Transcript of Question & Answer Session Investing in a Low Interest Rate World

Thank you for the enlightening comments. What I would like to understand, perhaps, is just, you mentioned in the first part of your speech around G20’s growth objectives, obviously the other piece of the G20 that has been focused upon is bank stability and financial sector stability. So I’d be very interested in your perspectives around how the trade-off between those two has been playing out in terms of that monetary policy transmission mechanism, particularly as we come into the G20 in Brisbane, discussions around the FSB putting out new, further bank capital regulatory requirements.

We tend not to think of there being a trade-off here. Ultimately a stable financial system is good for economic growth, not bad for it. On the financial side the main issue that we’ve really been trying to focus the G20 discussions on is completing, as much as we can, the regulatory reform agenda. And by and large we’re well advanced there, the capital and liquidity requirements are pretty much finalised, there’s a lot of work on shadow banking that’s coming to completion. The main outstanding issue is what’s known as TLAC or GLAC the total loss absorbing capital that an institution has and, at the meeting in Cairns and subsequently in Washington, there’s been broad agreement about the nature of the GLAC regime or the TLAC regime and I think proposals will be coming forward by the time of Brisbane about that and that’s going to be a significant issue that the regulatory community will want to consult with the financial institutions on, but some of the implications of what could happen or the changes there are quite profound. There will be a long period of consultation and discussion with industry and road testing of the various proposals. But from our perspective the key thing has been to, as far as we can, complete the post crisis response rather than keep on adding new elements to it. I don’t really see there being a trade-off between growth here. Ultimately we need a strong, stable, sound financial system to deliver the growth outcomes that are required.

Thank you, Dr Lowe I mean the policy agenda at the moment seems to involve trying to get us to build more houses, and we’re doing that. To get more non-mining CAPEX going, which has got a lot of construction activity in it as well. Infrastructure: obviously a big construction story there as well, and I can see that getting us through the next few years, but what other areas should we be looking to, to the medium and longer term, to drive growth in the Australian economy?

Well it’s a very good question. I mean ultimately we want to be a high wage, high exchange rate, highly productive economy. And the question is: how do we do that? We have some natural comparative advantages based on our natural resources, so a strong focus on there is obviously going to be both required and beneficial, but ultimately the main resource that we have is the quality of our people. So I really see, kind of, investment in people and investment in entrepreneurship and encouraging people to take risks. To take risks, develop new ideas, to have a punt, you know, our society needs to regenerate that enthusiasm for entrepreneurship. How one does that, that’s way beyond the realm of monetary policy, but I think if we want to be this economy with high wages, a high exchange rate, which means high living standards and high productivity, it’s the quality of what’s in here that’s ultimately going to be more important than the quality of what’s in our ground. And, you know, other people in this room probably are more expert on exactly how you do it, but I think that needs to be a central focus of policy. And it’s not something that monetary policy can do very much about. We can create a stable environment in which people are prepared to take risk, but we can’t make people take risk, we can’t make people develop new ideas, but we can help provide the environment in which people do that.

There’s one over at the back there, is that – if we can get you to state your name and affiliation, Chris.

Sure. My name’s Chris, Chris and I’m from the Commonwealth Bank. Dr Lowe can you expand on some of the modest and sensible changes you might be considering are on the table now to address the housing market developments and also the process on how the Bank and APRA may go about, I guess, deciding on those policies and implementing them if and when they’re needed?

Well Chris I don’t really want to speculate on what the precise measures are, because I don’t think that’s helpful and because the discussions we’re having are still ongoing, and ultimately these decisions are for APRA. As I said in my remarks APRA has for some months now, maybe it’s longer than that, been talking to financial institutions about their lending standards, and essentially that’s the art of good supervision. And APRA has long had a more proactive supervisory stance than regulators in a number of other countries and I think that served us very well and APRA continues to do that. And I think what they’re thinking at the moment is ‘well, are there some other elements of the existing structure that can be changed in areas where they see risk having built up.’ But it’s not the type of heavy macroprudential measures that have been implemented in some countries in Asia and other parts of the world. With tight restrictions on loan-to-valuation ratios or debt-servicing ratios, they’re not the type of things that I would expect to see here, but we could see some relatively modest and, as I said, sensible changes within the existing structure.

