Transcript of Question & Answer Session A Balance of Payments

Thanks for that Guy. It's absolutely fascinating to take a journey through the external accounts, which as you said, we don't spend as much time as we used to thinking about. I started life with the Aussie dollar as my main focus back at my Macquarie Bank days. So I used to think about these things quite a bit.

So maybe I'll start with a question and then I'll throw it out to a few people in the audience. We've talked a lot today about the currency and its important role as an economic stabiliser, and that's particularly important in a low interest rate world and in a world where the economic outlook is a little bit more challenged than we've seen.

So if I think back to my FX days, and I don't think it's changed too much, everyone's fair value model is pretty much the same, and really driven by interest-rate differential, commodities and the current account deficit. So in a world where we're seeing a divergence between the interest rate cycle and the commodity price cycle, in a low interest rate world and in a world where the structure of the current account deficit has changed, is that still a useful framework for fair value, and is fair value itself still a useful framework or tool to think about?

I think the drivers are still very much the same. In the model we have for the exchange rate – it was developed by Jenny [Wilkinson] and her husband, Dr Gruen – it hasn't changed all that much over the years. So it's still basically the terms of trade and interest differentials as you said. If you think about what's been going on over the last couple of years, those two things have been moving in opposite direction. The terms of trade is actually pretty high right at the moment, interest differentials are as low as they've been. But those two things have been working in somewhat opposite directions. The problem with fair value for exchange rates, and President Trump I think is very much aware of this, it depends on what time period you want to look it over. So the one thing which is slightly problematic, in anyone's model of fair value for the exchange rate is the sample period.

I can give you whatever value you want for fair value depending on what sample period you want to use. So if I go back, it depends whether I want to go back to the 70s, back to the 80s, just look at the 2000s, so that's always the hardest thing to work out. So putting aside effectively what the constant term is in your exchange rate, the two main drivers being commodity prices and interest differentials are still very much the same as they've been pretty much over this whole period, and by and large play about the same sort of roles as they ever have.

We might open it up to questions, so I'm actually going to start off with just highlighting that in the room we've been really fortunate to have some students from Canberra Grammar join us. One of the things I try to do at EY all the time is make sure that we've got some young people in our meetings and ensuring that we've got a diversity of views. So I might ask either Ethan or Sam if they'd like to stand up and ask the first question?

As the RBA consecutively lowered the interest rate by 0.25% in both June and July, now at 1%, how far is the RBA willing to lower interest rates to achieve economic growth? Likewise, what is the lowest interest rate that would be feasible for the RBA?

Actually, we got asked that question … a few weeks back when we appeared before the House Economics Committee … So we've done a fair bit of thinking about that, and if you look at what's happening in the US, Canada and the UK, when they got down to their lows, it was somewhere around about quarter to half a percent.

And so I think that probably gives us some sort of guide as to what the equivalent might be here. It's a good question. It's one we're spending a fair bit of time thinking about. Hopefully a question that we don't actually have to, in the end, worry about. But there's some chance obviously that we do, but as I said, we have spent a fair bit of time looking at the experiences of some other countries round the world, and at least looking at what the experience was in the US, the UK, and Canada would give you an idea that a number somewhere around there, may be reasonable to map that across to Australia.

Hi Guy. Thank you for that trip down memory lane. I guess in a sense you were sort of saying that in the '80s that the current account almost became like a fad or an obsession. I'm not sure how you'd look at it. I mean does the budget surplus these days sort of fall into that category a little bit with everybody sort of obsessing over it?

Well, I will leave that for others to opine. Was it an obsession back in the 80s? Absolutely. So the other section I worked in at Treasury at the time, besides the balance of payments section was the monetary policy section, interestingly. And in the '80s the current account was very much … I don't think it's unreasonable to say front and centre in monetary policy discussions back then. Keating's ‘Banana Republic’ comment was symptomatic of the focus that was on the external position back then.

So we've moved on from that, but I'll leave it to others to opine on where things are on budget positions today. I mean the interesting thing back then was very much, and it was much a driver of fiscal policy, the discussion was around the twin deficits. And so I suppose it's interesting that here we are sitting with a current account, which is somewhere close to surplus at the same time as a budget that's pretty close to surplus.

Could I just ask a quick follow up on the property market? Obviously the general feeling out of the RBA, was that as you've cut rates with circumstances have sort of calmed down in terms of borrowing, in terms of what might happen with prices, and yet it looks like the market's getting a bit of a head of steam. Is that causing any concern yet, or is that sort of reasonable reaction you'd say at this stage?

