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Address to the Association of Superannuation Funds of Australia: economic update - confidence is returning.

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Mon, 20th July 2009


The Hon Joe Hockey MP

Shadow Treasurer

The general tone of economic news over the past two years or so has been somewhat gloomy. We have

witnessed asset price shocks, global financial failures, deep recessions in many countries, a sharp decline in

global trade, and of course rising unemployment. There has been talk from time to time of another Great

Depression - ironically very few of us have ever experienced one.

Now that tone has thankfully changed. Over recent weeks we have seen a number of supranational organisations

such as the IMF and the OECD become more optimistic about the global economy and there is a firming view

that 2009 will be the low point for growth, that there will be a solid rebound in 2010, and that growth will return to

above trend by 2011, however I feel that that is somewhat overly ambitious.

But unquestionably that recovery will be led by the developing nations, particularly China, but even the developed

world can look forward to better days.

It seems the risk of a prolonged period of sub trend growth for the world is receding. While there are undoubtedly

risks and challenges ahead, it is increasingly likely that economic disaster has been averted for now.

The improvement in sentiment in the global outlook had been preceded by a stabilisation in financial markets and

this has led to a lift in confidence and the beginning of a return in appetite for risk.

Asset markets have been improving for some months. The Australian share market lifted some 18% between its

low in February and June (end month data). Although pleasing, it still has a very long way to go to regain the 50%

loss in value between October 2007 and February 2009. Nevertheless, we hope that the worst is passed. These

trends appear to be in line with movements in global markets, particularly the United States.

Measures of share market volatility have fallen from their highs, pointing to greater investor confidence.

Global term interest rates have begun to rise, in part because investors feel less need to be in safe haven assets.

I believe the large volume of new public sector debt issues has also been a factor in this, a point I will return to

later. So overall confidence is trending upwards, which is a good thing.

The Australian economy has performed very well during this period of global uncertainty. It has thus far avoided a

technical recession, defined by the economic boffins as two consecutive quarters of negative growth. Economic

growth remained positive over the year to June at +0.4%.

This was an impressive performance. Australia stands alone as one of the few, perhaps the only, developed

country in the world not to be in recession.

Furthermore, the prognosis for the Australian economy over the next year or two is better than most. Australia is

likely to record just one year of negative growth this financial year of -0.5%, but is expected to return to positive

growth in 2010-11 of around 2.25%.

This suggests the downturn in Australia will be on a par with - and certainly no worse than - the downturn in the

early 1990s. Again we can make a favourable comparison with the rest of the world, with the largest developed

nations being in the most severe economic contraction since the Second World War.

Australia still faces significant challenges. A number of sectors of the economy may continue to weaken over the

next year or two.

One of these is business investment. This country enjoyed a six year business investment boom up until the end

of last year. A lot of this was in the mining industry on the back of booming demand for resources particularly

from the rapidly growing economies of Asia. But the boom was more widespread than just that - it was impacting

on business sectors right across the country.

That boom is now over. Business investment is expected to contract sharply in 2009-10, in the order of 20%.

That is of significant concern. Business investment is critically important, not only as a driver of growth today, but

as a precondition for putting in place the infrastructure needed for stronger growth and more jobs in the future.

In a very literal sense business investment acts to lift the economy’s “speed limits to growth”. Private sector

investment is the engine room of future economic prosperity.

The second area of challenge will be the labour market. This economy has already lost 55,000 jobs since

October last year. All of these have been full time jobs. In fact, nearly 160,000 full time jobs have been lost in this

downturn. This has only partially been offset by a rise of 127,000 in part time positions.

The unemployment rate has begun to increase. It has now risen 1.8 percentage points from its low of around 4%

in early 2008, to 5.8% in June. Private sector leading indicators such as the ANZ job ads suggest worse is to


The Budget Papers point to the unemployment rate rising to 8.5% in 2010-11. It seems to be realistic. As I

observed earlier, this economic downturn is likely to be broadly of the magnitude of the 1990-91 recession - and

this is the key indicator - during that time the unemployment rate increased by roughly 5% to just under 11% over

three years.

The increase in the unemployment rate this time round of 4.5% is a similar deterioration but off a lower base. So

the impact on human beings, the impact on the labour market of this downturn still has some years to run.

We believe, as a policy response that some of the Government’s policies have been misdirected.

We have seen billions of dollars directed towards consumption. Some of this leaked out of Australia through

spending on imports. Some was spent on goods and services that most of us would not consider essential or

even worthwhile.

We have seen vast amounts of money directed to unnecessary school projects, with some schools receiving

halls they did not want at prices well above what could be supplied by local builders - it’s not politically popular to

say that at all, but it’s the right thing to say.

And what concerns us most is this spending has been funded by deficit financing. The federal government and

state governments plan to lift public sector borrowings to record levels.

