Melbourne APEC Finance Quarterly

Issue 6, March 2009

Welcome to the newsletter of the Melbourne APEC Finance Centre.

In our 6th edition we continue to look at issues associated with the continuing global credit crisis. Commonwealth Bank Chief Economist Michael Blythe comments on the various government stimulus measures introduced to combat the crisis; Dellfield Consulting’s David Jones offers cost saving ideas appropriate for the times, and JP Morgan’s Duncan Beattie looks at the “pre and post” market conditions for Australian borrowers in the international debt markets. Plus our own MAFC director Ken Waller provides his thoughts on the need for greater regional co-operation and co-ordination in Asia.

GLOBAL STIMULUS PACKAGES - WILL THEY WORK?

Michael Blythe is the Chief Economist for the Commonwealth Bank of Australia

Hopefully today’s policy makers have learnt from the past

Fear and loathing were the dominant themes of 2008. And unfortunately these sentiments seem to have carried over into 2009.

The risk lies with producing worse economic outcomes than can be justified based on the pure economic fundamentals. Comparisons between the current problems and the 1930s depression are, for example, very popular in the current environment. But the differences are probably just as important. The Great Depression was no doubt deepened and lengthened by some policy mistakes. Hopefully today’s policy makers have learnt those lessons and history won’t repeat. The size and speed of the global policy response is encouraging, as is the range of measures being deployed.

It is also worth remembering the policy reform efforts of the past couple of decades. The primary objective of those reforms was to improve the underlying workings of the economy and enhance the ability to withstand negative shocks.

Central Banks have a critical role

The key global issues for 2009 are:

• whether policy makers have done enough to restore liquidity, capital and confidence to the global financial system;
• whether policy makers have done enough to contain the knock-on effects to the real economy.

Central banks have flooded the system with liquidity to allow markets to function and accommodate the deleveraging process. Quantitative easing measures are being deployed. The expansion of central bank balance sheets provides graphic testimony on how far policy makers are prepared to go. The size of the Fed’s balance sheet, for example, has nearly tripled relative to the norm prior to the onset of the credit crisis. But progress in freeing up market workings has been painfully slow.

A fair amount of progress has been made in recapitalising the global banking system through private raisings and part government nationalisation. Some rough estimates by the IMF suggested that the global banks need about USD1.4trn of new capital. To date, those banks have raised USD01.0trn (or ≈69% of the IMF’s estimated requirements).

Confidence needs to be restored

The restoration of confidence remains elusive, however. One of the lessons from the current crisis is the importance of confidence to the operation of the financial system. And once lost how hard that confidence is to restore.

Much remains to be done in terms of the Fitch checklist for restoring confidence. But some, progress has been made:

• The global banks have announced losses and write-offs amounting to USD1.1trn. The IMF expects the total losses arising from the US sub-prime debacle to amount to USD2.4trn. So we are around the halfway mark of the disclosure process.
• Falling US residential construction and house prices will help clear the excess supply of dwellings and help stabilise house prices. US housing affordability has improved sharply. Swings in affordability typically lead swings in house prices.

Recovery may take longer than normal

The missing link is “economic recovery”. The major concern is that recessions preceded by a period of financial distress are typically larger and longer than “normal” recessions. The type of financial stress also matters. Recessions related to banking system stress are typically more painful than those following periods of securities markets or foreign exchange markets stress.

Recessions are more closely correlated with financial stress episodes when house prices and credit/GDP ratios rise quickly and firms and households are dependent on external financing. Unfortunately many of the advanced economies tick all of these boxes. And not surprisingly most are in recession.

The size of the global policy response dwarfs anything seen in modern times. Policy interest rates are at record lows in most economies. Very large fiscal packages have been announced. The IMF has estimated that the fiscal stimulus injected into the G-20 economies is worth 1½% of GDP in 2009 and a further 1¼% in 2010.

Fiscal measures have been biased towards the expenditure side, with many countries favouring increased spending on infrastructure. Revenue measures tend to focus on the household sector and involve cuts to personal income tax and indirect taxes.

