Asset sales and interest rates (wonkish)

by John Quiggin on February 4, 2015

One of the strongest most politically effective arguments made for selling publicly owned assets, such as government owned corporations is that, by reducing debt, it will reduce the interest rate on government bonds. This is plausible enough, and not by itself a conclusive argument. The interest saving (including the benefit of lower rates on remaining debt) needs to be set against the loss of earnings. But it would be nice to know how large this saving might be.

The Queensland state election, just passed, provides something of a natural experiment. The LNP government proposed to sell $37 billion in public assets and repay $25 billion in debt ($18 billion associated with the enterprises to be sold, and $7 billion in general government debt. Going in with 73 of 89 seats, the LNP was almost universally expected to be returned. Instead, they lost their majority and will probably lose office. Although the result is not yet final, everyone is now agreed that asset sales are off the table.

So, we should be able to look at the secondary market for QTC bonds to see how much this surprise changed the interest rate demanded by bondholders (this is what’s called an “event study” in the jargon of academic finance). You can get the data from https://www.qtc.qld.gov.au/qtc/public/web/individual-investors/rates/interactive%20rate%20finder/!ut/p/a0/04_Sj9CPykssy0xPLMnMz0vMAfGjzOLdnX2DLZwMHQ383QwtDDy9DUIsPTwDDA2NTPULsh0VAVfZvz4!/

and I’ve included it over the fold (a bit of a mess as I can’t do HTML tables)

The data shows that interest rates have generally been tending downwards, as you would expect given the Reserve Bank’s much-anticipated cut. On the trading day after the election, rates on longer term bonds rose by between 0.05 and 0.1 percentage points (or, in the market jargon 5 and 10 basis) points. But all of that increase, and more, was wiped out the next day when the RBA confirmed its cut. Overall rates on QTC debt have fallen by around 0.25 percentage points since Newman called, and then lost, his snap election.

To sum up, the surprise abandonment of one of the largest proposed asset sales in Australian history caused only a momentary blip in interest rates on Queensland government debt, immediately wiped out by a modest adjustment in monetary policy at the national level.

03/02 02/02/15 29/01/2015 22/01/2015 17/12/2014
QTC 14/10/2015 2.0350 2.1450 2.1800 2.3000 2.3400
QTC 21/10/2015 2.1500 2.2200 2.2700 2.3850 2.4250
QTC 21/04/2016 2.1150 2.2100 2.2000 2.3250 2.4200
QTC 14/09/2017 1.9750 2.1400 2.1000 2.2200 2.2850
QTC 21/09/2017 2.1200 2.2750 2.2200 2.3500 2.4200
QTC 21/02/2020 2.3100 2.4650 2.3600 2.5000 2.6350

{ 37 comments }

1

david 02.04.15 at 7:22 am

One of the strongest arguments made for selling publicly owned assets, such as government owned corporations is that, by reducing debt, it will reduce the interest rate on government bonds.

wha? But the government issuing those bonds now also has less assets to leverage, by definition. Why is the interest rate impact obviously negative? It’s a one-time windfall with no direct impact on future social insurance expenditures/revenue.

Any plausible gain would be a second-order one, e.g., by discarding public assets that are politically problematic, or by discarding public “assets” that actually are net liabilities due to staff costs, maintenance, etc., or by increasing taxable revenues through de facto privatization/otherwise politically untenable utilization and hence use charges, etc.

Alternatively, a fiscally disciplined government can limit the options of a feared future fiscally careless government by ensuring that the government has no free cash flow. But that doesn’t seem to have been the plan, either for the outgoing party or the new victors.

2

Peter T 02.04.15 at 7:24 am

So one of the “strongest arguments” is actually very weak?

3

John Quiggin 02.04.15 at 7:58 am

@1 The point is that reducing gearing is generally good for bondholders, even if it’s not financially beneficial to the government (or company) that does it. So a borrower who sells assets and pays down debt should (other things equal etc) expect an improved credit rating and a lower borrowing cost. There’s a complication here in that the LNP proposed to dissipate some of the proceeds in electoral bribes, but that is a common feature of privatisation, so it doesn’t really affect the validity of the test

@2 Quite so.

4

Ben 02.04.15 at 8:30 am

That’s the weakest argument.

The strongest argument is that they will be better run if privately owned, because they will have both the profit motive, and more importantly, the discipline imposed by the possibility of bankruptcy, which no public sector organisation has…

…and because they will lack the ultimate umbrella of political protection provided by being part of the bureaucracy itself – even if/when mistakes are made, all that will happen is “improved procedures”.

