(ISSN 1448-5974) Volume 17 Issue 5 May 2010

European debt crisis concern has been reflected in a significant

increase in the market interest rate being
Concerns over the level of debt held by some paid on Greece Government debt securities.
European nation governments dominated Investors are demanding a higher “risk
financial headlines over May. European premium” to compensate for the risk of non
governments, like most developed economy repayment (i.e. default) of the debt. There
governments, significantly increased has also been a significant fall in the value of
spending and experienced a decline in tax the Euro (the official currency of the
revenue in the period following the Global European Union), as well as declines on
Financial Crisis. However, there are now world stock markets over the past month.
fears that some European nations have built
up debt to unmanageable levels. Stock markets have fallen in response to the
European debt concerns due to fears that
Gross Government Debt as % GDP European economies will have to operate at
160%
a lower level of economic growth. This is
because the tightening of fiscal policy that will
120% be required in many European economies will
80%
detract from economic growth. This will in
turn impact on the earnings of companies
40% with direct, or indirect, exposure to these
economies. There has also been some
0%
concern that the earnings of banks who have
Ireland

Italy
Australia

Greece

Spain

Portugal
United

Kingdom
States
United

lent money to European governments could

be negatively affected if any of the
Source: WEO and IMF estimates for 2010. governments ultimately default on their debt.

As can be seen from the chart above, some In response to the escalating concern over
European nations have built up gross the European debt position, the European
government debt to levels in excess of 80% Union and the International Monetary Fund
of annual Gross Domestic Product (GDP). (IMF) established an emergency loan fund.
Growth in debt to these levels is not just a The European Union announced that the
feature of European nations however, with facility, totaling some 750 billion Euros, will
the chart indicating that the United States provide “assistance to any member state
has a similar level of debt to some of the which is experiencing or is seriously
highly indebted European nations. threatened with a severe economic or
financial disturbance caused by exceptional
However, the fact that economic growth in occurrences beyond its control.”
Europe tends to be lower than in other
regions of the world, has added to the In addition to the emergency loan fund, which
concerns over the position of some European is available to any European Union nation,
nations. A lower economic growth profile the IMF has also approved a 30 billion Euro
restricts the extent to which the government loan directly to Greece. In return, the Greece
tax base naturally increases to provide the Government has had to put in place a
funding required to service debt. program of reforms aimed at restoring fiscal
sustainability and international
Much of the concern over the debt situation competitiveness.
in Europe has been focused on Greece. This

Published by Plain English Economics Pty Ltd. PO Box 522 Jannali NSW 2226, plain.english@bigpond.com
 Q1: Why has the level of government debt in lowering of the debt financing task when
Europe been a greater cause for concern than compared to the expectations of the
government debt in the United States? Government announced in its Budget
Statement last year. The previous forecast
Q2: Describe the types of policies available to
was for a debt level of $188 billion in
governments that may bring about a reduction in
debt. 2012/13.

Australian debt forecast to decline The main mechanism the Government has
available to generate the finance required to
Whilst European governments are being fund its budget deficit is to issue (sell)
forced to contemplate significant changes in Government bonds. By issuing bonds, the
fiscal policy in order to turn around budget Government receives money (effectively a
deficits, the Australian Government has loan) from the buyers of the bonds. The
forecast a relatively fast return to a surplus Government then promises to pay regular
position without embarking on major policy interest and a repayment of the bond
change initiatives. The May Commonwealth principal (the loan amount) on the bond
Government Budget Statement confirmed a maturity date.
projected deficit of $40.8 billion (or 2.9% of
GDP) for 2010/11. Generally, a rise in the supply of bonds
issued by the Government will increase the
Following next financial year, the interest rate that is required to be paid by the
Government does anticipate a rapid Government. This is because more investors
improvement in its budget position. In are required to be enticed to purchase bonds
2011/12 the deficit is expected to contract to meet the larger supply. In this way, the
sharply to $13.0 billion, before returning to a movement in the price or yield on the bonds
small surplus the year after. Underpinning brings about equilibrium between the supply
this contraction in the size of the deficit is an and demand for bonds.
expectation of continued buoyant economic
conditions. Strong economic growth acts to Each series of issue of Government bonds
boost taxation revenues and reduces has a different maturity date so that at any
government expenditure requirements one time there is a range of different
around social security. Government bond yields available - given the
difference in maturity dates. Whilst the
Commonwealth Government Net Debt (% of GDP)
Reserve Bank is able to use open market
20% operations to “manage” the overnight cash
15%
interest rate to a desired level, longer term
interest rates across the economy tend to be
10% heavily influenced by the yields available on
Government bonds (which reflect the “risk
5%
free yield curve” interest rate for various
0% terms of investment).
1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

