public borrowing in australia. the functions, powers and operation of the australian loan council. ...

7/27/2019 Public Borrowing in Australia. The Functions, Powers and Operation of the Australian Loan Council. 8-1-1993

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PUBLIC BORROWING IN AUSTRALIA

The Functions, Powers and Operationof the Australian Loan Council

8 January 1993


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Table of Contents

INTRODUCTION, SUMMARY AND CONCLUSIONSIntroductionSummaryConclusionsTHE FAILURE OF LOAN COUNCIL QUANTITATIVE CONTROLSLack of optimum resource allocationOpportunity cost of capital investment forgoneIncentive to concealIncentive to use private infrastructureLack of net benefitPURPOSE OF QUANTITATIVE CONTROLSBackgroundProtection from S tate financial mis man agementEffects on other StatesManaging the public sector's call on savingsCoordinating monetary and fiscal policyPressure to improve perfotmance or to privatiseREGULATING STATE BORROWINGNo restrictionsQuantitative controlsEconomic guidelinesAccounting guidelinesMarket based systemsENFORCEMENTAppendices I: Shortcomings of private infrasffucture ffansactionsII: Internationai comparisons

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INTRODUCTION, SUMMARY AND CONCLUSIONSIntroduction

Summary5. In summary:

The effect of Loan Council, as it is currently operated, is to resffict theborrowings of the States, their authorities, and selected Commonwealthauthorities through the application of quantitative borrowing controls.Recently the Commonwealth Government has proposed broadening the scopeof quaniitative controls to cover the entire govemment sector. Under thesenew iurangements Loan Council would cover the total public sectorborrowing requirement ("PSBR") as well as each State's PSBR.Any government intervention in the operation of capital markets createsdisioitions, and the quantitative conffols imposed by Loan Council are noexception. In the early 1980s the quantitative controls imposed on theAustralian banking industry were recognised to be creating distortions whichoutweighed any eConomic benefit. Just as those controls were replaced withmore market driven mechanisms for rationing credit, it is now time to assesshow the Loan Council quantitative controls can be replaced with a moreefficient system.It might be argued that, because States have no shareholders, they are notsubjeit to marlet disciplines. In fact, State governments are subject to marketdisciplines, both through the bond market which sets their borrowing costs,and ultimately through the electoral process which allows their constituents tojudge their overall performance.The establishment of national and State financing arrangements conducive toimproving Australia's economic performance requires the creation of a marketdriven syitem of allocating capital among the States which is more efficientand les s -distortionary than th e bureaucratically determined quantitativecontrols currently administered by Loan Council.

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the current system of quantitative conffols on State borrowings createsa number of identifiable inefficiences in State economies and in thenational economy:it fails to provide any incentive for optimum resourceallocation;


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- there is an opportunity cost of capital investment forgone byStates due to excessively tight borrowing restrictions, and thereis an incentive for States, constrained in their borrowing, tomaintain current expenditure at the expense of capitalexpenditure thereby threatening productivity in the mediumterm;- there is an incentive for States to conceal borrowings, leadingto an uninformed markeq andthere is an incentive for the States to bypass the system entirelyby using "private infrasffucture" transactions which in manycases have a net adverse economic impact.set against these identifiable inefficiencies is a lack of evidence thatLoan Council quantitative controls have created any significant netbenefit;Australia appears to be alone among federations in imposingbureaucratically determined borrowing limits on member states.Accordingly, we have considered why Loan Council might seek suchpowers. We have identified five implicit or explicit objectives ofquantitative controls :

to protect citizens of each State from potential financialmismanagement by their State Government;to prevent financial mismanagement by some States fromaffecting the borrowing costs of other States, taking intoaccount the fact that overseas investors may not differentiatebetween individual States' creditworthiness;to manage the public sector's call on domestic and foreignsavlngs;

to enable the Commonwealth Government to coordinate fiscalpolicy at a national level so that it is consistent with monetarypolicy; andto place pressure on State budgets so as to encourage States to:

run down their holdings of liquid assets ("hollow logs");andseek greater returns from their authorities, oralternatively to privatise them.


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. having considered each of these possible objectives, we find nocompelling argument that they are both required and unable to beachieved without quantitative controls;

. accordingly, we have considered the entire range of mechanismsavailable for regulating State borrowing. We have identified fiveoptions:no resffictions;bureaucratically determined quantitative conffols such ascurrently used by Loan Council;

economic guidelines such as proposed in the Maastricht Treaty;accounting guidelines prohibiting borrowing other than forinvestment (such as used in Germany); andmarket-based measures.

. in relation to enforcement, we consider that Loan Council's ability toenforce its determinations solely by withholding Commonwealthglants to the States may not be workable:those States most likely to be in breach of their borrowinglimits or covenants are also those for which it would bepolitically impossible to cut grants. Indeed, theCommornuealth has actually increased assistance to Victoria inresponse to its economic crisis; andin any event, withholding grants may be politically difficult ifit creates an impression that the Commonwealth Governmentis "interfering" in State affairs.

based on the evidence and arguments set out in this paper, we concludethat:the amount of borrowing by State and Territory governmentsshould be determined by an informed market rather than by anyCommonwealth or Commonwealth-State bureaucracy;


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ffi'Schroders4-the appropriate function of Loan Council is:. to ensure that an informed market in governmentsecurities is maintained;. to apply sanctions to those States or Territories whichfail to maintain an informed market in their securities;and. to apply direct borrowing controls to those States orTerritories which fall below agreed prudential limits asassessed by private sector credit rating agencies.

Conclusion6. Accordingly, we have devised the following programme for reform of LoanCouncil:

monthly disclosure of State net financing and spending on a basisconsistent with the Commonwealth's current monthly statements;. subject to notification procedures discussed below, a generalexemption from borrowing limits granted to:

those States which maintain a credit rating equal to theCommonwealth's foreign debt rating; andthose State-owned enterprises which achieve such a rating.

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

. quantitative borrowing restrictions imposed on those States which losetheir rating or breach other requirements; and

. adoption of accrual accounting in relation to loans (at least as a note toaccounts) to prevent the abuse of zero-coupon and deep discountsecurities as a means of defening recognition of interest expense.