5

John Quiggin 02.04.15 at 8:45 am

Ben, I don’t really want to get into a general argument about privatisation here. Feel free to visit my blog johnquiggin.com and post on one of the regular open threads. For this post, I just want to stick to the topic.

6

PlutoniumKun 02.04.15 at 9:27 am

Nice study. I’ve heard the argument expressed several times, and I’ve always found it dubious, not least because its very rare for private sector companies to sell off assets for this reason, but I wasn’t aware of any concrete studies such as this. I’ve just heard an economist on the radio talk about the need for ‘privatisation and increased competition’ in the electricity sector here in Ireland to reduce costs to consumers – unchallenged of course by the interviewer. It seems that when economic arguments are useful to certain people, mere facts are not allowed stand in the way of ‘common sense’ assertions.

7

J Thomas 02.04.15 at 9:37 am

#4 Ben

The strongest argument is that they will be better run if privately owned, because they will have both the profit motive, and more importantly, the discipline imposed by the possibility of bankruptcy, which no public sector organisation has…

That depends on various theoretical beliefs. But in a mixed economy, profits don’t come so much from cutting costs and providing great services. The big profits come from “last man standing”. Survive until competition stops reducing prices, and then earn the rewards of surviving that long.

And so one of the results of government-owned businesses that can’t go bankrupt is to keep the competitors honest — they can’t reduce competition past that irreducible minimum, so they must stay at least as lean and fit as this last holdout. Of course, if the government-owned businesses in fact outcompeted the private alternatives, that would also reduce competition and it would represent a subsidy to customers in the short run, while in the long run it might put just as much a brake on innovation as entirely private consolidation would.

So if we can assume that the businesses would be sold to someone who would take them out of production, then investors realizing that this represented consolidation of those industries would bid up the price of competing businesses in anticipation. And the prices of those stocks would drop when the deal was cancelled.

I’d expect this would be less certain than the result JQ predicted and tested. Investors might not be sure that the sales would result in consolidation even if it was in fact a certainty, because they have imperfect information. You can never be sure what the market will do. (One second-order reason for this is that people who like to get things clear to lots of decimal points tend to go into bonds, while people who like to gamble with big uncertainties prefer to play the market.)

I think my prediction which is sort of analogous to JQ’s keeps this from being completely off topic, but I’ll try not to reply much about it here. If you’re interested maybe we could find an appropriate thread to discuss it on JQ’s blog.

8

Ben 02.04.15 at 9:38 am

John, I am sorry if a direct response to your opening clause is off-topic. It seems to me that at least the subsidiary goal of the post is to demonstrate that one of the strongest arguments is weak, so the dispute over whether the argument is strong, is relevant.

I am sure you can see how my mistake arose – see for example Peter #2, who appears to think whether the argument you attack is strong to be an important part of your overall case, and you at #3 where you appear to acknowledge this.

I don’t question it for your benefit, since I am sure you have your own views, and I am unlikely to dissuade you, but so visitors to this blog can at least see that the point is disputed.

9

Brett Bellmore 02.04.15 at 10:11 am

Why would you expect more than a momentary blip, from the cancellation of a *proposed* asset sale? And not even it’s cancellation at the brink of it’s anticipated occurrence, but some unknown period in advance. A somewhat attenuated “event” to base an event study off of, I should think.

An event study probably would be a useful test of the theory, but this was too much of a non-event to expect a clearly defined signal out of. Depending on the transfer function between debt and interest rates, you might not expect any effect at all from the cancellation of an asset sale. I think all we’ve established here is that, whatever the nature of that transfer function, it doesn’t involve a very large advanced element.

10

Zamfir 02.04.15 at 10:29 am

(Supposed) increased efficiency might well be the more important reason why strong supporters of privatization are strong supporters.

But the debt reduction argument is used to push privatisation even in cases when most people are not convinced of its inherent merits. It’s often used as a ‘necessity’ argument to implement privatisation while sidestepping a discussion on the actual merits of the case. Debt is too high, we must privatise, it’s the only responsible course of action. And people listen.

In that sense, it is a strong argument: it works to convince people who were not previously supportive. While efficiency arguments mostly convince people who were convinced anyway. Such arguments might strengthen the resolve of the supporters, or perhaps draw new strong supporters in the long run. But they don’t flip fence-sitters in the here and now.

11

John Quiggin 02.04.15 at 10:45 am

Exactly right, Zamfir.

