Tag Archives: economics

Bank funding costs

This post returns to the theme of interest rates on Australian mortgages. The first post showed the extent of the increases in mortgage rates over and above the Reserve Bank cash rate. The rationale banks have been giving for these increases is that their own funding costs have been continuing to blow out in the wake of the global financial crisis. In the spirit of occasional Stubborn Mule contributor @pfh007, it is time for some beer coaster calculations to see how plausible this argument is!

A number of commentators have accused the banks of out and out dishonesty on the subject of their funding costs. A few weeks ago in the Sydney Morning Herald, Ian Verrender focused on banks’ offshore borrowing and argued

if that really is the case, and only half their funding is sourced locally, then logically they should be raising interest rates by only half the rise in the official cash rate

Last week, also in the Herald, Richard Denniss built on this argument and argued that not only are offshore borrowings unaffected by Reserve Bank interest rate movements but so are all of their customer deposits. This led to the following conclusion.

Only about one-third of the banks’ funds come from the Australian money market, which means that when the official rate rises by 1 per cent, the banks’ costs only rise by about a third of 1 per cent.

But these simplistic arguments are incorrect. In saying this I am not defending the actions of the banks. There is no divine right for businesses to be able to preserve their margins at all times. Margin compression is a fact of life for many businesses. But more importantly, the ability Australian banks have to recoup costs from existing borrowers not just new borrowers is inherently anti-competitive.

Nevertheless, given the heat in the issue, it is worth getting a better understanding of exactly what is happening to bank funding costs.

A look at the balance sheet of any of the major Australian banks will show that their liabilities (which effectively represent the “funding” for their assets) are drawn from a range of sources. While the makeup will vary from bank to bank and change over time, roughly 50% of their funding is sourced from customer deposit balances and 50% from the wholesale markets (both domestic and offshore). Within those two categories, further distinctions can be made.

Wholesale Funding

Wholesale funding is a mix of short term “money market” borrowings and longer-term debt. Again, very roughly, about 50% of this wholesale funding is short-term (prior to the financial crisis, quite a bit more would have been short-term) and 50% long-term. Somewhat arbitrarily, “short term” tends to be defined as borrowings with a term of less than one year. Much of this borrowing takes the form of “certificates of deposit” (CDs) which are mostly bought by other banks or financial institutions like fund managers (much of the “cash” component of superannuation funds is invested in these sorts of instruments).

The interest rate paid on these deposits depends on the term and will be closely related to what the Reserve Bank does with its cash rate. For example, since the Reserve Bank just raised rates to 4.75% and it is almost a month until the next rate decision, the 30 day rate on CDs is currently very close to 4.75%. When the Reserve Bank hiked last week, markets were caught by surprise and the CD rate, which had been 0.20% lower jumped up in response to the central bank’s move. The correlation between these short-term borrowing rates and the Reserve Bank’s cash rate is not perfect, but on average over time, they are quite closely linked. So, the cost of this component of the banks funding can be expected to move in line with the cash rate, but should not increase significantly more than the cash rate.

Things are a bit different when it comes to long-term debt. For a start, most bonds are fixed rate: the interest the bank pays investors does not change even if the Reserve Bank cash rate goes up or down. However, while a fixed rate may suit investors, most of the bank’s assets have variable rates. Banks deal with this mismatch by using interest rate swaps (and other derivatives) which effectively convert their fixed rate borrowing into floating rate borrowing. The diagram below gives a simplified version of the mechanics of an interest rate swap. The bank enters into a contract with another party (typically another bank) to receive a fixed stream of interest payments in return for paying a variable or “floating” rate of interest. The floating rate is reset periodically, usually quarterly or semi-annually, with reference to a published rate which tracks short-term bank borrowing costs. The swap is set up to ensure that the fixed rate payments it receives match the payments it has to make on the bond. In this way, the fixed rate the bank pays on the bond is effectively turned into a variable rate from the bank’s perspective.

