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PUBLIC BORROWING IN AUSTRALIA

The Functions, Powers and Operation of the Australian Loan Council

January 1993

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Table of Contents
Page

INTRODUCTION, SUMMARY AND CONCLUSIONS

Introduction Summary Conclusions
1 1

THE FAILURE OF LOAN COUNCIL QUANTITATIVE CONTROLS

Lack of optimum resource allocation Opportunity cost of capital investment forgone Incentive to conceal Incentive to use private infrastructure Lack of net benefit
PURPOSE OF QUANTITATIVE CONTROLS

7
7 7
8 8 8

9
9 10

Background Protection from S tate financial mis man agement Effects on other States Managing the public sector's call on savings Coordinating monetary and fiscal policy Pressure to improve perfotmance or to privatise

t2 t2
15 T6

REGULATING STATE BORROWING

No restrictions Quantitative controls Economic guidelines Accounting guidelines Market based systems

t7
T7 T7

18 18

t9
22

ENFORCEMENT
Appendices

I: II:

Shortcomings of private infrasffucture ffansactions Internationai comparisons

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INTRODUCTION, SUMMARY AND CONCLUSIONS

Introduction
1.

The effect of Loan Council, as it is currently operated, is to resffict the borrowings of the States, their authorities, and selected Commonwealth authorities through the application of quantitative borrowing controls. Recently the Commonwealth Government has proposed broadening the scope of quaniitative controls to cover the entire govemment sector. Under these new iurangements Loan Council would cover the total public sector borrowing requirement ("PSBR") as well as each State's PSBR.

2.

Any government intervention in the operation of capital markets creates disioitions, and the quantitative conffols imposed by Loan Council are no exception. In the early 1980s the quantitative controls imposed on the Australian banking industry were recognised to be creating distortions which outweighed any eConomic benefit. Just as those controls were replaced with more market driven mechanisms for rationing credit, it is now time to assess how the Loan Council quantitative controls can be replaced with a more efficient system.

It might be argued that, because States have no shareholders, they are not subjeit to marlet disciplines. In fact, State governments are subject to market disciplines, both through the bond market which sets their borrowing costs, and ultimately through the electoral process which allows their constituents to
judge their overall performance.
4.

The establishment of national and State financing arrangements conducive to improving Australia's economic performance requires the creation of a market of allocating capital among the States which is more efficient driven syitem -distortionary than th e bureaucratically determined quantitative and les s controls currently administered by Loan Council.

Summary
5.

In summary:
the current system of quantitative conffols on State borrowings creates a number of identifiable inefficiences in State economies and in the national economy:

it fails to provide any incentive for optimum resource

allocation;

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-2-

there is an opportunity cost of capital investment forgone by States due to excessively tight borrowing restrictions, and there is an incentive for States, constrained in their borrowing, to maintain current expenditure at the expense of capital expenditure thereby threatening productivity in the medium term; there is an incentive for States to conceal borrowings, leading to an uninformed markeq and there is an incentive for the States to bypass the system entirely by using "private infrasffucture" transactions which in many cases have a net adverse economic impact.

set against these identifiable inefficiencies is a lack of evidence that

Loan Council quantitative controls have created any significant net benefit; Australia appears to be alone among federations in imposing bureaucratically determined borrowing limits on member states. Accordingly, we have considered why Loan Council might seek such powers. We have identified five implicit or explicit objectives of quantitative controls :
to protect citizens of each State from potential financial mismanagement by their State Government; to prevent financial mismanagement by some States from affecting the borrowing costs of other States, taking into account the fact that overseas investors may not differentiate between individual States' creditworthiness; to manage the public sector's call on domestic and foreign savlngs; to enable the Commonwealth Government to coordinate fiscal policy at a national level so that it is consistent with monetary policy; and to place pressure on State budgets so as to encourage States to:

run down their holdings of liquid assets ("hollow logs");

and

seek greater returns from their authorities, or alternatively to privatise them.

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-3-

having considered each of these possible objectives, we find no compelling argument that they are both required and unable to be achieved without quantitative controls; accordingly, we have considered the entire range of mechanisms available for regulating State borrowing. We have identified five options:
no resffictions;

bureaucratically determined quantitative conffols such currently used by Loan Council;

as

economic guidelines such as proposed in the Maastricht Treaty; accounting guidelines prohibiting borrowing other than for investment (such as used in Germany); and market-based measures.

in relation to enforcement, we consider that Loan Council's ability to enforce its determinations solely by withholding Commonwealth glants to the States may not be workable:

likely to be in breach of their borrowing limits or covenants are also those for which it would be politically impossible to cut grants. Indeed, the Commornuealth has actually increased assistance to Victoria in response to its economic crisis; and
those States most

in any event, withholding grants may be politically difficult if it creates an impression that the Commonwealth Government is "interfering" in State affairs.
based on the evidence and arguments set out in this paper, we conclude that:

the amount of borrowing by State and Territory governments should be determined by an informed market rather than by any Commonwealth or Commonwealth-State bureaucracy;

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4the appropriate function of Loan Council is:

. .

to ensure that an informed market in government securities is maintained;

to apply sanctions to those States or Territories which fail to maintain an informed market in their securities;
and

to apply direct borrowing controls to those States or Territories which fall below agreed prudential limits assessed by private sector credit rating agencies.

as

Conclusion

6.

Accordingly, we have devised the following programme for reform of Loan Council:
monthly disclosure of State net financing and spending on a basis consistent with the Commonwealth's current monthly statements;

subject to notification procedures discussed below, a general exemption from borrowing limits granted to:
those States which maintain a credit rating equal to the Commonwealth's foreign debt rating; and those State-owned enterprises which achieve such a rating.

. . .

adoption of a minimum average maturity covenant on outstanding debt to minimise liquidity risk which is not easily priced by the market;

quantitative borrowing restrictions imposed on those States which lose their rating or breach other requirements; and adoption of accrual accounting in relation to loans (at least as a note to accounts) to prevent the abuse of zero-coupon and deep discount securities as a means of defening recognition of interest expense.

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-51.

At present, the credit rating of the States reflects the implicit belief that States would receive some support from the Commonwealth in the event of near default. This raises an element of moral hazard in State financial management. To prevent this, the following additional restrictions might be
required:
measures to prevent market signals being masked by government

action:

permanent prohibition on the Reserve Bank or Commonwealth Government holding State debt securities; permanent prohibition on market privileges for State debt securities (such as the former "30120" rule); and

enunciation of Commonwealth policy not to support the debts of States or State-owned enterprises.
8.

Alternatively, some States (possibly the smaller ones) may prefer to borrow through the Commonwealth or with an explicit Commonwealth guarantee. In such cases a guarantee fee would be payable based on the State's credit rating. This would necessarily require the State to cede gleater conffol to the
Commonwealth.