Ben, please stop derailing. I’m happy to debate the efficiency arguments elsewhere, as I’ve done many times in the past, and I’ve offered you a venue.

Brett, I imagine you would have a different view if the numbers had gone your way. To avoid derailing, please stick to one comment per day on this thread.

12

Trader Joe 02.04.15 at 1:12 pm

I’m not a detailed student of Australian elections, but is it possible that debt markets already discounted the possibility that the assets wouldn’t be sold so the noted blip is essentially completion of what we call the ‘confirmation trade’ rather than an trade to absorb new information.

Secondly is a $25B reduction in debt a material amount compared to overall debt outstanding? Particularly considering only $7B of general debt was really being retired, I’d venture this was really (or shouldn’t have been) a market mover. Particularly if the cash flows from related assets were strong enough that credit analysts may have been implicitly subsidizing more debt than the $18B associated with the venture – i.e. not selling was in-fact credit positive given the asset involved.

Lastly, shouldn’t the daily interest move be weighed in the context of a basket of alternative or comp interest rates? A huge proportion of flows, particularly in australia, relate to the carry trade between currencies so even if interest rates dipped 25bp, if they should have dipped by 40bp relative, its actually a rise. I don’t have the comps at hand, so appologies if I’m making work…I’m really questioning whether absolute or relative movement is the right framework.

Interesting test case in any event…its not often you get a ‘living lab experiment’ in international debt financing.

13

Mr Punch 02.04.15 at 1:53 pm

The privatization argument is hardly irrelevant – it’s central. Most government entities exist to fulfill some necessary social function – you have to have, say, an airport. If they’re losing money, or have a poor ROI or incur undue risk, the government’s bond rating suffers and interest rates rise; but if the necessary function is not fulfilled, that hurts too. So interest rates will go down if the private sector can do the job/assume the risk better and the government gets cash.

Companies do similar things all the time, though usually for the benefit of stock prices and P/E ratios.

This is in principle. In fact, bond underwriting is … not serious. The US has had one state default in 150 years (just where you’d expect, due to backstopping local debt), yet states are not treated as better risks than many large corporations, which go belly-up all the time.

14

Map Maker 02.04.15 at 1:54 pm

Yes – the question is not the absolute level of QTC bond price changes, but the relative changes compared to other comparable bonds issued by other states of similar duration.

I suppose the other side of the equation – had the new government proposed selling the assets and spending the proceeds on an Olympic bid or something else that’s rubbish, would it follow that interest rates on debt should rise? I don’t think so. Assuming this state doesn’t have a balance sheet like Venezuela, changes on the margin do not have a linear relationship to the level of debt.

From finance theory, it is only when the leverage gets high enough that it changes the perception of the asset’s risk will it matter. If Bill Gates borrows two billion dollars, he’ll get a pretty low interest rate. If he sells $1b of stock, his cost of the remaining debt will not change whether he pays half the debt off or buys a big boat…

15

Brett Bellmore 02.04.15 at 3:22 pm

Sheesh, John: I produce a comment which is practically the Platonic ideal for “on topic”, and that’s the response I get from you? Did I mention efficiency? No. I was talking transfer functions. You’re attempting deconvolution here, as my college education was in electrical engineering, that’s a familiar topic for me.

This thread might get derailed, but it won’t be me that does it.

16

MPAVictoria 02.04.15 at 3:28 pm

“The US has had one state default in 150 years (just where you’d expect, due to backstopping local debt), yet states are not treated as better risks than many large corporations, which go belly-up all the time.”

When you put it that way it does seem crazy doesn’t it?

17

david 02.04.15 at 3:30 pm

The point is that reducing gearing is generally good for bondholders, even if it’s not financially beneficial to the government (or company) that does it. So a borrower who sells assets and pays down debt should (other things equal etc) expect an improved credit rating and a lower borrowing cost.

I confess to having trouble understanding the claim to begin with, never mind how it is being demolished in the essay – other things are not equal. For instance, the borrower now has less assets, to the extent that it has sold them to extinguish an equal amount of debt. Yes, reducing the debt lowers the gearing ratio – it now has more flexibility in its short-term capital structure to meet shock changes in expenditure/revenue. But reducing retained earnings liquidly held within the company (or government) would increase the gearing ratio. It has, after all, equally sacrificed something it could have sold to meet shock changes in expenditure/revenue – Modigliani-Miller should be the basic case. As a rough intuition, the net impact on the gearing ratio is just dependent on whether you think reducing debt is more ‘liquid’ in the event of a payments crisis, as Aussie state govt decisions go, than liquidating assets would be. Why would one generally expect the former to trump the latter?

