The new price of money

Wayne Swan looks set for a major disappointment.

He's hoping that removing the government's wholesale guarantee on bank borrowings will not push up the banks' borrowing costs.

And he's warned banks that they'll incur the wrath of the Australian government if they try to use the excuse of higher offshore borrowing costs to jack up local interest rates.

But the Treasurer's move to take away the wholesale guarantee comes just as global bond markets are re-examining the risk premiums they've been charging. And it looks like bond markets have decided to charge riskier borrowers a whole lot more.

The wholesale guarantee was introduced in the bleakest days of the financial crisis to help Australian banks raise offshore funds at a reasonable price.

In exchange for using the guarantee, banks were charged a fee. The big four banks, which enjoy a AA-credit rating, had to pay 70 basis points, while the banks with a single A-credit rating were charged 100 basis points.

Banks raised more than $150 billion using the guarantee. But from about the middle of 2009, conditions in global credit markets were greatly improved.

Australian banks found it was cheaper to borrow funds using their own credit ratings, than to pay the fee to use the government guarantee.

As a result, the country's main financial regulators – including the Reserve Bank, Treasury and the Australian Prudential Regulation Authority – concluded that the guarantee was no longer needed.

The big risk is that conditions in global credit markets are now starting to deteriorate (see Greece's crisis is contagious, February 4 and Return of the bond vigilantes, January 15).

The past year witnessed unprecedented fiscal and monetary stimulus as governments around the world massively increased their budget deficits, and central banks injected trillions of dollars into the global economy as part of their quantitative easing programs.

Central banks also conducted a coordinated campaign of slashing interest rates, in a deliberate attempt to force investors out of low-risk bank accounts and into more risky, high-yielding assets.

These reflationary efforts have met with spectacular short-term success, as witnessed by the soaring prices for all risk assets, including global equities and commodities. Speculative money also piled into high-yield bonds, narrowing the interest rate margin that risky borrowers had to pay.

But global bond markets are again clouding over. Once again, the focus is on risk.

Bond investors have decided that debt-plagued 'Club Med' countries of the eurozone – Greece, Portugal and Spain – should pay a much higher risk premium for their borrowings than, say, a country like Germany which has stronger government finances.

As a result, they're in the process of pushing up yields on Greek, Spanish and Portuguese bonds by several percentage points.

But as markets adjust the cost of debt for these countries, you can be sure they'll adjust the borrowing costs of other borrowers, including the big four Australian banks.

And some of our smaller, regional banks – with lower credit ratings – could see their borrowing costs spike even further.

The prospect of higher borrowing costs may tempt our banks to rush out and borrow billions of dollars before the government guarantee expires at the end of March. Given the skittish state of global bond markets, a flood of new Australian bank debt issues is likely to push up borrowing costs.

This leaves the Australian banks in an invidious position. If they comply with Swan's orders and confine their interest rate rises to official rate rises, they'll see their interest rate margins whittled back. This will put a dent in their spectacular profits, but it will buy them political peace.

Alternatively, they can risk the Treasurer's ire, and raise their interest rates above official rate rises.

History suggests they'll opt for the second option.