9.

In order to create an incentive for States to exercise due diligence in forecasting their total borrowing requirements, we propose the following notification and commitment mechanism:
States satisfying the minimum credit rating requirement would be permitted to borrow up to the annual amount previously notified to the Commonwealth; and

to discourage the States from submitting ambit claims for borrowing, a financial penalty would be payable on the shortfall between notified borrowings and actual borrowings. This would be analogous to the commitment fee payable to private sector banks on undrawn loan facilities. (Overdrawings might also be allowable subject to similar penalties.)

10.

We draw attention to the conffast between this approach and the quantitative conffols. Whereas quantitative conffols gives States an incentive to conceal borrowings or to bypass the system with-"private infrastructure" transactions, the market system provide States with an incentive to maintain a high credit rating and an informed market by: rewarding them with the flexibility to borrow as required; and

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-6-

penalising them for poor forecasting of their borrowing requirements through the commitrnent fee.

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-1THE FAILURE OF LOAN COUNCIL QUANTITATIVE CONTROLS

11.

The readily identifiable failures of the quantitative conffols include: the lack of any incentive for optimum resource allocation; the opportunity cost of capital investment forgone by States due to excessively tight borrowing restrictions, and the incentive for States, constrained in their borrowing, to maintain current expenditure at the expense of capital expenditure thereby threatening productivity in the medium term; the incentive for States to conceal borrowings, leading to an uninformed market; and the incentive for the States to bypass the system entirely by using "private infrastructure" transactions which in many cases have a net adverse economic impact.

Lack of optimum resource allocation

12.

Because the aliocation of capital among the States is not based on economic returns or ability to service debt, Loan Council's quantitative controls contribute nothing to the efficient allocation of resources.

Opportunity cost of capital investment forgone

13.

Not all public sector borrowing is "bad". State governments must borrow to fund the public works required for any economic activity to proceed. We comment in greater detail below on "good" borrowing and "bad" borrowing. It is enough to note here that, if Loan Council quantitative conffols prevent or delay productive public works, this will represent an opportunity cost to the economy. Prospects for accelerating productivity growth, and hence improving Australia's productive potential, will be undermined.
The distorlions caused by quantitative conffols rnay be much worse if States seek to maintain current expenditure within a tight borrowing limit. This may lead to a severe reduction in public sector investment in order to maintain current expenditure on borrowed money. Indeed, whenever economies enter a cyclical downturn with a borrowing cap in place, this is a virtually inevitable outcome as cyclical stabilisers begin to impact on current expenditure and receipts. This is supported by experience at both State and Commonwealth levels in recent years.

14.

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Incentive to conceal
15.

Recent events, leading to the establishment of a Senate Select Committee, have demonstrated that at both a State level and a Commonwealth level there may be insufficient incentive to maintain full disclosure of financial affairs. Indeed, quantitative controls give States an incentive to conceal borrowings which may lead to an uninformed market.

16.

In today's deep and liquid debt markets, with private sector rating agencies contributing to a more sophisticated view of the relative merits of various issuers, a regulatory framework providing for full disclosure of the financing arrangements of government borrowers (along the lines of the Commonwealth monthly statement of financial transactions) should be a priority of reform.

Incentive to use " private infrastructure"

T7,

States subject to quantitative controls have an incentive to bypass Loan

Council entirely by entering into "private infrastructure" ffansactions. In those cases where such transactions are driven mainly by a desire to bypass the quantitative controls, they tend to do little to promote private sector market disciplines and in many cases it is likely that they cause net adverse economic
consequences.

18.

The adverse effects of "private infrastructure" transactions are set out at Appendix I.

Lack of net benefit

19.
Set against these readily identifiable failures of quantitative conffols, there is a lack of evidence that quantitative controls have created any significant net benefit. Indeed, in recent years, all but two State governments have had their domestic credit rating downgraded and the Commonwealth's own foreign currency credit rating has been downgraded twice.

20.

This might be interpreted as an argument for broadening and tightening the Loan Council arrangements. However, this is a typical ex-post defence of a system which has failed. It would need to be demonstrated by those advocating broadening and tightening that it would work without giving rise to other distortions. (Such as an increasing reliance on private infrasffucture ffansactions)

2t.

It would be preferable to crcate a system that is not prone to distortions, been done with the private sector financial system.

as has

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-9PURPOSE OF QUANTITATIVE CONTROLS

Background
22.

Australian appears to be alone among federations in imposing bureaucratically determined borrowing lirnits on the member states. It is therefore reasonable to question why Australia requires Loan Council to perform this function at all. Before 1929 the six State governments and the Commonwealth each raised debt independently. It is well known that Loan Council arose out of a belief that this competitive approach raised interest rates in the small capital markets which then existed. However, Ausfalian and international capital markets have developed considerably in the past sixty years. Since the floating of the Australian dollar in 1983, and the removal of controls on capital flows, Australia has effectively been integrated into international financial markets.
Furthermore, in these more highly developed capital markets the Australian States are small but not insignificant players. We have presented at Appendix II a comparison of Australian State economies with other world economies and United States economies based on 1989 Gross Domestic Product ("GDP").

23.

24.

25.

In terms of its 1989 GDP, New South Wales would rank as the 15th state of the union if it were a member of the United States (lying between Indiana and Missouri). Victoria would be the 23rd state (lying between Louisiana and Alabama) and Queensland would be the 31st state (lying between Kansas and the District of Columbia).
Ontario and Quebec respectively contribute 42Vo and23Vo of Canada's GDP. New South Wales and Victoria (which respectively contribute 357a and277o of Ausralia's GDP) would rank as the third and fourth largest provinces of Canada ahead of British Columbia. Queensland, Western Ausffalia and South Australia would be the fifth, sixth and seventh largest provinces (lying between Alberta and Manitoba).
Compared with our regional competitors, New South Wales is considerably smaller than South Korea, but larger than Indonesia. Victoria lies between South Africa and Thailand while Queensland lies between the Philippines and New Zealand. Compared with smaller European countries, New South Wales is smaller than Denmark but larger than Norway. Victoria lies between Norway and Greece while Queensland lies between Portugal and Ireland.

26.

27.

28.

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-1029.

In considering these international comparisons, it might be noted that:

each of these comparable states and countries borrow in their own name, apparently without unacceptable consequences; and

in managing their economies and their public sector budgets they are not subject to the distortions created by externally imposed quantitative controls on their borrowings.
30.

Given these developments, it appears that the original function of Loan Council may no longer be valid. In its place a number of other implicit or explicit functions have been suggested. We have identified five possible objectives:
to protect citizens of each State from potential financial mismanagement by their State Government; to prevent financial mismanagement by some States from affecting the borrowing costs of other States, taking into account the fact that overseas investors may not differentiate between the individual States' creditworthiness; to manage the public sector's call on domestic and foreign savings; to enable the Cornmonwealth Govemment to co-ordinate fiscal policy at a national level so that it is consistent with monetary policy; and to place pressure on State budgets so as to encourage States to:

run down their holdings of liquid assets ("hollow logs"); and

seek greater returns from their authorities, or altematively to privatise them.