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-5-At present, the credit rating of the States reflects the implicit belief that Stateswould receive some support from the Commonwealth in the event of neardefault. This raises an element of moral hazard in State financialmanagement. To prevent this, the following additional restrictions might berequired:

measures to prevent market signals being masked by governmentaction:- permanent prohibition on the Reserve Bank or CommonwealthGovernment holding State debt securities;- permanent prohibition on market privileges for State debtsecurities (such as the former "30120" rule); andenunciation of Commonwealth policy not to support the debts of Statesor State-owned enterprises.

Alternatively, some States (possibly the smaller ones) may prefer to borrowthrough the Commonwealth or with an explicit Commonwealth guarantee. Insuch 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 theCommonwealth.In order to create an incentive for States to exercise due diligence inforecasting their total borrowing requirements, we propose the followingnotification and commitment mechanism:

States satisfying the minimum credit rating requirement would bepermitted to borrow up to the annual amount previously notified to theCommonwealth; andto discourage the States from submitting ambit claims for borrowing, afinancial penalty would be payable on the shortfall between notifiedborrowings and actual borrowings. This would be analogous to thecommitment fee payable to private sector banks on undrawn loanfacilities. (Overdrawings might also be allowable subject to similarpenalties.)

We draw attention to the conffast between this approach and the quantitativeconffols. Whereas quantitative conffols gives States an incentive to concealborrowings or to bypass the system with-"private infrastructure" transactions,the market system provide States with an incentive to maintain a high creditrating and an informed market by:

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rewarding them with the flexibility to borrow as required; and


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,ffi,Schroders-1-THE FAILURE OF LOAN COUNCIL QUANTITATIVE CONTROLS11. 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 toexcessively tight borrowing restrictions, and the incentive for States,constrained in their borrowing, to maintain current expenditure at theexpense of capital expenditure thereby threatening productivity in themedium term;the incentive for States to conceal borrowings, leading to anuninformed market; andthe incentive for the States to bypass the system entirely by using"private infrastructure" transactions which in many cases have a netadverse economic impact.

Lack of optimum resource allocation12. Because the aliocation of capital among the States is not based on economicreturns or ability to service debt, Loan Council's quantitative controlscontribute nothing to the efficient allocation of resources.Opportunity cost of capital investment forgone

Not all public sector borrowing is "bad". State governments must borrow tofund the public works required for any economic activity to proceed. Wecomment in greater detail below on "good" borrowing and "bad" borrowing.It is enough to note here that, if Loan Council quantitative conffols prevent ordelay productive public works, this will represent an opportunity cost to theeconomy. Prospects for accelerating productivity growth, and henceimproving Australia's productive potential, will be undermined.The distorlions caused by quantitative conffols rnay be much worse if Statesseek to maintain current expenditure within a tight borrowing limit. This maylead to a severe reduction in public sector investment in order to maintaincurrent expenditure on borrowed money. Indeed, whenever economies enter acyclical downturn with a borrowing cap in place, this is a virtually inevitableoutcome as cyclical stabilisers begin to impact on current expenditure andreceipts. This is supported by experience at both State and Commonwealthlevels in recent years.

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

In today's deep and liquid debt markets, with private sector rating agenciescontributing to a more sophisticated view of the relative merits of variousissuers, a regulatory framework providing for full disclosure of the financingarrangements of government borrowers (along the lines of the Commonwealthmonthly statement of financial transactions) should be a priority of reform.Incentive to use " private infrastructure"

States subject to quantitative controls have an incentive to bypass LoanCouncil entirely by entering into "private infrastructure" ffansactions. In thosecases where such transactions are driven mainly by a desire to bypass thequantitative controls, they tend to do little to promote private sector marketdisciplines and in many cases it is likely that they cause net adverse economicconsequences.The adverse effects of "private infrastructure" transactions are set out atAppendix I.

Lack of net benefitSet against these readily identifiable failures of quantitative conffols, there is alack of evidence that quantitative controls have created any significant netbenefit. Indeed, in recent years, all but two State governments have had theirdomestic credit rating downgraded and the Commonwealth's own foreigncurrency credit rating has been downgraded twice.This might be interpreted as an argument for broadening and tightening theLoan Council arrangements. However, this is a typical ex-post defence of asystem which has failed. It would need to be demonstrated by thoseadvocating broadening and tightening that it would work without giving riseto other distortions. (Such as an increasing reliance on private infrasffuctureffansactions)It would be preferable to crcate a system that is not prone to distortions, as hasbeen done with the private sector financial system.

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-9-PURPOSE OF QUANTITATIVE CONTROLSBackground

Australian appears to be alone among federations in imposing bureaucraticallydetermined borrowing lirnits on the member states. It is therefore reasonableto question why Australia requires Loan Council to perform this function atall.Before 1929 the six State governments and the Commonwealth each raiseddebt independently. It is well known that Loan Council arose out of a beliefthat this competitive approach raised interest rates in the small capital marketswhich then existed. However, Ausfalian and international capital marketshave developed considerably in the past sixty years. Since the floating of theAustralian dollar in 1983, and the removal of controls on capital flows,Australia has effectively been integrated into international financial markets.

24. Furthermore, in these more highly developed capital markets the AustralianStates are small but not insignificant players. We have presented at AppendixII a comparison of Australian State economies with other world economiesand United States economies based on 1989 Gross Domestic Product("GDP").In terms of its 1989 GDP, New South Wales would rank as the 15th state ofthe union if it were a member of the United States (lying between Indiana andMissouri). Victoria would be the 23rd state (lying between Louisiana andAlabama) and Queensland would be the 31st state (lying between Kansas andthe District of Columbia).Ontario and Quebec respectively contribute 42Vo and23Vo of Canada's GDP.New South Wales and Victoria (which respectively contribute 357a and277oof Ausralia's GDP) would rank as the third and fourth largest provinces ofCanada ahead of British Columbia. Queensland, Western Ausffalia and SouthAustralia would be the fifth, sixth and seventh largest provinces (lyingbetween Alberta and Manitoba).

