RISK MANAGEMENT AND THE RE-INVIGORATION OF REFORM

February 2003

Nicholas Gruen Ric SimesLateral Economics Chief Economist

ICAP (Aust)

Traditional ideas of the economy

Managing Risk: a new theme for reform

Micro reform 1983 forwardFacilitating internal and external trade

A new agenda for reform

•Theory is fairly mature and much of it is robust •Results are

often commonsensicalsometimes surprising Governments should often invest more offshore Governments can lower risk by increasing their

exposure to risky assets•Gains are substantial

The optimal allocation of risk

•Governments always have an intrinsic advantage in the passive bearing of risk …governments are collective institutions > pooling is inherenttaxation powers give them lower costs of capital and bearing risk

•… while individuals and markets will often have large advantages in actively manage risk.Suiting individual preferencesGenerating and making use of local information and incentives

The optimal allocation of risk

Passively bear risk Actively manage risk

Larger role for Govt

Non-diversifiable risks (eg incomplete markets)

Severe externalities (macro-economic feedback)

Larger role for the private sector

Adverse selection and other incentive problems

Low monitoring costs

Diverse preferences etc

Two functions for government

•Government should actively help manage certain risks particularly

systematic risks to the macro-economy where there are large externalities

•Where risk is best managed by the private sector, government can contribute by facilitating the development of the right instruments and infrastructure

Five areas of public policy *

•We sample five areas of policy where a risk perspective offers scope for gains …1 public private partnerships2 fiscal policy3 the management of financial crises4 retirement income policy and 5 the management of the government’s balance

sheet.

*Order differs in paper

1. Public private partnerships

The principle governing risk transfer is that risk will be allocated to whoever is best able to manage it at least cost, taking into account public interest considerations. If risk is transferred inappropriately, the Government will pay a premium.

Partnerships Victoria, 2001.

PassiveBearer ofRisk $

Active Manager of Risk $

1. Optimal risk allocation

Qantas, CSL and various other privatisations

PassiveBearer ofRisk $

Active Manager of Risk $

Govt

Private

Government tenanted properties

PassiveBearer ofRisk $

Active Manager of Risk $

Govt

Private

Road development

PassiveBearer ofRisk $

Active Manager of Risk $

Govt

Private

1. Public private partnerships

•There may be continuity of PPPs with earlier government risk minimisation rather than optimisation.

•Victorian Government draws attention to the benefits of “risk transfer, relieving government of the substantial, but often undervalued, cost of asset-based risks”

•Governments ‘compete’ to take on risks through the ‘public service comparator’ which has an illustrative real discount rate of 6% for government.

2. Fiscal policy

•Theoretical disputes aside, there is broad support in Australia for countercyclical fiscal policy.

The principles of sound fiscal management [include] that … fiscal policy contributes … to moderating cyclical fluctuations in economic activity, as appropriate, taking into account the economic risks facing the nation …

The Charter of Budget Honesty

2. Fiscal policy

•A bi-partisan public commitment to ‘balance through the cycle’.

•An inability to run large sustained surpluses through the upturns.

•Thus either our capacity to run deficits during downturns is

compromised or

‘balance through the cycle’ is code for small surpluses, large deficits and deficits through the cycle unless downturns become much rarer.

2. Fiscal policy: Some responses

•Some countries are tackling this ‘fiscal drift’ successfully.

•New Zealand is now partially funding its governments retirement incomes liabilities from the budget.

•In effect this ‘moves the goalposts’ of a balanced budget by re-definition of the goal

2. Fiscal policy: Norway’s Petroleum Fund

•Established in 1990 to invest the proceeds of the North Sea Petroleum windfall

Petroleum and financial wealth

0

50

100

150

200

250

1970 1980 1990 2000 2010 2020 2030 2040 2050

Illustration from Government Long Term Programme 1997

Per

cent

age

of G

DP

Financial w ealth

Petroleumw ealth

Sum

2. Fiscal policy: Norway’s Petroleum Fund

•Norway has run large budget surpluses ever since!

