Recent Capital Market Developments in Australia - Assignment Example

Recent Capital Market Developments in Australia 2009 Executive Summary Australia has been a net importer of capital over the last decade, in contrast to other developed economies of the west. The country’s financial sector was deregulated in the 1990s, resulting in higher foreign capital inflows, mostly from the United States. It has only been about a decade that foreign investments have been allowed into the capital markets and cross-border financial flows have been allowed. Much of the foreign capital inflows into Australia have been in superannuation funds as well as in derivatives in futures and options. While foreign capital inflows in most other countries are in short term in nature, Australia has had most capital inflows into the infrastructure sector. This does not only benefit the economy in the long term but is also more stable. Besides, capital inflows have been supported by foreign exchange inflows and trading. Also in contrast to most other developed economies, Australia’s financial intermediaries have witnessed moderate growth thus interest rates have not had phenomenally rise that could have led to financial difficulties in the economy. Since the financial sector has had a limited effect on the real economy, seen from the proportion of total employment in the sector compared to the entire economy, the global financial crisis has had a less of a negative impact on the economy. However, since the capital flows have gone down in general because of the financial meltdown, Australian financial sector has also been hit by the sub-prime crisis and the subsequent global events. But, Australia has been better equipped to handle the crisis than western economies since it has faced regional financial crisis earlier as a result of which the financial sector has been better regulated. Introduction The global financial crisis that erupted in 2008 was a result of excessive exposure of global capital in a host of countries that had low interest rates. Besides the lack of regulations on financial sectors of leading developed economies, excess liquidity in the systems as a result of low interest rates in countries like the United States, the United Kingdom and Japan, undervalued currencies in leading saving countries like China and accumulation of assets in sovereign funds led to over-leveraging of global financial flows that ultimately led to excessive speculative activities that could not be sustained (OECD, 2008). It began with the sub-prime crisis in the United States, which had its origin in the mortgage market, which, boosted by the low interest rates, had high demand for loanable funds. As a result, banks found themselves over-exposed to credit and many of them were in sub-prime accounts, with low credit rating. Despite the uncertainty of the recovery of these assets, investors continued to buy securities backed by these assets as collaterals. Similar was the case in other developed markets like the United Kingdom where interest rates had been low since 2000. When these assets began to default in 2007, it led to a spiraling effect on economies as banks were burdened with illiquid assets and the investments that were backed by these fell in value. Global financial institutions, beginning with Merril Lynch in the United States and Northern Rock in the United Kingdom, first reported huge losses in 2007 and ended up with the bankruptcies of mammoth institutions like Lehman Brothers and AIG having to be bailed out by the US government in 2008. This had repercussions on the global financial system since the global capital markets have been interlinked with multinational financial institutions investing in almost all capital markets that offer returns. In this paper, I will discuss the developments in the Australian capital market that has made it a net importer of capital and the resulting effect of the global financial crisis on the economy. In particular, the mortgage market, the superannuation industry which is dependent on global capital and Australian financial institutions have been affected directly. The present financial crisis is different from previous financial crises, like the Asian financial crisis of 1997, which were regional rather than global. I will also discuss the response in government policies to the financial crisis. Government policies and developments in Australian capital markets Australia began to liberalize the capital market in 1983 when the Australian dollar was floated and exchange controls were abolished. The banking system was also opened up to foreign competition. As a result, cross-border financial flows were allowed in Australia. In 2007, the regulators took the liberalization a step ahead by allowing foreign exchange brokers to operate in the United States in return of mutual recognition by the foreign regulator (Henry, 2008). All these steps expanded the financial market in Australia greatly, not only in terms of size and growth, but also with greater disintermediation of financial systems in which rather than through banks and financial institutions, companies could raise funds directly through the market. As a result, the turnover of the securities market was over three times the nominal GDP of the country by the turn of the new millennium (Battelino, 2000). In the 2000s, Australia became one of the top five net capital importing countries in the world, with the United States topping the list. Japan, China, Germany and the oil-rich economies make up most of the global savings. In particular, with the fast growth of the Chinese economy over the last decade, the Chinese government has been the leading investor in the US Treasury Bonds, through which the US