Protection from State financial mismanagement

3r.

The appropriate role of the Commonwealth in overseeing the States'financial management depends on political views regarding the roles of the Commonwealth and State Governments in general. This is influenced by the following factors:

in any federal system where two levels of government may be held accountable for economic performance it is likely that each will seek to manage this risk;

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- 11-

the Australian federal system does not have any formal principle of "subsidiarity" (such as exists in the European Community) which might resolve issues of control; and

in the absence of such a principle, it is to be expected that each level of government will exercise whatever instruments it has available to assert its conffol, unless mechanisms can be put in place to manage the risk without active intervention.
32.

We note that based on their current credit ratings, the Australian States appear to be prudently managed by world standards.

JJ.

All Australian

States other than Victoria have a Moodys credit rating of Aa2 foreign on currency liabilities. This is the maximum possible for a State due to Australia's national rating of Aa2 on foreign currency liabilities. In three cases the State rating might have been higher but for this national limit:

Foreign currency
New South Wales Queensland Western Australia Victoria's rating is A1 34.
Aa2 Aa2 AaZ

Domestic currency Aaa Aaa Aa1

The majority of the states of the United States which have a rating for general obligation bonds are rated Aa which corresponds to the Aa2 ranng of the Australian States. States with the lower A1 rating include Michigan, Pennsylvania and West Virginia. New York, Louisiana and Massachusetts have still lower ratings.
Canada currently lias a national rating of Aaa (although it is currently under review for possible downgrade). This high national rating has enabled two provinces - Alberta and British Columbia - to achieve a rating of Aal. Ontario has a rating of AaZ while Manitoba and New Brunswick are rated A1.

35.

36.

In western Europe, most countries are rated Aaa or Aal. Countries with a rating of Aa2 include Finland and Spain. Portugal has a rating of A1. In Asia, the rating of Australian States (other than Victoria) is exceeded only by Japan. New Zealand and Singapore have ratings of Aa3 while Korea has a rating of A1.
Given that the Australian States appear to have maintained reasonably good creditworthiness by international standards, it would appear possible to create market oriented mechanisms based on credit ratings that can manage the risk of economic mismanagement without introducing the distortions caused by quantitative controls. These are discussed in greater detail below.

37.

38.

,&ji'Schroders
-12Effects on other States
39.

As noted above, the original belief which led to the formation of Loan Council in the 1920s was that the Australian States were too small and insignificant to borrow in their own right without paying excessively high interest rates. A related argument is that a deterioration in the credit quality of one State might affect the borrowing costs of others. However:
as noted above, the Australian States are by

world standards

moderately large economic entities;

Loan Council quantitative controls do not insulate States from one another. Following Victoria's recent downgrading financial markets focussed on the possibility of further downgradings for South Australia and Tasmania. Their borrowing costs have risen accordingly; and
we do not envisage any substantial adverse change under a market driven approach. The fundamental determinant of a State's borrowing cost will be its creditworthiness. A high level of creditworthiness will be required to qualify for exclusion from quantitative controls.

Managing the public sector's call on savings

40.

At the macro level the rationale for reducing public sector borrowing lies in
concerns over the adequacy of national savings and consequent implications for Australia's external and internal balance: that is the relationship between domestic saving and external borrowing.

4r.

A deterioration in the public sector's savings performance early in the 1980s is held partly responsible for persistent current account deficits, and the subsequent accumulation of foreign debt, over the decade (see Edey and Britten-Jones, 1990, and Tease, 1990). At their most simplistic level, these arguments are embodied in the so-called "twin deficits' theory" which suggests that an improvement in the public sector's savings performance will produce an identical improvement in the extemal balance.

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_13_
Four points are to be made in relation to establishing a public sector saving target as a national objective: Professor Pitchford's work, and subsequent and prior work by others including Fahrer and Corden, have convincingly argued that Australia's preoccupation with its external balance, and consequently with aggregate natibnal saving, is misplaced as long as borrowing is undertaken to finance productive investment. To this end, a current account deficit resulting from high productive investment expenditure may be viewed as "good" since investment will produce a future income sffeam sufficient to meet principal and interest on loans. A current account deficit resulting from high consumption expenditure financed by borrowings is viewed as "bad" since there is no future income sffeam to meet debt obligations. Rather, in this instance, higher borrowing costs can only be met either by borrowing more or by lowering living standards in the future. A body of empirical evidence suggests that much of the borrowing in the 1980s went into productive investment; the notion of "good" and "bad" current account deficits can equally be applied to public sector borrowing. Edey and Britten-Jones note that Australia's-fiscal balance was restofed to surplus over the latter half of the 1980s at the cost of much lower levels of public investment. The Commonwealth's increased contribution to savings was primarily the resuit of reducing payments to States, from asset sales, from reduced transfer payments in a cyclically strong economy (helped by improved benefit targeting), the Commonwealth/State debt switchl, one-off alterations to the timing of tax collections, and finally by cuts in Commonwealth capital spendin g.
States have reacted to cuts in their grants and borrowing limits by reducing capital spending. Indeed, Edey and Britten-Jones note the largest reductions in expenditure on goods and services were made at the State and local level. They go on to note that: 42.

"the decline in the relative provision of public sector capital may have a detrimental long term effect on aggregate

productivity."
This point has also been made by Aschauer (1989) and Barro (1989) in the United States. If public sector savings come at the cost of infrastructure projects with high economic returns, and hence a reduction in economic productive potential, they may lead to higher current account deficits for any given level of GDP in the medium to long term.

43.

At the 1990 Premiers'Conference the Commonwealth and the States agreed to arangements
whereby the States would refinance debt previously issued on their behalf by the Commonwealth.

,ffi,Schroders
-14There is a considerable element of concern in recent debate that this may in fact be the case in Australia. While EPAC found little evibence of generalised underinvestment in infrastructure in its 1988 report, this r-port predates the budget Sffesses and economic slowdown of tgg\-gZ. Mosfeconomists now recognise the need for an adequate and efficiently run infrastructure base as a prerequisite for improving Ausffalia's longer term economic performance;

national economic policy has three objectives in this regard:

to achieve a desired balance between government consumption and investrnent spending; to achieve adequate public investment in infrastructure at the aggregate level; and
to ensure an efficient allocation of funds on a sectoral or project basis;

using an arbitrary mechanism such as Loan Council's quantitative controls to achieve these objectives is as likely to produce underinvestment as overinvestment on a sector basis or in aggfegate. It will do little in the short term to influence government decisions on public consumption. While the impact of overinvestment has immediate implications for the current account deficit, the consequence of underinvestment may only become obvious in the medium term but the effect is just as insidious.