Governments are putting a lot of money on the table

Many governments are taking the opportunity to deal with previous policy shortcomings. The focus on infrastructure spending is appealing. It will have a significant impact on economic activity. But the lags are long. Tax measures should have a more immediate impact. But they need to be targeted at the groups most in need and most likely to spend.

The Australian approach to applying fiscal stimulus has some appeal. The experience with earlier attempts to pump prime that were too small or too slow has resulted in a mantra to “go hard, go early and go households”. The idea has been to inject enough immediate stimuli to carry the economy through to the point where lower interest rates and infrastructure spending generate a self-sustaining recovery.

A lot of public money is being put on the table. The IMF estimates the general government balance for the G-20 nation will deteriorate by 3½% of GDP in 2009. This resort to the public purse brings with it demands to keep the money within the domestic economy. This turning inwards could pose a threat to world trade and policy that would limit the contribution to economic recovery. Hopefully policy makers can resist the temptation.

COST REDUCTION – SOURCING NEW IDEAS

David Jones is Director of Dellfield Consulting Pty Ltd.

As the Global Financial Crisis deepens, the financial services industry is looking to rein in costs.

The continuing global financial malaise is forcing participants in the financial services industry to stringently review their cost structures. As markets contract and revenues fall, it’s vital for companies to ensure that their ongoing cost bases are sustainable.

One of the most immediate reactions in a market downturn, is to reduce headcount. However, staff reduction programs should occur in a rational manner and with an eye to the medium term. The financial services industry in particular, comprises a highly skilled workforce, and studies undertaken have demonstrated that some “big bang”, enterprise wide staff reduction programs can cut too deeply resulting in a widespread loss of corporate memory and the ability to operate efficiently. Additionally, a “survivor” syndrome can develop, with members of the remaining workforce disillusioned and unwilling to put in the effort the company has previously taken for granted. These factors, coupled with redundancy costs, can materially erode benefits, and leave companies poorly positioned to take advantage of the market rebound when it does occur.

The Sourcing function can play a key role

Commencing in the 1990s, the finance sector has significantly increased levels of sophistication, and the quality of expertise devoted to what was previously termed “purchasing”. Purchasing was an inefficient clerical activity; decentralised and carried out by junior or unskilled staff in a task orientated manner. Now, companies across the finance industry have replaced purchasing clerks with skilled teams of strategic sourcing specialists, contract and project managers responsible for constantly reviewing and implementing strategies to drive operating costs down.

Sourcing professionals can play a key role in extracting cost savings from non labour expenses in the current environment, and help to balance the need for headcount reduction, as part of enterprise wide cost reduction programs.

Sourcing impacts across multi billion dollar cost portfolios – the rewards can be significant

Sourcing activities impact across multi billion dollar expenditure portfolios; categories which include IT hardware and software, voice and data, postage, stationery & supplies, insurances, travel, training, accounting audit & taxation services, consultancy & legal services, recruitment agency costs, marketing, and print; hence the rewards from a “can do” program of cost savings initiatives can be significant. Even after years of restructuring and process improvement, there will still be untapped opportunities to reduce costs. Although these opportunities will differ from company to company depending on the maturity of their respective sourcing programs and the categories of expenditure to which attention has previously been devoted, there are some common strategies which are appropriate to consider in the prevailing conditions.

• Review existing contracts. The breadth of the global downturn presents an opportunity to review and renegotiate many existing supplier arrangements. Rivalry will be keen as suppliers endeavour to protect and aspire to increase their share of wallet.
• Are variable expenses reducing as they should? Expenditure on certain goods and services (eg domestic travel, office consumables, and many high cost professional services) should be reducing automatically in keeping with reduced headcount and business activity. If not, reasons should be investigated, and management action taken.
• Implement demand management strategies – particularly those which substantially reduce or eliminate cost altogether. For example, is all software maintenance essential? Software is a major expenditure item across the financial services industry, and there are ongoing maintenance and support agreements costing around 20% pa of original licensing payments for most applications. A surprising percentage of these applications are non critical, very stable and there hasn’t been a need to fix, upgrade or otherwise avail of the vendor’s maintenance services. Hence they could be dispensed with, or converted to time and materials “insurance” type agreements. Another example - International air travel is expensive and many companies permit business class – expanded use of tele and video conferencing in lieu will yield material savings.
• Revisit initiatives previously consigned to the “too hard” basket. The best of any initiatives previously deferred, should be brought back to the table. Many of those ideas will have been sound – it would just have been that they were not deemed to be the highest priorities on the list when they were considered and/or buoyant business conditions did not deem them to be an imperative at the time.