government has been funding its current account deficits since the early 2000s after the dotcom boom burst. As a result, the US accounted for two-third of global capital imports. Even as the US remains the top net capital importer, US-based multinational financial institutions have been investing heavily in capital markets around the world. Out of the global assets under management of these institutions, about 10 percent is in hedge funds, which can magnify the effect of any adverse financial market situation by many times. The turnover in all capital markets have been growing tremendously as speculative activities have been on the rise. This has not only increased the number and volume of trades of shares but also derivatives that are in futures and options. This has been evident in Australia, as in other countries. By 2005, the capital market in Australia reached a size of $A3 trillion, which was as much as 175 percent of the level ten years ago. The importance of the Australian capital market is obvious from the fact that it amounted to 322 percent of the GDP of the country. In Australia, most of the cross-border capital flows have been through mergers & acquisitions. For about a decade, the real economy in Australia witnessed a reasonably high growth, backed by investment by non-financial organizations that had higher financial liabilities. Companies raised investible funds through primary share issues and secondary fund raising like rights issues and share placements. As a result, gross capital raising was 4.6 percent of the average market capitalization of firms in 2006. By then, the Australian share exchange index outperformed other major global indices like those on Hong Kong, London and New York. The Australian Stock Exchange had 12 percent of the global real estate assets compared to 2-3 percent of global equity assets in 2006. In contrary to other stock exchanges that attract short term equity assets, the Australian stock exchange has attracted infrastructure assets. While most infrastructure projects are largely debt-funded, many of the global infrastructure projects have raised funds from the Australian stock exchange. Perhaps this was why the listed asset classes in the Australian stock exchange has given high returns for the 20 years prior to 2006. Yet, the dependence of the Australian capital market on the global financial system may be gauged from the fact that 32 percent of the assets listed on the stock exchange is owned by global financial organizations, 22 percent by Australian pension funds and life insurance companies, 24 percent by Australian households, 16 percent by domestic financial institutions, 2 percent by domestic non-financial institutions and 1 percent each by the domestic banks and insurance companies and the Commonwealth government (ASX). Portfolio investment in Australia is mostly in the hands of US financial institutions, followed by nearly half the amount by UK institutions. Much smaller holdings are in the hands of institutions from the Netherlands, Japan, Luxembourg, Canada, New Zealand, Italy and Sweden. Out of the foreign equity in the Australian capital market, most of it is in the hands of pension funds and life insurance companies, followed by private non-financial corporations. Most of the household financial savings are in superannuation funds, which have grown the most as managed funds. Contributions and benefits have both grown moderately, with strong investment returns. The return growth has been on account of increase in superannuation funds investments in shares that have given higher returns. There has also been some increase in capital raised through global private equity funds that have been used to structure takeovers and mergers, with a more relaxed regulatory framework. Most of the private equity activities have been in the consumer goods industry. Most non-financial organizations have expanded both debt and equity but Australian companies have expanded equity more than debt over the recent years, which have made them more vulnerable to risks as a result of negative capital market movements (ASX). Despite the growth in the financial market in Australia, it has not been excessively speculative. This has been because the phenomenon has been accompanied with development of the foreign exchange and money markets and interest rates have been stable. Foreign exchange trading has not been disproportionately high as in some other countries that have had high capital inflows. Besides, the financial market has not been confined to trading by financial organizations. Household investment in the capital market has also increased, in excess of the nominal GDP growth. This has meant that the financial flows into the capital market has been long term and not only for speculative purposes. With bank deregulation, there was a sharp expansion of credit and building societies and credit unions, which had thrived during times of bank regulation, diminished in size and activity. Hence, there has been a relative shift of household savings in financial assets and bank holdings. Banks became more eager to shift funds from balance sheet earnings to higher returns, hence the rise of investment banking, home loans and insurance activities. Another important effect of higher household savings in financial assets in Australia was in the expansion of superannuation funds. All permanent employees in Australia began to hold superannuation funds, compared to 45 percent prior to the 1980s. These funds were managed by professional managers and hence were diverted into the capital market to increase returns (Battelino, 2000). Since the 1990s, the fall in inflation and interest rates gave rise to non-bank financial entities that earlier were