Morrison’s nukes yield geo-political game-changer

Christopher Joye

Coolabah Capital

In the AFR I write that it is the single most important national security decision Australia has made since the Second World War: Prime Minister Scott Morrison forging a new “three-eyes” alliance with the US and UK (aka “AUKUS”) to equip Australia with at least eight of the most lethal, stealthy and, crucially, nuclear-powered fast-attack submarines on the planet. Australia will join just six other countries fielding these highly strategic weapons.

The most likely candidate, an improved version of the pump-jet propelled US Virginia Class boat, which this column has advocated as a solution to Australia’s existential security crisis for a decade now, will carry vertical launch tubes that can fire medium-range cruise, ballistic, and hypersonic missiles at any future adversary. (Btw, how do we protect the Kiwis, who spend nothing on defence, if they won’t let our nukes in their waters?)

For the first time in history, we will possess a truly credible, second-strike deterrence to deliver devastating strikes on any nation that seeks to inflict harm upon us through the Virginia’s ability to lurk for months underwater undetected with unlimited range in contested areas such as the East China Sea, South China Sea and/or Taiwanese Straits.

This long overdue decision has been galvanized by the mortal threats presented by China’s vain attempts to relentlessly subjugate Australia and its interests to President Xi’s grand vision of communism with Chinese characteristics prevailing in what he says is an inevitable conflict with capitalism and its state-sponsors. Despite the denials, the drums of war only beat louder.

As one of our China advisers once observed, "Xi picked the wrong country at the wrong time with the wrong prime minister to bully". Given Australia’s ingrained anti-authoritarian heritage, we don’t respond well to anyone trying to coerce us into bending the knee. It was never going to happen.

Way back in 2012, this column revealed that the Coalition was considering buying nuclear submarines from the US or UK on the front page of this newspaper. “Senior Coalition frontbenchers told The Weekend Financial Review that acquiring or leasing Virginia-class nuclear submarines equipped with conventional weapons, such as cruise missiles, would be supported by the Obama Administration,” we reported. “Purchasing the submarines is not yet Coalition policy but some shadow ministers have discussed the idea with United States officials.”

We argued that the Virginia Class boats were demonstrably the most attractive choice, that the door to acquiring this US capability was wide open, and that continuing to free-ride off much higher US military spending was not a tenable long-term position.

In 2016 this column characterised the horrific decision to buy $90 billion worth of an unproven diesel-electric French submarines based on a nuclear-powered design as the biggest white elephant in history.

As recently as May this year, I asked a senior cabinet minister why Australia did not just procure the UK Astute-class or US Virgnia-class boats to once-and-for-all cauterise our never-ending, conventional sub dramas.

One important development that accompanied this geo-political game-changer was Morrison’s announcement that he would be lifting defence spending to significantly more than 2 per cent of GDP, which is the minimum required at a time when the probability of major power conflict has increased to 50 per cent.

Taken together, Australia is finally, and belatedly, starting to insure against the risks it faces. It is a brave decision that will irreversibly alter our strategic path.

In very different contexts the community has benefited from two other courageous decisions in the last week. The Reserve Bank of Australia’s governor Phil Lowe hit the ball out of the park with a brilliant speech on Martin Place’s approach to monetary policy in a Delta-ridden world.

Lowe acknowledged that we have moved from a pandemic to an endemic. While he is confident that Australia will bounce-back robustly, Lowe notes that there are a range of downside risks, including further lockdowns, decaying vaccine potency, new virus variants, and the fact that exiting lockdown into an endemic is very different to last year’s experience.

This is why the RBA has prudently maintained significant ongoing monetary stimulus via its bond purchase program, which keeps downward pressure on interest rates and the Aussie dollar to “provide some additional insurance against downside scenarios”.

The RBA has, in fact, boosted its expected bond purchases by about 40 per cent compared to the path revealed in July, which is necessary given the current shock and the rich array of “known unknowns” and “unknowns unknowns” policymakers now face.

It was particularly pleasing to see the RBA resisting its recent impulse to try to forecast the future rather than the safer approach of nowcasting, or relying on hard data, when calibrating its stimulus. “In today's low inflation world, we do not want to run the risk that we increase the cash rate on the basis of a forecast that ultimately does not come to pass, leaving inflation stuck below the target band,” Lowe said. “We want to see actual results, not forecasted results, before we lift the cash rate.”

This was a dovish speech in which Lowe doubled-down on highlighting that the RBA is years away from getting the wage growth required to meet its inflation target, which is why it has no plans to raise its overnight cash rate until 2024. It emphatically wants to be the last developed central bank to start unwinding its stimulus.

And despite the hyperbole in some quarters, house prices are not going to undermine this commitment. Lowe knows that if lending practices and/or credit growth become a concern, the Australian Prudential Regulation Authority proved between 2014 and 2016 that it can ruthlessly crush any dysfunctions. While APRA would never admit it, its macro-prudential constraints on lending ultimately precipitated the healthy 10 per cent correction in house prices between 2017 and 2019.

That brings us back to one of the boldest regulatory decisions made in recent times: APRA shocking a cock-a-hoop banking system last Friday by announcing that it was shutting down the $139 billion Committed Liquidity Facility (CLF) by the end of 2022.

While we had forecast this would happen over two years, APRA’s entirely sensible 2022 timetable blindsided everybody. Despite APRA repeatedly writing to the banks and warning them that the CLF would disappear in the “foreseeable future”, they had convinced themselves that APRA did not actually mean what it said, with most expecting no material changes in 2022.

Taxpayers have a lot to be thankful for in respect of Wayne Byres’ fearless leadership of the banking, superannuation, and insurance tzar. The implications of this move are profound, although bank analysts who regularly do their balance-sheets' bidding will claim otherwise. It’s complex but a quick summary is as follows.

The CLF was designed as a substitute for banks holding government bonds as their emergency liquid asset, which is the gold standard globally. It is currently 80 per cent made-up of internal bank loans, which are completely illiquid, with the remaining 20 per cent accounted for by bank bonds and residential mortgage-backed securities (RMBS).

Simplistically, the banks will have to replace the $139 billion CLF with government bonds or cash they hold at the RBA. There are two problems with the cash at the RBA. The first is it pays zero interest, which hurts bank revenues, in contrast to government bonds that pay positive interest.

The second is that the $360 billion of surplus cash at the RBA will quickly disappear over time as the banks repay the $188 billion they borrowed under the RBA’s 3-year Term Funding Facility (TFF) and as the bonds the RBA has bought since March 2020 mature.

Modelling these factors, and accounting for lending and deposit growth, we estimate that the banks will have to buy more than $250 billion of government bonds over the next few years to maintain their Liquidity Coverage Ratio (LCR) targets of 125 per cent.

One bank analyst suggested banks could simply drop these LCR targets. But with the global average LCR amongst the banks’ peers sitting at around 155 per cent, it is inconceivable that APRA (or their boards) would consent to banks running higher liquidity risks.

Replacing the 80 per cent of the CLF that is made-up of internal loans, plus the $188 billion TFF, will require the banks to normalise their debt issuance in coming years. Our modelling implies that the four majors will have to issue, on average, a bit over $150 billion each year of term debt, which is similar to what they did in the 10 years preceding the COVID-19 crisis.

While this will push-up the credit spreads on bank bonds and RMBS back towards their post-GFC averages, it will reduce the interest rates that taxpayers pay on the much larger quantum of public debt.

And although lenders can easily absorb these costs, if they feel pressed, they can nudge-up home loan rates, which would be welcomed by regulators exercised by the current housing ebullience.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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