Banking and Finance of Reserve Bank of Australia - Assignment Example

ASSESSMENT OF ONE BANKING AND FINANCE Institution : Tutor : Course : Why does the Reserve Bank of Australia (RBA) largely restrict its trading transactions to government and semi-government securities? The Reserve Bank of Australia (RBA) is one of the three independent agencies tasked with the role of monetary authority in Australia together with The Australian Prudential Regulation Authority (APRA) and The Australian Prudential Regulation Authority (APRA). Established in 1959, the agency was tasked with the responsibility of determining and implementing monetary policy, issuing Australian currency notes, being the government’s banker, overseeing the payment system, issuing treasury securities, providing the market for treasury securities and the management of the financial system liquidity and the holding of foreign exchange by the government (IMF, 2012). One of the principal instruments used by RBA to perform the roles mentioned above is Open Market Operations that involves buying and selling of financial securities. However, RBA largely restricts its trading transactions to government and semi-government securities. The bank deals only with Commonwealth Government securities (CGS) and state and territory central borrowing authorities securities (semis) that are denominated in Australian dollars and lodged in Austraclear. As such, it does not trade in securities held as Euro Entitlements. In addition, the bank transacts in two categories of Repurchase Agreements (Repos); those that have an outright eligibility and those that must meet minimum rating standards to be eligible (IMF, 2012). Government and semi-government securities include but are not limited to Commonwealth and Government bonds commonly known as Treasury Fixed Coupon Bonds and Treasury Capital Indexed Bonds. These securities are considered by investors to have a very low or no risk owing to the fact that the probability of default by the government is relatively small. In addition, the short-term interest rate government and semi-government securities including treasury bills that have a maturity of 5, 13 and 26 weeks are also issued by the RBA. The bonds issued by RBA are Australian-Dollar denominated and have an unconditional guarantee from Commonwealth. They, therefore, have the highest credit rating (IMF, 2012). From the facts highlighted above, the following reasons why RBA has largely restricted its trading activities to government and semi-government securities can be seen. Firstly, since one of the primary roles of RBA is to determine and implement monetary policy to ensure economic stability, these securities offer the tool to perform this task. In the case of a budget deficit and high inflation the RBA pursues a contractionary monetary policy. Notably, the government, through the RBA borrows from the public through issuing treasury bonds and treasury bills to finance the deficit. By so doing, the government reduces the money in circulation in the economy bringing down the general rise in prices. On the other hand, in case of a budget surplus and deflation the RBA adopts an expansionary monetary policy. The government buys back the treasury bonds and bills releasing money into circulation and hence causing a rise in prices (Fender, 2012). Secondly, the preference of government and semi-government securities to other securities by investors from their high credit rating makes these securities the best instrument for the RBA to undertake its chief role of maintaining market liquidity. Securities issued by the government through the RBA are primarily fixed rate debt securities in addition to inflation-indexed bonds and short-term treasury notes. The central borrowing authorities of the State and Territory Governments issue the highly liquid and mainly traded semi-government securities. Government bonds pay a guaranteed interest and the face value at maturity. In addition, they possess possible capital gains or losses from secondary trading before maturity. Treasury fixed coupon bonds, for example, pay interest semi-annually based on the coupon rate on the face value and the face value at maturity. This makes these securities highly preferable by investors. The RBA provides the primary and secondary markets for these bonds (Berkelmans & RBA, 2005). Thirdly, through Open Market Operations the RBA can maintain the cash rate at the desired level. Through selling and buying government and semi-government securities, the RBA can manage the supply of ESA funds to banks so as to maintain the cash rate at its desired level. In case the cash rate is low, the RBA reduces the supply of ESA funds to banks through selling securities. Conversely, if the cash rate is high, the RBA increases supply of ESA funds through buying the securities. The control of the cash rate is not possible with non-government securities such corporate bonds because their prices and returns are purely determined by the forces of demand and supply. As such, since the RBA can manipulate the price and returns from government and semi-government securities, they become the best instrument to trade in (Axilord & IMF, 2006). Examine the likely consequences for economic growth when the Reserve Bank of Australia (RBA) sells Commonwealth