Two political decisions that will reverberate through ages

Christopher Joye

Coolabah Capital

In the AFR this weekend I wrote that we’ve been recently gifted two rare cases of outstanding political leadership and bipartisan cooperation that will reverberate through time. The first is Prime Minister Scott Morrison’s bold decision to acquire eight nuclear-powered submarines via a new “three-eyes” alliance with the US and UK (hence “AUKUS”).

The Economist characterised this as a “profound shift” globally that will drive change in the “tectonic plates of geopolitics” akin to “Suez in 1956, Nixon going to China in 1972 and the fall of the Berlin Wall in 1989”. Australia’s finest national security commentator, Greg Sheridan, described it as an “astonishing development” that had “gobsmacked” the world. Sheridan stresses that Labor’s bi-partisan support is no less “historic”, although questions remain about the integrity of this commitment.

The second unprecedented event during the week was NSW Treasurer Dominic Perrottet’s remarkable decision to repay $11 billion of taxpayer debt at a time when NSW had been racking up record budget deficits and over $100 billion in debt due to the impact of the 1-in-100 year pandemic. Long-time market participants cannot recall any Australian government ever pre-emptively repaying debt to reduce fiscal risk in this fashion since possibly Victoria in the mid 1990s.

Credit rating agency Moody's applauded Perrottet, assessing that NSW’s debt retirement would "support the state’s AAA credit rating". "As a result, the state’s borrowing requirements will materially reduce over the next two-three years,” they said.

The head of at least one State government debt issuance agency was immediately asked by his treasurer to explain why they couldn’t do something similar.

The fundamental difference with NSW was Perrottet’s foresight back in 2018 to create a massive fiscal shock absorber called the NSW Generations Fund, which he seeded with $3 billion of surpluses and $7 billion from the sale of the first-half of WestConnex.

This money is held by a subsidiary called the Debt Retirement Fund, which under legislation Perrottet passed in 2018 requires its capital to be used to reduce State debt and to be managed in a way that maintains NSW’s AAA credit rating, lowers debt servicing costs, and avoids inequitably burdening future generations with unnecessary liabilities.

Bond markets were shocked despite the fact this solution had been publicly advocated by a few, including this column, former NSW parliamentary budget officer Dr Stephen Bartos, NSW Shadow Treasurer Daniel Mookhey, and this newspaper’s economics editor, John Kehoe.

In recent months NSW has been forced to pay higher interest rates on its debt than any other major Australian State, which had not happened before. After the news, the market compressed NSW's cost of capital inside South Australia and Victoria.

The Shadow Treasurer, Daniel Mookhey, one of the brightest young politicians going (who is also friends with his rival), and his Princeton-educated leader, Chris Minns, warrant special mention for offering Perrottet bi-partisan support.

Neither the putative premier prospect Perrottet, nor the Labor team have, however, revealed how they will use the circa $15 billion remaining in the Debt Retirement Fund to further reduce fiscal risks. Perhaps this becomes a key election issue.

The ostensible trigger for the decision was Perrottet’s sale of the second-half of WestConnex, which crystallised $11 billion in cash. While technically this must be deposited in the Debt Retirement Fund, Perrottet declared on Monday that it would be “used to retire an equivalent amount of debt”. NSW’s debt issuance arm, TCorp, subsequently clarified that this would be in the “next 12 to 24 months”.

One thing NSW cannot do is simply let its bonds mature, which it would have to repay with new debt. For the $11 billion to retire debt, either the Debt Retirement Fund has to buy-back the bonds or it could subscribe to a new NSW bond issue to allow NSW to repay them.

Perrottet concurrently announced a $5 billion commitment to building infrastructure in Sydney’s west, which has been hardest hit by the lockdowns. Following speculation this would be netted off the $11 billion in debt retirement, TCorp explained it was entirely independent of it.

This money could easily be reallocated from existing $20 billion in NSW capex that was slated for this financial year and has been underutilised. Alternatively, since the Debt Retirement Fund has $3 billion in accrued profits, and had more than $2 billion of taxpayer revenue allocated to it last year that was replaced with debt, it could subscribe for a new NSW bond that would pay for the $5 billion in WestInvest money, should this be needed.