Compared with our regional competitors, New South Wales is considerablysmaller than South Korea, but larger than Indonesia. Victoria lies betweenSouth Africa and Thailand while Queensland lies between the Philippines andNew Zealand.Compared with smaller European countries, New South Wales is smaller thanDenmark but larger than Norway. Victoria lies between Norway and Greecewhile Queensland lies between Portugal and Ireland.

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-10-In considering these international comparisons, it might be noted that:

each of these comparable states and countries borrow in their ownname, apparently without unacceptable consequences; andin managing their economies and their public sector budgets they arenot subject to the distortions created by externally imposedquantitative controls on their borrowings.

30. Given these developments, it appears that the original function of LoanCouncil may no longer be valid. In its place a number of other implicit orexplicit functions have been suggested. We have identified five possibleobjectives:

to protect citizens of each State from potential financialmismanagement by their State Government;to prevent financial mismanagement by some States from affecting theborrowing costs of other States, taking into account the fact thatoverseas 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 fiscalat a national level so that it is consistent with monetary policy;to place pressure on State budgets so as to encourage States to:

run down their holdings of liquid assets ("hollow logs"); andseek greater returns from their authorities, or altematively toprivatise them.

Protection from State financial mismanagementThe appropriate role of the Commonwealth in overseeing the States'financialmanagement depends on political views regarding the roles of theCommonwealth and State Governments in general. This is influenced by thefollowing factors:

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

policyand

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the Australian federal system does not have any formal principle of"subsidiarity" (such as exists in the European Community) whichmight resolve issues of control; andin the absence of such a principle, it is to be expected that each level ofgovernment will exercise whatever instruments it has available toassert its conffol, unless mechanisms can be put in place to manage therisk without active intervention.

We note that based on their current credit ratings, the Australian States appearto be prudently managed by world standards.All Australian States other than Victoria have a Moodys credit rating of Aa2on foreign currency liabilities. This is the maximum possible for a State dueto Australia's national rating of Aa2 on foreign currency liabilities. In threecases the State rating might have been higher but for this national limit:

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New South WalesQueenslandWestern Australia

Victoria's rating is A1

Foreign currencyAa2Aa2AaZDomestic currencyAaaAaaAa1

The majority of the states of the United States which have a rating for generalobligation bonds are rated Aa which corresponds to the Aa2 ranng of theAustralian States. States with the lower A1 rating include Michigan,Pennsylvania and West Virginia. New York, Louisiana and Massachusettshave still lower ratings.Canada currently lias a national rating of Aaa (although it is currently underreview for possible downgrade). This high national rating has enabled twoprovinces - Alberta and British Columbia - to achieve a rating of Aal.Ontario has a rating of AaZ while Manitoba and New Brunswick are rated A1.In western Europe, most countries are rated Aaa or Aal. Countries with arating of Aa2 include Finland and Spain. Portugal has a rating of A1.In Asia, the rating of Australian States (other than Victoria) is exceeded onlyby Japan. New Zealand and Singapore have ratings of Aa3 while Korea has arating of A1.Given that the Australian States appear to have maintained reasonably goodcreditworthiness by international standards, it would appear possible to createmarket oriented mechanisms based on credit ratings that can manage the riskof economic mismanagement without introducing the distortions caused byquantitative controls. These are discussed in greater detail below.

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-12-Effects on other States

As noted above, the original belief which led to the formation of LoanCouncil in the 1920s was that the Australian States were too small andinsignificant to borrow in their own right without paying excessively highinterest rates. A related argument is that a deterioration in the credit quality ofone State might affect the borrowing costs of others. However:

as noted above, the Australian States are by world standardsmoderately large economic entities;Loan Council quantitative controls do not insulate States from oneanother. Following Victoria's recent downgrading financial marketsfocussed on the possibility of further downgradings for South Australiaand Tasmania. Their borrowing costs have risen accordingly; andwe do not envisage any substantial adverse change under a marketdriven approach. The fundamental determinant of a State's borrowingcost will be its creditworthiness. A high level of creditworthiness willbe required to qualify for exclusion from quantitative controls.

Managing the public sector's call on savingsAt the macro level the rationale for reducing public sector borrowing lies inconcerns over the adequacy of national savings and consequent implicationsfor Australia's external and internal balance: that is the relationship betweendomestic saving and external borrowing.A deterioration in the public sector's savings performance early in the 1980s isheld partly responsible for persistent current account deficits, and thesubsequent accumulation of foreign debt, over the decade (see Edey andBritten-Jones, 1990, and Tease, 1990). At their most simplistic level, thesearguments are embodied in the so-called "twin deficits' theory" which suggeststhat an improvement in the public sector's savings performance will producean identical improvement in the extemal balance.

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Four points are to be made in relation to establishing a public sector savingtarget as a national objective:Professor Pitchford's work, and subsequent and prior work by othersincluding Fahrer and Corden, have convincingly argued thatAustralia's preoccupation with its external balance, and consequentlywith aggregate natibnal saving, is misplaced as long as borrowing isundertaken to finance productive investment. To this end, a currentaccount deficit resulting from high productive investment expendituremay be viewed as "good" since investment will produce a futureincome sffeam sufficient to meet principal and interest on loans. Acurrent account deficit resulting from high consumption expenditurefinanced by borrowings is viewed as "bad" since there is no futureincome sffeam to meet debt obligations. Rather, in this instance,higher borrowing costs can only be met either by borrowing more orby lowering living standards in the future. A body of empiricalevidence suggests that much of the borrowing in the 1980s went intoproductive investment;the notion of "good" and "bad" current account deficits can equally beapplied to public sector borrowing. Edey and Britten-Jones note thatAustralia's-fiscal balance was restofed to surplus over the latter half ofthe 1980s at the cost of much lower levels of public investment. TheCommonwealth's increased contribution to savings was primarily theresuit of reducing payments to States, from asset sales, from reducedtransfer payments in a cyclically strong economy (helped by improvedbenefit targeting), the Commonwealth/State debt switchl, one-offalterations to the timing of tax collections, and finally by cuts inCommonwealth capital spendin g.States have reacted to cuts in their grants and borrowing limits byreducing capital spending. Indeed, Edey and Britten-Jones note thelargest reductions in expenditure on goods and services were made atthe State and local level. They go on to note that:

"the decline in the relative provision of public sector capitalmay have a detrimental long term effect on aggregateproductivity."This point has also been made by Aschauer (1989) and Barro (1989) inthe United States. If public sector savings come at the cost ofinfrastructure projects with high economic returns, and hence areduction in economic productive potential, they may lead to highercurrent account deficits for any given level of GDP in the medium tolong term.