Government Securities (CGS) to raise funds for the Australian Government. In case the Australian Government decides to raise funds through sale of Commonwealth Government Securities (CGS)by the Reserve Bank of Australia (RBA), the action would have a number of consequences on growth of the Australian economy. First, there would likely be crowding out. When the Australian government sells the CGS, the supply of these securities increases, which decreases the price of securities in the market. The sale of government securities has potential to affect prices in the Australian securities market because they usually form the highest percentage of the securities traded in the market. Decrease in securities’ prices increases their yield that in turn raises the interest rates for the securities. If this increase in interest rates in the securities market has a cascading effect on other interest rates in the economy, then the overall cost of borrowing for private investors increases. This increase in cost of borrowing in turn leads to a decrease in private investment, a phenomenon known as crowding out of private investment. The ultimate effect of the crowding effect is a decrease in real GDP both in the short-run and the long-run (Lowe, 2005). Secondly, the financing of the deficit through sale of CGS leads to trade deficits. In the case of the likely outcome of higher interest rates (and crowding out) from the sale of government securities, then the domestic CGS become preferable to foreign investors. The increase in foreign investment in domestic securities results in a higher demand for Australian dollars. Increase in demand for Australian dollars causes an appreciation in its value. The resultant change in exchange rates for currencies would make foreign-made goods cheaper for domestic consumers and domestic-made goods more expensive for foreign consumers. Net exports would decrease decreasing real GDP in turn (Mayes et al, 2007). Thirdly, borrowing through sale of government securities would result in future government budgets containing a portion of interest payments. The CGS securities sold by the RBA would require the government to pay interest to investors in the future. On one hand, if these interest payments are made to local investors using taxes collected from domestic taxpayers, then there would be a zero net change in national wealth. However, there would be wealth redistribution from the taxpayers to the investors. On the other hand, if these interests are paid to foreign investors, it would represent wealth outflow from the Australian economy causing worsening of standards living of the Australian citizens (Sherris & Macquarie University, 2005). Such a situation represents a condition where foreigners own a considerable percentage of the national debt. However, the real effect on the Australian economy from foreign ownership can be seen from opportunity costs. The net gain from the sale of CGS securities to foreigners would be measured from the growth in domestic output from the sale vis a vis the future interests to be paid (Mishkin et al, 2011). In case the government of Australia decides to borrow through selling CGS securities as a monetary policy instrument, the likely consequence would be the desired state of economic indicators such as level of inflation. Demand-pull inflation, for example, is caused by there being too much money in circulation (“too much money running after too few goods”) would be solved through domestic borrowing. Selling CGS securities by the RBA would mop the excess cash from the economy that would bring down the level of inflation leading to the desired economic growth (Lowe, 2005). In conclusion, it is can be seen from the above discussion that the consequences on economic growth from financing Australian Government expenditure through selling of Commonwealth Government Securities (CGS) would depend on the reason for the need for debt financing and the group of investors who invest in the securities, either domestic or foreign investors. As such the overall effect of the sale can only be measured by the net effect. It is also clear that the sale of government securities is an active monetary policy instrument for the RBA. REFERENCES Axilrod, S. H., & I.M.F. (2006). Transformations to open market operations: Developing economies and emerging markets. Washington, D.C: International Monetary Fund. Berkelmans, L., & Reserve Bank of Australia. (2005). Credit and monetary policy: An Australian SVAR. Sydney: Economic Research Dept., Reserve Bank of Australia Department, I. M. F. M. C. M. (2012). Australia. Washington: International Monetary Fund. Fender, J. (2012). Monetary policy. Hoboken, N.J: Wiley. Lowe, P. (2005). The link between the cash rate and market interest rates. Sydney: Economic Research Dept., Reserve Bank of Australia. Mayes, D. G., Toporowski, J., Taylor & Francis., & CRC Press. (2007). Open market operations and financial markets. New York, N.Y: Routledge. Mishkin, F. S., Serletis, A., & Kiryakos, S. (2011). The economics of money, banking, and financial markets. Toronto: Pearson Canada. Sherris, M., & Macquarie University. (2005). Interest rates risk factors in the Australian bond markets. Sydney: School of Economic and Financial Studies, Macquarie University. Read More