Philip Gaetjens, Secretary to the Treasury, delivered this speech at the 9th Caixin Summit: Global Challenges, Global Solutions in Beijing on November 18.
In my opening remarks, I’d like to briefly address crisis responses — both standard and less conventional, reflecting particularly on a few observations about the Australian approach.
Firstly, let me set the pre-crisis starting point for Australia. Credit growth between the early-2000s and 2007 was robust with acceleration in business credit growth. There had been a lift in commodity prices and a mining investment boom was underway. Prudential policy began to tighten amidst some evidence of declining lending standards as new mortgage securitisers entered the market to challenge the dominance of our major banks. The Australian stock market reached record highs just prior to the crisis supported by ample margin lending.
After successive budget surpluses, government debt was negligible and monetary policy was progressively being tightened. In sum, we entered the financial crisis in about as good a shape as one could possibly hope when strains in money markets and bank funding became evident in the middle of 2007.
Swift monetary and fiscal stimulus
In response to the GFC, we were able to delve into a conventional toolkit of liquidity support for the financial system, and swift monetary and fiscal stimulus. While discretionary fiscal policy was based ex ante on a high-level framework of ‘timely, targeted and temporary’, there was also a focus on exit strategies in addition to the measures themselves. It remains evident today that those countries which were forced to consider newer, less conventional responses have found it harder to exit.
A common response to the GFC was for central banks to provide liquidity. But with time, they were increasingly forced by events to become ever more creative in broadening the definition of good collateral and widening the eligibility for access to central bank funds. This illustrated that the basic tenets of the lender of last resort function remain unchanged and effective nearly 150 years after they were first clearly articulated by Walter Bagehot “… lend to all that bring good securities quickly, freely, and readily.”
Similar to its overseas peers, amid an increased demand for liquidity from banks, the Reserve Bank of Australia progressively adjusted its open market operations in three ways: it markedly increased the amount of liquidity in the financial system; it increased the range of acceptable non-government securities it was prepared to hold as collateral; and it increased the maturity of repurchase agreements undertaken.“Australia’s explicit deposit insurance ensures depositor protection in the unlikely event that an Australian Authorised Deposit-taking Institution fails, and is now an ongoing feature of our financial landscape.”
After the failure of Lehman Brothers, when Ireland announced on 29 September 2008 that it was guaranteeing all bank deposits and debt, the British soon followed, and numerous countries were forced to undertake similar measures. Deposit insurance in Australia became explicit from 12 October 2008 along with a guarantee scheme for wholesale bank debt.
Australia’s explicit deposit insurance — the Financial Claims Scheme — ensures depositor protection in the unlikely event that an Australian Authorised Deposit-taking Institution fails, and is now an ongoing feature of our financial landscape.
The wholesale debt guarantee introduced in 2008 has long since been removed. But at the time it was effective in reducing fears that banks (and the Australian states) would be unable to access term funding markets. It mainly covered new bond issuance and not existing bonds. The Australian scheme saw banks and state governments use the guarantee scheme to improve their liquidity in the first instance. But once market dislocations subsided and Australian banks felt secure enough, many banks bought back their guaranteed debt and replaced it with unguaranteed debt in order to cease paying the guarantee fees. Careful design choices helped facilitate a timely exit from the policy. No claims against the government were made under the scheme and in recompense for the risk taken by the Government, it received $4½ billion in fee revenue.
Australia also used the standard macro-policy levers — fiscal and monetary policy — with a high degree of coordination. In this environment, a key objective for Government policy — whether fiscal or monetary — should be to reduce the expected depth and duration of any economic downturn.
Monetary policy action was the first mover to stimulate the economy. The Reserve Bank cut its policy rate from 7.25 to 3.00 per cent between August 2008 and August 2009.
Australia’s flexible exchange rate regime also helped soften a slowdown in the real economy. Since the Australian dollar was floated in 1983, it has helped to smooth the traditional boom-bust cycle associated with sharp movements in commodity prices. The near 40 per cent decline in the Australian dollar from mid to late 2008 made Australian exports more competitive.
The sharp depreciation in Australia’s exchange rate did not come with added anxiety over the ability of Australian institutions to repay foreign liabilities. Australian borrowers in international markets, notably banks, have traditionally handled the currency risk through hedging markets. Perhaps relevant to some emerging markets, the development of domestic money markets which, in turn, facilitates the development of hedging instruments, is a pre-condition for realising the full benefits of flexible exchange rates.
Discretionary tax cuts and temporary spending increases were also used to support aggregate demand and shift perceptions about the expected duration of the crisis. Fiscal policy can help to broaden the policy support beyond those parts of the economy that are sensitive to interest rates, especially when financial shocks are interfering with the monetary policy transmission channel. In just five months between October 2008 and February 2009, four packages amounting to a total fiscal stimulus approaching 6 per cent of GDP were announced. Although the efficacy of the later packages remains a source of contested debate, confidence was maintained, a technical recession did not occur and the unemployment rate did not reach its forecast heights. The impact on our commodity exports from the significant fiscal stimulus in China also provided significant support.
At the time these fiscal packages were announced, the Government — and the subsequent Government since then — articulated exit strategies to return the Budget to surplus and pay down debt.