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

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There is a considerable element of concern in recent debate that thismay in fact be the case in Australia. While EPAC found littleevibence of generalised underinvestment in infrastructure in its 1988report, this r-port predates the budget Sffesses and economic slowdownof tgg\-gZ. Mosfeconomists now recognise the need for an adequateand efficiently run infrastructure base as a prerequisite for improvingAusffalia's longer term economic performance;national economic policy has three objectives in this regard:- to achieve a desired balance between government consumptionand investrnent spending;- to achieve adequate public investment in infrastructure at theaggregate level; and- to ensure an efficient allocation of funds on a sectoral orproject basis;using an arbitrary mechanism such as Loan Council's quantitativecontrols to achieve these objectives is as likely to produceunderinvestment as overinvestment on a sector basis or in aggfegate.It will do little in the short term to influence government decisions onpublic consumption. While the impact of overinvestment hasimmediate implications for the current account deficit, theconsequence of underinvestment may only become obvious in themedium term but the effect is just as insidious.

44. In summary:public sector savings rose over the latter half of the 1980s. WhileLoan Council's quantitative controls played a role in securing thisresult, its task was made easier by a cyclically strong economy;the rise in public sector saving did not lead to a similar improvementin Australia's external balance. Indeed, the current account balanceactually improved as public saving deteriorated from 1'990;to the extent that the improvement in public saving resulted from acurtailment of public infrastructure investment, there is the possibilitythat it may in fact result in a relatively higher culrent account deficit inthe medium term. In short, the quality of the public sector'scontribution 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 themedium term. To increase the rate at which savings grow, andtherefore the rate at which the economy may grow without causing adeterioration in the external balance, requires a significantimprovement in Australia's productivity performance. To a significantextent this will depend on the effectiveness of public and private sectorinvestment decisions; and

. the rationing device for capital investment must be commerciality(where applicable) rather than some artificial or non-market constrainton funding such as that imposed by quantitative controls. This is trueof both the public and private sectors.45. We believe that the market-oriented mechanisms discussed below are morelikely to achieve an efficient rationing and allocation of capital than thecurrent quantitative controls.Co-ordinating monetary and fiscal policy46. In Australia, the Commonwealth has responsibility for national and macro-economic policy. The Commonwealth has sole conffol of monetary policythrough the Reserve Bank. It is valid to ask whether the Commonwealth'scontrol of fiscal and monetary policy requires it to have quantitative conffol ofState borrowings.47. We note the following in relation to this point:

. such quantitative controls are not required by the central governmentsof other federations suggesting that state fiscal policies in thosefederations do not undermine national fiscal objectives;

. such a view also assumes that there is a real danger that Stategovernments would pursue fiscal policies which tend to undermineCornmonwealth fiscal policy and, given the relative sizes of the Statesand the credit rating limits proposed under a market system, would infact do so;

. even with quantitative controls in place, States could (if they were soinclined) continue effectively to borrow through "privateinfrastructure" fran sactions ;

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

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


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

Pressure to improve performance or to privatiseTight borrowing restrictions may put pressure on State governments toimprove 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 byraising prices; andunder current Commonwealth income tax arrangements, the Stateshave a financial incentive to privatise businesses with minimal ffansferof risk to the private sector. This tends to give rise to the "privateinfrastructure" arrangements described above and at Appendix I. Sucha-rrangements rarely transfer investment decision making to the privatesector and therefore do little to increase private sector disciplines in theallocation of capital.

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REGULATING STATE BORROWING50. We identify five methods of regulating State borrowing:

o ro restrictions;. bureaucratically determined quantitative conffols such as currentlyused 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 restrictions51. Other federations cope without an institution like Loan Council, so it is notinconceivable that the institution could simply be abolished without netadverse consequences.52. However, before proposing such a radical change, it is valid to questionwhether institutional arrangements which work in large federations such as theUnited States or confederations such as the European Community are suitablefor Australia. In particular, because Australia is a relatively small participantin international capital markets, the poor performance and creditworthiness ofsome States may affect the borrowing costs of other States and theCommonwealth (although, as noted earlier this has already occurred inAustralia even with quantitative conffols in place).Quantitative controls53. Loan Council currently operates on the basis of quantitative controls. Thejustification for this system rests on the twin assumptions:

. that such controls need to be imposed in order for the Commonwealthto discharge its responsibility in relation to the conduct of nationaleconomic policy; and

. that the bureaucracy charged with administering the system hassufficiently good judgement in relation to appropriate borrowing limitsto produce net beneficial consequences from this approach.


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As noted earlier, it is easy to identify the adverse consequences of quantitativecontrols. These clearly identifiable adverse consequences increase the burdenof proof on those advocating such controls to demonstrate both the need forthem and the ability to set them appropriately. A review of the historicalperformance of Loan Council suggests that this will be difficult.Economic guidelines55. Instead of rigid quantitative conffols, the Maastricht Treaty for EuropeanEconomic and Monetary Union proposes a system of flexible guidelinesrelated to economic indicators. In summary, these are:

inflation within I.5Vo per annum and interest rates within ZVo petannurn of the three best performing states;a budget deficit less than 3Vo of GDP; anda national debt less than 607o of GDP.

It is worth noting that few of the European nations (and not Germany) wouldcurently meet these requirements. In Australia the Commonwealth would failto satisfy the budget deficit requirement.Bishop (1990) has suggested an additional minimum average maturitycovenant. As the maturity of a debt portfolio shortens, the risk of a suddenliquidity crisis rises. The risk of a liquidity crisis is difficult for markets toprice. Although the level of debt may be acceptable, if the structure is poor itmay prove impossible to refinance in the short-term. Accordingly, Bishopproposes that government borrowers be required to maintain minimumaverage rnaturities of debt portfolios.Such an approach gives member states greater flexibility to manage theiraffairs.frorn year to year while preventing borrowing which is clearlyexcesslve.