Net Foreign liabilities

-150% -100% -50% 0% 50% 100% 150%

Italy

Belgium

Japan

Euro area

Canada

Germany

Austria

France

United States

Netherlands

Spain

United Kingdom

Iceland

New Zealand

Denmark

Australia

Sw eden

Korea

Finland

Norw ay

2. Fiscal policy: some numbers

•Prudent policy requires governments to be able to apply sufficient stimulus during downturns.

•Average downturn lasting for two years with the stimulus removed over the following two years suggests access to at least $30 billion.

•Options include, access of an existing bond market, the accumulation of financial assets, the issuance of new paper and the printing of money.

•We need net government assets of around 30 billion before we should contemplate removing bond market

2. Fiscal policy and government balance sheets

•Fiscal policy also needs to be able to address medium-term issues …

•… including through sustaining sizeable (structural) surpluses).

•New institutional arrangements and changed atmospherics are central.

•As discussed, Norway and NZ (and others) have moved down this path, so can we.

3. The management of financial crises

•Low risk events with large and lasting consequences.•The literature on the minimisation and management of financial crises is still in its infancy …

•… but the Australian economy and financial system scores very highly on any reading.

3. The management of financial crises

•“Despite its close trade and financial ties to Asia, the Australian economy exhibited few signs of contagion from contiguous economies, arguably because Australia already had well-developed capital markets as well as a sturdy banking system. But going further, it is plausible that the dividends of financial diversity extend to more normal times as well. The existence of alternatives may well insulate all aspects of a financial system from breakdown.”

Alan Greenspan

3. The management of financial crises

•Any alternative to bond futures would involve instruments based on liabilities of the major banks (eg swaps, or US treasuries hedged into A$).

•A consequence of the loss of diversification (and a greater degree of implicit government guarantee) would be the need for tighter regulatory oversight.

4. Retirement incomes: Risk sharing

•IG risk sharing tends to be best with defined benefits where the benefits are state contingent (eg pensions).

•Government is best placed to manage risk across generations because of its taxing powers.

•Also, to the extent that it influences aggregate saving rates, government can affect the total resources available to any particular cohort.

4. Retirement incomes: practice

•The shift to individual accounts was driven by a range of important considerations …

•… to allow for individual preferences …•… concerns over the management of funds and …•… especially, the need to lift national saving levels without being able to do so on the Government’s own account.

•Risk considerations entered in a secondary way.

4. Retirement incomes: some consequences

•A leading funds manager advertises the fact that selecting a manager who outperforms by 2% pa matters.

•Two individuals with identical histories and preferences that face the possibility of receiving retirement incomes, say, 20% apart may have been happier to have shared the risk beforehand.

•Similarly, Burtless (2000) found that pensions received by workers in the US averaged 80% of replacement rates in 1972 and only 40% in 1974.

4. Retirement incomes: role of government

•Many of the individuals bearing the increased risk are not well placed to bear or manage it …

•Reflecting this, many do not want to manage it . . . •… heightening the need for government to ensure that the infrastructure and tools for individual risk management are effective.

•Government can also influence national saving if there is over or, more frequently, under accumulation of assets for generations as a whole.

5. Government balance sheets

•Such objectives will arise more naturally if we can start to view Government’s balance sheets as an integrated whole.

•There will be governance issues, but manageable ones. These will be addressed in this afternoon’s session.

•Here, we simply note that the approach being advocated allows important questions such as IG income smoothing to be addressed.

Conclusions

•A focus on risk management suggests a range of improvements to economic policy.

•Partial views of debt, deficits and public ownership have side-tracked the desirability of integrating effective risk management into many areas of public policy.

•As part of this, the Government’s own portfolio of assets and liabilities should be managed as a portfolio

both as a whole of government portfolio and also in context of the wider national economy.

Implications for the debate over the bond market

• Counter-cyclical fiscal policy is aided by ready access to the bond market or, failing that, a portfolio of financial assets.

• Retirement income policies (as well as insurance more broadly or hedging by the corporate sector) argue for the government to ensure the best infrastructure and instruments for the private sector management of risks.

• A broad diversified financial system underpinned by strong banks and government paper represents best practice in minimising and mitigating the dangers of financial crisis.

• (Risk management is but one line of argument in support of the bond market – others include cost of capital, the efficient allocation of saving into investment, etc.)