Speech The Outlook for Financial Stability – Globally and in Australia

We are joined by Dr Brad Jones, who is Assistant Governor in charge of financial systems at the RBA, and he will be speaking with Damian Hill, CEO of the Commonwealth Superannuation Corporation and ASFA Board Member.

Well, everyone, welcome to this fireside chat in keynote 2. We’ll be delving - we intend to delve into the international economic developments around the globe and the interaction of the superannuation funds of Australia in the financial system. And I’m joined here by Dr Brad Jones, and just to continue the theme that the Assistant Treasurer raised, Brad tells me that he’s got a 15-year-old daughter who is also a Swiftie, and should be equally unimpressed by the size of this audience versus the Taylor Swift concert. When we look around the globe there’s a lot of areas of instability, whether it be the wars that are happening, whether it just be politics that play at various parts of the globe, whether it’s the technology that is changing so rapidly in front of us. We’ve seen the financial services - well, the financial services payment systems, et cetera, a lot of digitisation in that, and each and every one of us benefit from that each day in the convenience that we have. But as it continues to go that way, as more technology is provided, it means money and other aspects of the financial services system move more rapidly around. And so without those frictions, what may be at play?

So what we thought we’d do is we’d start in the international environment, spend some time there, and then go into more of the super funds and the domestic environment. So if we start at the international markets. Brad, one could be forgiven for saying it’s boom times. We’ve got stock markets at record highs. We’ve got credit spreads near lows. The private credit market is booming. What’s to worry about? So really interested in what are the sort of things that you worry about and that worry the RBA?

Thanks, Damian, and terrific to be here. There’s plenty of things for us to worry about, in some sense that’s our job. To rattle off a list, I think first and foremost is the fragmentation we’re starting to observe in the international system. That’s got a security dimension, it’s got a trade dimension, it’s got an international financial dimension. Second would be the levels of sovereign debt around the world. It’s becoming increasingly difficult to see how anything other than a protest or a crisis, even in the bond market, is going to be sufficient to jolt decision-makers, fiscal authorities from their current path. Most G7 countries now have debt to GDP ratio in excess of 100 per cent. We’re normalising the running of wartime-like deficits in fairly benign economic conditions. And at the same time there’s rising supply of sovereign debt internationally. There’s less demand from - let’s them captive buyers. So there’s a few things to worry about there. A third would be, just as you alluded to in your question, the levels of risk premiums being so low across equity, credit and bond markets and the scope for a very sharp re-pricing, given how leverage is being used in some of those markets and given the concentration risks now in some of those markets. A fourth concern would be the long-running issues around the macro financial imbalances in China. I can speak about that a bit later if you like. And a fifth would be, as you also touched on, the scope for major operational disruptions in our financial system to coalesce with liquidity risk. And that could happen either through confidence channels or through major disruptions to the plumbing, to the actual movement of payments and the settlement of transactions. So they’re all the things that keep us awake at night.

That’s a good list of start with, I suppose. Yeah. Just getting back to the risk premiums, et cetera, and where they’re at. Obviously you and the bank have a view that some sort of re-pricing is going to take effect. You can’t necessarily tell exactly what that is. But why do you think that the prices aren’t where they should be at the moment? What’s sustaining that?

It’s not so much that we think that the levels of risk premium are completely unsustainable. We’re just surprised that there’s not a bit more reflected in those levels of spreads, given what we observe, which is quite a confronting set of potential risks. I think this issue comes up a lot internationally. A lot of central banks are scratching their heads as to why market pricing looks so benign. The sort of explanations that I’ve heard in my travels, number one, the fact that various tail risks have not materialised so far this year is sort of emboldening the animal spirits a bit. That could be one. Another could be, I hear some market participants play back to me, a sense that, well, if things ever started to get disorderly that the authorities, fiscal, monetary, whatever, would step in and put out the fire. Personally I think that’s a pretty dangerous way to be allocating capital but that’s a view I have heard in the markets. And I think a third is, particularly with respect to geopolitical risk. Markets just have a heck of a time trying to price binary events, extreme events, that they may not have had any lived experience with. I look back, just for instance, at the Cuban Missile Crisis, which we stood on the brink of catastrophe. The stock market fell about two or three per cent over that period. So I think just as a general rule the global financial markets have a tough time pricing binary risks, like geopolitical risk.