It’s a follow on question probably to that one as well. You mentioned earlier in your speech about residential property being held in selfmanaged super funds and I’d be interested in your comments around the risks of, the additional risks of, that policy that’s growing quite heavily in the market and any sort of response or view around that space and how it overlies with an ageing population and need for companies, for individuals to be self-sufficient in their retirement.

Well it’s a very interesting question. Many issues about superannuation come down to tax and I suspect one of the elements here is that many people have reached the conclusion that borrowing to buy property inside a super fund is very tax advantageous and many people have done that. So at an individual level I can understand the attractiveness of that strategy. If the question — the rhetorical question I’d really pose is — is that sensible for society as a whole, to allow such tax-preferred investment in residential property financed by a debt to take place. And different people are going to come to different judgements about that. I think at the margin it’s adding to the upward pressure on prices but probably only at the margin I think there are these bigger forces at work where the investors more broadly are saying well investment in property given the low interest rates is not such a bad thing to do. And the issue we are trying to bring to people’s attention is, well you need to think about the risks involved in this investment strategy. In an environment of low interest rates, one needs to ask the question whether those low interest rates will be there indefinitely and when house prices are already quite high relative to income, is it reasonable to expect that they will continue to rise more quickly than income or will there be a period where that goes into reverse? And I think that applies not just to the investors who are buying property through super funds, but the investment community more broadly.

Thank you Dr Lowe, Rob Nikel from the RFM. I’m just wondering if you could describe in broad terms how you would see Australia’s preparedness to deal with another major external shock such as what we saw in the GFC, not the GFC, but another major external shock.

Well I think we’re much better prepared than almost any other advanced economy. We still have positive interest rates so, in principle, one could see a monetary response. We have a flexible exchange rate, which I think if you look at the sweep of the last 30 years, that’s actually been the key stabilising influence on our economy. And, in the type of the scenario you’ve painted, we still have scope on fiscal policy. I mean, we have a medium-term challenge to put the budget on a more sustainable footing, but it’s a medium-term challenge, so depending on fiscal policy, monetary policy and the flexible exchange rate, we’re in a better position than many other countries. I’m not saying that kind of a downturn in the global economy would not be difficult for us, but I think we can have some confidence that we’re in a better position than many others.

Thank you Dr Lowe, Andrew Bishop’s my name, Australian Rail Track. You mentioned government policy and we’ve just had tax raised. Would you care to comment on the degree to which you think tax incentives will loosen up some of this capital and what part they play in a policy perspective going forward to try and stimulate the economy. And we’ve seen tax driven incentives in the past which maybe have led to some dubious investment decisions, but clearly it’s one of the levers that, from a policy perspective, can be pulled and I’d be interested in your comments.

Well moving further beyond my area of competency. In general the idea that you promote investment through reduced rates of tax doesn’t seem very sensible to me. What we want to do is create an environment where the expected return on new capital investment is high because the underlying investment will return decent returns. I think on infrastructure, my sense is our societies, particularly our capital cities, but also in some regional areas, there are a lot of projects out there that would have higher social rates of return and maybe even private rates of return greater than the government’s cost of borrowing at the moment, the 10 year bond rate, what is it, 3, 3.3, 3.4? So, the government here, the cost of funding for the government in general is very low. The cost of funding to private infrastructure is quite low, there’s plenty of money there. The issue is having the project design and the contracting and the project governance I think to me that’s, and the pipeline of projects, they’re the areas that we should be focusing on, identifying amongst those many projects out there that probably have an expected rate of return greater than the cost of funding, which ones are the best ones to do? And how can we have confidence that if the public or the private sector do them, that we’re getting value for money. To me, that is a better focus than saying well can we drive greater spending in parts of the economy by giving tax concessions to certain groups.