44.

In summary: public sector savings rose over the latter half of the 1980s. While Loan Council's quantitative controls played a role in securing this result, its task was made easier by a cyclically strong economy;
the rise in public sector saving did not lead to a similar improvement in Australia's external balance. Indeed, the current account balance actually improved as public saving deteriorated from 1'990;

to the extent that the improvement in public saving resulted from a curtailment of public infrastructure investment, there is the possibility that it may in fact result in a relatively higher culrent account deficit in the medium term. In short, the quality of the public sector's contribution to national savings matters as much as the quantity;

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there is a need to achieve an adequate level of national saving in the medium term. To increase the rate at which savings grow, and therefore the rate at which the economy may grow without causing a deterioration in the external balance, requires a significant improvement in Australia's productivity performance. To a significant extent this will depend on the effectiveness of public and private sector investment decisions; and
the rationing device for capital investment must be commerciality (where applicable) rather than some artificial or non-market constraint on funding such as that imposed by quantitative controls. This is true of both the public and private sectors.

45.

We believe that the market-oriented mechanisms discussed below are more likely to achieve an efficient rationing and allocation of capital than the current quantitative controls.

Co-ordinating monetary and fiscal policy

46.

In Australia, the Commonwealth has responsibility for national and macroeconomic policy. The Commonwealth has sole conffol of monetary policy through the Reserve Bank. It is valid to ask whether the Commonwealth's control of fiscal and monetary policy requires it to have quantitative conffol of State borrowings.
We note the following in relation to this point:

47.

such quantitative controls are not required by the central governments of other federations suggesting that state fiscal policies in those

federations do not undermine national fiscal objectives;

such a view also assumes that there is a real danger that State governments would pursue fiscal policies which tend to undermine Cornmonwealth fiscal policy and, given the relative sizes of the States and the credit rating limits proposed under a market system, would in fact do so;

even with quantitative controls in place, States could (if they were so inclined) continue effectively to borrow through "private infrastructure" fran sactions ;

priori there is no more reason to expect the States, in aggregate, to adopt fiscal policies which are not conducive to the national interest than there is to expect the Commonwealth to do so; and
a

on the other hand, there is merit in the individual States being perrnitted to run fiscal policies which reflect regional differences and which are not synchronised.

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48.

In principle, rather than impose quantitative conffols to coordinate Commonwealth and State fiscal policy, it should be necessary only for States to advise the Commonwealth of their proposed fiscal stance for the following year to allow the Commonwealth to formulate its own fiscal position. In practice, it may be necessary, even under a market system, to give the States a financial incentive to exercise due diligence in estimating their borrowing requirements (including planned private infrastructure ffansactions) for the following year. The nature of these financial incentives is discussed below.

Pressure to improve performance or to privatise

49.

Tight borrowing restrictions may put pressure on State governments to improve the performance of their State-owned businesses or to privatise them. However, this in itself may not improve economic efficiency:
States may seek higher returns from State-owned businesses simply by raising prices; and

under current Commonwealth income tax arrangements, the States have a financial incentive to privatise businesses with minimal ffansfer of risk to the private sector. This tends to give rise to the "private infrastructure" arrangements described above and at Appendix I. Such a-rrangements rarely transfer investment decision making to the private sector and therefore do little to increase private sector disciplines in the allocation of capital.

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-r7
REGULATING STATE BORROWING
-

50.

We identify five methods of regulating State borrowing:

o . . . .

ro restrictions;
bureaucratically determined quantitative conffols such as currently used by Loan Council;

flexible guidelines such

as proposed

in the Maastricht Treaty;

accounting guidelines prohibiting borrowing other than for investment; and market-based measures.

No restrictions

51.

Other federations cope without an institution like Loan Council, so it is not inconceivable that the institution could simply be abolished without net
adverse consequences.

52.

However, before proposing such a radical change, it is valid to question whether institutional arrangements which work in large federations such as the United States or confederations such as the European Community are suitable for Australia. In particular, because Australia is a relatively small participant in international capital markets, the poor performance and creditworthiness of some States may affect the borrowing costs of other States and the Commonwealth (although, as noted earlier this has already occurred in Australia even with quantitative conffols in place).

Quantitative controls

53.

Loan Council currently operates on the basis of quantitative controls. The justification for this system rests on the twin assumptions:

that such controls need to be imposed in order for the Commonwealth to discharge its responsibility in relation to the conduct of national economic policy; and that the bureaucracy charged with administering the system has sufficiently good judgement in relation to appropriate borrowing limits to produce net beneficial consequences from this approach.

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_18_
54.

As noted earlier, it is easy to identify the adverse consequences of quantitative controls. These clearly identifiable adverse consequences increase the burden of proof on those advocating such controls to demonstrate both the need for them and the ability to set them appropriately. A review of the historical performance of Loan Council suggests that this will be difficult.

Economic guidelines

55.

Instead of rigid quantitative conffols, the Maastricht Treaty for European Economic and Monetary Union proposes a system of flexible guidelines related to economic indicators. In summary, these are:

inflation within I.5Vo per annum and interest rates within annurn of the three best performing states;
a budget

ZVo

pet

deficit less than

3Vo

of GDP; and

national debt less than 607o of GDP.

It is worth noting that few of the European nations (and not Germany) would curently meet these requirements. In Australia the Commonwealth would fail to satisfy the budget deficit requirement.
56.

Bishop (1990) has suggested an additional minimum average maturity covenant. As the maturity of a debt portfolio shortens, the risk of a sudden liquidity crisis rises. The risk of a liquidity crisis is difficult for markets to price. Although the level of debt may be acceptable, if the structure is poor it may prove impossible to refinance in the short-term. Accordingly, Bishop proposes that government borrowers be required to maintain minimum average rnaturities of debt portfolios.
Such an approach gives member states greater flexibility to manage their affairs.frorn year to year while preventing borrowing which is clearly excesslve.

51.

Accounting guidelines
58.

Under Gennan law each Land has the power to determine the amount of its borrowings, as well as access to several sources of taxation revenue.

59.

Article 109 of the federal constitution provides for federal legislation:

to establish principles governing budgetary law;

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_19_ for explicit controls on the maximum amount of borrowings by territorial entities (G ebietskoerperschaften) ; and for L[nder to maintain minimum interest-free deposits at the
Bundesbank.
60.

However, such legislation requires the consent of the Bundesrat which comprises Liinder representatives.

61.