Accounting guidelinesUnder Gennan law each Land has the power to determine the amount of itsborrowings, as well as access to several sources of taxation revenue.Article 109 of the federal constitution provides for federal legislation:

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_19_for explicit controls on the maximum amount of borrowings byterritorial entities (G ebietskoerperschaften) ; andfor L[nder to maintain minimum interest-free deposits at theBundesbank.

However, such legislation requires the consent of the Bundesrat whichcomprises Liinder representatives.In addition, the federal constitution, and the constitutions of some Liinder,contain accounting constraints on government borrowing. Article 115 of thefederal constitutional provides that "revenue obtained by borrowing shall notexceed 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 toborrow for productive investment while preventing borrowing to coverrecurrent costs.However, we see a nurnber of issues which would need to be addressed:

definitions of both "borrowing" and "investment"; andgiven the likely vagueness of such definitions, the mechanisms toquickly identify and act against a State in breach of the guidelines.

Market based systems

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63.

64. Since Loan Council was originally devised sixty years ago both the Australianand intemational capital markets have become much deeper and moresophisticated. Credit rating agencies maintain ratings on the borrowings ofeach of the Australian States. These support an independent view ofindividual States' merits as borrowers. In an environhent characterised by afull and tirnely flow of inforrnation on States fiscal positions, the relativeimportance of credit rating agencies in determining a consensus view of aState will, paradoxically, be diminished.Accordingly, we envisage a package of market based measures could beadopted to replace Loan Council quantitative controls:

monthly disclosure of State net financing and spending on a basisconsistent with the Commonwealth's current monthly statements;

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_20_subject to notification procedures discussed below, a generalexemption from borrowing limits granted to:

those States which maintain a credit rating equal to theCommonwealth's foreign debt rating; andthose State-owned enterprises which achieve such a rating.

adoption of a minimum averago maturity covenant on outstanding debtto minimise liquidity risk which is not easily priced by the market;quantitative borrowing restrictions imposed on those States which losetheir rating or breach other requirements; andadoption of accrual accounting in relation to loans (even as a note toaccounts) to prevent the abuse of zero-coupon and deep discountsecurities as a means of deferring recognition of interest expense.

At present, the credit rating of the States reflects the implicit belief that Stateswould receive some support from the Commonwealth in the event of neardefault. This raises an element of moral hazard in State financialmanagement. To prevent this, the following additional restrictions might berequired:

measures to prevent market signals being masked by governmentaction:permanent prohibition on the Reserve Bank or CommonwealthGovernment holding State debt securities;permanent prohibition on market privileges for State debtsecurities (such as the former "30120" rule); and

enunciation of Commonwealth policy not to support the debts of Statesor S tate-owned enterprises.Alternatively, some States (possibly the smaller ones) may prefer to borrowthrough the Commonwealth or with an explicit Commonwealth guarantee. Insuch 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 theCommonwealth.

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-2t-In order to create an incentive for States to exercise due diligence inforecasting their total borrowing requirements, we propose the followingnotification and commitment mechanism:

States satisfying the minimum credit rating requirement would bepermitted to borrow up to the annual amount previously notified to theCommonwealth; andto discourage the States from submitting ambit claims for borrowingwe propose a financial penalty which would be payable on the shortfallbetween notified borrowings and actual borrowings. This would beanalogous to the commitment fee payable to private sector banks onundrawn loan facilities. (Overdrawings might also be allowablesubject to similar penalities.)

We draw attention to the contrast between this approach and the quantitativecontrols. Whereas quantitative confiols gives States an incentive to concealborrowings or to bypass the system with "private infrastructure" ffansactions,the market system provide States with an incentive to maintain a high creditrating and an informed market by:rewarding them with the flexibility to borrow as required; andpenalising them for poor forecasting of their borrowing requirementsthrough the commitment fee.

69.


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,ffit Schrodersaa

69.

70.

17.

12.

73.

14.

ENFORCEMENT

. in any event, withholding grants may be politically difficult if itcreates an impression thiithe Commonwealth Government is"interfering" in State affairs.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 resffainb;;;;iltr. In the ""i"t of a d'owngiading below the.agreed minimum limit,if-t" Co-fronwealth could then interiene to exercise direct control over theSiut"'r economic policy in general and borrowings in particular.This approach is similar to that used by the Intemational Monetary Fund at anationii level: countries which fail to achieved an agreed-standard ofcreditworthiness must submit to external intervention in their economies ifthey are to qualify for further financial assistance'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

should only be used after an independent adjudicator (such as a ratingagency) has found against the State in question'

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 acreditworthiness aspect, this State was least in needbf a borrowing resffiction'In practice, it may simply not be-pos-1ible to consffuct a credible enforcementmechanism 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.eduiriSt-." to Victoria in response to its economic crisis; and


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,&d,Schroders-23-

75. Withholding grants would continue as the penalty for failure to maintainminimum maturitY covenants.

8 January 1992 Brett AllenderChief EconomistSteohen MorrisInv'estment Banking Divi sion


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ffi'schroders

1.

,)

APPENDIX IShortcomings of private infrastructure transactions

States facing quantitative conffols have an incentive to enter into privateinfrastructure transactions. Under current Commonwealth taxationarrangements they also have an incentive to transfer minimal risk to theprivate sector under such arrangements.The terms of such transactions vary widely, but they commonly have twocharacteristics:

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 suchtechniques as guaranteed purchase ofproduct.Particularly in those cases where private infrasnucture transactions are aimedprimarily at bypassing Loan Council consffaints, they may contribute little tothe application of market disciplines to public works. The main disadvantageof such transactions are as follows:

decisions on the scale and timing of investment are still made by theState so there is no conffibution to dynamic efficiency. Indeed,investment decisions may be made worse. There is some evidence ofcertain public works projects being promoted simply because they canbe funded outside Loan Council.prices are determined by conffact or according to indexation formulaerather than being set by market forces, so there is little conffibution toallocative efficiency;

the conffacts often grant the private operator an unregulated monopolyconcession for 20 or 30 years. This constrains the operation oftheprice mechanism and reduces the flexibility to respond to changingconditions. For example, a private concessionaire facing increaseddemand and income has an incentive to take the extra profit as a higherdividend 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

J.


