APRA is pushing up the Australian dollar

Whilst the RBA and politicians dance around addressing the strength of the Australian dollar, crushing many productive sectors of the economy, APRA and Mega Bank use policies that pass massive risk to the taxpayer and inflate the level of the AUD.

How so?

The traditional and “official” view is that if a financial institution or ADI borrows offshore in a foreign currency, then the lowest risk position is to fully hedge the FX exposure, by using the FX to buy AUD and swapping the future repayment obligations of the FX into AUDs. This view is incorrect and in Mega Bank’s case results in a large distortion in the economy.

Whilst it may be arguable that for a small ADI that borrows a small percentage of its liabilities in FX and actually repays both principal and interest on a timely basis, a full hedge is the lowest risk position. For a large ADI with significant offshore FX borrowings aka Mega Bank, full hedges are not the lowest risk position

When an ADI borrows offshore a fixed amount of FX is received on certain terms. When those borrowings are hedged, contracts for differences are entered into to turn those funds into $As for the ADI. Whether those contracts are called swaps or derivatives is not relevant. What is relevant is that the contracts create the AUD exposure, AUDs are not “purchased” because they did not exist, they are only “created” through the contracts, but the FX debt does exist in the foreign currency. Almost exclusively those FX contracts are written with international banks that actually carry the risk of the FX differences.

Conventional wisdom says that hedging to match FX liability payments eliminates the risk. However, what that piece of wisdom does not take account of is the situation when the borrower is most unlikely to be able to actually repay the debt. In Australia unless the government in effect takes on the offshore debt as has been happening in the last few years, Mega bank cannot actually repay the foreign debt without massive deleveraging. In this situation, a hedge creates different types of risk.

Firstly, the rolling of the hedge as the debt is rolled or refinanced is subject to the FX rates at the time and the availability of both funds and FX demand from international banks. These international banks benefit from knowing well in advance Mega Bank’s requirements resulting in pricing that is weighted to those banks. Even if borrowings do not increase in AUD terms as the currency increases in value, the offshore currency requirements do increase and at pricing which is determined again by the international banks.

Baring a massive shift of offshore borrowings to the government’s or RBA’s balance sheet the never ending hedge rolling creates a continual counter party risk with the international banks with Mega Bank at the centre. The intertwining of the AUD derivative markets is fine whilst its liquidity continues, however, as has been shown in the credit derivatives market it only takes one significant counter party to go down and the whole game ends.

What price does Australia pay for carrying these risks? Mega Bank has about $700Bn of offshore borrowings including those defined as deposits. Of this about $550Bn (Per RBA Statistics) is denominated in foreign currencies and swapped back to AUDs with a never ending timetable already mapped out to rollover that debt and the corresponding hedge.

The continuing program of rolling FX hedges and increasing foreign debt through balance sheet building rather than on income/trade account inflates the value of the dollar at the huge cost to various sectors of the economy, including manufacturing and tourism but with benefits to other sectors, including housing and retail.

How is this allowed to happen out of the public eye and proper debate? The culprit, besides Mega Bank itself, is our old friend APRA. My readers will not be surprised to learn that once again, misallocation and underallocation of capital are the mechanisms that both APRA and Mega Bank use to ensure that the Australian taxpayer and certain sections of the economy support the activities of the financial sector at no cost.

Put simply, APRA’s policy is that Mega Bank’s offshore borrowings should be hedged to a large degree based on the notion that this is the lowest risk position with the capital required to hold against the counter party risk of the hedge significantly lower than capital requirements of borrowing unhedged. Besides the fact that over the history of building up the $550Bn of foreign currency borrowing, that the assumption of fully hedging is the lowest risk position proved not to be correct, surely this is also not consistent with APRA’s macroprudential responsibilities to work with the RBA on these types of matters

The RBA does, but rarely, interfere with the free markets of the AUD and when it does it is with much scrutiny. Yet APRA in conjunction with Mega Bank, does so every day to the detriment of productive sectors of the economy and to the benefit of the politico housing complex.

So what would be a policy that would be consistent with a prudent macroprudential policy to reduce the market distortion?

  • APRA should recognise the systemic risks in borrowing and hedging such a large amount of FX borrowings with more equivalent capital treatment for Mega Bank carrying FX risk and the counter party risk of the hedge, and or
  • Mega Bank should be severely limited to the proportion of FX borrowings which can be hedged so that the capital allocation or provision for FX risk will limit the amount of offshore borrowings, and or
  • Mega Bank must hedge its offshore borrowing FX risk only with the RBA which then uses hedge pricing as part of macroprudential policy to limit or otherwise offshore borrowings

Whatever the policy there should be at least a public policy which can be debated on this important issue which seems to fly well under the radar.