-5%
Given the recent significant lowering in
forecast government debt and required
Source: 2010/11 Budget Papers. Estimates 2009/10 onwards.
financing activity, there has been a significant
lowering in the expected volume of new
Despite the improvement in the fiscal government bonds required to be issued.
position, the fact that the budget is still With the rise in the supply of bonds now less
expected to be in deficit for the next two than previously anticipated, some pressure
financial years means that the size of the may have been taken off the interest rate
Government’s debt is expected to increase. level that the bonds will need to offer in order
From $42 billion in 2009/10, debt is expected to entice investors to purchase them. This
to jump to $79 billion in 2010/11 (5.6% of may in turn contribute to a decline in the
GDP) and reach $94 billion by 2012/13 (6.0% general level of interest rates across the
of GDP). This represents a significant economy.
Disclaimer: Whilst we attempt to ensure the accuracy of information contained in this publication, no liability is held by the
publishers as a result of any use of the contents of this document. 2
 Commonwealth Government Bonds on Issue ($bn)
$250
$200
$150
$100
$50
$-
2008 2009 2010 2011
Source: 2010/11 Budget Papers & Reserve Bank of Australia
Q3: Explain the difference between the terms
“Government budget deficit” and “Government net
debt”.
Q4: How do governments normally raise money in
order to fund budget deficits?
Q5: What impact, if any, is a lowering of
government debt expectations likely to have on
interest rates?
Please Note: More detail on the Federal Government
Budget Statement is available in a Special Issue of
Plain English Economics. If you have not received this
issue, please email us at info@plain-english.com.au
Monetary policy tightened again
Consistent with the tightening of fiscal policy
described by the Commonwealth
Government in its Budget Statement, the
Reserve Bank has continued its program of
monetary policy tightening. For the third
consecutive month, the Reserve Bank
decided to lift interest rates, with the
overnight cash rate moving from 4.25% to
4.5% in early May.
In announcing the tightening of policy, the
Reserve Bank Board suggested interest
rates paid by borrowers would now return to
“average” levels:-
“With the risk of serious economic contraction in
Australia having passed some time ago, the Board
has been adjusting the cash rate towards levels
that would be consistent with interest rates to
borrowers being close to the average experience
over the past decade or more. The Board expects
that, as a result of today’s decision, rates for most
borrowers will be around average levels.”
Disclaimer: Whilst we attempt to ensure the accuracy of information contained in this publication, no liability is held by the
publishers as a result of any use of the contents of this document.
Consumer spending flat
Possibly due to the program of higher
interest rates, retail spending by Australian
household has been relatively flat over recent
months. Following a 1.3% fall in February,
the value of retail sales in the month of March
rose by just 0.3%. Sales are now only 1.2%
above the level recorded one year ago. With
population growth above 2% per annum and
inflation nearly 3%, the recent retail sales
growth numbers highlight a reduction in real
spending per person.
As can be seen from the chart below, retail
spending was growing more strongly at times
through 2009. However, this growth took
place before the commencement of the
program of higher interest rates. Sales in this
period also benefited from the Government’s
stimulus cash payments.
Retail Trade - Annual Growth
10%
8%
6%
4%
2%
0%
Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10
Source: Australian Bureau of Statistics 8501
The drop off in the growth of consumer
spending is typical of a period of rising
interest rates. Higher interest rates provide
households with more incentive to save,
rather than spend; whilst those households
with loans have to divert more of their
disposable income to interest payments. This
reduces the amount available for
consumption spending.
The combination of subdued consumer
spending, and the fact that the Reserve Bank
has now judged that interest rates on loans
have returned to average levels, may have
reduced the need for further increases in
interest rates in coming months. It is possible
that the Reserve Bank could conclude that
rising interest rates have had the desired
impact on household spending and thereby
taken upward pressure off inflation.
3
 Q6: Explain why consumer spending by
$A / $US Exchange Rate
Australians may have been weak in recent
100
months.