In addition, the federal constitution, and the constitutions of some Liinder, contain accounting constraints on government borrowing. Article 115 of the federal constitutional provides that "revenue obtained by borrowing shall not exceed the total of expenditures for investments provided for in the budget". Such constraints allow flexibility to borrow for investment in public woiks, but prevent borrowing to cover current expenditure.
We see considerable merit in this approach since it allows flexibility to borrow for productive investment while preventing borrowing to cover recurrent costs. However, we see a nurnber of issues which would need to be addressed: definitions of both "borrowing" and "investment"; and given the likely vagueness of such definitions, the mechanisms to quickly identify and act against a State in breach of the guidelines.

62.

63.

Market based systems

64. Since Loan Council was originally devised sixty years ago both the Australian and intemational capital markets have become much deeper and more sophisticated. Credit rating agencies maintain ratings on the borrowings of each of the Australian States. These support an independent view of individual States' merits as borrowers. In an environhent characterised by a full and tirnely flow of inforrnation on States fiscal positions, the relative importance of credit rating agencies in determining a consensus view of a State will, paradoxically, be diminished.

65.

Accordingly, we envisage a package of market based measures could be adopted to replace Loan Council quantitative controls:
monthly disclosure of State net financing and spending on a basis consistent with the Commonwealth's current monthly statements;

,el. _20_
subject to notification procedures discussed below, a general exemption from borrowing limits granted to:
those States which maintain a credit rating equal to the Commonwealth's foreign debt rating; and

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those State-owned enterprises which achieve such a rating.

adoption of a minimum averago maturity covenant on outstanding debt to minimise liquidity risk which is not easily priced by the market;

quantitative borrowing restrictions imposed on those States which lose their rating or breach other requirements; and
adoption of accrual accounting in relation to loans (even as a note to accounts) to prevent the abuse of zero-coupon and deep discount securities as a means of deferring recognition of interest expense. 66.

At present, the credit rating of the States reflects the implicit belief that States would receive some support from the Commonwealth in the event of near default. This raises an element of moral hazard in State financial management. To prevent this, the following additional restrictions might be
required:
measures to prevent market signals being masked by government

action: permanent prohibition on the Reserve Bank or Commonwealth Government holding State debt securities; permanent prohibition on market privileges for State debt securities (such as the former "30120" rule); and

enunciation of Commonwealth policy not to support the debts of States or S tate-owned enterprises.
67.

Alternatively, some States (possibly the smaller ones) may prefer to borrow through the Commonwealth or with an explicit Commonwealth guarantee. In such cases a guarantee fee would be payable based on the State's credit rating. This would necessarily require the State to cede greater control to the
Commonwealth.

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-2t68.

In order to create an incentive for States to exercise due diligence in forecasting their total borrowing requirements, we propose the following notification and commitment mechanism:
States satisfying the minimum credit rating requirement would be permitted to borrow up to the annual amount previously notified to the Commonwealth; and

to discourage the States from submitting ambit claims for borrowing we propose a financial penalty which would be payable on the shortfall between notified borrowings and actual borrowings. This would be analogous to the commitment fee payable to private sector banks on undrawn loan facilities. (Overdrawings might also be allowable subject to similar penalities.) 69.

We draw attention to the contrast between this approach and the quantitative controls. Whereas quantitative confiols gives States an incentive to conceal borrowings or to bypass the system with "private infrastructure" ffansactions, the market system provide States with an incentive to maintain a high credit rating and an informed market by: rewarding them with the flexibility to borrow as required; and penalising them for poor forecasting of their borrowing requirements through the commitment fee.

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Schroders

ENFORCEMENT
69.

Any system of regulating borrowing.s re-quires a credible enforcement *e|tta"lst11 in thieventihat borroriing limits or covenants are breached.
Much has been made of the 1988 Loan Council meeting in which Quee-nsland *uiifn"ut"ned with a reduction in Commonwealth gfant1. Ironically, fr.oq a creditworthiness aspect, this State was least in needbf a borrowing resffiction' In practice, it may simply not be-pos-1ible to consffuct a credible enforcement mechanism based soleiy-on withholding Commonwealth glants:
those States most iikely to be in breach of their borrowing.limits or .ournunt, are also thoie for which it would be politically impossible to .ut gruntr. Indeed, the commonwealth has actually.increas.ed uiriSt-." to Victoria in response to its economic crisis; and

70.

17.

in any event, withholding grants may be politically difficult if it creates an impression thiithe Commonwealth Government is "interfering" in State affairs.

12.

A credible enforcement mechanism is available through the ratings agelgi^e;' irO""O, t" a significant degree this mechanism has been working since.1989' Witf-t Siut. .re?it ratings r6ceiving greater public attention, the p^olitical .oni"[u.n.es of a .i.f,it Oowngriding Tai be.sufficient in itself to resffain minimum limit, b;;;;iltr. In the ""i"t of a d'owngiading below the.agreed over the control if-t" Co-fronwealth could then interiene to exercise direct particular. in Siut"'r economic policy in general and borrowings
a This approach is similar to that used by the Intemational Monetary Fund at of agreed-standard nationii level: countries which fail to achieved an if creditworthiness must submit to external intervention in their economies they are to qualify for further financial assistance'

73.

14.

However, in order to be a credible deterrent to economic mismanagement, such external intervention:

should not be used routinely (as is the case with the quantitative .""tt"fi)-Jince ttris would debase it as a symbol of penalty; and (such as a rating should only be used after an independent adjudicator agency) has found against the State in question'

,&d,Schroders
-23-

75.

Withholding grants would continue as the penalty for failure to maintain minimum maturitY covenants.

8 January 1992

Brett Allender Chief Economist

Steohen Morris Inv'estment Banking Divi sion

ffi'schroders
APPENDIX

Shortcomings of private infrastructure transactions

1.

States facing quantitative conffols have an incentive to enter into private infrastructure transactions. Under current Commonwealth taxation arrangements they also have an incentive to transfer minimal risk to the private sector under such arrangements.

,)

The terms of such transactions vary widely, but they commonly have two characteristics:

they are undertaken on an asset by asset basis; and there is extensive govemment involvement in the commercial detail, and often i[rangements whereby government accepts risk through such techniques as guaranteed purchase ofproduct.
J.

Particularly in those cases where private infrasnucture transactions are aimed primarily at bypassing Loan Council consffaints, they may contribute little to the application of market disciplines to public works. The main disadvantage of such transactions are as follows:
decisions on the scale and timing of investment are still made by the State so there is no conffibution to dynamic efficiency. Indeed, investment decisions may be made worse. There is some evidence of certain public works projects being promoted simply because they can be funded outside Loan Council. prices are determined by conffact or according to indexation formulae rather than being set by market forces, so there is little conffibution to allocative efficiency; the conffacts often grant the private operator an unregulated monopoly concession for 20 or 30 years. This constrains the operation ofthe price mechanism and reduces the flexibility to respond to changing conditions. For example, a private concessionaire facing increased demand and income has an incentive to take the extra profit as a higher dividend rather than to reinvest it to increase capacity;

the cost of capital is unnecessarily high due to: the small size of the projects. the unique risks presented by the projects; and

& Schnoders
-2-

the high level of financial sffucturing necessary to minimise the tax burden.

