Category: Fiscal Policy

SA Operation Reverse Twist

Bond markets: Operation twist in reverse, or just bowling a wrong ‘un?

The US Federal Reserve System has been conducting operations to reduce the interest yield on long dated US Treasury Bonds, and by so doing attempting to twist the yield curve, that is buying longer dated bonds in order to reduce long term interest rates.

Meanwhile in SA, we are seeing something of a twist in reverse. We will discuss this topic further in this piece, but first some explanation of the US version.

The Fed has been borrowing short from its member banks to buy long dated US government debt. It has committed some US$400bn to the scheme. The Fed owns about US$1.675 trillion of US government debt or over 10% of all US debt in issue. It also holds US$841bn of mortgage backed securities issued by Fannie Mae and Freddie Mac, the government sponsored enterprises that support the mortgage market in the US. The Fed has been buying these securities in the market and the sums paid out have mostly ended up as excess cash reserves (deposits) held by banks with the Fed itself. What the Fed pays out has ended up with the Fed.

Mortgage loans in the US are typically long dated loans for up to 30 years, at fixed rates of interest linked to the yield on long dated Treasuries. The intention of the Fed is to reduce mortgage rates to encourage demand for homes and house prices. By so doing it would encourage a recovery in home building activity. Higher house prices would also help US households recover some of the equity they have lost in their homes.

According to US Flows of Funds Accounts published bty the Fed, the average US home is worth 30% less than it was in 2006. In 2005 homeowners’ equity in their homes (the difference between the market value of their homes and their mortgage liabilities) was worth over $13 trillion. The value of this equity had shrunk to $6.2 trillion by September 2011 and the share of owners’ equity in their homes from 59.8% to 38.6%. The net worth of US households has held up much better than their equity in homes over this period, having declined marginally from over $59 trillion in 2005 to $58.7 trillion in 2011. This represents 5.1 times the disposable incomes of households, which is a very high wealth to income ratio by international standards.

Without a recovery in the housing market, the prospects for US economic growth cannot be regarded as promising: hence Operation Twist. Long term interest and mortgage rates have remained exceptionally low, presumably mostly attributable to the safe haven status of US government debt in a highly risk averse world, rather than to Operation Twist itself or the quantitative easing (purchases of bonds and other securities) already conducted by the Fed.

And so to the reverse

The SA Treasury has also been conducting its own intervention in the market for SA government debt. This may be described as the reverse of operation twist. The Treasury has been very busy extending the maturity profile of RSA government debt, actively buying up short dated government securities before due date and issuing much long dated securities of both the conventional and inflation linked variety. With the yield curve in SA upward sloping and getting more so (see below) this means that for now, or until the yield curve turns flat or negative, the SA taxpayer is paying up to 2% per annum more for its longer term borrowing. This additional expense of servicing interest bearing domestic rand denominated debt of the order of R800bn might well be better incurred helping the poor or giving tax relief to businesses to employ them. Why then the rush to roll over RSA debt before it matures and especially to convert lower interest short term debt to higher longer dated debt, before it is required to do so?

Source: Investec Securities and Investec Wealth and Investment

The average duration of SA debt, that is the time it takes for investors to recover their capital through a mixture of coupon payments and principal repayment, has risen significantly over recent years as we show below. Zero coupon bonds issued at a discount have a duration equal to the time to maturity. For debt with a predetermined coupon, the higher the nominal coupon payment, the shorter the duration. The average duration of US government debt is shorter than RSA debt – somewhere between four and five years.

Were these refinancing operations of the SA Treasury being conducted in the vanilla bonds alone, one might conclude that the Treasury, in preferring long to short, had a negative view on the inflation outlook for SA. Borrowing long is a good idea when inflation turns out to be unexpectedly high – borrowing short makes sense when the market overestimates the inflation rate incorporated into long term interest rates.

However the opposite is true when issuing inflation linkers and the Treasury has been especially aggressive converting its short dated inflation linkers into much longer dated inflation linkers. If inflation was expected to rise above expectations, an issuer would much prefer issuing short dated inflation linked securities, rather than the longer dated maturities. These long dated linkers would bring ever higher interest payments and receipts as inflation rose.

At recent auctions the Treasury has been issuing inflation linkers with 20 years to maturity (for example the R202) at real yields of 2.6% to redeem the once dominant R189 that is due to mature in 2013. The R189 is currently priced to offer a negative real yield of -0.07%. Or in other words, the Treasury is now paying out something like 240bps extra to roll over this inflation linked debt, rather than waiting for this shorter term debt to mature in two years time.