On a related matter, I’m astounded that there is no policy in relation to Australian governments selling AUD securities to offshore investors, currently about AUD180Bn. Ex RBA board member Prof. McKibbon understanding the issue of offshore borrowers buying AUD debt with detrimental effects to certain sectors of the economy, has suggested that the RBA print the equivalent amount of AUDs as debt is in offshore hands, and buying foreign currency debt to offset. Printing money is something that is very politically unpalatable.

This policy suggestion has received much media but ultimately little support. A policy that may get more support but can achieve a similar result, would be to reverse hedge the exposure. A reverse of the APRA policy for Mega Bank to hedge foreign borrowings, the RBA could, as part of macroprudential policy, swap into a foreign currency exposure a set proportion of Australia’s AUD exposure to foreign investors. These swaps could be with the relevant central banks to significantly reduce counter party risk.

The policy measures I’m suggesting are not meant to eliminate offshore debt investors into Australia, rather they are about aligning the systemic risks to where they exist and managing balance sheet exposures and risks which create detrimental distortions on the trade account.

Comments

  1. So if the AUD was drop significantly would that not have an big effect on the repayments of the 700 Billion. Meaning that this would raise the costs of the repayments and funding.

  2. ” These swaps could be with the relevant central banks to significantly reduce counter party risk.” I’m not sure I agree with that. Adding a Central Bank to the process doesn’t remove the counter party risk from the initial underlying commercial hedge. It may ‘offset it’ but doesn’t eliminate the risk inherent with whoever it may be in the ‘real’ world.

  3. I read this as though there is a conspiracy between the big four banks and APRA – but my understanding is that it’s an APRA requirement that the banks don’t particularly like. They are required to borrow a percentage of their funding on 5 and 10 year terms to help maintain system stability.

    Borrowing short has in the past given the banks their most profitable funding, but it has it’s own dangers in a global credit squeeze – so insisting on a percentage of borrowings on long term 5 and 10 year funding helps stabilize the system, and it allows the banks to plan their rollovers well in advance – not that they don’t have plans in place for short term borrowing.

    You will recall the problems that short term borrowers such as RAMS had during the GFC when they couldn’t rollover short term funding.

    Obtaining the long term funding overseas is the only option at present, but we could develop our own long term bond markets to satisfy this, as long as APRA will play ball and make some compromises.

    I have read other comments that also criticise APRA over this. What do you see as long term solutions to the problem?

    • Peter

      You don’t seem to have understood my point.

      Mega Bank borrows offshore because local credit demand is not met by the the local bond market and we have a CAD. There mature bond markets in Australia which could be larger but if funds are allocated away from say equities, what will fill the gap.

      Of course the largest bond market in Australia is the bank deposit market which is effectively investing in mortgages.

      There is no conspiracy on this matter, just policy not well thought through with detrimental unintended consequences. However, I admit its a difficult topic to grasp

      • The only source of funding that I can think of is via the growing Super fund holdings. I don’t think that will be a popular suggestion here, but nevertheless it should be discussed. It wouldn’t be possible to simply substitute local for overseas funding quickly, it would have to grow to fit – I believe it’s in the order of $300 to $400 Billion, so for this country it’s a large amount.

        Pulling that level of funding out of equities is not the solution, but as the super funds grow they need other more diverse investment opportunities. Not sending billions of $AUD overseas in interest payments would be one advantage.

        • Why shouldn’t the RBA just cut to the chase and lend to the banks whatever they cannot finance otherwise in Australia? Gets rid of the risk for the banks, the interest accrues to the government instead of foreign lenders, everybody should be happy.

          • Oh Canada!!!

            No I think that the market should fund it Alex. There are plenty of superannuants who want a portion (if not all) of their holding in cash (bank deposits)

            If they were offered bank guaranteed RMBS that paid more than TD’s it should appeal to enough many holders. Whether the demand would be sufficient to cover all funding currently sourced overseas is something that is hard to determine, but even half of it would make a difference. It would need to be phased in gradually though.

          • I did say “whatever they cannot finance otherwise”. Your proposal would fall into the “otherwise” category.

  4. Thanks for this article, Deep T. Do you know if there’s been any academic interest in this topic (i.e. research papers)? Or does it just ‘fly under the radar’ in academia as well?

    More generally, do you see any fundamental solution to this risk for small open economies with their own currency? It seems like the alternative (adopting a Euro-style multinational currency) carries its own risks.

    Thanks

    • RATW

      I’m not aware of any academic research but that doesn’t mean there isn’t any.

      I’m highlighting the issue to point out that the $A is not freely floated as is generally perceived because most analysts are mostly concerned about the trade account and forget the balance sheet.

      Lastly, why does manufacturing for instance have to suck it up if there an exporter and the currency goes up but somehow Mega Bank does not have to wear the reverse risk if the currency decreases?

      • It does look like a good argument for the banks to pay an explicit guarantee fee to the Government, for the FX risk that the latter implicitly accepts.