Interest Rate Swap

This starts to make the cost of long term borrowing look a lot like the cost of short-term borrowing, but there is another factor: credit risk. If an investor buys a 5 year bond issued by, say, ANZ then it runs the risk that ANZ will collapse some time over the next five years. As compensation for this risk, the investor will demand an extra “premium” on the interest rate. This premium, also known as the “credit spread” or “credit margin” was fairly small before the global financial crisis, but shot up when investors suddenly realised that banks were not so safe after all.

Fortunately for banks (unlike their poor customers), they only had to pay the higher margin on new bonds. Even today, banks would still be paying off bonds issued before the crisis which have very low margins compared to the new bonds they are issuing. The average term of bonds issued by banks is around 3 years and the chart below shows how credit spreads have behaved over the last 12 years* along with a 3 year rolling average which gives a reasonable indication of the overall credit spread Australian banks are paying.

Credit Spreads for Financial Institutions (1998-2010)

The first thing to notice is that, although credit spreads have reduced since the peak of the financial crisis, the rolling average effect means that the effective cost of wholesale funds is still going up. Having old, cheap bonds maturing is adding to their cost of funds more than the fall in current spreads is saving them. On this point, at least, it would appear that banks are telling the truth!

But what about all of their borrowing outside Australia? Contrary to Verrender’s argument, Australian banks are not getting huge benefits by borrowing in countries with lower interest rates. Anyone with memories long enough to recall the notorious Swiss franc loans taken out by farmers and other small businesses in Australia in the late 1980s would appreciate that low interest rates do not count for much if the Australian dollar drops, thereby pushing up the amount of money you owe. Banks have no interest in running this sort of currency risk and so, much like their interest rate risk, they use swaps to hedge themselves. A “cross-currency swap” can be understood with a very similar diagram to the one above. Simply replace “Fixed” with, say, “US$ interest” and “Floating” with “A$ interest” and you have the picture for a cross-currency swap. This means that hedging is not a matter of paying some sort of small insurance fee, rather it effectively converts foreign interest rates to Australian interest rates. Even though perhaps half of the term funding raised by Australian banks is sourced offshore, it may as well be raised locally as far as the costs are concerned.

But how much is this increase in spreads costing the banks? As mentioned above, long term wholesale funding provides about half the wholesale funding for Australian banks, which is in turn about half of their total funding. So, a back-of-the-envelope estimate can be made by taking 25% of the 3 year rolling average. While I am at it, I will also project the rolling average forwards, assuming that credit spreads stay where they are today.

Estimated Impact of Term Spreads on Bank Funding Costs

This suggests that banks will see their funding costs continue to rise for about another year, but the overall impact of elevated costs in wholesale markets is only about a 0.45% increase. Compare this to what has been happening to mortgage rates.

Australian Mortgage Spread to the Cash Rate 1998-2010

The increase in mortgage rates over and above the cash rate has been about 1.2%, which is a lot more than 0.45%. So, while it may be true that wholesale funding costs are still increasing, it would appear that banks have already charged home buyers far more than the increase in costs the banks have suffered.

There is another source of costs for the banks that we need to consider: customer deposits. As wholesale funding costs rose during the financial crisis, banks began to compete aggressively for customer deposits as a (somewhat) cheaper alternative to wholesale funds. So, it is only fair to take the cost of customer deposits into account as well.

Customer Deposits

It is certainly true that on some of the customer deposits there is little or no interest paid, but there are also customer deposits which, particularly in recent years, pay very decent rates of interest. These include corporate deposits: imagine if a large mining company were to deposit a lazy $100 million into their account with one of the majors and was offered no interest…how long would it take for that money to move to another bank prepared to pay something very close to wholesale funding rates? Not long.