Dr Lowe, Rory Robertson, Westpac Group Treasury. The Reserve Bank and others are rightly cautious about the housing market, but one of the features, one of the developments after the early 90s recession was a structural decline in Australian interest rates, which ultimately drove a structural increase in Australian house prices, relative to incomes. And most people now agree that’s sensible and understandable. We seem, perhaps, to have been in the process of having another structural decline in interest rates, and if that’s correct then aren’t investors, housing investors, you know, making quite sensible choices? I understand the Reserve Bank’s got to be cautious about that, but if there is a structural decline in interest rates, and right now you can get a five-year fixed rate housing loan for under 5 per cent for the first time in Australia’s history, the discount rates are lower, shouldn’t asset prices be higher on a perhaps sustainable basis?

Well they should be higher. Lower interest rates, as you point out, mean that the discount rate is lower and the asset prices are higher, and I talked about them in my remarks. I think the open question is whether, really globally, equilibrium rates are going to stay as low as they currently are. Certainly from a cyclical perspective one can see low global interest rates maintained being maintained for some time, but ultimately the interest rate is tied down by the global productivity of capital. And so, are we really saying, and some people do argue this, that somehow the fundamental productivity growth in the global economy is permanently structurally lower. Now it may turn out that that is the case, and if it is and there are a lot of other adjustments that have to take place. I’m not so pessimistic I think that ultimately the rate of technological progress in our society is not fundamentally slowing down, and so I’m relatively optimistic that the structural rate of interest is not permanently lower. I mean what we really want is a fairly, in a sense globally higher interest rates than we have now and on a sustainable basis because that means the return on capital is higher, that’s the world we should be hoping for and I don’t think that’s unattainable, although it’s some time before we obviously get back there given the scarring from the financial crisis. But as I said, it ultimately comes down to whether you think the global growth is just structurally lower because underlying technological progress in our societies is lower than it has been for the last 20 years. And I said I’m an optimist there, not a pessimist.

Richard Grace, Commonwealth Bank. Dr Lowe, you made some comments that government borrowing for social infrastructure investment may not be countered as part of government debt, can you expand on those comments please, because it wasn’t so long ago that financial markets were particularly concerned about the levels of government debt that were building across the global economy.

Well I was making the point, kind of globally really, that when interest rates are as low as they are, when governments can borrow as cheaply as they could ever borrow and in some countries they were actually paid to lend money to the government, and there’s a shortfall of infrastructure in some of those countries, there may be opportunities for the governments to use their balance sheets to build the infrastructure. And that would promote global growth, it would add to supply capacity take the pressure off monetary policy, so that’s the kind of the broad context. The counter argument to this is that, or there are two, the current fiscal environment in many countries is so dire that any extra dollar of debt is bad even if there is an asset to go with it. My own view is that’s certainly not the case in Australia, our fiscal position is sound, we’ve got a medium term issue but we don’t have the same dire situation as in many other countries. And the other concern and I think this is a legitimate one, that if you accept the proposition that the government can borrow to build assets, particularly hard assets: road, rail, public transportation. Can then you go the next step in saying the government can borrow to build, and you used the word social infrastructure. So some people might think of that as education and health, and if you say ‘well it’s okay to borrow to build hard infrastructure and also the soft infrastructure’, then the whole fiscal discipline that is required in so many countries can break down. This is where I think, ultimately, governance is incredibly important because if governments are going to say ‘we are prepared to borrow to build assets’, the community very rightly needs to demand a higher level of governance around that because it’s very easy to waste money. On the other hand, many of our societies really need these assets, I think, and they would improve both aggregate demand and the welfare of the citizen. So how is it that you put the governance around the project selection so that the public can have confidence that whether the government building these assets gives us a decent social rate of return? Or if the private sector is building it then they deliver a social rate of return. So it’s the governance, I think, where the main focus needs to be. And we’ve discussed this extensively in the G20. What type of mechanisms can be put in place so that the financial community, but more importantly our societies can be confident that if governments are going to use their balance sheets in this way during a period in which global interest rates are regulated, that they’re actually getting value for money and delivering the right projects for the society. There’s not an easy answer, but I think it’s the right question: what type of governance mechanisms should be put around any sense that in some countries you could loosen up the fiscal environment a little to help global demand and ultimately take the pressure off money creation by the major central banks.