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& Schnoders-2-the high level of financial sffucturing necessary to minimise thetax burden.

While cost of capital may not be a concern in a closed economy, it isrelevant for an individual State if the investment funds come frominterstate, or for the counffy as a whole if the investment funds comefrom overseas;. the tendering process for such projects is time consuming, costly andcannot be relied on to provide the best results; and. the arrangements are not ffansparent. The conffacts are usuallyconfidential. As a result:

they do not engender public confidence; and

they do not provide the sort of yardsticks or stock market rate-of-ieturn daia which can be used by regulators to set prices forthe natural monopoly components of utilities.


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,&5'Schroders

APPENDIX IIInternational comparisons

INTRODUCTION1. This Appendix compares the Australian States with other counffies and withthe States of other federations in terms of:

Gross Domestic Product ("GDP"); andMoody's Credit Ratings.

GROSS DOMESTIC PRODUCT2. We have compared the Australian States and Territories with:

. states and territories of the United States;

. Canadian provinces;western European counffies; and

. other counffies.3. Sources of information for this comparison are:

. Ausralian Bureau of Statistics. 1990-91 Australian NationalAccounts: State Accounts (ABS5220.0) This has been used to provideGDP at market prices by State and Territory for 1989190.

. US Departrnent of Commerce, Bureau of Economic Analysis. SuJYeyof Current Business. December 1991. This has been used to provideGross State Product ("GSP") for 1989.

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


29/48

, i Schroders

4.

5.

6.

7.

8.

Statistics Canada. Canada Business Facts 1992. This presents GrossProvincial Product for 1990.Both the Australian GDP and United States state and territory GSP figureshave been adjusted according to the United Nations international comparisonsto give comparable figures in United States dollars. The process ofadjustment is set out in the accompanying tables.In terms of its 1989 GDP, New South Wales would rank as ttre 15th state ofthe union if it were a member of the United States (lying between Indiana andMissouri). Victoria would be the 23rd state (lying between Louisiana andAlabama) and Queensland would be the 31st state (lying between Kansas andthe District of Columbia).Ontario and Quebec respectively contribute 42Vo and23Vo of Canada's GDP.New South Wales and Victoria (which respectively contribute 35Va and2TVoof Australia's GDP) would rank as the third and fourth largest provinces ofCanada ahead of British Columbia. Queensland, Western Australia and SouthAustralia would be the fifth, sixth and seventh largest provinces (lyingbetween Alberta and Manitoba). Tasmania, the ACT and the NorthernTerritory are all larger than the tiny Prince Edward Island (which has apopulation of 130,0-00 and a gross provincial product of less than US$2billion).Compared with our regional competitors, New South Wales is considerablysmaller than South Korea, but larger than Indonesia. Victoria lies betweenSouth Africa and Thailand while Queensland lies between the Philippines andNew Zealand.Compared with smaller European countries, New South Wales is smaller thanDenmark but larger than Norway. Victoria lies between Norway and Greecewhile Queensland lies between Portugal and Ireland.

MOODY'S CREDIT RATINGS9. We have compared the Australian States with:

states of the United States;

Canadian provinces;

western European countries; and

Asian countries.


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'&d'Schroders10.

-3-The Moody's rating system is summaried below:

Highest

Lowest

New South WalesQueenslandWestern AustraliaVictoria's rating is Al

Normal ratingAaa

BaalBaa2Baa3

Foreign currencyAa2AAAa2

US StatesAaa

BaalBaaBaa

Domestic currencyAaaAaaAa1

Aa1AaAaA1AA

Aa1Aa2Aa3A1A2A3

11. All Australian States other than Victoria have a Moody's credit rating of AaZon foreign currency liabilities. This is the maximum possible for a State dueto Australia's national rating of Aa2 on foreign cuffency liabilities. In threecases, the State rating might have been higher but for this national limit:

12.

13.

t4.

The majority of states of the United States which have a rating for generalobligation bonds are rated Aa which corresponds to the Aa2 raing of theAustralian States. States with the lower A1 rating include Michigan,Pennsylvania and West Virginia. New York, Louisiana and Massachusettshave lower ratings.Canada cuffently has a national rating of Aaa (although it is currently underreview for possible downgrade). This high national rating has enabled twoprovinces - Alberta and British Columbia - to achieve a rating of Aal.Ontario has a rating of Aa2 while Manitoba and New Brunswick are rated A1.In western Europe, most countries are rated Aaa or Aal. Countries with arating of Aa2 include Finland and Spain. Portugal has a rating of A1.In Asia, the rating of Australian States (other than Victoria) is exceeded onlyby Japan. New Zealand and Singapore have ratings of Aa3 while Korea has arating of A1.

15.


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ffi'Schroders

Australian Gross State Products

ABS State Data UN NationalDatar.989/90 GSP

US$millionState

New South WalesVlctonaQueenslandWestem AustaliaSouth AustraliaTasmaniaACTNorthem TerritoryABS TotalUN estimateDiscrepancy

1989/90 GSPA$million129734101076558673751827693790870693940

370805312172

13670.37Vo

AdjustedState Data

1989/90 GSPUS$million1001637803743t33289662138r610554583442

286286


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ffi SchrodersUnited States Gross State Products

State

CalifomiaNew Yo*TexasIlli-ccisPennsylvaniaFloridaOhioNew lerseyMchiganMassachusettsVirginiaNorth CarolinaGeorgiaIndianaMissouriMarylandWashingtonWisconsinMinnesotaTenneseeConnecticutl,ouisianaAlabamaColoradoKentuckyArizonaSouth CarolinalowaOklahomaOregonKansasDistrict of ColumbiaMississippiArkansasNebraskaUtahNevadaWest VirginiaHawaiiNew MexicoNew Hampshirelv{aineAIaskaRhode IslandIdanoDelawarelr{onlaaaVermontNorth DakotaSouth Dakota\\'r'omingDep of Commerce TotalL\ E,srimateD.crcpancy

Department of CommerceState Data1989 GSPUS$mllllon

697381441068340057256478227898226964211541203375181821t44791136497130085129776105314100081

990'1496233939789355992267888637S13867886661 806585865306601 50525745234252118488293936338135371693lll528135279602',7922257 55254142450423474195821 8807l 6339154181310411502I 12311113511115