Management empowerment, planning and execution are important.

Sourcing departments are typically incorporated within a Shared Services or CFO’s unit, so empowerment by top management is necessary when prosecuting major initiatives generally, and particularly when seeking to introduce a step change in cost savings. Careful planning and high quality execution are also vital to the success of any major project. To navigate these challenges:

• An explicit mandate should be obtained, and be demonstrably supported by top management.
• The program should be adequately resourced. It is unreasonable to expect teams responsible for delivering a material (and accelerated) program of savings, to manage their business as usual commitments as well. The former will inevitably be at the expense of the latter. Also the right people should be allocated to the work – if additional resources are required, then secure the best expertise available.
• Direct stakeholder involvement is vital - working groups comprising key internal stakeholders should be mobilised and actively involved in the process.
• The program should be adequately resourced. It is unreasonable to expect teams responsible for delivering a material (and accelerated) program of savings, to manage their business as usual commitments as well. The former will inevitably be at the expense of the latter. Also the right people should be allocated to the work – if additional resources are required, then secure the best expertise available.
• The program should be overlaid with an effective governance regime – including steering committees comprising appropriately senior executives, to address roadblocks and facilitate agile decision making.
• Targeted savings should be baked into discrete business unit budgets – this creates a shared responsibility between Sourcing and the Business Units themselves to deliver on agreed targets, and also ensures the savings are sustainable.

In summary

Companies operating in the financial services industry should be looking to their Sourcing specialists for meaningful cost reduction contributions at this pivotal time. There will be untapped opportunities no matter how much attention has been devoted to cost containment in the past, provided the right degree of planning and commitment is exercised.

THE GLOBAL CRISIS AND FORCES REQUIRE ENGAGEMENT BY ASIA IN SHAPING INTERNATIONAL FINANCIAL STRUCTURES

Ken Waller is the Director of the Australian APEC Centre at RMIT

The global financial crisis has shaken the global financial system and is seriously impacting on the economic and social base of countries around the world. In response, many economies are implementing policies that even 6 months ago would have seemed remote and unthinkable.

The major decline in global activity is accompanied by a continuing shift in the balance of economic power toward China, a shift evident for over two decades and one which will continue as a consequence of the pull of economic forces shaping investment and trade flows globally and as a consequence of the present crisis and the realignment and write-down of asset values.

While China is still not a market economy and has underdeveloped market structures which could impair its ability to adjust to the current crisis, it does have the fiscal strength and liquidity in its banking system to adjust and to realign its domestic investment and consumption policies to maintain a strong positive, even if a reduced, growth rate. IMF forecasts growth in China this year at 6.5% and rising to 7.5% in 2010 and and with no growth in the ASEAN (5) economies this year but rising to 2.3% the following year.

Even though the forecasts for China and Asia are subject to the caveat of being part of the highly uncertain outlook, a significant aspect of the composition of the IMF’s world growth forecast is that developing Asia, including India, China and ASEAN (5), is projected to grow by 4.8% this year and rise to 6.1% in 2010.

The global financial crisis is seriously impacting on real activity, trade and employment. The flow of credit to corporate borrowers and to individuals is seriously impaired in many countries. Credit contraction is also seriously impacting on trade credit and contributing to the sharp reversal in global trade volume, forecast to fall to -2.8% this year, from 4% in 2007.

Improvements in credit flows will be dependent on banks being recapitalized to a level where they have the capital base to support expanded lending and have the confidence to lend to corporate clients and to each other.

Critical to the restoration of financial systems and their functioning in the processes of global economic integration will be the need for countries to ensure that financial markets are open to authorized and well capitalised firms and institutions, that institutions do continue to provide risk capital to firms and individuals and that savings and investments are sensibly safeguarded under sound prudential management regimes. Prudential standards which reflect the interests of all stakeholders must underpin regulatory regimes and enhanced standards of corporate governance should be at the heart of regulatory regimes and apply with equal force to regulatory agencies and to private and public financial bodies.