I think the market is showing signs of stabilisation. That's better than not showing signs of stabilisation, I think. And it's still quite diverse around the country, but there's more signs that the market has certainly bottomed, but at the same time it doesn't seem to me to be off to the races at the moment.

So we're in Canberra, which obviously … lots of bureaucrats and policy makers with lots of power in the room. Given that the Reserve Bank can't do everything to manage the nuances of a macro economy, what would you like the Canberra bureaucracy to do there?

Again I would refer back to the answer Phil gave two weeks ago on this … so I think there's a couple of areas, we've obviously talked a bit about infrastructure. I suppose the point we were making there, so slightly more nuanced, it's not about necessarily building big things, although big things are good too, but there's a fair amount of capacity and I really mean capacity in the actual sense in terms of smaller projects: widening roads, getting rid of level crossings and the like, which are sort of smaller stuff, and they're spread out across the country in the regions where potentially there's more unused capacity.

There's not a lot of capacity for more large infrastructures projects in Sydney I can personally attest, living on top of two of them at the moment simultaneously. But there is around the country, the capacity for small stuff. And then I suppose the other point that Phil has continually stressed, is just more general reforms around giving businesses the opportunity to innovate and expand, and Treasury certainly very much is focused on that side of things. Well, particularly in your previous hat on the structural policy side, Meghan, so there is opportunity there as well.

We hear a lot about China, and I was wondering how much attention the RBA gives to the net foreign debt of our close Asian countries and what your views are on that …

Well that's a good question. China is interesting … so when I talked about emerging markets getting into trouble with foreign currency debt. So China has foreign currency debt, but its debt is mostly domestic currency. So China does have a decently large amount of debt, but the vast bulk of it is domestic, and that is not the same vulnerability – similar to us – as it would be if it was a foreign currency problem, or foreign currency denominated. So China's debt is mostly an internal issue for them, not an external one. The prospect of the equivalent of a sudden stop in China I think is extremely remote because of that. If they've got a debt issue it's something for them to sort out amongst themselves basically, who's going to bear the cost of adjustment if they want to do something about that debt. But that's a domestic issue, not one driven on the foreign side. So it's quite a long way away from the sort of Asian crisis issues that Korea, Thailand and Indonesia faced.

I also meant in terms of the smaller Pacific Island Nations.

Oh, okay … That's something I suppose I don't know so much about. Although I did work on PNG in the mid 90s, so I do have a little bit of history there, but not so much up to where things are today on that. Sorry. Another question at the back.

Thanks for speaking Guy. Just wondering, yesterday the Treasurer made some comments about dividends and share buybacks, amid a call for business to invest. It seems a while ago, but Glenn Stevens used to talk about hurdle rates for investment as a reason why people weren't investing. I'm just wondering if there is an issue here and I recall some RBA research talking about how the dividend imputation system encourages firms to pay dividends, more, since the 1980s onwards compared to something like the '60s but I'm just wondering what do you reckon here, is there an issue?

I can't remember that. I do remember us looking at hurdle rates. I don't think we've updated that but at the same time from my general conversations with people in the business sector, I don't think they've by and large come down too much, even as the risk free rate has come down to very low numbers. But at the same time, there's a fair amount of uncertainty out there at the moment too, which you can see evidence of that absolutely affecting investment decisions. So that's something we probably should re-examine now. I think we looked at it about four years ago.

2015.

Yep, right, there we go, 2015, around hurdle rates, and it's probably worth refreshing that now given risk-free rates are probably a couple of percentage points lower now than they were back then. But back then they hadn't actually come down much from where they were through most of the 2000s.

Thanks Guy. Actually, a similar question to Michael's, but you did mention the uncertainty part of capex a couple of weeks ago in one of your speeches. But I just think there's a slight nuance in this one in the sense that it's sort of not about investing money in brand new projects but investing money into areas where you can get productivity gains. And I just wondered, you see the difference in that and is there, have you seen any numbers that would show that maybe corporate Australia isn't doing enough work into trying to put money into that side of the equation as opposed to just new projects?

I'm not sure that the investment decision matters too much, exactly, whether it's a new or existing. I mean there's potentially more uncertainty around something brand new. I mean the size matters because bigger stuff is harder to reverse than smaller stuff. Empirical evidence by and large says that uncertainty matters with bigger stuff, rather than smaller stuff, mostly because of its irreversibility, and just how fast you can actually get a return on it.