On this basis, we can reasonably assume that the cost of raising at least a portion of the banks’ customer deposits has risen as much as the increase in wholesale funding costs. To be generous, I will assume that all of their customer deposits have experienced this cost increase (although there are, of course, still plenty of low interest deposit balances out there…have a look at your own savings interest rates). Based on this assumption, I have recalculated the estimates of the increase in bank funding costs (i.e. taking 75% of the rolling average increase in wholesale spreads).

Estimated Impact of Wholesale and Customer Spreads on Bank Funding Costs

This revised estimate gets to an increased cost for banks of 1.3% which, given that the calculation is definitely too generous on the customer deposits side, is reasonably comparable to the increases passed through to mortgages.

However, the increases passed through to other types of loans (small business, credit cards, corporate loans, etc.) have been even bigger than those passed through to mortgages. So the only conclusion that can be drawn from this beer coaster is that:

The banks are not lying when they say their margins are still increasing, but
They have already gone beyond recouping these increased costs from their customers.

* Data source: Merrill Lynch. This data is the average asset swap spread across the financials sector and includes non-bank financial institutions and thus the spreads for the Australian major banks would, if anything, be slightly lower. I have now also got hold of data on some individual bonds issued by the majors and I will also analyse that to confirm it fits the same pattern.

Sister can I lend you a dime?

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Today’s post is written by Zebra (James Glover), an occasional contributor to the Stubborn Mule, who turns his mind this time to microcredit, and the internet lending site Kiva.

Dolly lives in a mobile home and works in the fast food industry. I met her on the internet 5 weeks ago and almost immediately I lent her $500. She said she wanted the money to start her own business. Nothing too strange about that you might think. Single, lonely man meets woman online is a story as old as the internet. Nothing strange except Dolly’s mobile home is actually a tent. And when I say tent I mean a ger (or yurt), and Dolly lives in Ulan Butor in Mongolia not a trailer park in Baton Rouge. Perhaps this sounds like one of those internet scams but I didn’t meet her on MongolianWives.com either and she is a married woman with four children. In fact three of them go to university. Here is a link to Dolly’s profile so you can look and tell me if I am a sucker for an online scam.

You’ll be relieved to know that Doljinjav (her real name) has since paid back all of that loan. The website is kiva.org, dedicated to facilitating microloans to poor entrepreneurs in third world countries like Mongolia.

Microcredit works by making small loans to third world entrepreneurs like Dolly who would otherwise be unable to borrow from banks due to lack of credit history, assets and being female. It originated in Bangladesh in 1976 when Prof Muhammad Yunus set up a research project to better enable rural villagers to develop. He identified that it was lack of capital that was majorly inhibiting economic development. This is not surprising – imagine the sclerosis if financing was removed from the western economic system. In 1983 Grameen Bank (“Grameen” mean “villages” in Bangla) was set up to facilitate microloans. In 2006 Yunus and Grameen Bank were awarded the Nobel Prize for Peace. (Incidentally, Grameen Bank is the only business corporation to win a Nobel Prize).

Since then microcredit has been enormously successful. Part of the reason is that the default rate (1-2%) is negligible by standards based on historical criteria. This is attributed to the borrowers initially being collectives of women who borrow the money to set up small businesses. If one is unable to meet her obligations the others step in to support her. In practice these days, microloans are made to men as well as women, individuals as well as collectives and even in the US.

Microcredit turns around the banking paradigm that poor+woman = bad credit risk, which of course, on paper, they are. In fact it has been so successful that mainstream banks are getting in on the act themselves. Organisations like Kiva have also been set up to facilitate loans from charitable minded westerners who perhaps want an alternative to passive giving.

Kiva works by listing applications for funds by people like Dolly, which registered lenders can match in part or in whole. Typically the loans range from a few hundred to a thousand dollars. The lenders themselves have committed funds to the Kiva organisation for dispersal. Kiva don’t lend the money directly themselves but work with local partners who arrange the loans and collect the repayments. In practice the loans have already been made and the lenders are “backfilling” them. This has been a source of controversy (see below) but ultimately makes the whole process more efficient and from the borrowers point of more predictable.

