currency in the market.

For a short period during the worst of the market turbulence, the Bank did temporarily meet the Government’s foreign currency needs from reserves but subsequently offset these transactions in the market as conditions improved.

But the most dramatic picture was painted by the rather prosaic commentary about demand for bank notes during the crisis.

The Reserve Bank responded to a surge in demand for banknotes around the time of the global banking crisis, as some depositors withdrew cash from banks. Although this demand was met from the Bank’s contingency stocks, Note Printing Australia stepped up production as these stocks fell sharply.

As calm was restored this flow abated, but by the end of the financial year currency in the hands of the public, at about $48 billion, was still about $4 billion higher than would have been expected based on trend growth in the economy.

Currency on issue increased sharply in October last year as the turbulence in financial markets resulted in higher demand for banknotes. Some of the increased demand has since unwound, though currency holdings remain somewhat elevated.

Over time, demand for currency has been rising at an annual increase of around 5 per cent. In late 2008, however, several factors led to a significantly sharper increase in demand.

Specifically: Developments in global financial markets reduced the public’s financial risk appetite.

One manifestation of this was that public demand for currency increased as households made large cash withdrawals from financial institutions.

The sharp depreciation of the Australian dollar encouraged a range of individuals to convert their foreign currency holdings into Australian dollars. These individuals included tourists, expatriates and families of students studying in Australia.

The Australian Government announced a stimulus package, including direct payments to households, which boosted demand for cash when these payments were made in December.

In response to these developments, commercial banks increased their precautionary holdings of banknotes to ensure that they would be able to manage possible cash withdrawals at short notice.

The RBA said that the combined effect of these factors was to boost the value of banknotes in circulation by 19% in the three months to December, several times larger than the typical seasonal rise.

Although the public’s demand for banknotes has since eased, the value of banknotes in circulation remains around 14 per cent higher than at the start of the financial year, well above the average growth rate experienced in recent years.

Demand was particularly strong for $50 and $100 banknotes. The value of these banknotes on issue rose by 18 per cent and 14 per cent respectively over the past year.

This represents the highest annual growth rate for these denominations since 2002, when new cash distribution arrangements were introduced.

At the same time, there was a decline in the number of $20 banknotes in circulation. This shift has largely been driven by an increased preference for the $50 banknote in ATMs.”

As at end June 2009, there were 1 billion banknotes in circulation worth $48.1 billion. This is equivalent to 47 banknotes worth $2,200 for every Australian.

The Reserve Bank held a sufficient stock of $5 and $10 banknotes to meet public demand, and therefore did not need to print these denominations during the year. In the case of higher denominations, the amount held in stock was not sufficient and during the year the Bank purchased 98 million $20 banknotes, 130 million $50 banknotes and 46 million $100 banknotes from Note Printing Australia.

And out of all this drama came some good: the Reserve Bank has paid a record dividend to the federal government of $5.23 billion for the 2008-09 financial year, up from $1.4 billion the previous year. The RBA’s annual report shows the central bank made an accounting profit of $8.81 billion in the year to June 2009. That compared to an accounting profit of $1.43 billion in 2007-08. Underlying earnings rose to $2.15 billion in 2008-09, from $2.07 billion the previous year.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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