Why Does the Reserve Bank of Australia Largely Restrict Its Trading Transactions to Government - Assignment Example

Question 1 RBA’s trading operations are restricted to government and semi-government securities. Such transactions have been attributed to a number of factors guaranteeing the transactions. Essentially, government and semi-government securities are mostly known as “risk-free” investment (Council of Financial Regulators, 2011). It is in view that sovereigns cannot default on their payments; hence a guarantees payments (Boge, 2011). The government in question has the capability of printing currency. Therefore in nominal terms the government can inevitably fulfil its promise. A developed market security offers a higher propensity in facilitating the application of the market based or indirect instrument of market policy such as repo operations (Stevens, 2008). An increased recourse through the government’s capability to adhere to the functioning requirements increases the illegible sets of collateral (Olivan, 2012). As a result, it enables RBA to conduct monetary policy through the available instruments. The expansion of the quantum of the collaterals enhances RBA’s flexibility in sterilizing the capital flows (Australian Financial Markets Association, 2011). Reduced Risk (“Risk-Free”) Government securities offer a platform for a fixed income market, through risk-free benchmarking. The bond market, for instance, is considerably lesser risks due to the following reasons; i. Bonds are typified by the promise from the issuer in presenting the face value of the security upon maturity ii. Government bonds offer fixed rates of interest income supported by a promise from the issuer. iii. The bond market’s history precedes its reduced vulnerability to price swings for stock market volatility. Liquidity The Australian Treasury bond, on the other hand, offers great liquidity because it facilitates market participants to gain interest or hedge exposures in an efficient manner (Olivian, 2012). Therefore, it offers support for the functionality of the Australian market through its provision of medium to long term risk-free interests rate (Flint, 2010). Nevertheless, the liquidity decreased during the global financial crisis of 2008; given the participant’s reaction to volatility and uncertainty. More recently, indicators have suggested that liquidity has fully recovered. It is evident from intraday liquidity that markets are more liquid at open and closing session of trading days (Zurawski, 2012). Bonds offered by the Australian Government are traded in wholesale markets typified as the deepest and most liquid in the market. More often than not, government securities can be purchased and sold like goods available on NDS-OM otherwise known as Negotiated Dealing System Order Matching) (Australian Financial Markets Association, 2011). Such securities have proffered, or good liquidity since financial institutions and banks participate in such markets (Stevens, 2008). The medium and short-term government securities are ideal because they are exceedingly attractive to the commercial banks which assist in the management of liquidity. The preference of the banks for the treasury bills makes the strategy significantly important to RBA in influencing liquidity and levels of interest rates; both of which are imperative to any monetary policy. More often, government securities are consolidated in monetary policy operations, otherwise known as open markets. The incorporation of the government securities in the open markets are crucial since they shun from probable quasi-fiscal losses and interest cost from RBA (Council of Financial Regulators, 2011). Arguably, because the need of the open markets is as a result of the fiscal expansion, the use of the government securities are instrumental in recognizing such expansions. The Australian Treasury Bond, on the other hand, incorporates the derivatives that offer protection against an exposure to the interest rates. Simply put, the risk affects the value of liabilities and assets in the market (Boge, 2011). Thus, the Treasury Bond Feature is an important market aspect, essential in managing risks; typified by turnover that are significantly larger than physical Treasury Bond market. RBA mainly uses physical treasury bonds given their low cost and ease in of transaction. Hence, a well featured and proffered Treasury Bond futures market offers a number of benefits in the Australian financial markets. Higher Yields Government securities offer good yields given its longer trading duration (Zurawski, 2012). Capital Gains Government securities have a higher propensity for capital gains. An inverse relationship exists between interest rate and bond price. The pricing of bonds rise with a decrease in the interest rate (Flint, 2010). A proffered government bond is significant to the capital market development because it offers a benchmark necessary in the pricing of securities offered by other parties. Given that government securities have reduced the risk they are referred to as “risk-free” return on the subsequent investments. Simply put, such attribute important in the pricing of other assets. Diversified Portfolio Government securities are increasingly important in diversifying the country’s portfolio. With the addition of the government security in its portfolio, will diversify its portfolio hence, mitigating the risks since government securities are risk-free. Tentatively, it enables RBA to rebalance the available portfolios through participation in secondary markets (Council of Financial Regulators, 2011). It is evident, therefore that trading transaction of government and semi-government securities are essential to any policy body. Question 2: Effects on the Economy RBA’s monetary policy significantly impacts Australia’s economy across various platforms. In this regard, selling of the government securities otherwise known as CGS has an effect on the supply of money exchange in the accounts held by different banks. In the case when RBA sells available CGS, the country’s money supply will considerably reduce. In order counterbalance the shortfalls realized in the bank’s ESAs, the banks will be compelled to borrow funds from the STMM. Higher interests rate result to a dampening effect in the economic activity thereby reducing consumer spending and investment. Whilst