It all sounds like a virtuous circle. Lenders get a more active giving experience, borrowers get access to credit they wouldn’t be able to normally access and as the loans are repaid lenders are able to relend it to others. While the lenders themselves aren’t paid interest the borrowers are charged interest. Theoretically the interest goes to pay any administration costs and any funds left over go to grow the balance sheet of the partner organisation.

But all is not well in Kiva land. Next to each applicant are posted statistics of the partner organisations and these reveal an uncomfortable truth. Typically the interest charged is 20-40% which is very high by western standards. Kiva also publishes the median interest rate of non-partner lenders in the region (ie. “money lenders”) but these are often twice as high. There has been an ongoing discussion online from dissatisfied lenders who would happily lend the money at a zero interest rate. After all they don’t get the interest themselves and besides they aren’t in it for the money. Kiva acknowledges these concerns but says the profits to the partner organsisation, after costs, are modest (typical ROA is 2-6%) and most of these are not-for-profit so goes to grow the balance sheet and increase lending. Here is a blogpost on the controversy and how Kiva responded.

The good news here is that the costs and profits are transparent and info is posted on the website. Kiva addresses its lenders concerns honestly and at the end of the day it is up to us to decide if we are happy with the process. Personally the question I ask myself is if the borrower is happier than the alternative – no credit or much higher interest. It makes you think about their situation. To consider the saying: “Walk a mile in my shoes” and then decide if you want to deny them this loan. This, in my opinion, is really the main benefit of giving, not the feel good factor. It is a privilege to be given this insight. To quote E.M. Forster, who himself lived for a long time in India, all we can hope for is “to only connect”.

I hope your interest in microcredit has been pricked. If you are already on Kiva or decide to sign up then we (the Mule and me that is) have set up a Kiva lending team called “Stable Hand” you can join. Lending teams don’t decide on how your funds are distributed but are a way to make contact with others with a similar interest. Please consider joining.

Standard variable rate mortgages

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The last post looked at the increasing margins on Australian mortgages and small business loans. On the way is another post that tries to estimate how much the banks’ own margins have been increasing. Interesting though that may be, the real problem with Australian mortgages has nothing to do with whether bank margins are or are not going up. The problem is the product itself. This post explains why.

There was an article in the the Sydney Morning Herald today which explored exactly this issue, pointing out that Australia’s “standard variable rate” mortgage, which is the most common type of mortgage in Australia, is quite an unusual type of mortgage by international standards.

Banks tend to talk about “standard variable rate” mortgages, but a better term used in the industry is “discretionary variable rate”. The problem with Australian mortgages is encapsulated in that word “discretionary”. I can clearly remember almost 15 years ago trying to explain to European and US investors who were considering buying Australian mortgage-backed securities how a discretionary variable rate mortgage worked. The conversations went something like this:

INVESTOR: So, the bank can change the interest rate whenever they like to whatever they like?

ME: Yes.

INVESTOR: Why would anyone ever accept a mortgage under those terms?

ME: Well, it’s the standard product, so people are used to it and in practice the banks tend to just change the interest rates in line with the Reserve Bank cash rate.

INVESTOR: But they don’t have to do that?

ME: No.

Why were these investors so surprised by these sorts of mortgages? It’s certainly true that in many other countries, such as the US and France, the most common type of mortgages have fixed rates, but variable rate mortgages are found all over the world too. The difference is that most of these variable rate mortgages are pegged to some kind of indicator rate that the lender cannot control. Sometimes referred to as “tracker rates”, these mortgages would specify a fixed margin (say 2%) over a benchmark rate. This benchmark may be a central bank cash rate or some other kind of short-term market rate, but the important point is from then on that margin can never change. In contrast, with Australian mortgages, variable rates move up and down with market interest rates, but banks can also tweak the margin over market rates whenever they see fit.