Just understand where we were at - After paying off previous governments’ debt, the Coalition government ran

budget surpluses, and I must say they were very hard to run.

Just to digress for a moment, there’s been some criticisms that have said “well, it was all the mining boom

proceeds”. Well in fact the Terms of Trade were at their most favourable for any government in the last eight

months. The Terms of Trade when we lost government were not as favourable to Australia as they were eight

months ago, even six months ago.

And so the mining boom has continued but we have seen a significant deterioration in Budget and overall that

was hugely impacted by the $124 billion of new spending commitments by the current government.

This Government has now commenced a sustained deficit spending program. It plans to run deficits for seven

years. At end June this year the gross debt on issue clicked over $100bn. And by June 2014 that debt will be


We believe this run up in debt is excessive. The Government’s own estimates suggest the economy will be

operating below its trend rate of growth for only three years and yet the Government plans to run deficits for

seven years.

Three years of need, seven years of massive deficits.

It is a very significant challenge for the economy on a number of fronts.

Firstly, government debt ultimately impedes private sector investment flows by pushing up the cost of debt and

crowding out sources of finance. It might be argued this is not of concern while private sector demand for funds is

weak, but of course private sector demand for financing will not remain subdued forever. As soon as growth

returns to the economy, the private sector needs to start to stimulate, therefore borrowing money. And of course

the government, as the 800 pound gorilla in the markets with a triple AAA rating, is going to be a very attractive

competitor to anyone that is seeking to find funds.

Now this is an environment in which the Australian private sector will want to return to the capital markets in force

by 2011, if not earlier. A prudent government would make room by vacating the pitch. But from what we

understand, the government is going to continue borrowing for a further three years after that so there will

inevitably be fierce competition for funds - and in this competition the Government will be the winner.

The Government should be doing everything it can to encourage business investment, but what we find is that by

the government continuing to borrow money to fund its deficits, it will be shackling businesses with less readily

available and more costly finance.

Now I think it is very important in order to understand where the global economy is heading, I think it’s very

important that you look at the competition and particularly the examples of the United States, the United Kingdom

and Japan - major developed countries that have gone down the road of high public sector borrowings.

International Examples

Turning first to Japan, if you want to know what government debt is about, have a look at Japan. In mid May,

Moody's Investors Service downgraded the Japanese government foreign currency credit rating from AAA to

Aa2. Moody's was the last of the three international ratings agencies to strip Japan of its triple-A rating.

Japan’s government debt is very large, at more than 170 per cent of gross domestic product, making it the most

indebted government in the OECD.

We need to remember that Japan got into this position as a result of massive government spending and

borrowing programs from the early 1990s. And has it helped? Well today Japan is in the most severe recession

since WW2.

Turning next to the United Kingdom, also in mid-May, Standard and Poor’s switched the UK’s rating outlook from

stable to negative citing there was a "one-in-three" chance that the UK’s AAA credit rating on its sovereign debt

may be cut.

This outlook revision was based on the view that the United Kingdom's net general government debt burden will

approach 100% of GDP.

Again this is the legacy of a sustained period of deficit financing of the UK government, not just of recent

measures associated with the global financial crisis.

The UK is also in the deepest recession since WW2.

In the UK the financial historian Niall Ferguson, who has written that wonderful tome “The Ascent of Money’ - has

warned of the dangers arising from the deterioration in the UK’s public finances. He suggests the probability of a

sterling crisis is around one in three and the probability of major tax hikes and cuts in public spending is roughly

one in one. He suggests yields on UK debt will have to rise significantly to attract buyers, and of course the UK

for the first time in 300 years is printing money to buy its own debt.

And what about the world’s largest economy, and it’s the one I’m most concerned about, the Triple AAA rated

United States?

There is a projected budget deficit for this year of around 13% of GDP, with accumulated government debt held

by the public projected to rise to US$17 trillion or 82% of GDP by 2019, and that doesn’t take into account

Obama’s massive commitments in relation to health care and also demands in the US for a further stimulus

package to try and get the US economy going.

Net interest payments on that debt in 2019 will be in the order of US$800bn a year. Interest payments will

comprise almost 16% of total US government expenditure, and this is assuming low interest rates. That’s nearly 1

in 5 of every taxpayer dollars being spent by the government just on interest. And this raises a whole raft of other


Traditionally these economies have inflated to lower the impact of government debt, and you are going to see

around the world a massive stoush between central bankers and governments, as governments hope to inflate

their way out of this massive burden of debt and central bankers fear the massive burden of debt and the

massive rise in interest rates and it’s impact on global growth.

There has been recent speculation in the media that the enormous size of the current and proposed fiscal

stimulus could eventually threaten the AAA rating of the United States.

On 18 June Standard and Poor’s said it was “unlikely” to lower its rating on U.S. government debt in the “near-term” despite noting the significant weakening in public finances - that doesn’t give me too much hope that the

US isn’t going to lose its Triple AAA rating.