Average duration of RSA Inflation and Vanilla Bonds

Source; Investec Securities and Investec Wealth and Investment

Why Europe is not a good example

Why then would the Treasury be pursuing such aggressively expensive debt management? Hopefully it is not in response to the difficulties European governments and their debt managers have been seen to have in rolling over their debt with highly bunched maturity schedules. These refinancing difficulties arise because the Greek, Portuguese, Italian and Spanish governments cannot call upon the services of their own central banks to convert, without limit, interest bearing into non-interest bearing government debt- that is to say cash. Their central bank sits in Frankfurt and appears very reluctant to convert longer dated Euro debt into cash. This is not a problem for the US. If faced by any temporary reluctance to bid for longer dated Treasuries, the Fed could come to the rescue with extra cash.

So could the SA Reserve Bank, if called upon, issue rands in exchange to overcome any refinancing emergency that might show up. Rolling over debt can only become a solvency or liquidity problem when the borrowing is undertaken in a foreign currency. Rolling over debt cannot be an issue when the debt is issued in an inconvertible currency that can be created without limit by a central bank should this be forced upon a government with its independent central bank. And most important, the knowledge that in last resort, government debt issued in the inconvertible currency of the land can always be converted in to cash, would surely be enough to fully overcome fears that government debt could not be rolled over. By exchanging cash for government securities (if conducted without limits), a central bank could invoke an inflation problem. However it could also overcome any refinancing problems (as the Italians and Greeks, now without such a fallback position, are fully aware).

There is presumably a case for smoothing what may be bunched repayment schedules for maturing government debt. But there is also a case for anticipating them in advance when scheduling debt, to avoid bunched repayments making such smoothing operations unnecessary in the first place. Paying a large interest premium to do so does not make good sense; nor is long dated debt issued by the RSA necessarily superior to issuing shorter dated debt.

Long term interest rates are the geometric average of expected short rates over the same period. To think otherwise is to second guess the market in fixed interest and there is little reason to believe the issuers of debt have superior insight about the direction of interest rates than lenders have. There are however some unintended consequences of longer duration: the longer the duration the more responsive the All Bond Index will be to unexpected changes in interest rates. Adding risks to fixed interest rate bonds in general discourages demand for them.

Furthermore the recent debt management operations in the inflation linkers (which have meant additional demand for them) have made this class of bonds an outperformer over the past year. Is the SA Treasury, in its urgency to substitute long dated for short dated RSA securities (to avoid what it regards as potential embarrassments in the debt market), misreading the nature of the Euro debt problems – at the expense of the SA taxpayer? Brian Kantor

Asset Class Performance 2011 to November 18th

Source; I-net Bridge and Investec Wealth and Investment

US debt ceiling: Triumph of the Tea Party

The good news for the equity markets over the agreement to lift the US debt ceiling was overtaken by further doubts about the US and global economy due to the weak ISM manufacturing report that came in below expectations. The index indicated that manufacturing output in the US had barely expanded in July and the subsectors of the index reporting on orders and employment intentions offered little comfort about the outlook for the economy.

The agreement found overwhelming support in the House of Representatives from Republicans, while Democrats were evenly split 91-91. The Senate will undoubtedly follow suit today. The Republicans had successfully held the line against tax increases and the Wall Street Journal described the outcome as representing a new dawn for fiscal outcomes in the US (spending cuts without tax increases) and a triumph for the Tea Party activists.

It is clear that faster economic growth in the US and other debt assailed economies is what is needed. The debate in the US will be how to realise this faster growth. Higher tax rates (on the rich and highly paid) may be regarded by some as only fair but they are surely not good for growth. Extra government spending financed by higher taxes surely crowds out private spending over the longer run. And even when an economy is operating well below its potential the threat of more government spending (and the taxes to follow) may immediately frighten away business and household spending. That the limits to the ability of the Federal Government and of municipal and state governments in the US to raise tax rates have been reached might well be regarded as very good for growth.

Also good for growth everywhere would be reforms of the entitlement programmes that encouraged workers to retire later. Essential too would be to mean test medical benefits for the over 67s (or should it be over 70s?), and in so doing recognise much improved life expectancies. A genuine market place for medical services and for private insurance to cover medical expenses would help greatly to discipline spending on doctors and prescription drugs.

Finding the path to faster growth in the US need not be complex. What it does require is the appropriate political will. The will to resist higher tax rates, has been demonstrated in the US. However the will to pare back entitlements and to rationalise access to them has still to be demonstrated. This debate in the US will intensify as the elections of 2012 approach. President Obama knows his re-election prospects will be much diminished if the unemployment rate does not recede sharply from the current 9%. Unless he can encourage households and especially firms to spend more, he will not succeed in this. He might therefore well become a great deal more business friendly: this would also be good for US growth

2011-2012 Budget: Getting value for government money

The first impression one has of the Budget proposals is just how strongly government revenues have grown over the past fiscal year, something around 13%. Also, how strongly tax revenues (not tax rates) are expected to increase over the next few years. At around a 10% per annum rate, or in real terms by about 5%, government expenditure is planned to grow at around an 8% rate or around equivalent to a 3% rate in expected inflation adjusted terms.