Last year Westpac was pilloried when it tried to use the analogy of a banana smoothie to explain why mortgage rates were rising. It may not have worked for Westpac, but the analogy can help to highlight how strange discretionary variable rate mortgages are. Imagine that the cost of bananas goes up due to a cyclone-induced banana shortage. It may well be that the price of banana smoothies goes up (although it may also be that café owners take a portfolio view of their business, value their customers and absorb a bit of margin compression on their smoothies, but that’s another story). What certainly does not happen is that café owners go around to everyone who has bought a smoothie in the last year, explain to them that bananas are now more expensive and demand that their customer pays a bit more now for last year’s smoothie.

That is essentially what happens with discretionary rate mortgages. You might have taken out a mortgage a few months ago after doing extensive research comparing interest rates and deciding that the best value mortgage you could find was from the Commonwealth Bank as it was 0.1% cheaper than the next best offer (this may or may not have actually been the case). So far Commonwealth Bank is the only bank to have hiked their mortgage rate by 0.2% more than the Reserve Bank and now your “cheap” mortgage is 0.1% more expensive than the bank you turned down. So much for shopping around! Banks may argue that you are free to change to another bank if you are unhappy (although you can expect exit fees, particularly if you received any kind of rate or fee reduction when you first took on the loan). This does not change the fact that it is a rather unusual product that allows the seller to increase their margins after they have done the deal.

This hypothetical example highlights one of the real problems with the discretionary variable rate mortgage. It is inherently anti-competitive. There is little point shopping around for the cheapest mortgage when after next week it may not be the cheapest any more and you are locked in for 25 years. Is it any wonder that most people shrug their shoulders, say that the banks are all as bad as each other, hold their noses and just pick one almost at random?

There is another problem with discretionary variable rate mortgages, as one Mule reader pointed out in an email. It has the surprising effect of creating some credit risk for the borrower. Normally, depositors are exposed to the risk that the bank will fail, while banks are exposed to the risk that the borrower will fail. But, if you take out a discretionary variable rate mortgages, you may end up paying more if the credit quality of the lender deteriorates. The Herald article gave this hypothetical scenario:

Suppose one of our banks got downgraded from a AA to B. What would happen at the moment is they would just increase the margin on their mortgage rates to cover the extra costs they would face, whereas that risk should fall on the management and the shareholders.

But this sort of thing actually has happened! Many of the non-bank lenders like RAMS got into trouble during the global financial crisis and found funding through securitisation difficult, if not downright impossible. Some collapsed or turned to banks for support, but all of them suffered fast rising costs. Many borrowers who took out mortgages with these lenders saw their interest rates go up as a result. Some were able to refinance their mortgages with another lender, but those struggling the most to pay the higher interest rates would also be the ones least able to get refinancing approved.

In my view, abolishing discretionary variable rate mortgages, though unlikely to happen, would be a good thing for the Australian market. There’s certainly no guarantee that margins would drop. But it would change the stakes for banks considering raising rates to preserve their margins. Rather than being able simply to recoup that margin from their existing mortgage book, they would have to seriously consider the impact the move would have on new business, because it would only be new loans that would be paying the higher margins.

Banks, banks, banks

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There has been a frenzy of bank bashing in Australia over the last few weeks. The attacks intensified on Tuesday when the Commonwealth Bank decided to raise their standard mortgage rate by 0.45%. As the national broadcaster did not want us to miss, this was almost double the Reserve Bank’s interest rate increase of 0.25%. Politicians have been particularly keen to get into the action, with some peculiar results. One minute shadow treasurer Joe Hockey was pilloried for advocating tighter regulation of banks when supposedly representing the party of free markets, while days later the Commonwealth Bank’s move made him look penetratingly prescient.