US Cents per A$1

90

Q7: Should the Reserve Bank lift interest rates 80

again June? Why or why not? 70

60

$A comes under selling pressure 50

40

Oct-99

Oct-00

Oct-01

Oct-02

Oct-03

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09
There was a significant fall in the value of the
Australian currency over May. From a month
opening level of United States (U.S.) 93.0 Source: Reserve Bank of Australia
cents, the $A fell to U.S. 81.8 cents in the
third week of May, before recovering Currency depreciation can have a significant
somewhat to be U.S. 85.2 cents at the time impact on local economic conditions. By
of writing (28th May). making exports from Australia cheaper on
world markets, and making imports into
The sudden drop in the value of the Australia more expensive, a fall in the $A will
Australian currency appears to be largely the normally improve the Balance of Trade.
result of the following two factors:- Hence, for exporters, at least some of the
recent fall in commodity prices (i.e. the price
• The concern over the European debt of items such as coal, wheat and metals) is
situation and the expectation that this offset by the impact of the lower value of the
may trigger a lowering in the overall level currency. This improvement in net income
of global economic growth. This from trade can act as a stimulant to
expectation has led to a fall in the level of economic growth by boosting local incomes
commodity prices. As Australia is a large and providing incentive for investment
exporter of commodities, movements in spending in export and import competing
its currency will often be heavily industries.
influenced by movements in commodity
prices. A decline in the value of the currency can
also be inflationary. When the $A falls, the
• The increased likelihood that the Reserve cost of imports into Australia in $A terms
Bank may be approaching the end of its increases. The higher cost of imports can
program of lifting interest rates. The then create higher prices for consumers.
impact of the European debt situation on Higher inflation caused by a lower currency
global economic growth, combined with could lead to additional pressure for higher
local factors such as softer consumer interest rates.
spending, may have reduced the
probability that Australian interest rates
will be increased further. If so, this limits Q8: Provide a possible explanation for the decline
in the value of the Australian dollar over May.
the future profit available to international
investors buying Australian dollars to gain
exposure to rising interest rates in
Australia. Stats on Australia Latest Previous
Year
Economic Growth 2.7% (Year to Dec) 1.0%
The drop in the $A over May followed a Inflation 2.9% (Year to Mar) 2.5%
similar pattern to that set during the period of Unemployment 5.4% (Apr) 5.5%
the Global Financial Crisis. The prospect of Employment Growth 2.2% (Year to Apr) 0.1%
Wage Price Index 3.0% (Year to Mar) 4.1%
falling local interest rates and lower global Exchange Rate (TWI) 67.8 (28th May) 62.5
economic growth saw the $A fall from U.S. Cash Interest Rate 4.5% (May) 3.0%
95 cents to U.S. 65 cents in the year to Current Account Deficit $17.5 bn (Dec Qtr) $7.6 bn
Foreign Debt (% GDP) 51.4% (Dec Qtr) 56.2%
February 2009.
Source: Australian Bureau of Statistics & Reserve Bank

Disclaimer: Whilst we attempt to ensure the accuracy of information contained in this publication, no liability is held by the
publishers as a result of any use of the contents of this document. 4