As there have been varied responses in many countries to deal with the financial crisis, through direct intervention in markets and through monetary policies, so also are countries implementing policies to ameliorate the impact of the contraction in global growth. The forecast fiscal stimulus in G.20 countries will represent around 1.5 to 2% of GDP; in China a massive stimulus package equivalent to an estimated 14% of GDP is underway.

A question that will almost certainly arise as this crisis runs its course will be about the relevance of regional groupings in contributing to resolving the crisis – both in regard to the financial turbulence on regional financial markets and systems and in terms of ameliorating the contraction in real activity. The IMF and other major groups, including G-20 and APEC, emphasize the importance of coordinated action among economies to offset economic contraction and to promote growth and to maintain open markets for trade and investment flows.

Now, more that ever, governments and international and regional groupings need to resolve to approach the crisis with policies that aim to keep markets open and to ensure the cross border growth in trade, services and capital. Since these objectives are common to APEC and other regional groupings, it is timely that those groups developed strong and forceful roles in shaping the institutional framework that will form the architecture governing financial and goods and services markets.

As noted earlier, the shift in global economic strength toward China and India and Asia is on a positive continuum. That shift is being reflected in the forums that will shape future international economic and financial relationships. Governance in the IMF is changing to recognize these forces and most importantly, the G20 which does include major developing countries of the Asian region, Latin America, and in which Australia has an important voice, is developing a more prominent role in shaping the policy framework that will guide global arrangements.

APEC, ASEAN and other regional groupings and their regional business and academic supporters should become much more active than they have been to date in developing and promoting policies that will influence the emerging global financial architecture and they should carry those policies into G20 and other relevant forums.

The focus should be to develop robust policies on such matters as the limits that might apply to leveraging by financial institutions, to a policy framework requiring early and sufficient data from major capital markets on cross-border capital flows, particularly those into the region, but also more broadly, on agreement on the exchange of data between international and regional financial regulators and the publication of data to financial markets on a timely basis. Some important work on early warning systems has been undertaken by ABAC, the APEC Business Advisory Council, and this should be revisited and further developed.

This proposed regional approach is not intended to duplicate that of the IMF, the World Bank, the Financial Stability Forum and other groupings. Rather, it is that regional groupings, including APEC and ASEAN, should develop positions that would carefully reflect regional interests and which should be major inputs into the policies that will shape emerging international architecture.

INTERNATIONAL BOND MARKETS POST THE "CRUNCH"

Duncan Beattie is Executive Director Debt Capital Markets at J.P. Morgan Australia Limited

Following the “crunch”, Australian financial and corporate borrowers have been dealing with dramatically different circumstances when approaching the global bond markets to roll over existing, or raise new term debt.

Australian Bank Issuers: Access to Wholesale Funding

Australian banks remain in very good shape compared with their international peers and continue to fund their lending activities through two principal sources, customer deposits and wholesale funding. Deposits have grown substantially recently but the ongoing global financial crisis has made it harder to access the wholesale funding markets and also significantly increased the cost of this funding. The term debt funding requirement of the four majors for the current fiscal year totals AUD 100bn, and all the majors are well on their way to successfully completing this funding task well ahead of schedule.

However, the unguaranteed market remains extremely challenging and only open to a very small number of issuers.

Before the onslaught of the credit crunch the majors would have been able to complete the AUD 100 billion term debt funding requirement by issuing unguaranteed bonds to both domestic and offshore investors. However, with the market dislocation the unguaranteed market remains extremely challenging both domestically and offshore with only a very limited number of unguaranteed trades since Lehman Brothers filed for bankruptcy. These include CBA in the domestic market, Goldman Sachs in US dollars and HSBC, BBVA, Caixa Geral and Rabobank in Euros, illustrating investors preference for highly rated “national champion” credits when they do buy in unguaranteed format.

The government guaranteed market has become the principal source of term debt funding for the Australian banks.