Yeah. Certainly I talked to my CIO, it’s almost - it’s not that you ignore them, but you sort of say, what can I control? How do I keep optionality in that sort of environment? So I’m not hit one way or the other just by the binary nature, as you say, of some of those risks. You mentioned in the answer to the opening question, your concerns about fragmentation of the financial system, et cetera, like that around the globe. I wonder, what do you mean by that? What’s the standing or the drivers of it and what really are the concerns and what should we be aware of?

This is a prime example of an area where we’re focused. Where we’re thinking very deeply about how the next crisis could look quite different from the last crisis or, in fact, the types of crises we’ve observed the last 30 or 40 years. I should say at the outset, I think we have to resist viewing all changes in the international system as being symptomatic of fragmentation. That term is getting bandied around now pretty loosely, as a bit of a catch all, and I think it can obfuscate as much as it illuminates. Just as an organising principle, I think about fragmentation, I think about it being a deliberative strategy to negate the risks of a perceived strategic arrival, so it’s got an economic security underpinning to it, which is quite different from the, sort of, just natural organic changes that will occur over time in the international system because of changes in, say, the economic balance of power. So as countries become more preponderant in global trade, you would expect certain things to change in terms of the usage of its currency globally. So we need to, sort of, demarcate changes along, I think, those two dimensions. But where we see some evidence of fragmentation occurring internationally, there’s four or five areas.

First of all, the deployment of financial sanctions, quite clearly, is one area. Another, capital flows. What we observe there is a little more fragmentation on the foreign direct investment side, which makes sense because it’s most closely tied to trade, as distinct from other types of, say, portfolio flows. We see some emerging evidence of fragmentation playing out in reserve asset holdings for central banks. So, for instance, the rise in gold holdings. There’s a certain cohort of countries that basically explain all of the increase in gold holdings from central banks. And clearly the risk of asset seizures, sanctions is sitting behind some of that. We also observe some evidence of fragmentation in the global payment system. And, finally, the global financial safety net is another area that has been spoken about as a potential example where fragmentation may occur. I would say as of today that’s more a fear than lived reality. But they’re the sort of - that’s the scope of issues that are in play when we’re thinking about this issue.

Can we just perhaps dive a little bit deeper into just one of those, and you talked about the fragmentation of the payment system. Or starting to see that. What do you mean by that? And what would we, as super funds, be observing, or should be observing in that area?

What we’re seeing is some countries internationally are establishing a system, a payment system, either messaging system, or settlement infrastructure, or both, that would basically allow payments to move across borders, without necessarily touching the US dollar or the US dollar clearing system. So that’s one example. There’s a whole range of initiatives that we observe internationally. We don’t see any of them, sort of, posing a systemic threat yet to, I think, the mainstream mechanisms for financial systems like ours to move capital around the world. It’s sort of happening more on the periphery with a certain cohort of countries but it is gathering some momentum.

Yep. Okay. Something to keep an eye out for, I suppose. You said at the start, obviously our economy is very tied to China. And we used to, when the United States caught a cold - sorry, sneezed, we caught a cold. And now we’re obviously a lot more tied with China. How are you seeing the risks in the Chinese economy, and also their financial system?

Yeah. We don’t see a sudden stop type of scenario as being the base case for the resolution of all the imbalances that have built up steadily over time. In China the idea of a sudden stop, where the financial system has like a cardiac arrest is really a model that we have observed over the span of history and emerging markets that owe a lot of debt to foreign creditors. That run big trade deficits and have to plug that with external finance. And that’s not how the financial system is configured in China. There is a lot of debt, but it is principally owned domestically. And so what we’re observing in China now in response to, say, the imbalance in the property sector is a long, drawn out, de-leveraging, and where the authorities get to dictate the pace of that de-leveraging, in a not dissimilar way to what we saw in Japan in the late 90s, early 2000s after their asset price boom.

