RISK MANAGEMENT AND THE REINVIGORATION OF REFORM

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• RISK MANAGEMENT AND THE RE-INVIGORATION OF
  REFORM
• February 2003
• Nicholas Gruen Ric Simes
• Lateral Economics Chief Economist
• ICAP (Aust)

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Traditional ideas of the economy
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Micro reform 1983 forward Facilitating internal
and external trade
Managing Risk a new theme for reform
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A new agenda for reform

• Theory is fairly mature and much of it is robust
• Results are
• often commonsensical
• sometimes surprising
• Governments should often invest more offshore
• Governments can lower risk by increasing their
  exposure to risky assets
• Gains are substantial

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The optimal allocation of risk

• Governments always have an intrinsic advantage in
  the passive bearing of risk
• governments are collective institutions gt pooling
  is inherent
• taxation 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 preferences
• Generating and making use of local information
  and incentives

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The optimal allocation of risk
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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

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Five areas of public policy

• We sample five areas of policy where a risk
  perspective offers scope for gains
• 1 public private partnerships
• 2 fiscal policy
• 3 the management of financial crises
• 4 retirement income policy and
• 5 the management of the governments balance
  sheet.

Order differs in paper
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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.

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1. Optimal risk allocation
Passive Bearer of Risk
Active Manager of Risk
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Qantas, CSL and various other privatisations
Passive Bearer of Risk
Private
Govt
Active Manager of Risk
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Government tenanted properties
Passive Bearer of Risk
Private
Govt
Active Manager of Risk
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Road development
Passive Bearer of Risk
Private
Govt
Active Manager of Risk
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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.

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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
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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.

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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

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2. Fiscal policy Norways Petroleum Fund

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

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2. Fiscal policy Norways Petroleum Fund

• Norway has run large budget surpluses ever since!
• Net Foreign liabilities

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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

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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.

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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.

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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

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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.

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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.

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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
  Governments own account.
• Risk considerations entered in a secondary way.

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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.

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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.

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5. Government balance sheets

• Such objectives will arise more naturally if we
  can start to view Governments balance sheets as
  an integrated whole.
• There will be governance issues, but manageable
  ones. These will be addressed in this
  afternoons session.
• Here, we simply note that the approach being
  advocated allows important questions such as IG
  income smoothing to be addressed.

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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 Governments 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.

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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.)