the economy’s high-interest rate, firms and individuals find it increasingly difficult to borrow funds to finance investment and consumption. Evidently an increased spending increases unemployment levels, which further reduces consumption and income (Sheen, 2013). The lower aggregate demands results to an increase in the downward pressure on price levels. For instance, the GFC of 2008 to 2010 witnessed a reduction in the interest rate with the objective of stimulating the aggregate demand and hence it boosted economic growth. It, therefore, increased the employment rate, which is simply a derived demand of growth. An increase in the interest rate affects a firm’s activities; witnessed through the fall in fixed investment given the resultant cost in borrowing money from banks and affiliated financial institutions. Fixed investment is simply capital investment. Hence, it reduces the expected output. Contrariwise, consumer’s disposable income reduces, because the high-interest rate of existing payments (Sheen, 2013). Moreover, individuals are forced to increase savings as opposed to engaging in consumption activities. Business, on the other hand, faces reduced profits on account of increased interests rates imposed on loans. Such initiatives are compounded by declined sales due to reduced consumptions levels (Lewis, 2012).In response to reduced consumptions, firms are forced to reduce prices on commodities; with the objective of maintaining sales that translate to lower inflation rates. RBA conducts the monetary policy in a manner that satisfies Australia’s liquidity. Therefore, interest rates function as transmission rates whereby the second stage of the transmission mechanism consolidates four channels. As such, these channels possess its effect on the aggregate demand and supply which dictates the commodity pricing. i. Interest rate Channel Long and medium term rate relies on, among other factors, on the anticipation of the future short-term interest rate. When the cost of the capital in financing the projects increases, a subsequent decrease in investment is realized. In this regard, an increase in real interests rate, result to an increase in the propensity of cost for consumption; hence reducing the consumption rate. Therefore, both elements have follow-on effects on the aggregate demand and eventually inflation. ii. Credit channel Investors can be attracted to the domestic financial assets as opposed to foreign financial assets. Consequently, it may trigger an increase of the nominal exchange rate, hence relocating the expenditures in the economy. An increased number of foreign investors into the country projects a higher capital inflow in the country. Investment in the country necessitate for the Austrian dollar, resulting to an appreciation (Finlay, 2012). However, an appreciation reduces the international competitiveness since exports from Australia become increasingly expensive,therefore worsening the Australian dollar. A higher level of foreign liabilities is realized hence deteriorating the Primary Incomes account in subsequent years. These exponential effects may considerably impact Australian industries such as tourism and agriculture. Such occurrence are attributed to the adjustments that appear to decrease the import prices, as it raises the prices of exports. In the long run, it tends to reduce or slow the aggregate demand that ultimately reduces inflation in the country (Finlay, 2012).The appreciation of the exchange rate initiates the depreciation in the imported commodities, hence reducing Australia’s inflation. A decrease in import prices, increasingly benefits the economy substantially given the benefits realized on the firms usingimported products. iii. Complementary asset-price channel Bonds turn out to be increasingly attractive given the increase in the interest rate. It inevitably reduces the demand for equity hence decreasing the value of assets. More often than not, situations that compel a decrease in a firm’s value subjects the firm to lower capacity ofaccess financing. As a result, the firmsstall in initiating new investment projects; thus a slower aggregate demand is realized, hence reducing inflation rate (Australian Financial Markets Association, 2011). Housing Market Given the characteristic blunt instrument of the monetary policy, its varying impacts is realized in the housing sector. As the interest rate rises, buyers find it increasingly difficult to purchase new housing units. On the other hand, individuals withexisting mortgages find it significantly harder to satisfy their needs and may be compelled to sell theirhomes. As such, reduced demand in the housing reflects a flow-on effect to other aspects of housing such as retailers and tradesmen. Conclusively, the effects of selling government securities showcase divergent effects on the economy in question. References AFMA (Australian Financial Markets Association). (2011). 2011 Australian Financial Markets Report. Retrieved fromhttp://www.afma.com.au/afmawr/_assets/main/lib90013/2011%20afmr.pdf Boge, M., & Wilson, I. (2011). The Domestic Market for Short-term Debt Securities. RBA Bulletin, September, pp 39–48. Blanchard, O., & Sheen, J. (2013). Macroeconomics; Australasian Edition. Boston, Pearson Higher Education AU. CFR (Council of Financial Regulators). 2011. Central Clearing of OTC Derivatives in Australia. Retrieved from http://www.rba.gov.au/publications/consultations/201106-otc-derivatives/pdf/201106-otcderivatives.pdf Finlay, R., & Olivan, D. (2012). Extracting Information from Financial Market Instruments. RBA Bulletin, March, pp 45–54. Hubbard, G., Garnett, A., Lewis, P. (2012). Essential of Microeconomics. Boston, Pearson Higher Education AU Lepone, A., &Flint, A. (2010). The Impact of an Increase in Minimum Tick in the ASX 3 Year Commonwealth Treasury Bond Futures Contract’, Market Insights, Edition 31. Retrieved from http://www.sfe.com.au/content/sfe/trading/market_insights_issue_31_201002_february_2010.pdf Lien, B., & Andrew Zurawski, A. (2012). Liquidity in the Australian Treasury Bond Futures Market retrieved from http://www.rba.gov.au/publications/bulletin/2012/jun/6.html Olivan, D. (2012). Extracting Information from Financial Market Instruments. RBA Bulletin, March, pp 45–54. Stevens, G. (2008). Liquidity and the Lender of Last Resort. RBA Bulletin, May, pp 83–91. Read More