But we are also seeing that uncertainty is affecting investment in new and old right around the world at the moment. That is very apparent including in the US, even the numbers overnight, that the uncertainty out there is having a sizable impact on corporate investment decisions, for whatever reason. And that's a global story reflecting the global nature of that uncertainty. And I'd probably guess that over the past week that uncertainly probably hasn't gotten any less, it may have gotten a little bit more. So that issue is very much front and centre, but it's particularly on the global side of things as much as on the local side of things.

What is the Reserve Bank doing to combat climate change? What policies have you developed?

So we don't develop policies in this front, other people do that. I suppose what we've done, what I've done, is highlighted some of the issues around it, because it does have macro consequences. So that's something which falls in our bailiwick. So talking about uncertainties, that's uncertainty possibly on an even greater scale than some of the other uncertainties we're seeing at the moment.

We are working, including as part of a group of central banks globally called … NGFS, which is the Network on Greening of the Financial System. It's originated by the Banque de France, so maybe it sounds better in French than it does in English. But anyway, we're working with them and one of the things we're doing there is coming up with some useable scenarios for businesses, both in the corporate and the financial side of things, to think about in terms of the resilience of their businesses, and of the assets they hold or the assets they lend to support.

So that's one thing we're doing. The other thing I suppose, which is more coming out of APRA and ASIC, but we're very much supportive of, is around disclosure and providing investors – this is much more coming from the financial side – investors with the information necessary to make informed investment decisions depending on the climate exposure, and from our point of view that comes, which I think was part of Sam's question to the financial stability aspect of it, which is, climate has implications from a financial stability point of view in terms of potentially large movements in asset prices in the future depending on how things evolve. And that's something we're intending to provide a bit more information on in our next financial stability review.

Really look forward to that. I actually think Guy, your speech on climate change last year was a really tipping point here in Australia in terms of …

Not a good phrase to use in this space, but anyway, okay.

… bring it into the mainstream. And certainly, at EY, we engage with a lot of students around the country and it's certainly front and centre for that generation. Can I jump in and just ask another question? We've talked a lot today around interest rates, around the term structure of the yield curve, around uncertainty. We've obviously seen yield curve inversion in the US, three times in two weeks. Some would argue it's a good indicator that recession is coming … Just wondering actually if you could repeat your thoughts on that and if the yield curve isn't a good indicator, what are some of the things that we should be looking at? And I guess I ask that in terms of Australian corporates are facing this uncertainty, the world has changed and if we're trying to encourage investment, whether that's around productivity or just cyclically, to support the economy, what kind of indicators can corporate Australia be looking at?

I'll repeat the answer I gave on the yield curve a couple of weeks back … The yield curve normally has this thing called a term premium. So if I hold a 10-year bond rather than something for only three months, I want to be compensated for the fact that 10 years is a lot longer than three months and that means there's more risk. So normally there's this term premium, which is normally pushing up to somewhere close to a percentage point. So in normal times there's, 10 year yields are normally about, putting aside anything else that's going on, I want about an extra percentage point compensation for the extra risk I'm taking.

So at the moment in the US, the best guess of that is it's probably a negative number, which is odd in and of itself. So what that means is if I look at the yield curve and I just go the 10 year yield minus the Fed funds rate, or minus the two-year yield or whatever, I get a very low number or I get a negative number. But if I add it back on any sort of reasonable or normal, term premium, that number goes back to being quite a solidly positive number. And so that's the question of how useful is that as an indicator for stuff at the moment, given we've got this very unusual thing going on with the term premium. So if that hasn't got quite the information content it had in the past, what else do you have a look at?

I think there are a few things going on. One is, the cost of corporate borrowing at the moment is as low as it's ever been in history. So one thing which is also interesting going on out there at the moment is at the same time as government bond yields are very low, yield curves are inverted. Corporate bond spreads, the spread between how much a corporate can borrow and how much the government can borrow, that's as low as it's ever been in history. Which is interesting if you think there's a lot of risk out there, which I think is reasonable to assume there is, for whatever reason investors aren't requiring much compensation for that risk either. So either they think that that's because central banks have completely got their backs or they're basically chasing yield and driving down some of those spreads.

But it's an unusual situation where you've got the yield curve negative, but corporate bond spreads at historic lows. So you can look across financial indicators and get quite a different impression than you would from just looking at the yield curve. So like most things, it's best, I think, to take account of the full suite of information available rather than just relying on one summary indicator.