The majors have all been very active in the domestic AUD government guaranteed market where funding costs are lower than the offshore markets. We have also seen all the major Australian banks and Macquarie Bank active in the USD government guaranteed market which currently offers the best pricing of the offshore markets. The first USD government guaranteed transactions were sold to mainly to bank treasuries with the more recent transactions seeing a wider distribution to a broader group of investors including bank treasuries, asset managers, agencies, central banks, insurance companies and pension funds, as the investor base has grown. Other offshore markets are open to the Australian banks with Suncorp accessing the Sterling market in January and both Westpac and ANZ accessing the Samurai market in February.

The offshore government guaranteed market is now firmly established with the equivalent of USD 363 billion priced across US dollars, Sterling and Euros from thirteen jurisdictions since the guaranteed market was established in the fourth quarter of 2008. This looks like being the main source of term funding for the Australian banks until the unguaranteed market begins to function again and makes it more difficult to remove the government guarantee in the short term. Any concerns we have around access to the government guaranteed market centre around investor fatigue from the significant issuance or if there was an event that negatively impacted the government guaranteed investor base.

Source: J.P. Morgan as of 3 March 2009

The Australian banks have seen a dramatic increase in the cost of term debt funding since the start of the credit crunch.

By looking at the spread of recent government guaranteed transactions, adding the cost of the guarantee and then comparing this with the spread on unguaranteed transactions prior to the credit crunch you can get a sense of how much the cost of term debt funding has increased for the majors. In the domestic market this is around +125bps per annum for 5-year term debt funding and even greater in the offshore markets.

Australian Corporate Issuers: Access to the International Bond Markets

The offshore corporate bond markets have seen record issuance in the first two months of this year.

The corporate bond markets in the US and Europe have seen record volumes in the first two months of 2009. This has been driven by the significant cash balances investors currently hold, as well as the attractive yields offered, particularly when compared with yields on government debt. Supply has been concentrated from highly rated issuers in defensive sectors such as telecom, utilities, pharmaceutical and tobacco sectors. As part of the global deleveraging process, corporates have sought to access the bond markets in order to diversify their funding sources and place less reliance on their banks in a capital constrained environment.

Source: J.P. Morgan as of 3 March 2009

The most notable transaction this year has been a USD 16.5 billion multi tranche offering by Roche, the Swiss pharmaceutical company, in the middle of February which was also the largest USD bond ever. The sheer scale of the transaction illustrates the current strength of the market. They followed up the USD offering with a EUR 11 billion multi tranche offering at the end of February. Other notable issuers in the USD market this year include Anheuser-Busch InBev, Electricite de France, ConocoPhillips, AT&T, Verizon Wireless, Proctor & Gamble, Altria, Novartis, Unilever, Cisco, Hewlett Packard, Abbott Laboratories and Chevron. In the Euro and Sterling market has seen issuance recently from BMW, Tesco, Siemens, Imperial Tobacco, Vodafone, Shell, RWE, Volkswagen, KPN and Nokia.

Woodside completed the first Australian corporate bond issue in 2009 with a USD 1 billion 5-year and 10-year transaction in February.

Woodside successfully demonstrated that Australian corporate issuers have access to the international bond markets with a USD 1 billion issue at the end of February. They priced a US$400 million 5-year tranche at US Treasuries + 625bps and a US$600 million 10-year tranche US Treasuries + 612.5bps with strong support from asset managers and insurance companies. Like the Australian banks, corporate issuers have also seen their credit spreads dramatically affected by the credit crunch, although the low government yields mean the coupon levels generally remain attractive on an absolute and historical basis.

Conclusions

Australian financial and corporate issuers currently have access to the international bond markets, however these markets look set to remain volatile and characterised by periods of instability. The catalyst for a more stable environment will be tangible evidence that the global economy is improving and progress is being made restructuring the US and European banks. It remains unclear when we will see this will happen. There is a substantial risk that spreads remain elevated for the intermediate term. Issuers who have funding needs should not wait for a return to a lower spread environment which may not materialise. The simple conclusion for all issuers is to fund when the markets are open rather than when you need the funding and also to be as flexible as possible with regard to pricing, size and tenor.

The Melbourne APEC Finance Quarterly is edited & published by MAFC.

Copyright © 2009 RMIT University