Do Tony Abbott, Joe Hockey and the rest of the federal Opposition have the real courage to do something that would block off their rabid attack on the federal government’s debt?

Dare they agree to a change of tack on debt and government bonds that would improve the financial strength and stability of the country’s banks and the economy?

The question is emerging slowly emerging from the black lagoon of finance, also known as the Australian bond market.

It would require an about-face, but one that could mean better management of the banks, insurers and others in the financial system and a rational policy on using debt wisely for the national good. It’s an argument that Peter Costello, for example, never comprehended as he and John Howard pursued the reduction of debt in the decade up to 2007.

But now, backed by key regulators, including the Reserve Bank and APRA, the Australian government used last night’s budget papers to float the suggestion that the current $190 billion of Commonwealth Government Securities (aka bonds) not be redeemed in the mad rush (driven by Abbott and the Opposition) against debt. Only a couple of reporters, including Eric Johnston of The Age cottoned on to the story this morning.

It’s a big change, in terms of the politics, regulation and will require, at some stage, the public support or involvement of the RBA and APRA in any debate. Otherwise if it founders on the obvious political sticking points, both will be left with a second-rate method of ensuring liquidity is available for our banks in times of stress.

The government said it has consulted a panel of key financial regulators as well as state government-based bond agencies on the outlook for the bond market. The RBA and APRA, the two regulators whose opinions matter, are understood to have supported the move. It could make their oversight of the financial system much easier.

There are two arguments in favour of having a pile of bonds on issue; one is to improve the liquidity management of our banks, especially at times of stress, the second is to make sure we have a deep and liquid bond market (which helps set interest rates for companies and state governments and for insurance companies and super funds who have long term (30-50-year liabilities).

“To maintain a liquid and efficient bond market that supports the three- and 10-year futures market and the requirements of the new global bank liquidity standards, the panel agreed that the CGS market should be maintained around its current size — that is, around 12% to 14% of GDP over time,” the budget documents said.

The new global bank regulations will boost demand for the AAA-rated government bonds among Australian banks, a move that will have “important” implications for liquidity in the government bond market.

The face value of the total stock of Commonwealth Government Securities on issue in June 2011 is expected to be $192 billion. Net debt is expected to peak at 7.2% of GDP next financial year.

The federal government says it has not made a final decision on the size of the bond market; it said it will continue to monitor developments and consider the advice of the panel, “to ensure the market remains of a sufficient size to support these objectives as the budget returns to surplus”.

The budget papers said the global financial crisis ”affirmed the value in maintaining a CGS market of sufficient size to support the long-term stability of the financial markets and to ensure the government is well placed, in a practical sense, to respond to sudden events with large fiscal impacts”.

The new global capital rules due to start in 2014-15 and the discussions have got nothing to do with the federal government, the RBA, APRA, federal Treasury and the banks and insurers changing their minds on reducing the federal deficit.

Australia doesn’t have enough bonds on issue to be used by banks as the core liquidity holding under the new rules. That’s why APRA, the RBA and Treasury came up with the slightly radical idea of using securitised mortgages (and the about to be introduced covered bonds) as the core liquidity holdings.

And instead of following the lead  from offshore, the RBA and APRA agreed to construct a liquidity facility that the banks could access for a fee each year and sell the securitised mortgages (but not their own, and the covered bonds) in times of liquidity crises, as we saw in the final quarter of 2008 after Lehman Brothers collapsed and Australian banks were cut off from offshore funding markets.

That saw the banks and others sell tens of billions of dollars in self-securitised mortgages to the RBA in exchange for cash. At one stage the RBA held more than $45 billion in these mortgages. The banks later redeemed them as financial conditions improved.

But there are continuing concerns that the system planned for Australia over-depends on housing-related debt (mortgages and the covered bonds that will be used to raise funds for home lending). It is quite possible the next financial crisis in Australia could start in the housing sector, from falling prices putting pressure on bank assets values and cash flows. A commercial property crisis could follow.

That means the values of those mortgages and covered bonds would come under downward pressure, meaning they may not be as liquid as thought, which in turn would increase the strains on the system and on force the RBA and or the government to directly aid banks in trouble.

On the other hand, federal government debt is the most liquid security there is in Australia and would be ideal for the new liquidity arrangements and for matching the long-term liabilities of the likes of the AMP, IAG and QBE, plus the various super funds run by banks, unions and companies large and small. But if we pay them off over the next five years, there won’t be enough and the financial system and economy will be left the poorer and unbalanced.

Peter Fray

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