And has the US economy benefited from years of accumulating debt? Well like Japan and the UK, the US is in

the most severe economic downturn in six decades. Note also that the Congressional Budget Office estimates

that the recent stimulus package (The American Recovery and Reinvestment Act of 2009) will certainly add to

economic activity in the near term, but could actually reduce real GDP by up to 0.2% in the final 5 years of the 10

year forecast period.

So governments that spend excessively now are going to pay a price for it further down the track in economic


Now what is interesting is that the US Congressional Budget Office is now warning against the long run dangers

inherent in the US fiscal stimulus packages. It warned in June that the US federal budget was on an

unsustainable path, and on current policy settings would continue to grow much faster than the economy over the

long run.

Now one of the reasons why there was such an aversion to government debt is because it actually reduces the

budget flexibility for the government. If I can speak bluntly, 95 per cent of your budget is locked in, in pensions,

aged pensions, single parent pensions, unemployment benefits, defence spending, Medicare, the PBS - all those

thigns which the Australian community expects to continue - roughly represents 95 per cent of the, roughly $340

billion of government expenditure. And so when you have net interest payments, as we will in Australia, of

roughly $10-11 billion per annum, that has a massive impact on politically sensitive areas of expenditure. Or you

have to increase taxes. None of those are particularly palatable, and that’s when political pain starts to hit home.

You can only run deficits for so long, but if you get to the point like the United States where you are simply

collecting taxpayer’s money to pay interest and still not being able to meet the challenges that the United States

has to, for example with global warming, terrorism, war, with a whole range of domestic factors, then you are

going to see, I believe, some significant political issues that will result in an economic growth cap over the next

few years.

I just want to touch on the global financial crisis and the superannuation industry. You would be more familiar

than I with how the industry has coped but I do want to touch on a couple of points.

The headline impact has been on the returns of funds. APRA data show six consecutive quarters of negative

returns on assets to the March quarter this year.

A recent private sector report estimates that the typical medium balanced investment option had negative returns

of around 13% over 2008-09 as a whole, the second consecutive year of negative returns. In 2008-09 cash funds

did best, with small positive returns, while property indexes scored worst with negative returns of over 30%.

There have also been some interesting findings on the relative performance of different types of funds. APRA

research shows that retail funds using balanced or growth strategies have generated significantly lower returns

on average than not-for-profit funds.

The key reason for the underperformance was expenses, with retail funds having arguably higher fees than other

fund types on average.

Recent APRA research also shows an inverse correlation between net performance and management expenses.

In other words the value add from active management is unable to overcome higher costs.

This may be encouraging investors to minimise their dependence on the managed fund market and is likely to

have been a factor in the recent rapid growth in self managed funds.

The problematic investment environment has obviously impacted on the growth of the industry.

APRA data show that at the end of March assets of superannuation funds totalled $1,032bn - just over $1trillion,

which is a very large amount of money. This was, however, around 11% below the level of a year earlier.

Data from the Australian Bureau of Statistics show that in March 2007, around 10% of fund assets were invested

in cash and in securities, just over half was in equities, and about 20% was invested offshore.

Two years later, the allocation to cash had increased to nearly 20%; securities were about the same; equities had

fallen to just over 40%; and investments offshore had eased to 17%. Some of these changes were the result of

conscious investment decisions and others resulted from changes in market pricing.

There has also been renewed focus on fees charged by superannuation funds. There has been the odd investor

who has not fully understood why their super fund has continued to charge fees while underperforming the index

or even losing money!

The question of fees has been identified as a key theme of the Super System Review, as Pauline alluded to

earlier the Cooper Review.

Now there are clearly many challenges ahead for the superannuation industry and whilst we were concerned

about the calling of yet another review, I would urge all of you to very actively participate in that review. And

certainly it’s a good initiative by the government to invite you to submit someone to work with that.

I began this address today by noting there had recently been an improvement in confidence about financial

market conditions and some prospects for the global economy. This has been reflected in, amongst other things,

a lift in some asset prices which I am sure has come as a welcome relief as much as a pleasure for you and for

your members.

While the Australian economy has performed well, there will be challenges ahead. The forecast slump in

business investment and the deterioration in labour market conditions are of special concern.

I want to thank you for your contribution to the investment of Australians over a number of years. I think there is a

tendency in some quarters to blame others for losses and to accept credit for the wins - not unlike politics,

everyone wants to claim a win as their own and blame losses as the fault of some other person and

superannuation isn’t really any different!

But fortunately we, whilst facing difficult conditions over the next few years, fortunately Australia continues to

have relatively low unemployment, it has a prosperous economy and good domestic consumption and even if the

world does go through other troughs and peaks over the next few years I am very confident that the Australian

economy will withstand a lot of the pressures from offshore and will be well-placed to take advantage of the

massive growth in the Asian region in the 21st Century.

Thank you.