18

mpowell 02.04.15 at 4:37 pm

Okay, so it this a post on the sterile issue of whether this asset sale would have lowered bond rates or not? Or it is a post trying to make a substantive claim about the wisdom of privatizing? It hardly matters that JohnQ doesn’t want a serious debate here on the broader topic, but it does seem pretty silly to write a blog post that sounds an awful lot like it’s about the wisdom of privatizing (including a somewhat incendiary opening statement) and then immediately claiming when that generates a response among everyone commenting.

19

Zamfir 02.04.15 at 4:50 pm

If this doesn’t work, perhaps governments should buy some more assets to lower their risk of default.

20

J Thomas 02.04.15 at 5:00 pm

21

J Thomas 02.04.15 at 5:01 pm

Oops, I don’t know how that happened. Sorry.

22

jgtheok 02.04.15 at 6:04 pm

#11 JQ

I’m not a wonk, but a couple of points brought up here (even if by the usual suspects) seemed to me potentially valid reservations that should be addressed. Would you mind terribly if I asked for clarification?

If I understood correctly, BB asked how closely “proposed to sell” + “almost universally expected to be returned” = “done deal.” That seemed to be the implication from your original post, but do you have any direct way to gauge the pre-election level of confidence that the proposed asset sale would actually happen?

Trader Joe brought up a different issue – perhaps debt level is largely judged on a categorical rather than continuous basis (e.g. ‘no problem’, ‘likely ok,’ ‘too much’) and proposed changes that do not cause movement to a new region have little impact? Dunno how realistic that is (and, if so, begs the question how often any asset sales would actually change it), but not obviously foolish (at least, not to me).

23

John Quiggin 02.04.15 at 6:17 pm

As to whether the asset sale was regarded as a done deal, betting markets had the incumbent government at very short odds to win,

http://www.justbetting.com.au/other/political/queensland-state-election-lnp-odds/
as did nearly all political pundits. I changed my mind in the last few days as did a handful of others, but the general response was “No one could have predicted this” .
https://twitter.com/margokingston1/status/561506624859168768

The polls all favored the LNP, though not as strongly as the pundits and betting markets.

It’s theoretically possible that markets expected the LNP to win, then reverse course, but that seems highly improbable – their entire program depended it, its a unicameral Parliament with very tight party discipline, and privatisation is supported by nearly all of the political elite.

24

John Quiggin 02.04.15 at 6:19 pm

On the categorical point, the asset sales would have reduced gross, whole-of-government debt by $25 billion, which is big in absolute terms, and around a third of the total. If that’s not enough to cross category boundaries, what would be?

25

John Quiggin 02.04.15 at 6:29 pm

@MapMaker As I mentioned, there was a 0.25 percentage point cut in the official rate around this time. That was reflected in market rates for Australian government debt

http://www.rba.gov.au/statistics/tables/#interest-rates

Queensland rates fell by around 0.15 percentage points, which implies an impact of around 0.1 percentage points from the election result, as observed on the first day of trading.

26

Trader Joe 02.04.15 at 6:46 pm

Thank you for the answers. They pretty clearly suggest that IF asset sales were a positive (which may not be a given), then there must be something that largely or more than compensates for the major change in plan.

The inference I would draw – at a 12,000 mile distance – is that the debt markets were positive on the 1-2 punch of the official rate cut + the move away from the LNP…I don’t know these parties, but perhaps they are viewed as more pro-growth or will raise taxes or some other policy agenda that is viewed as likely to be more lucrative than simply pawning government assets (which in my experience is usually pretty efficiently priced that buyers do little more than pay for the cash flows the related debt would have received anyway).

If this theory is correct, it could be tracked by seeing how rates diverge (if at all) once the new party’s policies crystallize.

The other point I’d throw in is that it may take a bit more time for the market to fully digest the change since a government reshuffle adds uncertainty (+ and – ) that may have caused some participants to “hold” rather than react. Debt markets in high rated government paper are very efficient over a period of months, but can be inefficient over a period of days since many owners of the related debt are simply hold-to-maturity owners and their lack of activity reduces market depth (please, no interest in a market efficiency discussion – but sometimes markets are not as quick as many like to think).

A great think question for the econ instructors out there….