While cost of capital may not be a concern in a closed economy, it is relevant for an individual State if the investment funds come from interstate, or for the counffy as a whole if the investment funds come from overseas;

. .

the tendering process for such projects is time consuming, costly and cannot be relied on to provide the best results; and the arrangements are not ffansparent. The conffacts are usually confidential. As a result: they do not engender public confidence; and they do not provide the sort of yardsticks or stock market rateof-ieturn daia which can be used by regulators to set prices for the natural monopoly components of utilities.

,&5'Schroders

APPENDIX

II

International comparisons

INTRODUCTION

1.

This Appendix compares the Australian States with other counffies and with the States of other federations in terms of:
Gross Domestic Product ("GDP"); and

Moody's Credit Ratings. GROSS DOMESTIC PRODUCT

2.

We have compared the Australian States and Territories with:

. .

states and territories of the United States;

Canadian provinces;

western European counffies; and

. 3.

other counffies.

Sources of information for this comparison are:

Ausralian Bureau of Statistics. 1990-91 Australian National Accounts: State Accounts (ABS5220.0) This has been used to provide GDP at market prices by State and Territory for 1989190.
US Departrnent of Commerce, Bureau of Economic Analysis. SuJYey of Current Business. December 1991. This has been used to provide Gross State Product ("GSP") for 1989.

United Nations. 37th Statistical Yearbook. This presents national GDP statistics both in domestic currency and in United States dollars. This has been used to bring all GDP and GSP data into an equivalent United States dollar measure.

, i Schroders
Statistics Canada. Canada Business Facts 1992. This presents Gross Provincial Product for 1990.

4.

Both the Australian GDP and United States state and territory GSP figures have been adjusted according to the United Nations international comparisons to give comparable figures in United States dollars. The process of adjustment is set out in the accompanying tables.

5.

In terms of its 1989 GDP, New South Wales would rank as ttre 15th state of the union if it were a member of the United States (lying between Indiana and Missouri). Victoria would be the 23rd state (lying between Louisiana and Alabama) and Queensland would be the 31st state (lying between Kansas and the District of Columbia).
Ontario and Quebec respectively contribute 42Vo and23Vo of Canada's GDP. New South Wales and Victoria (which respectively contribute 35Va and2TVo of Australia's GDP) would rank as the third and fourth largest provinces of Canada ahead of British Columbia. Queensland, Western Australia and South Australia would be the fifth, sixth and seventh largest provinces (lying between Alberta and Manitoba). Tasmania, the ACT and the Northern Territory are all larger than the tiny Prince Edward Island (which has a population of 130,0-00 and a gross provincial product of less than US$2 billion).
Compared with our regional competitors, New South Wales is considerably smaller than South Korea, but larger than Indonesia. Victoria lies between South Africa and Thailand while Queensland lies between the Philippines and New Zealand. Compared with smaller European countries, New South Wales is smaller than Denmark but larger than Norway. Victoria lies between Norway and Greece while Queensland lies between Portugal and Ireland.

6.

7.

8.

MOODY'S CREDIT RATINGS

9.

We have compared the Australian States with:

states of the United States;

Canadian provinces;

western European countries; and

Asian countries.

-310.

'&d'Schroders

The Moody's rating system is summaried below:

Normal rating
Highest
Aaa Aa1 Aa2 Aa3 A1

US States Aaa Aa1

Aa Aa
A1

A2 A3 Baal Baa2
Lowest
Baa3

A A
Baal
Baa Baa

11.

States other than Victoria have a Moody's credit rating of AaZ on foreign currency liabilities. This is the maximum possible for a State due to Australia's national rating of Aa2 on foreign cuffency liabilities. In three cases, the State rating might have been higher but for this national limit:

All Australian

New South Wales Queensland Western Australia Victoria's rating is

12.

Foreign currency Aa2

AA

Aa2

Domestic currency Aaa Aaa Aa1

Al

The majority of states of the United States which have a rating for general obligation bonds are rated Aa which corresponds to the Aa2 raing of the Australian States. States with the lower A1 rating include Michigan, Pennsylvania and West Virginia. New York, Louisiana and Massachusetts have lower ratings.

13.

it is currently under has enabled two rating possible high national This for downgrade). review provinces - Alberta and British Columbia - to achieve a rating of Aal. Ontario has a rating of Aa2 while Manitoba and New Brunswick are rated A1.
Canada cuffently has a national rating of Aaa (although

t4.

In western Europe, most countries are rated Aaa or Aal. Countries with rating of Aa2 include Finland and Spain. Portugal has a rating of A1.

15.

In Asia, the rating of Australian States (other than Victoria) is exceeded only by Japan. New Zealand and Singapore have ratings of Aa3 while Korea has a rating of A1.