Read the full story in the Daily View here: 2011-2012 Budget: Getting value for government money

SA economy: Why we need to do all we can to get it going

The focus of fiscal policy in South Africa on the long run interests of the economy by living within your means has been admirable. It means building balance sheet strength in the good times when revenue growth is strong rather than indulging in a spending fever. So that when the economy slows down, more debt can be raised to finance government spending to avoid a self destructive resort to higher tax rates. Higher tax rates in a recession can easily lead to less rather than more tax revenue and slow down the economy and revenue growth further.

On reading the Medium Term Budget Policy Statement (MTBPS) one was gratified that the Treasury and its Minister understood these facts of economic life very well. No resort to higher taxes was to be made while government spending was to be sustained. And then the Minister of Finance in comment later last week, in all innocence presumably (hopefully) pronounced on the necessity to raise taxes should the economy not grow as expected.

This is very worrying. The most urgent task facing those responsible for managing the economy is to do all they can to get the economy moving again. This means all the encouragement they can offer households and firms to spend more now. It should mean lower rather than higher tax rates. For example temporarily accelerated investment allowances would help private sector capital formation, which has stalled so badly, as would every effort made to accelerate the award of tenders for the infrastructure programme about which the construction industry is so concerned.

Monetary policy also needs to try a lot harder than it has to get money and credit supply growing again. Lower interest rates might not help much on their own any more, but if accompanied by the quantitative easing practiced everywhere else to pump extra cash into the economy, it would do no harm and might do some good.

Yet despite the recession and the deflation of prices at the factory and farm gates one still hears whispers out of official circles of the danger of self fulfilling inflationary expectations. The theory that inflation can be self perpetuating irrespective of the state of demand in the economy is wanting in ordinary circumstances – it is simply damagingly nonsensical at times like this.

The biggest danger to the recovery of the economy would be the much higher charges Eskom would like to impose on the economy, charges that would allow Eskom to avoid to a significant degree drawing on the government balance sheet to finance its essential capital expenditure. Incidentally this capex is particularly welcome at this stage of the business cycle.

Such price increases well above the cost of supplying additional electricity (costs understood to include an appropriate return on capital to be invested) should be resisted by raising more government debt. That is to say, it should be financed with more Eskom debt, assisted by a further government guarantee, should the considerable guarantees provided for Eskom debt to date be insufficient to the purpose of avoiding excessive price increases.

Increased charges (i.e. taxes) for electricity would continue to add to measured inflation as they have done to date. They will also, as they have done to date, tax away spending on almost everything else. Could the SA authorities, despite the state of the economy, not only raise taxes in the form of excessive charges for electricity but in addition also raise interest rates because of the impact higher electricity prices will have on inflation, and maybe therefore on inflation expected? Such responses are not apparently impossible to contemplate and so represent a most dangerous threat to the long term health of the economy.

The long term health of the economy and the willingness to invest in its long term potential will depend on the confidence investors and households will have in the ability of the authorities to manage the business cycle in a sensible way. They would spend and invest more now knowing that the path back to sustainable growth has been clearly marked out. Some of the signals received from the Treasury and the Reserve Bank about how to make the transition from the short to the long run do not always inspire confidence.

The global recession has led the monetary and fiscal authorities to usefully recall the advice Milton Friedman offered on how to deal with a banking crisis by the central bank acting as the lender of last resort (in his Monetary History of the US published in the late 1960s) and the instruction John Maynard Keynes provided on how to deal with depression with vigorous government spending (in his highly influential General Theory of Employment Interest and Money, published in 1936). Keynes was cynical about the human condition but it might be well for our authorities to be reminded in current circumstances of his celebrated remark that “in the long run we are all dead”.

How Keynesian are we?

Back from Davos

Maria Ramos, once Director General of the Finance Department, then CEO of Transnet and now of Absa and also incidentally newly married to long serving Minister of Finance Trevor Manuel, returned from Davos to tell us “We are all Keynesians now”

This is what Time magazine thought prematurely in 1965

This was in fact the heading of an iconic Time Magazine story written on 31 December 1965. Economists were then very confident that by fine tuning government spending and taxes, the Keynesian prescription, they could maintain full employment without inflation. Ramos might have been surprised that Time magazine in its “We are all Keynesians now” title was quoting none other than Milton Friedman. It was he more than any other economist who helped suppress the Keynesian revolution in economics.

Continue reading How Keynesian are we?