27

John Quiggin 02.04.15 at 7:02 pm

@david Modigliani-Miller can be used to show the reasoning underlying the claim. Suppose the MM result holds exactly, so the weighted average cost of capital is independent of the mix of debt and equity. Start out as a AAA borrower, facing a bond interest rate lower than the equity rate. Now replace equity completely with debt. Your interest rate should be equal to the old weighted average cost of capital, which is obviously higher than the AAA rate. In essence, the bondholders are now holding something that looks like a mixture of debt and equity.

28

John Quiggin 02.04.15 at 7:02 pm

As to why the effect was so small in this case, I’d suggest
(a) given the earnings of the assets and the tax power of the state, the risk of default was always minuscule
(b) a fair bit of the proceeds were to be dissipated in electoral goodies and pet projects. It’s generally the case, in my experience, that privatisation, by presenting governments with what looks like “free” money, is bad for fiscal discipline

29

Collin Street 02.04.15 at 8:26 pm

This is in principle. In fact, bond underwriting is … not serious. The US has had one state default in 150 years (just where you’d expect, due to backstopping local debt), yet states are not treated as better risks than many large corporations, which go belly-up all the time.

And black people were — are — treated as worse credit risks than white. Transparent policy decisions based partially on the conclusions of non-transparent processes let you smuggle in all sorts of dodgyness.

30

jgtheok 02.04.15 at 8:41 pm

# 28 JQ

(a) So, perhaps going from 25% to 17% debt-to-gross-product (or whatever the numbers are) moves the debt needle from ‘no problem’ to ‘no problem.’ Sorry if I wasn’t clear, that’s what I was driving at with the categorical point.

31

Agog 02.04.15 at 8:58 pm

In an unequal society, private assets and the income they produce are mostly owned by rich people. This follows from the definitions of ‘unequal’ and ‘rich’.

Somehow it’s not seem surprising that calls to transfer assets into private hands should continue despite various justifications for those calls turning out to be false.

32

Peter T 02.04.15 at 10:56 pm

The assumption is that bond yields are related in some direct way to risk. As Mr Punch points out, the evidence is that this is not the case. As Piketty points out, long-term returns on wealth are not related the supply and demand of “capital”. As D2 points out, many significant debts are not about returns at all but about political and social control. The shapes of livers and the alignments of the stars do not foretell events, yet we keep sacrificing goats and reading the astrology columns….

33

Roger Gathmann 02.05.15 at 2:32 am

You need another comparative example, where after an election, the state assets were sold. I would imagine that there, too, the affect on interest would be extremely short term and washed out by other factors.

34

derrida derider 02.05.15 at 2:35 am

“perhaps debt level is largely judged on a categorical rather than continuous basis (e.g. ‘no problem’, ‘likely ok,’ ‘too much’) and proposed changes that do not cause movement to a new region have little impact?”

For that to work either the category boundaries that individuals in the market use would have to be largely identical across individuals or the market would have to be so thin that an individual’s category boundaries affects the price. Because the sum of a large number of different categorical distributions approximates that of a continuous one over their domain (or so I remember from my high school calculus). Marginalist economics in general depends heavily on that; otherwise you can’t posit those beautifully behaved twice differentiable curves that make the maths work.

35

John Quiggin 02.05.15 at 3:43 am

@Roger Good point. As it turns out, the previous election provides the kind of test we want. The Labor government was elected on a platform of no asset sales, then very suddenly and completely reversed position. There was some doubt as to whether the sales would go ahead, but still the probability went from near 0 to substantially positive (i’d say more than 0.5) in a very short time.

36

Daniel 02.06.15 at 12:05 am

(a) given the earnings of the assets and the tax power of the state, the risk of default was always minuscule

Yes, this is clearly it. When you think how valuable an asset “the power to tax Queenslanders, ie 4.5 million citizens of an OECD country” is, then a real economic balance sheet for the government would be utterly dominated by this huge asset, and even the biggest privatisation programs of sellable things would appear to be (as they in fact are, everywhere in the world except funny corner cases in low-population natural resources states) much too small to move the dial.

37

dax 02.06.15 at 10:31 am

Not knowing anything about Aussie politics, I have to take John’s word that the election result was unexpected, and so that the cancellation of asset sales was unexpected. But if that’s the case, then this is as good a natural experiment as any, and the only thing that would counter it would be if there were other substantial differences between the two parties which has a countervailing impact. With that said, the type of asset sales – their generation of future cash flow – and the price they were likely to fetch, the total amount of debt, and other details would be important. Unfortunately, the details are important, and I’m not sure one can generalise to “All asset sales are…” What you have instead is a counterexample to “”All asset sales are…”.

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