Friday, December 15, 2006

Ian Macfarlane's worried, Glenn Stevens is worried...

The former head of the Reserve Bank says “major financial instability” is likely to hit Australia within the next two decades and he believes we lack the tools to deal with it.

In the sixth and final of his Boyer Lectures to be broadcast on the ABC on Sunday Ian Macfarlane says he believes that Australia faces a threat “greater than the threat of inflation, deflation, the balance of payments and the other familiar economic variables that we have confronted in the past”...

The former Governor says he is concerned about the effect of performance-based pay on fund managers who are under increasing pressure to lift returns. “There is an incentive for them to take on more risk, particularly to hold assets that offer a high expected return in order to compensate holders for the possibility that, in rare circumstances, there will be a huge loss. It can have the effect of encouraging managers to chase short-term profits, even if long-term risks are being incurred, because if the risks eventuate, they will show up on someone else’s shift,” he said.

Mr Macfarlane’s comments amplify those made by his successor as Reserve Bank Governor Glenn Stevens who on Tuesday expressed concern about the growth of leveraged buyouts funded by private equity firms of the type that have bid for Qantas and Coles Myer.

Until this year leveraged buyouts in Australia in Australia averaged only $1.5 billion each year. This year up until Thursday the total was an unprecedented $13 billion. The Qantas deal, announced on Thursday, adds another $11 billion to that total.

Dr Stevens said that leveraged buyouts by private equity funds were essentially bets by that share prices would remain strong and that the cost of funding their debts would stay low.

The funds typically borrow heavily to buy and privatise large public companies, refloating them on the stock exchange five to ten years later at what they hope will be a profit.

Mr Macfarlane said the Australian public was more exposed to the fallout from any collapse in financial markets than ever before. Household debt was at an all time high. Many people had “taken on higher levels of debt than they desire, because they felt it was the only path to home ownership, given the strong rise in house prices over the past decade.” And more than half of adult Australians now owned shares directly, and many more through superannuation funds.

The former Governor said that the growth of superannuation and with it a shift to share market-based accumulation funds had increased the exposure to risk.

Whereas once employers had shouldered financial risks for their workers by offering defined-benefit payouts now most super payouts depended on the earnings performance of a particular fund. “In other words, it depends on what happens to share prices, bond yields, property prices and so on,” Mr Macfarlane said.

“I do not wish to criticise the current arrangements for retirement incomes in Australia because over time they will allow most people to retire on higher incomes than formerly. The only point I wish to make is that for a large part of the population, their standard of living in retirement will depend to a significant extent on how the value of financial assets perform, and hence they are more exposed to financial risk than under earlier arrangements.”

Mr Macfarlane said that the increased exposure to financial markets and the increased tolerance of risk in those markets was likely to make the economic effect of future booms and busts bigger.

He said he expected such a challenge within next two decades and he doubted that the public would accept the Reserve Bank pushing up interest rates to prevent it.

“If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not,” he said.

The Reserve Bank had “a very limited armoury with which to fight against a potentially dangerous asset price boom”, its chief weapon being jawboning in the form of speeches, parliamentary testimony and research papers, which was “of limited effectiveness”.

“How would [the Reserve Bank] cope if it faced an asset price boom of the magnitude of those that occurred in the United States in the 1920s or Japan in the 1980s? Not very well, I expect, but it would probably be held largely responsible for the distress that accompanied the bubble’s eventual bursting,” the Mr Macfarlane said.

The lecture will be broadcast at 5.00pm Sunday on Radio National. The series will be published as a book by Allen and Unwin entitled The Search for Stability.