51646695l 32000

-32669-0.63%

LIN NatlonalData1989 GSPUS$milllon

AdJu$edState Data1989 CSPUS$mllllon

692970438278337906254856226456225528210205202089180677143875l?563412926212895510464899448984479562493384929679168388301786376745765761654416489359770522415201 15178848520391 l437894369343091 82795727',l832774525592252532434923326I 94581868816236153201302111429111601 r06511045

51 32000r 32000


33/48

&'schroders

State

CalifomiaNew YorkTexasIllirnisPerrrsylvaniaFlori4sOhioNew ierseyMichiganMassachuseffsVirginiaNodh CamlinaGeorgiaIndianaNew Soutb WalesMissouriMarylandWashingtonWisconsinMinnesotaTenneseeConnecticutl-ouisianaVictoriaAlabamaColoradoKentuckyArizonaSouth CarolinaIowaOklahomaOregonKansasQueenslandDstrict of ColumbiaMississippiArkansasNebraska\ilestern AustraliaUtahNevadaWest VirginiaHawaiiNew MexicoNew HampshireMaineSouth AustraliaAlaskaRhode IslandIdahoDelawareMontanaVermontNorth DakotaSouth DakotaWyomingTamraniaACTNorthern TerritoryUnited States Total

Australian and USState and Territory 1989 GSP

1989 GSPUS$mllllon692970438n83379M25485622f/.5622552821020520208918067714387513563412926212895510498100163

9944898M79562493384929679r68388301786377W37674576576t654416489359770522415201 I517884852043133391r43'7894369343091828966279572'1783n745255922525324349233262138119458I 8688162361532013021rt42911160l 106511045610554583042

5 132000

Rank

I)3456789

10111tl314

15t6t71819202l,,'23242526n28293031

32JJ3435365t3839404142434445464748495051


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,&ll' Schroders

Canadian Gross State Products

ProvinceOntarioQuebecBritish ColumbiaAlbertaManitobaSaskatchewanNova ScotiaNew BrwrswickNewfoundlandPrince Edward Island

Statistics CanadaProvincial Data1990 GSPC$million28l2l0t5't2lo

8108571203239902c4941691613187

87322001

UN NationalDatar.989 GSPUS$million

AdjustedProvincial DataImputed 1989 GSPUS$million

223896r25r695r''559566911910i1631713468t049969521593

6't6028 538245 538245

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


35/48

ffi'Schroders

Australian and Canadian Gross State Products

StatelProvinceOntarioQuebecNew South WalesVictoriaBritish ColumbiaAlbertaQueenslandWestern AustraliaSouth AustraliaManitobaSaskatchewanNova ScotiaNew BrunswickNewfoundlandTasmaniaACTNorthern TerritoryPrince Edward Island

1989 GSPUS$million2238961251691001637803764s595669r43133289662138119101163r713468r049969526105545830421593


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& SchrodersAustralasia, Asia, South Africa

1989 GSP

State

JapanChinaIndiaKoreaNew South WalesIndonesiaSouth AfricaVictoriaThailandHong KongPhilipprnesQueenslandNew ZealandMalaysiaWestern AustraliaSingaporeSouth AustraliaTasmaniaACTPNGNorthern Territory

1989/90 GSPUS$million2868442

3453952733142t1864100163939668943578037696816289t44424431334105037606289662765521381

6105545833493042


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ffi'Schroders

Australian and European1989 GSP

StateGermanyFranceItalyUnited KingdomSpainNetherlandsSwedenSwitzerlandBelgiumAustriaFinlandDenmarkNew South WalesNorwayVictoriaGreecePortugalQueenslandIrelandWestern AustraliaSouth AustraliaLuxembourgTasmaniaACTNorthern Tenritory

1989/90 GSPUS$millionrt1662t955175865819853r273802M225895191298tgrt25152992126775115232106303100163902897803754r774527143I3334170289662L3877018610554583042


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Australian and US State and Territory1989 Gross State Products

ffi US statcsIt-acr trIseffirvlffiQ,*u"aI vi.r"titlNsw

700000600000

smooou? 400mDa 3oooooS zoooooo\

r00000

s i i = Fn' f ei sg tu i E 3gi l s g s ! s E $ g' 3 Es 3f g* 3 3 =E 3* f $* 3 * $ t i s s g t 33' g

'ffi'Schroders


39/48

Australian State and Canadian Provincial1989 Gross State Products

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

@CnpCno\aog\

r50000

r00000

!!dkx!;F?EJEZ^?ETiE'E3Ezif z2 EzE-U.E.XEe.:EE6-d9=9.qeE9t&z::rfriiEAZ&E-t>,frTo-za

' '


40/48

Australia, Asia, Oceania, SouthAfrica 1989 Gross State Products

^ 400000E ssooooA 3000mpp zsoooofi zoooooq)cE 150OOOrhV)g 100000c\ 5000000o\

0* fi ,E .E E P C E E r .E P .! .r F (" .'.6e*tco4 o.r i t : $ i t"s 6 s f E $8e27. iE'r*${Eu';F;8qEtiEtrot,oa{z>2

ffi'schroders


41/48

Australian and European 1989 Gross State Products

;. 200000d4 rs0000(nDA rooooo0loo\Ft 50000

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


42/48

&'SchrodersAustralian and United StatesCredit Ratings

Stat Moodyrs RatingAaaAaaAaaAaaAaaAaaAaaAaaAaaAaaAa1Aa1AazA^2Aa2A^2A^2

AaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaAaA1AiA1A1A

BaalBaa

GeorgiaIllinoisMarylandMissouriNew JerseyNorth CarolinaSouth CarolinaTenneseeUrahVirginiaCaliforniaMaineNew South Wales (1)Queensland (1)South AustraliaWestern Australia (1)TasmaniaAlabamaAlaskaArkansasConnecticutDelawareFloridaHawaiiKentuckyMinnesotaMississippiMontanaNevadaNew HampshireNew MexicoNorth DakotaOhioOklahomaOregonRhode IslandTexasVermontWashingtonWisconsinVictoriaMichiganPennsylvaniaWest VirginiaNew York[nuisianaMassachusettsSources: Moody's. 1992.Note: 1" State foreigr currency credit rating limited byAustralian national loreign currency rating of Aa2.