A larger concern would be if the Chinese external sector were to lose access to foreign markets because you’ve seen a very deliberative strategy by the authorities in China to build out their industrial and technological prowess. And that has resulted in a lot of investment support - the export sector. If we ever got to a point where other countries just said, we don’t want to absorb those exports anymore for whatever reason, that would obviously start to create some real problems. There’s arguably some tentative evidence of excess capacity in certain pockets of the Chinese economy already in the industrial sector, and we see some evidence of that in the fact that there’s deflation in China now. Nominal GDP is increasing at a slower rate than real GDP. And in economy that has a lot of debt, deflation can be quite problematic. So they’re the sorts of things that we have on our radar.

So, you’re keeping a close eye on all the trade banter, I’ll just call it banter, that’s probably a bit kind, between the United States and China.

I think every country is keeping a close watch on that.

Yeah. So what concerns you, just the same concerns or anything in particular that, sort of, comes out of that?

No. Well, as I said, it’s really the big question on the trade front is that, will the rest of the world continue to absorb Chinese exports?

Yeah, whether there’s reasons for them not to. Okay. Changing tack a little bit, there’s been a lot of buzz around stablecoins and digital assets in the US now that some key reforms have gone through recently, and obviously they’ve got a very public backer in those reforms, and we see the tokenisation of assets all the way through. You - one of your responsibilities, and I think like many people my knowledge of the Reserve Bank was, sort of, Michele Bullock and setting interest rates and monetary policy, but obviously there’s a lot more to it and you lead another area of the bank. But one of the areas you lead is the future of money program at the RBA. So maybe you want to tell the audience exactly what that is. But how are you viewing the developments of stablecoins and all those things and what it might mean for Australia?

Yeah. We’re - as you can imagine, we engage very intensively with our counterparts internationally to make sure that we really understand all the issues associated with new forms of digital money, by digital money I’m referring to central bank digital currency, tokenised bank deposits and stablecoins. So that’s the universe. We’ve actually been - at the RBA, in conjunction with our research partners, Digital Finance CRC and also with industry. In recent years we’ve conducted a number of exercises. In fact, right now we’re in the middle of a pilot program where we are examining how wholesale central bank digital currency, stablecoins and tokenised bank deposits, could potentially be used as the settlement asset for transactions in tokenised asset markets. So, for instance, the use cases that are in the scope of our, what’s called Project Acacia, includes everything from the tokenisation of government bonds to the tokenisation of trade receivables, tokenisation of carbon credits, all of those areas are in scope. So we’re really focused on the question of, how could new forms of money, how could new forms of settlement infrastructure help uplift the functioning of our financial system?

Outside of the work that we’re doing at the RBA with our research partners in industry, there’s also some important work that government are advancing. One of those threads relates to a review of their enhanced regulatory sandbox, which at the bank we very strongly support. We think there’s a great opportunity to make sure that experimentation in the frontier technologies, in digital finance, can occur in a responsible way, and so we’re very supportive of that review. And there’s also a piece of work coming down the pike related to payments licensing reforms that we expect to advance last year - next year rather, which will create more certainty for industry to innovate with very clear - within very clear guardrails and provide concrete protections for users of these innovative sources of money and payment facilities. So that’s basically the scope of our work there.

But I would just step back and just leave you with this, I guess, two messages. One, as it relates to the domestic retail payment system, we think it is extremely competitive by global standards. It’s in good shape. There’s always ways it can be improved, and we’re actually looking at that right now. But generally speaking, we see two major opportunities for significant uplift in innovation in this area. One relates to our wholesale markets and the role that tokenisation of financial securities could play. And the other relates to cross-border payments. The movement of money offshore is still very expensive. It takes a lot of time. We think there’s big opportunities to improve there. And, in fact, it’s actually a commitment that Australia has to the G20 to make progress there. So they’re all the use cases that are very much in focus as we think about how new forms of money and financial infrastructure could uplift the functioning of our financial system.

So, if you look, say, ten years in those two areas, you look ten years forward as to, you know, and Australia has taken the opportunity to innovate in this area. What does it look like?

We don’t know, which is why we’re running all of these pilots and experiments. I would stress we have a generally open mind. We see our role here at the Reserve Bank to ensure competitive neutrality for industry. To innovate, to level the playing field, so to speak. To make sure that our payments infrastructure is as resilient and conducive to innovation, as it can be, in a way that preserves monetary and financial stability. But beyond that we really think it’s important that the private sector take the lead on innovation. We can provide the base layer, trust in money, trust in settlement, a competitive playing field. Beyond that we really want to see industry, sort of, unleash the innovative spirits and - who knows?