This brings us to an important point that has been overlooked thus far. NSW has been diverting royalties and State-owned corporation dividends to the Debt Retirement Fund, which have to be replaced by new debt because the budget is in deficit. (This is not legislated, just a policy choice.)

Perrottet’s inspiration for establishing the fund, Peter Costello, who created the Future Fund, says that governments should only divert cash to sovereign wealth funds when their budget is in surplus. It would certainly be oxymoronic for the Debt Retirement Fund to repay $11 billion of debt while diverting billions in State revenue to it that must then be replaced with additional debt. In NSW’s 2022 budget, there was $7.2 billion of revenue allocated to funds in 2022 and a further $13 billion over the forward estimates.

As Perrottet is now transitioning the Debt Retirement Fund from its savings accumulation phase when he was delivering surpluses into the current fiscal risk reduction strategy as deficits mount, there is clearly a case for the revenues being funnelled into it to be returned to the State until the budget is in surplus in line with Costello’s maxim.

Future NSW governments should aspire to replenish Perrottet’s fiscal shock absorber with asset sales and structural budget surpluses to ensure it continues to serve as a globally unique counter-cyclical tool.

While in May we took profits on about one-quarter of our NSW government bonds, we retained a minority exposure because we forecast three key events: first, that NSW’s 2021 budget deficit would be much smaller than markets expected (it ended-up $12 billion lower than projected); second, that the Reserve Bank of Australia would announce a final round of government bond purchases worth $100 billion or more (current estimates expect it to total $147 billion); and, finally, that the Australian Prudential Regulation Authority would deliver on its promise to require banks to stop using their own illiquid loans and bank bonds as emergency liquidity and instead hold higher rated, and far more liquid, government bonds in the “foreseeable future” (despite bank lobbying, APRA announced this long-telegraphed decision two weeks ago).

What was an unwelcome surprise was the crazy proposal we unearthed in June to get NSW to stealthily take-on as much as $20 billion to $47 billion in extra taxpayer debt to allow TCorp to invest this money in Perrottet’s Debt Retirement Fund, which would then allocate it to equities, junk bonds, illiquid private equity, and hedge funds in what would have been the mother-of-all leveraged "carry trades".

This would benefit the banks paid to advise on the debt issuance, the fund managers that earn fees managing the money, and TCorp, which is paid to oversee them. But if interest rates ever normalised, and equities (and other risky asset-classes) ever mean-reverted back to historic valuation norms, it would have punished NSW taxpayers via a massive, pro-cyclical spike in their debt at the worst possible time. Standard & Poor’s and CBA arrived at similar conclusions.

And so, as the AFR previously reported and this column outlined, we embarked on an activist “environmental, social and governance” (ESG) campaign to highlight the risks of the scheme and put forward the alternative case for the Debt Retirement Fund to be used for the purpose Perrottet originally had in mind when he created it: that is, to reduce, rather than aggressively increase, fiscal risk.

The core “governance” (or ES‘G’) concern here was the extreme “moral hazard” associated with having a State government issue mountains of debt implicitly guaranteed by the Commonwealth, and which the RBA was buying, to enable fund managers and bankers to line their pockets in a “heads if stocks go up they win, tails if stocks go down taxpayers lose” dynamic. All power to Perrottet for ensuring NSW taxpayers avoided this fate.

Activist campaigns are never easy. You end up upsetting a lot of people: TCorp doles out as much as $100 billion to fund managers, including our peers and those owned by my largest shareholder, Pinnacle (ASX: PNI); banks lose out on highly lucrative debt issuance fees and any NSW bonds they were short-selling; and many warned that we would be punished with inferior allocations on new bond issues, although this has never actually happened.

On the subject of ESG, a similarly simple insight could have saved investors from exposure to the extreme ructions resulting from fears that large Chinese companies that issue vast quantities of debt into US dollar markets, like Evergrande and Huarong, will default on their repayments. And that is don’t provide funding to companies based in and/or owned by non-democratic states. While this seems extremely obvious, I have not seen others apply it (there must be some!). It is pretty hard to get comfortable with the rule of law, property rights, human rights, the absence of corruption, and freedom of private enterprise when you are dealing with autocracies...

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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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