ffi'Schroders
Australian Gross State Products

ABS State Data

UN National Data
r.989/90 GSP

Adjusted State Data

1989/90 GSP

State

1989/90 GSP

A$million
New South Wales Vlctona
Queensland

US$million

US$million
100163

Westem Austalia South Australia Tasmania

ACT Northem Territory

ABS Total UN estimate Discrepancy

129734 101076 55867 37518 27693 7908 7069 3940 370805 312172 1367
0.37Vo

78037

43t33
28966

2138r
6105 5458 3442

286286

ffi Schroders
United States Gross State Products

Department of Commerce State Data

State 1989 GSP

LIN Natlonal

AdJu$ed
State Data 1989 CSP

Data
1989 GSP

US$mllllon Califomia
New
697381

US$milllon

US$mllllon
692970 438278 337906 254856 226456 225528 210205 202089 180677 143875

Yo*

Texas

Illi-ccis Pennsylvania

Florida
Ohio New lersey

441068 340057 256478 227898 226964 211541 203375

181821

Mchigan
Massachusetts

t44791
136497

Virginia
North Carolina Georgia Indiana

l?5634
129262 128955 104648 99448 98447 95624 93384 92967 91683
88301

130085 129776 105314

100081 990'14

Missouri Maryland
Washington Wisconsin Minnesota
Tennesee

Connecticut

96233 93978 93559 92267 88863

7S138

l,ouisiana
Alabama Colorado Kentucky Arizona South Carolina

78637
67457

67886
661 80

65858 65306
601 50

lowa
Oklahoma
Oregon Kansas

District of Columbia
Mississippi Arkansas Nebraska Utah
Nevada

52574 52342 52118 48829 39363 38135 37169

65761 65441 64893 59770 52241

5201
1

51788 48520
391

l4

37894 36934
3091 8

3lll5
28135 27960
2',7922 257 55

27957
27',l83

West Virginia Hawaii New Mexico New Hampshire

lv{aine

27745

25592
25253 24349 23326 I 9458
18688

AIaska Rhode Island Idano Delaware lr{onlaaa Vermont North Dakota South Dakota

25414 24504 23474 19582

1

8807

l 6339

16236
15320

15418
13104

11502
I 1231 11135 11115

13021 11429
11160
1

r065

\\'r'oming

11045

L\

Dep of Commerce Total

E,srimate

D.crcpancy

5164669 5l 32000 -32669

-0.63%

5r 32000

51

32000

&'schroders
Australian and US State and Territory 1989 GSP
State
1989 GSP

Rank

US$mllllon
Califomia New York
Texas 692970

438n8
3379M
254856

)
3

Illirnis
Perrrsylvania

4
5

22f/.56
225528 210205 202089
180677

Flori4s Ohio New iersey Michigan

Massachuseffs

6 7
8

9 10
11

Virginia Nodh Camlina

Georgia Indiana

143875 135634 129262 128955

1t

l3
14 15

10498
100163 99448

New Soutb Wales Missouri Maryland

Washington

98M7
95624

t6 t7
18 19

Wisconsin
Minnesota
Tennesee

93384
92967

9r683
88301

20

Connecticut

2l

l-ouisiana

78637

,,'
23

Victoria
Alabama

7W37
67457

Colorado Kentucky Arizona South Carolina

6576t
65441 64893 59770 52241
5201

24
25

26

n
29
31

Iowa
Oklahoma Oregon
Kansas

28

Queensland Dstrict of Columbia Mississippi

Arkansas Nebraska

51788 48520 43133

30

391r4
3'7894

32
JJ

\ilestern Australia
Utah Nevada West Virginia

36934 30918 28966 27957

2'1783

34 35 36

5t
38
39

n745
25592
25253 24349 23326 21381
19458
I 8688

Hawaii New Mexico New Hampshire Maine South Australia Alaska

Rhode Island Idaho Delaware Montana Vermont North Dakota South Dakota

40
41 42 43

16236 15320 13021

44 45 46
47

rt429
11160 l 1065 11045

48
49

50
51

Wyoming

Tamrania

ACT
Northern Territory
United States Total
5

6105 5458 3042 132000

,&ll'

Schroders

Canadian Gross State Products

Statistics Canada Provincial Data Province Ontario

Quebec

UN National Data
r.989 GSP

Adjusted Provincial Data Imputed 1989 GSP US$million

223896

1990 GSP

C$million

US$million

28l2l0 t5't2lo
81085

r25r69
5r''559

British Columbia
Alberta Manitoba
Saskatchewan

71203 23990

56691

1910i
16317

2c494
16916
13187

Nova Scotia

13468

New Brwrswick Newfoundland Prince Edward Island

t0499
6952
1593

8732
2001

6't6028

538245

538245

Product' is based on Statistics canada data of 1990 Gross Pro'incial Notc: The allocatio* of canada,s l9g9 GDp between provinces 1990' and 1989 slightly betweell The relatir.e size of provincial econornies rnay have changed

ffi'Schroders

Australian and Canadian Gross State Products

StatelProvince
Ontario
Quebec

1989 GSP

US$million 223896
125169 100163 78037 64s59

New South Wales

Victoria
British Columbia Alberta Queensland Western Australia South Australia Manitoba
Saskatchewan

5669r
43133 28966 21381
19101

Nova Scotia New Brunswick Newfoundland Tasmania

ACT Northern Territory

Prince Edward Island

163r7 13468 r0499 6952 6105 5458 3042 1593

& Schroders
Australasia, Asia, South Africa
1989 GSP

State

1989/90 GSP

US$million
Japan

China India Korea New South Wales Indonesia South Africa

2868442 345395 273314

2t1864
100163 93966 89435 78037 69681

Victoria
Thailand Hong Kong Philipprnes

6289t
44424 43133 41050 37606 28966 27655 21381 6105 5458 3349 3042

Queensland New Zealand Malaysia Western Australia Singapore South Australia Tasmania

ACT
PNG

Northern Territory

ffi'Schroders

Australian and European

1989 GSP

State
Germany France

1989/90 GSP

US$million

rt1662t
955175 865819 853r27

Italy
United Kingdom Spain Netherlands Sweden Switzerland Belgium Austria Finland Denmark New South Wales Norway

3802M
225895 191298

tgrt25
152992 126775 115232 106303 100163 90289 78037 54r77 45271

Victoria
Greece

Portugal

Queensland Ireland Western Australia South Australia Luxembourg Tasmania

43I33
34170 28966 2L387 7018 6105 5458 3042

ACT Northern Tenritory

Australian and US State and Territory 1989 Gross State Products

700000 600000
ffi
US statcs

It-acr tr
Ise
ffirvl
ffiQ,*u"a
I vi.r"tit

smooo
u? 400m D

a
S o\

3ooooo

lNsw

zooooo r00000

i
=

Fn'

f ei

sg tu

3gi l

sgs

! s E $ g'

Es

3f

g*

3
3

=E

* t

3* f $*

i s s g 33' g t

'ffi'Schroders

Australian State and Canadian Provincial 1989 Gross State Products

Note: Gross Provincial Products are derived from 1989 UN data on Canada and 1990
Statistics Canada data on the provinces.

r50000 @
Cn

p
Cn

r00000

o\ ao g\

&z::rfriiE AZ&E-t
>,frTo za
u-

E-U.E.XEe.:EE '6-d9=9.qeE9t

!!dkx!

^?ETiE :'E3

;F?EJ zEZ

Ezif

z2

Australia, Asia, Oceania, South Africa 1989 Gross State Products

^
E

400000 ssoooo

A p 3000m

zsoooo zooooo
150OOO

fi
q)

cE rh

g
V)

100000

c\ 00
o\

50000
0

* fi ,E .E E P C E E r .E P .! .r F 4 o.r i t : $ i t"s 6 s f E $8e27. E'r*${Eu';F;8q

(.6e *tco

("

.'

EtiEtrot,oa{ z>2

ffi'schroders

Australian and European 1989 Gross State Products

;.

200000

rs0000 d4 (n D

A
o\ Ft
0lo

rooooo

50000

g EEEE? 3 E I f s E E E E A EAEE ?'AE&;;:FE

a c c d y 4 > 6 0 = .c''6 6 6 S 6 t<

z(n?(r.EEj{

z'2

ffi'schroders

&'Schroders
Australian and United States Credit Ratings
Stat
Georgia

Moodyrs Rating
Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aa1 Aa1

Illinois
Maryland

Missouri
New Jersey North Carolina South Carolina
Tennesee

Urah

Virginia
California Maine New South Wales (1) Queensland (1) South Australia Western Australia (1) Tasmania
Alabama

Aaz

A^2
Aa2

A^2 A^2
Aa Aa Aa Aa Aa Aa Aa Aa Aa Aa Aa Aa Aa Aa Aa Aa

Alaska
Arkansas

Connecticut
Delaware

Florida Hawaii Kentucky Minnesota Mississippi Montana

Nevada New Hampshire

New Mexico North Dakota Ohio

Oklahoma Oregon Rhode Island Texas

Aa
Aa Aa Aa Aa Aa Aa

Vermont Washington Wisconsin

Victoria
Michigan
Pennsylvania West Virginia

A1

Ai
A1

A1

New York

A
Baal
Baa

[nuisiana
Massachusetts

Sources: Moody's. 1992.