Yeah. Well, that’s a great segue. We might move more to the domestic market and the super funds. Obviously you put out a financial stability report. But, in effect, your focus and analysis of the sector has increased dramatically, and ASFA has been a part of that interaction with you. Now, there was a time when the super system was so small that it probably - it didn’t matter so much. I don’t want to say that we’re ever a rounding error, but now that we’re $4.3 trillion and going a lot further in that regard, obviously systemically we can have a lot more impact on it, and we sort of talked about some of those perhaps in the opening to this session. So from a financial stability perspective, and that’s one of the key roles of the RBA, what are the things that you do worry about? And, indeed, what are some of the things that perhaps you don’t worry about?

Let me echo the sentiments from the Assistant Treasurer and the Treasurer earlier, which is we think that the retirement savings pool in Australia is a national asset. And I would also say that historically the super fund sector has been a stabilised - had a stabilising influence on our financial system. So that’s the starting point. And we don’t see the sector posing systemic risk today. That said, and as your question kind of set it up neatly, the system is evolving. It’s growing rapidly. And so it would be, if you’re like, a dereliction of our duty not to be thinking about potential scenarios where over the passage of time, conditions could evolve and change and risk could emerge. And so we do spend a lot of time thinking about, well, how could that play out? What states of the world could that be an issue?

On the liquidity risk side, which from a systemic point of view is a key issue, that’s sort of well within our wheelhouse at the RBA, we think about systemic liquidity risk. The thing that would concern us the most is if you had a confluence of shocks. So that could be a major market stress event, coinciding potentially with a wave of operational attacks, cyber-attacks. You know, we arguably had a dry run in April earlier this year where those two things coincided. Where you could see an undermining of confidence in the sector. And added to that would be, if there were policy changes, which for instance early withdrawal in a crisis, which meant the system was no longer a closed-loop system. Because it’s really managed as a closed-loop system. So money can move around within it from defensive assets, and from growth assets and the defensive assets but it stays within the system currently. If you had a major external shock and then a net withdrawal of liquidity from the system at the same time, that’s going to make life for you and your colleagues and, in fact, for many folks here, quite difficult. By virtue of the sheer size of the industry now, the ownership share of the super fund sector in certain liabilities. The super fund sector holds between 35 and 40 per cent of the bank bill market, for instance. It would be unrealistic to expect all those funds to be able to sell those assets to meet liquidity calls at the same time without creating real disruptions, particularly if you had capital calls at the same time and maybe you had margin calls on your FX hedges.

Now, I want to make sure I’m providing a balanced assessment here. There has been a significant uplift in liquidity risk management practices across the sector. On the whole, I think the general sense from regulators is it’s been a bit uneven though, so that some of the larger funds, and you see that, for instance, in the sort of expertise they’re bringing into their institutions, are really doing liquidity risk management in a much more rigorous way than in the past, and the events of 2020 were a good, sort of, I think, catalyst for that uplift, but it is a bit variable. And so that’s an area I know that our colleagues at APRA are watching.

The other area, additional liquidity risk, is on the foreign exchange risk side where we just have a watch on. The growth in assets, you know, half of the asset pool now is invested abroad. Over time that share will go up. More of that will be hedged because more of those flows will be fixed income related as a result of our demographic profile, and there tends to be a higher hedge ratio for fixed income holdings abroad. So - and the margin requirements will probably become less favourable as the counterparties that your industry engages with expand beyond, just say, the major banks. So you can see a world where hedging demands are going to increase and the management of foreign exchange risk is going to become a bigger deal for the industry. So what I would say there is, you know, using stress tests and reverse stress tests very creatively. Not assuming that historical correlation patterns are necessarily going to hold. Just in general, don’t assume the past is a good guide to the future, would be a general piece of advice.

I think I’ve read that in a PDS somewhere, I’m pretty sure.

You may well have.

Yeah. Now, Brad, I know that you’re only recently off a plane from, I think New York and Washington and all that, and I’ve got to get you back on a plane out of here very quickly. So thank you very much for your generosity of your comments. Can you please join me in thanking Dr Brad Jones.

Thank you. Thank you, Damian, Cheers.