at a disadvantage to banks who could raise low-cost deposits. With falling interest rates, housing borrowers and small businesses thrived on credit from non-bank financial intermediaries. Despite cost reductions, bank margins fell through the 1990s and 2000s. This is evident from the employment in the finance sector, which has been falling despite the growth in financial activities in the economy. This indicates that financial activities have risen in the sectors for which finance is not the core operations. On various counts, therefore, Australia, even before the financial crisis, did not have the financial sector at par with the United States or European countries. On the other hand, it may be considered to be equivalent to the financial systems of Japan or Canada (Battelino, 2000). Typically, higher the per capita income of a country, higher is the proportion of the financial market in the economy. The size of the financial market should not be analyzed only in terms of the asset turnover in the capital markets. On the other hand, it may be compared from the extent that the companies, and hence the economy, depend on the capital market for financial requirements and the importance of fund managers to earn revenues for financial organizations. In the United States, less than 30 percent of the financing occurs through financial intermediation of banks or other financial organizations, the rest happening directly through the capital market while financial intermediation is as high as 75 percent in Germany. At the same time, fund managers are more important in the US than in Germany, indicating capital markets are more crucial for the US economy than the Germany economy. This phenomenon is also supported by the fact that corporate equity and debt markets have been more volatile in the US than in Germany. Australia, in comparison to both the US and Germany, has had a mixed financial system, with 60 percent financial intermediation. Thus, the capital market has been dynamic but not at the cost of financial intermediation of banks and institutions which depend on balance sheet activities rather than off-balance sheet activities (Battelino, 2000). The opening up of the euro-Australian dollar market has increased financial entities going to the offshore market and swapping currencies. There has therefore been an increase in the offshore bond issuance. Effects of the global financial crisis on the capital market Like all countries that are net capital importers, the global financial crisis has affected the Australian financial market and the economy. However, the underlying financial structure in the country has been resilient and has so far been able to withstand the global crisis. The country’s financial sector has an asset of AUS$4.3 trillion, which is nearly four times the nominal GDP. The finance and insurance industry together generate 8percent of the real GDP of the economy. The turnover of the capital market grew by 3.1 percent in 2007-08, which is certainly less than the 14 percent growth in the previous decade, is still higher than the more developed economies. Besides Japan, the Australian capital market is the largest in Asia and its market capitalization is 25 times that of the Hong Kong market and 5 times that of the Singapore market (Austrade, 2008). Till the 1990s, Australian interest rates on home loans were relatively high and default rates low. Even with rising funding costs, banks had not raised mortgage rates in the early 1990s and even when funding costs fell, with liberalization of the financial market, banks left the mortgage rates at the earlier higher levels. As a result, home loan interest rates were higher than bank interest rates. Yet, banks that did not have high mortgage activities were ready to provide specialized mortgage services that raised bank profitability without incurring high costs and risks while mortgage originators began to offer home loans, first at high rates and then at reducing interest rates. These mortgage originators raised money from the financial system through real estate backed securities. Hence the securitization of home loans began to grow. These securities were mainly US or Euro dominated with the proceeds going into Australian dollars. Along with the mortgage originators, mortgage brokers have also entered the field with more households getting access to mortgage (Broadbent, 08). The securitization market on the back of the mortgage market grew from less than 5 percent in the mid 1990s to 25 percent in 2007. As much as one-third of the home loans in the country originate from the brokers. As a result of financial innovations in which cross-currency swaps have been common, household and corporate debt in the economy has grown by a significant amount over the decade and has grown sensitive to interest rate changes. The situation has been aggravated by the fact that nearly 90 percent of the home loans are in variable interest rates. Hence, any change in monetary policies that affected interest rates was immediately passed on to the mortgage market. At the same time, business loans are also on variable interest rates, making tem susceptible to interest rate changes induced by monetary policies. So, the government had little choice in terms of monetary policies to regulate liquidity in the economy when the global financial crisis stuck since the financial innovations through the securitization of the mortgage market and the inter-currency swaps had already created a self-sustaining system that was highly responsive to interest rate changes. Funding of banks in Australia has also got affected by the global financial crisis. The turbulent capital markets since 2007 has directly affected bank funding, 43 percent of