Open borders are the next big regime change

Christopher Joye

Coolabah Capital

In the AFR today I write that a crucial new development in the COVID-19 debate has been State governments declaring their hands on when Australia should resist lockdowns and gradually re-open its borders. All roads lead to “herd immunity”, which will loom much faster than you think. Excerpt only:

Last week this column argued that herd immunity would arise when all Australians who wanted to be vaccinated had been vaccinated, which should equate to jabbing around 90 per cent of adults (or 70 per cent of the total population). If that seems ambitious, Canada, the UK and Israel have already administered first doses to almost 70 per cent of their overall population.

The previously isolationist Victorian Premier Dan Andrews reportedly exclaimed that State governments should refuse to launch lockdowns once those who wanted a jab had been offered one. “We’ve got to get 70, 80, whatever the percentage is, of the community (who) have had the jab, or to put it another way, anyone, everyone who wants to be vaccinated has been given an opportunity to do that,” Andrews remarked. “And then it’s on them if they don’t choose to get vaccinated…We wouldn’t be having lockdowns to protect people who weren’t prepared to protect themselves.”

This column’s research showed that Australia should vaccinate up to 91 per cent of all adults (70 per cent of the population) by February next year, if not earlier, depending on the speed of the roll-out. This modelling conditioned on the linear vaccination growth paths of 16 peer countries, which Australia is tracking, and then used Israel’s non-linear slow-down once 80 per cent of adults had their first jab, reflecting saturation and residual vaccine hesitancy.

Our analysis focussed on the adult population: one caveat on timing is that governments may want to ensure all eligible children are also inoculated. The Pfizer and Moderna vaccines, which are highly effective against all COVID-19 variants, should be available to children aged 12 years or more this year.

Reports claim that national cabinet has been presented with similar modelling. Once herd immunity is reached, even the most paranoid States are going to embrace a radically different approach to the Fortress Australia mentality. Lockdowns will end and thereafter borders will slowly prise open.

This is profoundly important for the Reserve Bank of Australia’s decision-making, especially if herd immunity materialises ahead of our conservative assumptions (eg, before the end of the year). Opening borders to vaccinated and rigorously-tested human capital flows, presumably after a March 2022 federal election, will precipitate a wave of skilled, and much needed, overseas talent coming into Australia. While this will be vital for future productivity, it will also start reversing the labour supply bottlenecks that have temporarily contributed to sharply reducing Australia’s jobless rate and boosting advertised vacancies.

Conscious of the historic difficulties associated with trying to restore full employment and 3 to 4 per cent annual wages growth, the RBA has consistently pushed-back on the market’s attempts to bully it into tapering stimulus ahead of the US Federal Reserve or the arrival of hard data that proves, beyond reasonable doubt, that it has secured sustainable economic outcomes consistent with annual core inflation in its target 2 to 3 per cent band.

The RBA is not searching for data that supports rubbery forecasts that it might eventually get to 3 to 4 per cent wages growth and target inflation. It wants to see the economy comfortably producing these results on a sustainable basis before it fiddles with its settings.

Governor Phil Lowe and Deputy Governor Guy Debelle have wisely warned that the road back to normality will not be a straight-line, but rather “bumpy”. And so it has proved with NSW, Queensland, Western Australia and the Northern Territory all in growth- and confidence-sapping lock-downs as at Friday morning.

One existential challenge for the RBA that has attracted no attention is that it has to calibrate its stimulus to cope with both closed and open borders, which bring with them conflicting shocks. Economist calls for the RBA to taper stimulus in the absence of hard data on sustainable wages and inflation growth ahead of the wholesale opening of borders in less than 12 months, and the deflationary headwinds this will inevitably bring, appear naïve.

This reminds one of the classically myopic economic forecast, straight-lining off contemporary circumstances, and ignoring the massive regime change that lies in wait. It is why every analyst in the land claimed house prices would plummet 10 to 20 per cent in March last year. And yet prices fell merely 2.2 per cent and transitioned into a big boom six month later as we divined.

The secret to unlocking this specific future was accounting for the regime-change triggered by the RBA unleashing its monetary stimulus. And the next big regime change will be open borders.

Expect Martin Place to start educating economists on the need to look-through transitory blips in wages and inflation pressures arising from closed-borders, and the importance of being able to sustainably meet its employment and inflation goals in a world of relatively frictionless human capital flows. There was the first hint of this in Lowe’s last speech following which he pointed toward the prospect of a surge in population growth.

Sustainability means wages growth and inflation that will durably persist when a combination of Australian ex-pats, skilled migrants and non-resident workers arrive to support business and the economy at large expand its productive potential. It will be a once-in-a-generation opportunity to attract and retain the world’s best brains.

Another profound policy shift is the dramatic transition of fiscal stimulus from the Commonwealth to the States. Whereas the Commonwealth has reported three consecutive monthly budget surpluses, and is going to materially downgrade the debt issuance required to pay for its deficits, the States are continuing to fund massive infrastructure investment programs that have been initiated with the RBA’s glowing endorsement.

Judged by the debt issuance to fund these deficits, the States will be providing broadly similar levels of stimulus to the Commonwealth over the next year or two, which is a radical change from last year when the Commonwealth issued 2.5 times more debt than the States. NSW alone has signed-up to $108.5 billion of infrastructure spending over the coming years. So whereas the Federal Government has won back its AAA (stable) credit rating, NSW and Victoria were downgraded from AAA last year precisely because of these big spending plans.

While the State deficits did come in materially lower than the market had expected (as we projected), NSW’s $35.5 billion borrowing program for the 2022 financial year was a nontrivial surprise. And although NSW TCorp did subsequently highlight that last financial year they projected $36 billion of debt supply only to raise just $24 billion (ie, chunky downward revisions are possible), the market has punished NSW with a large increase in its debt servicing costs.

Interest repayments on NSW government bonds have jumped as much as 15 basis points since this surprise. In fact, the market appears to have had a sense of this news some weeks prior with the total increase in NSW interest costs summing to as much as 15 to 20 basis points (a little like the Aussie dollar jumped almost half a cent before the jobs data surprise released last month).

All the other State’ borrowing costs have been dragged up by almost as much as NSW, costing taxpayers as much as $700 million a year in extra interest assuming all existing and new debt is refinanced at these higher rates over time. This puts State borrowing costs back to where they were in October 2020 before the RBA’s QE program started, wiping-out the 10 basis point benefit research implies the RBA's bond purchases bequeathed.

The States do still capture the value of lower Commonwealth government bond yields since they borrow at a spread to this benchmark even though they are effectively a similar credit risk. And the RBA’s QE program remains a huge success, sparing exporters and import-competing business an Aussie dollar trading at US85 cents or more.

While the RBA has signalled through media conduits that it does not want to taper QE ahead of the Fed, and wants to observe the impact of other central banks withdrawing stimulus, economists and the market are convinced it will prematurely exit this policy, leaving the Aussie dollar to its own devices, by June 2022.

This betrays an inherent contradiction: if the consensus thinks the Fed will taper through the entirety of 2022, why would the RBA get ahead of the world’s most important central bank, and allow Aussie rates and our dollar to climb at the same time as we open our borders to a deflationary human capital shock?

In fact, it is not hard to imagine a world where the RBA rationalises maintaining tapered QE all the way through to the first hike in its cash rate some time in 2023. In that way, it would create a smooth continuum between long-term interest rates and the Aussie dollar gradually climbing and the first change in the official cash rate.

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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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