The unwinding of the largest terms of trade boom in Australia’s modern history proved difficult to forecast and the path to surplus became a never ending story. Slower than anticipated income growth resulted in revenue write-downs for a number of years.
Only since 2015 have budget updates consistently projected a budget surplus being achieved in 2020-21. Most recently, the achievement of budget balance was brought forward to 2019-20.
While the Budget position has recently been improving on the revenue and spending sides, we have some work to do to reduce the Government debt accumulated over the past decade, if we are to be as prepared to deal with future crises as we would like to be.
While Australia’s experience with the financial crisis was predominantly one of utilising the standard crisis response toolkit, many countries used somewhat new and unconventional policy responses, particularly with respect to monetary policy. A vast amount of literature exists on the effectiveness or otherwise of these unconventional monetary policies such as quantitative easing, negative policy interest rates and forward guidance. There is consensus that they were somewhat successful in flattening yield curves and compressing term premia. However, many observe that these policies have not proved as effective as policy makers had previously hoped. Furthermore, they have proved easier to enter than to exit and the normalisation from these settings post-crisis remains elusive for many countries and regions.
In addition, the various quantitative easing programs appear to have had more of an impact through the asset price channel than conventional policy. Anticipation of central bank purchases pushed down the yields available on safe government (and in some instances private sector) securities, pushing investors further out the credit and risk spectrums in order to maintain nominal returns. Open questions remain whether these policies continue to exert pressure on asset prices (even as most programs have ceased or at least slowed their accumulation of assets) or whether the prices of many financial assets are justified by what are perhaps lofty expectations for future cash flows.
Risks to financial stability globally
Some financial vulnerabilities are evident recently in certain emerging market economies, with some discussion of the normalisation of US monetary policy settings as a possible cause. While higher US interest rates and the appreciation of the US dollar are surely having an impact in a number of emerging markets, particularly those with significant amounts of US dollar denominated debt, most of the proximate causes for recent volatility seem far more idiosyncratic. The international financial architecture exists to provide support in these kinds of circumstances and so it is appropriate that we have recently seen assistance provided by the International Monetary Fund to Argentina.
Although recent developments have been largely idiosyncratic, risks to financial stability globally have increased somewhat in recent years. While the potential triggers for any crisis may vary — trade and geopolitical tensions, policy mistakes, exuberance in asset markets — it is typically excessive leverage that fundamentally sits behind most major crises.
Global indebtedness has increased significantly since the financial crisis. In part, this reflects an increase in public sector debt in a number of advanced economies immediately following the crisis as many governments moved to support their economies and financial systems. But in recent years, much of the growth in global debt has been driven by private sector debt. There are risks to the sustainability of this debt if there are shifts in the current environment of low interest rates, high asset prices and the solid pace of growth in borrower incomes. Given this we could ask whether more should have been done to build resilience.
In the aftermath of the financial crisis, there was recognition that the regulation of individual institutions, while important, may have been insufficient to prevent the build-up of risks across the financial system. Even with intensive microprudential supervision, risks in the financial system can build through time if individual institutions adopt practices that become systemically risky when aggregated across the entire system. Systemic risks can also build beyond the regulatory perimeter in the shadow banking sector.“Whilst the Australian banking system performed strongly through the financial crisis, its aftermath revealed shortcomings in existing prudential regulation in many countries.”
Globally, much effort has been devoted to macroprudential policy in order to achieve financial stability. There is an ongoing debate as to the effectiveness of macroprudential policy and, to the extent it has some merit, what approach we should take to best achieve financial stability. Even though questions on effectiveness and approach remain, it is sometimes better for policy makers to act rather than do nothing. For example, in Australia we came to view a high share of interest-only mortgage lending — loans where interest but not principal is repaid during the initial years of the loan — as a structural vulnerability and our prudential regulator introduced policies which have been effective in reducing the share of IO loans.
Whilst the Australian banking system performed strongly through the financial crisis, its aftermath revealed shortcomings in existing prudential regulation in many countries. International policy lessons resulting from this experience included the need to: raise capital requirements for banks; improve bank liquidity; encourage central clearing of over-the-counter derivatives; and mitigate risks resulting from shadow banks. International reforms to address each of these lessons have largely been progressed and agreed through the Financial Stability Board of the G20 and are a significant reminder of what can be achieved through international cooperation.
Building upon the foundation of international reforms, policy and supervisory actions by the Australian prudential regulator have further strengthened the resilience of the Australian banking system.
Key reforms in the last decade include the introduction of “unquestionably strong” capital requirements which build upon Basel III capital reforms to increase the quality and quantity of capital, Basel III liquidity and funding reforms, enhanced accountability through the Bank Executive Accountability Regime, various supervisory measures to enhance lending standards, an enhanced crisis management toolkit, and the recently proposed introduction of increased “loss absorbing capital” requirements to ensure orderly resolution. These reforms set a strong foundation for the Australian banking system whatever might be on the horizon.
We won’t necessarily know beforehand where or when the next crisis will start. This is not to say that one is imminent.
But if trouble arises, Australia’s experience demonstrates the old toolkit of responses still works. And our strong fiscal starting point in 2007 also emphasises the need to replenish buffers to be ready for a future shock.
Finally, while governments have a responsibility to do what they can with what they’ve got in uncertain and tumultuous times, the Australian experience indicates the importance of exit strategies.