which is through the capital markets, more from the offshore than the domestic market. Larger banks have more funding through deposits and smaller, particularly regional banks and foreign-owned banks depending more on the capital market and securitization of mortgages. While all types of funding has become more costly because of the global crisis, capital market funding has become even more costly and unpredictable (Reserve Bank of Australia, 2008). Comparison of the current crisis with previous crises Financial crises have occurred ever since the global financial systems have been interconnected in the 1980s. In the 1990s, the Asian financial crisis and the Latin American crisis were essentially regional with limited spillover in other markets. The stock market crash in the late 1990s, which resulted as a result of the crash of technology stocks and the bust of the dotcom boom in the United States was more broad-based because economies became inter-connected through outsourcing of production and services and interconnection of real economies. In all of the earlier crises, there were miscalculations of prices, either of stocks or products. In the present crisis, there was the additional problem of lack of information about counterparty credit risk that led to over-optimism about risk management by financial organizations. It is now recognized that capital flows and international capital market volatility is not a zero-sum game in which the financial entities who can time the market always win. In the contrary, despite short-term movements, the capital markets are related to the real economies through price and liquidity. As a result, real parameters like output, employment and prices are affected through the movement in capital flows. Response to the crisis With the availability of overseas portfolio funds, banks became flushed with residential mortgage-backed securities (RMBS) to form the bulk of home loan (Gans et al). Besides large commercial banks, other financial entities like regional banks and builders became the alternate funding avenues. This was possible because of the lack of regulation in the home loan market. When liquidity in the economy diminished as a result of the global financial crisis, there was an immediate effect on the real estate. As a result of the bankruptcy of non-bank financial entities, which were either forced out of the market or merged with other entities, the banks could return to the home loan market. Hence, the Australian real estate sector had a limited negative impact on account of the global financial crisis. However, the limited balance sheet of the larger banks meant that credit to small businesses, corporate firms and commercial property developers continue to be rationed. Conclusion The Australian capital market has been less affected by the global financial crisis than the United States and Europe, despite being a net importer of capital, because it has been liberalized late and the mortgage market has not been as broadbased as in other countries. Interest rates on home loans have traditionally been higher than in the west because, following the Asian crisis in the 1990s, Australian banks had raised interest rates and mortgage rates had remained higher than the broader bank rate even when the general interest rate fell. On the other hand, the capital market spread more through the securitization of the mortgage market, in which the smaller regional banks have been the major players, while larger banks concentrated more on balance sheet operations. As a result of the global financial crisis and the subsequent turbulence in the liquidity of the monetary system, there has been a shake up and many of the regional banks have had to either close down or merge. This has thrown up opportunities for larger banks to return to the mortgage market. Besides the mortgage and the real estate market, the other major effect of the crisis has been on the superannuation industry, which has greatly increased over the last decade. Not only on account of higher financial savings by households, this has resulted from the dynamic capital markets attracting fund managers to earn higher returns. As capital inflows have slowed down, the capital markets suffered from liquidity shortages that in turn affected the returns of the superannuation funds. Works Cited Australian Stock Exchange (ASX), Global Economy and Markets: Key Pressures, http://www.asx.com.au/about/pdf/capital_markets_trends_drivers_sydneyuni.pdf Blundell-Wignall, Adrian et al, The Current Financial Crisis: Causes and Policy Issues, OECD, 2008, http://www.oecd.org/dataoecd/47/26/41942872.pdf Joshua Gans et al, Australia needs a Comprehensive Financial System Enquiry, https://senate.aph.gov.au/submissions/comittees/viewdocument.aspx?id=8028534b-c15f-4b8d-b2e8-914c1c43bba0 Henry, Ken, Mutual Recognition of Financial Services Regulation: Opportunities and Challenges for Australia, February 2008, http://www.treasury.gov.au/documents/1345/PDF/FINAL%20ASIC%20Summer%20School%20Speech.pdf Battelino, R, Australian Financial Markets: Looking Back and Looking Ahead, Reserve Bank of Australia Bulletin, March 2000, http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/REP_134.pdf/$file/REP_134.pdf Austrade, Australia’s Financial Market: A Snapshot, 2008, www.austrade.gov.au/.../Data-Alert-081202-Financial-Markets-Snapshot.pdf.aspx Broadbent, John, Financial Market Innovation in Australia: Implications for the Conduct of Monetary Policy, http://www.bnm.gov.my/files/publication/cp/bnmbis/08_broadbent.pdf Reserve Bank Bulletin, The Impact of the Capital Market Turbulence on Bank Funding, June 2009, http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jun09/impact-cap-mkt-turb.html Read More