Note: 1" State foreigr currency credit rating limited by

Australian national loreign currency rating of Aa2.

ffi'Schroders
Australian and Canadian Credit Ratings

State Alberta British Columbia New South Wales (l) Queensland (1) South Australia Western Australia (1,) Tasmania Ontario
Quebec

Moody's Rating
Aa1 Aa1
Aa,z

Aa2
Aa.z

Laz A^2

AA
Aa3 A1 A1 A1

Victoria
Manitoba New Brunswick Nova Scotia Prince Edward Island
Saskatchewan

A2
A3 A3 Baal

Newfoundland Sources: Moody's. Canadian Credit Report March 1992.

Note: 1. State foreign curency credit rating limited by Australian national foreign currency rating of Aa2.

'ffi'Schroders
Australian and European Credit Ratings

State Austria
France

Moody's Rating
Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aa1

Germany Luxembourg Netherlands Switzerland United Kingdom Belgium Denmark Norway Sweden New South Wales (1) Queensland (1)

Aal
Aa1 Aa1

South Australia Western Australia (1) Tasmania Finland

Spain Ireland

Aaz ALz Aa2 Aa2 Aez

AA
Aa2 Aa3 Aa3 A1 A1 Baal

Italy

Victoria
Portugal
Greece

Sources: Moody's. November 1992. December 1992

Note: 1. State foreign currency credit rating limited by

Ausfalian national foreign curency rating of Aa2.

&'Schroders

Australasian and Asian Credit Ratings

State
fapan New South Wales (1) Queensland (1)

Moody's Rating
Aaa Aa2

Aaz

South Australia Western Australia (1) Tasmania New Zealand Singapore

L^2
Aa.z

Aaz
Aa3 Aa3 A1 A1

Victoria
Korea Thailand Hong Kong Malaysia India Sources: Moody's. November 1992. December 1992
Note

A2 A3 A3
Ba2

1. State foreign curency credit rating limited by Australian national foreign currency rating of Aa2.

&'schroders
BIBLIOGRAPHY
D A Aschauer Does Public Capital Crowd Out Private Capital Journal of Monetary Economies, No. 23 1989
RJ

Barro

Macroeconomics John Wiley & Sons, New York 1984

Creation of an EC "Hard Money" Union Salomon Brothers. Graham Bishop London 1990

W M Corden Inflation. Exchange Rates and the World Economy Clarendon Press, Oxford 1977
Economic Planning Advisory Council Economic Infrastructure in Ausffalia Council Paper June 1988, Australian Government Publishing Service, Canberra
Jehrome

Fahrer

Is Pitchford Right? Reserve Bank Discussion Paper, Ausfalia

r990 Martin

Feldstein
13 June 1992.

The Case Against

EMU

The Economist.

D Pitchford Does Australia Really Have Papers, No. 8, 1989

a Current

Account Problem? Economic

Proceedings of a conference
The Australian Macro-Economy In The 1980s

Editor:

Stephen Grenville 1990, Research Department Reserve Bank of Australia

(i)

Malcolm Edey Mark Britten-Jones

Savins &

Investment

oase 79

158

(ii)

Warren Tease The Balance of

Pavments

oase 759 - 221

,ffi,Schroders

REFORMING LOAN COUNCIL

1.

Since its creation over sixty years ago, the Australian Loan Council's contribution to econotnic rnanagement has been undermined by market developments to such an extent that it must be asked whether it continues to serve ahy worthwhile purpose. Among the major federations, Australia stands alone in trying to impose quantitative controls ("global limits") on the borrowings of its member States. The United States, Canada and the EuropeanCommunity have nothing remotely equivalent to quantitative contrbls. Gerrnany has provision for fiscal coordination, but only with the approval of the Bundesrat (States' house).
_

2.

In the Australian banking industry, quantitative credit controls were abolished in the early 1980s when it was recognised that they created distortions in the rationing of credit which outweighed any economic benefit. Similarly, it is possible to identify the inefficiencies created by the system of quantitative conffols on the States' borrowings:

it fails to provide any incentive or tnechanism for optimum resource

allocation; there is an opportunity cost of capital investment forgone by the States due to excessively tight bor:rowing restrictions, and there is an incentive for the States, constrained in their borowing, to maintain cur:rent expenditure at the expense of capital expenditure thereby threatening productivity growth in the medium term; there is an incentive for the States to conceal borrowings, leading to an uninforrned market; and there is an incentive for the States to bypass the system entirely by using "private infrasnuctttro" transactions which in many cases have a net adverse economic irnpact.
Set against these identifiable inefficiencies is a remarkable lack of evidence that Loan Council's quantitative controls have created significant net economic benefit. Indeed, in defending Loan Council's performance as a tool of economic policy, the principal argument appears to be an assertion that conditions would have been worse under a less controlled system.

J.

4.

The recenrly established Senate Select Committee Inquiry into the Functions, Powers and Opelation of the Austlalian Loan Council provides an excellent opportunity to review the perforrnance of bureaucratically determined quantitative controls in cornparison with a market-based approach to coordinating public borrowing in Australia.

'$S,Schroders
5.

In Schroders' new report Public Borrowing in Australia: The Functions, Powers and Operation of the Australian Loan Council we have set out the basic framework of a market-based system:
improved disclosure of the States' financial positions;

for those States and State-owned enterprises which achieve a credit rating equal to the Commonwealth's foreign debt rating;
a general exemption from quantitative controls

for those States which qualify for the general exemption, a notification system requiring them to advise the Commonwealth of forthcoming
borrowin g requirements; and

financial penalties for bomowing in excess of notified requirements or below notified requirements (similar to commitment fees on bank facilities.)
6.

The contrast between this market-based system and quantitative conffols is obvious. Whereas quantitative controls give States an incentive to conceal borrowings or to bypass the system with "private infrastructure" fansactions, the malket system provide States with an incentive to maintain a high credit rating and an informed rnarket by:

rewarding them with the flexibility to borrow as required; and penalising them for poor forecasting of their borrowing requirements through the commitment fee mechanism.
7.

Loan Council has outlived its usefulness. It is time to give it a decent funeral.

19 January 1993

Brett Allender

Steohen Morris