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ffi'Schroders

Australian and CanadianCredit Ratings

StateAlbertaBritish ColumbiaNew South Wales (l)Queensland (1)South AustraliaWestern Australia (1,)TasmaniaOntarioQuebecVictoriaManitobaNew BrunswickNova ScotiaPrince Edward IslandSaskatchewanNewfoundland

Moody's Rating

Sources: Moody's. Canadian Credit Report March 1992.Note: 1. State foreign curency credit rating limited byAustralian national foreign currency rating of Aa2.

Aa1Aa1Aa,zAa2Aa.zLazA^2AAAa3A1A1A1A2A3A3

Baal


44/48

'ffi'SchrodersAustralian and EuropeanCredit Ratings

StateAustriaFranceGermanyLuxembourgNetherlandsSwitzerlandUnited KingdomBelgiumDenmarkNorwaySwedenNew South Wales (1)Queensland (1)South AustraliaWestern Australia (1)TasmaniaFinlandSpainIrelandItalyVictoriaPortugalGreece

Moody's RatingAaaAaaAaaAaaAaaAaaAaaAa1AalAa1Aa1AazALzAa2Aa2AezAAAa2Aa3Aa3A1A1

BaalSources: Moody's. November 1992. December 1992Note: 1. State foreign currency credit rating limited byAusfalian national foreign curency rating of Aa2.


45/48

&'Schroders

Australasian and AsianCredit Ratings

StatefapanNew South Wales (1)Queensland (1)South AustraliaWestern Australia (1)TasmaniaNew ZealandSingaporeVictoriaKoreaThailandHong KongMalaysiaIndia

Moody's Rating

Sources: Moody's. November 1992. December 1992Note : 1. State foreign curency credit rating limited byAustralian national foreign currency rating of Aa2.

AaaAa2AazL^2Aa.zAazAa3Aa3A1A1A2A3A3

Ba2


46/48

&'schrodersBIBLIOGRAPHY

D A Aschauer Does Public Capital Crowd Out Private Capital Journal of MonetaryEconomies, No. 23 1989R J Barro Macroeconomics John Wiley & Sons, New York 1984Graham Bishop Creation of an EC "Hard Money" Union Salomon Brothers.London 1990W M Corden Inflation. Exchange Rates and the World Economy Clarendon Press,Oxford 1977

Economic Planning Advisory Council Economic Infrastructure in AusffaliaCouncil Paper June 1988, Australian Government Publishing Service,CanberraJehrome Fahrer Is Pitchford Right? Reserve Bank Discussion Paper, Ausfaliar990Martin Feldstein The Case Against EMU The Economist.13 June 1992.J D Pitchford Does Australia Really Have a Current Account Problem? EconomicPapers, No. 8, 1989Proceedings of a conferenceThe Australian Macro-Economy In The 1980s

Editor: Stephen Grenville1990, Research DepartmentReserve Bank of Australia

(i) Malcolm EdeyMark Britten-JonesSavins & Investment oase 79 - 158

(ii) Warren TeaseThe Balance of Pavments oase 759 - 221


47/48

,ffi,Schroders

1.

REFORMING LOAN COUNCILSince its creation over sixty years ago, the Australian Loan Council'scontribution to econotnic rnanagement has been undermined by marketdevelopments to such an extent that it must be asked whether it continues toserve ahy worthwhile purpose. Among the major federations, Australia standsalone in trying to impose quantitative controls ("global limits") on theborrowings of its member States. The United States, Canada and theEuropeanCommunity have nothing remotely equivalent to quantitative _contrbls. Gerrnany has provision for fiscal coordination, but only with theapproval of the Bundesrat (States' house).In the Australian banking industry, quantitative credit controls were abolishedin the early 1980s when it was recognised that they created distortions in therationing of credit which outweighed any economic benefit. Similarly, it ispossible to identify the inefficiencies created by the system of quantitativeconffols on the States' borrowings:

2.

it fails to provide any incentive or tnechanism for optimum resourceallocation;there is an opportunity cost of capital investment forgone by the Statesdue to excessively tight bor:rowing restrictions, and there is anincentive for the States, constrained in their borowing, to maintaincur:rent expenditure at the expense of capital expenditure therebythreatening productivity growth in the medium term;there is an incentive for the States to conceal borrowings, leading to anuninforrned market; andthere is an incentive for the States to bypass the system entirely byusing "private infrasnuctttro" transactions which in many cases have anet adverse economic irnpact.

J.

4.

Set against these identifiable inefficiencies is a remarkable lack of evidencethat Loan Council's quantitative controls have created significant neteconomic benefit. Indeed, in defending Loan Council's performance as a toolof economic policy, the principal argument appears to be an assertion thatconditions would have been worse under a less controlled system.The recenrly established Senate Select Committee Inquiry into the Functions,Powers and Opelation of the Austlalian Loan Council provides an excellentopportunity to review the perforrnance of bureaucratically determinedquantitative controls in cornparison with a market-based approach tocoordinating public borrowing in Australia.


48/48

'$S,Schroders5. In Schroders' new report Public Borrowing in Australia: The Functions,Powers and Operation of the Australian Loan Council we have set out thebasic framework of a market-based system:

improved disclosure of the States' financial positions;

a general exemption from quantitative controls for those States andState-owned enterprises which achieve a credit rating equal to theCommonwealth's foreign debt rating;for those States which qualify for the general exemption, a notificationsystem requiring them to advise the Commonwealth of forthcomingborrowin g requirements; andfinancial penalties for bomowing in excess of notified requirements orbelow notified requirements (similar to commitment fees on bankfacilities.)

The contrast between this market-based system and quantitative conffols isobvious. Whereas quantitative controls give States an incentive to concealborrowings or to bypass the system with "private infrastructure" fansactions,the malket system provide States with an incentive to maintain a high creditrating and an informed rnarket by:rewarding them with the flexibility to borrow as required; andpenalising them for poor forecasting of their borrowing requirementsthrough 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

6.

public borrowing in australia. the functions, powers and operation of the australian loan council. ...

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