I suppose one thing while we're talking about answering questions from schools, one thing, and this applies to those of you who had left school as well, if you didn't get any of what I said about the balance of payments, we have on our education part of our website, we have a helpful explainer about the balance of payments, that will probably be a hell of a lot more intelligible than what I've just said.

But it is out there, particularly aimed at the secondary education years 10 through 12, but if any of the rest of you want a bit of a brush up from what you may or may not have learned 30 or 40 years ago, it's there as well, and so I would just highlight that that's out there if you want to try and understand some of this stuff as well.

Well, I think that's really useful because once you delve into the details of the balance of payments, it all gets a bit confusing. It's a bit more accounting like than economic like in many responses. We've got time for one more question, conscious of getting everyone back to work at two o'clock.

My question to you is, there's predictions basically about another cut of interest rates, and given the volatility of the Australian dollar, are we worried about the Australian dollar going down as low as 50 as it did a decade ago? And what do you think the implication will be towards basically the stability of the, obviously the current account given the impact it will have on import prices.

Jo used to be in the business of currency forecasting, but … the currency's come down some, it may well go down further, depends partly on what others do as well. In fact, it depends quite a bit on what others do as well. But I would say the depreciation of the currency we've seen has been helpful for the macro economic outlook, and if it would depreciate further, that would also be helpful for the macro economic outlook, both in terms of economic growth and also inflation, because as you said, with import prices going up.

So that would help move us closer to our objectives both on the real economy side and also on the inflation side. Whether it gets down as far as 50, I don't know, so no disrespected to Jo in her former profession, but …

Former, it's okay.

The best predictor of where the exchange rate is going to be tomorrow is where it is today. And the economics profession after a few decades of deep, and a hell of a lot of analysis, that's still the case, so maybe, but at the same time, the best guess at where it's going to be tomorrow is pretty much where it is today.

And I don't think there's any forecast as low as 50 cents.

Just two things, I think which both have very short answers. One, the first question from the student was how low might interest rates go? You said half a percent is the sort of guide quoting the Governor. What happens then? I assume that what happens then is not nothing, but what happens then is quantitative easing, which is buying government and corporate bonds, that's correct?

They're some of the options we've thought about.

It's not that you would do nothing, when you got to a level that was practically zero, which is half a percent is getting into zero territory. It's that you would do something, is it? In other words, that answer could be interpreted as "Well. When it gets down to half a percent we stop." And it's not …

Well, I mean, as I said, if you look at where the others land, it was somewhere, a quarter, half, somewhere around there, depending on the …

But you would then do something, if needed.

If we are not achieving our objectives, then we have a mandate to try and achieve our objectives, which would probably require doing something rather than doing nothing for a long period of time. Yes.

The other question is about the light bulb, but a disturbing light bulb that went on in my head. My daughter and others are studying economics. I tried to talk her out of it. I suggested physics. She didn't do it. Anyway. She says, ‘Well how are people made richer by the mining boom?’ The standard answer is that the customers need to buy Australian dollars, pushes up the exchange rate. That means that a pensioner in Gungahlin can buy more foreign goods because they're cheaper. And the light bulb that went on in my head was when you said, ‘Oh, well, most of the money never comes near Australia, is never converted into Australian dollars.' So I assume that what we did see in the mining boom is just that small portion of, yeah, maybe a quarter of the money that did come in. In fact, the simple answer I've been giving is wrong.

Your answer is still mostly right. So I'm talking about one part of the resource revenue. Back in the mining boom they were also probably bringing more onshore to pay for the investment. The investment had some foreign capital component and also a large domestic capital component. So if I'm digging a new hole out near Port Hedland somewhere I have to pay people, Australians, to dig that hole.

So a decent chunk of that investment was capital which was basically paid in foreign currency and a decently large chunk of it was still in Australian dollars. So the impact was less than it might otherwise have been. The other point to make is profits. Profits are also used to pay tax and royalties to the Australian governments both Commonwealth and state and they're paid in Australian dollars so that money is coming onshore.

There's a number of channels that …

So there are a number of channels where that comes in. All I'm saying is not all of it does, even though it's recorded as doing so by the balance of payments. So … it's a less of a boost to national income than you might otherwise think because some of it goes out to foreigners but a decently large chunk still comes into all the domestic shareholders, the domestic workforce and also to the governments both Commonwealth and state in terms of royalty and tax.

There would've been a portfolio flowing to the currency as well …

Well look on that note we'll wrap it up Guy. Thank you. Really fortuitous time with a lot going on in the economy, so it is great to have you here. Thank you for being so open in your Q&A and thank you for the journey through the balance of payments.