Why government debt must grow forever

Even as the federal budget returns to surplus, government debt will have to rise to maintain the liquidity of Australia's AAA bond market at around 12-14 per cent of GDP.

Here's something to think about next time you hear someone bang on about the growing level of gross government debt in Australia – over the next five and probably 10 years, the Australian government will continue to borrow money, thereby boosting the level of gross government debt, whether it needs the money or not.

Why borrow money if you are running a budget surplus?

This is because there is a requirement for Australia to have a high grade, liquid and tradeable government bond market that grows in size over time, in proportion to the size of the economy.

Just this week, the Australian Office of Financial Management, the custodian of Australia’s government debt, issued its annual report. The report presented a sober, balanced and incisive view of government debt.

The AOFM has as its primary role, the issuance of Commonwealth Government Securities (bonds and T-Notes) at least cost, of course subject to an acceptable level of risk, while maintaining the integrity and efficiency of the market. Rob Nicholl, the chief executive officer in presenting the annual report, noted that "supporting liquidity in the CGS market will once again become a lead factor in AOFM thinking and operations.”

This is a clear reference to the concerns from market participants over the past decade that the market for CGS remain liquid (in other words tradeable) even during times of crisis and that it provides a foundation for the futures market.

In 2002, Treasurer Peter Costello undertook a review into the future of the CGS market. At the time, Costello was keen to pay off all debt and given the state of the government’s finances at the time, could have easily done it. It seemed a good idea in that it would eliminate all government interest costs and allow for the non-government bond market to grow and expand.

Having sought feedback from market participants who overwhelmingly opposed the elimination of the CGS, Costello rather reluctantly kept the bond market and with the excess funds, established the Future Fund.

The key reasons for maintaining CGS, that is keeping gross government debt at a particular level, was to have a risk free security that would be the benchmark for the pricing of all other debt and that would underpin the three and 10 year bond futures contracts.

It turned out to be a prudent decision from Costello.

While liquidity and bond market turnover receded in the period up to 2008, the onset of the GFC saw the AOFM easily and cost effectively issue bonds thereby borrowing the funds required to fund the budget deficit.

In 2010 and 2011 when it was clear that the budget would be returning to surplus, some market participants were concerned that liquidity would be eroded as the supply of CGS contracted in line with the budget surplus.

Treasurer, Wayne Swan, undertook a review of the long-run future of the CGS market in which a panel of market participants, the RBA and financial regulators were consulted.

According to Swan, the review found that it was crucial to have "a liquid, AAA rated CGS market and associated futures market during the crisis and supported retaining liquidity in these markets as the primary objective for the CGS market in the future.”

The review also found "to maintain a liquid and efficient bond market that supports the three and 10-year futures market and the requirements of the new global bank liquidity standards, the panel agreed that the CGS market should be maintained around its current size — that is, around 12 to 14 per cent of GDP over time.”

The critical aspect of this is the 12 to 14 per cent of GDP benchmark.

This suggests that as the economy grows, so too will the amount of CGS on issue. In other words, and going back to the starting point, the amount of government gross debt in dollar terms will rise forever.

One issue that the Gillard government has not yet addressed is what to do with the money it raises from the bond market, that it clearly wont need as the budget returns to surplus.

The Howard Government pumped its excess and unneeded cash into the Future Fund. The Gillard government may well follow that path as the medium-term surpluses roll in.

With the budget surplus a thin $1.1 billion in 2012-13 rising to $2.2 billion in 2013-14, the issue of what to do with the excess cash is still a couple of years away, unless of course there is any Costello like windfall revenue in the near term.

As the AOFM annual report also noted, "the government has highlighted its commitment in the last two budgets to maintaining a liquid CGS market and it will continue to monitor the size of the market in relation to liquidity considerations.”

So despite which side wins the next election, despite the overblown rhetoric from some about the rise in gross government debt and working on the reasonable assumption that we are set to get a run of budget surpluses, gross debt will rise.

The more pertinent question is what the government will do with all the money it raises from issuing bonds that it doesn’t need. A nice problem for any government to have.

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