Home ownership is a topic close to the hearts of many Australians and it should come as no surprise that, as mortgage rates rise and some borrowers start to experience real financial distress, the actions of banks should come under the spotlight. Unfortunately, very few commentators seem to have a good understanding of how banks operate which means that while there are some good questions being asked (such as why are banks so quick to put the squeeze on the customers who can least afford it while they are turning record profits and paying themselves such generous bonuses), there are also plenty of red herrings cropping up (like the idea that banks are getting a free kick from their offshore borrowing since interest rates are lower overseas).

For a few weeks now I have been contemplating a blog post that attempts to make the mechanics of banking a little clearer. There is too much to fit comfortably in one post, so here are some of the subjects I’ll aim to cover over the next week or so (in no particular order):

Are bank funding costs really still going up?
If bank lending creates deposits, why do they need to borrow in offshore markets at all?
How does offshore funding work and how much does it cost for the banks?
Is there a problem with competition in banking in Australia and (if so) what can be done about it?

While I will not get to any of these questions in this post (other than touching on the first), I will give some historical perspective on mortgage rates and other lending rates.

The chart below shows the history of some key interest rates over the last 20 years. The lowest of these is the Reserve Bank cash rate, and coming in at the top is the average rate banks charged small businesses for unsecured loans. Interest rates for small business loans secured by property are somewhat lower. The mortgage rates are based on a simple average of the rates offered by the four major banks on loans for owner-occupiers.

Australian Interest Rates 1990-2010

Since everyone’s eyes have been on changes in mortgage rates compared to the Reserve Bank’s overnight cash rate, here is a chart showing the difference between these two rates. It is not clear yet which (if any) of the other banks will follow the Commonwealth Bank’s lead in raising mortgage rates by 0.2% over the Reserve Bank move, but for the purposes of this chart I have assumed half the banks lift their rates 0.25% and half 0.45%, thereby pushing the average spread up 0.1% to 3%.

Australian Mortgage Spread to the Cash Rate 1990-2010

This chart provides an interesting historical perspective. As interest rates began to fall in the early 1990s, banks were slow to push through the reductions to borrowers, thereby building up healthy margins. This helped them recover from a rather painful period for Australian banks. Westpac in particular had come close to collapsing in 1992. Then in the mid-90s, aided by securitisation non-bank lenders like Aussie Home Loans and RAMS introduced new competition to the market, pushing the margins down. Margins were then stable for a number of years. During this period, then treasurer Peter Costello established the political sabre-rattling to keep banks in line, which cemented the idea that mortgage rates should move in lock-step with Reserve Bank cash rate moves. Prior to this, the relationship had not been so stable.

Now, in the wake of the global financial crisis, driven by a combination of increased bank funding costs and the fading of non-bank competitors, the spread to the cash rate has been on the rise once more, although it is yet to reach the levels of the early 1990s. However, as the chart below indicates, small businesses have seen their margins rise even more rapidly. A few commentators have noticed this fact, but most of the indignation of pundits and politicians has been focused on mortgages.

Australian Interest Rate Spread to the Cash Rate 1990-2010

Despite the fact that the link to the cash rate is so well established, the cash rate is not the primary driver of banks’ funding costs. Changes in the rates on bank bills with maturities in the range of 30 to 90 days give a better indication of day to day changes in bank funding costs. On top of that, funding they source from domestic and international bond markets adds a margin on top of these bill rates. Although there is a high correlation between changes in the Reserve Bank cash rate and bank bill rates, the relationship is not perfect. This means that the spread between lending rates and the 90 day bank bill rate (labelled BB90 in the chart below) provides a better indication of changes in bank margins, although it does not capture increases in bond market margins in the wake of the global financial crisis.

Australian Interest Rate Spread to 90-day Bank Bills 1990-2010

One thing that this chart highlights is that the strong link to the cash rate in fact introduces quite a bit of volatility in bank margins. Over time this volatility averages out and banks can also use derivatives (primarily “overnight indexing swaps”) to smooth this volatility.

Without taking into account the margins banks face in the bond market, these charts are not enough by themselves to determine whether banks are reasonably passing on rising margins or are simply lining their pockets. That is a question I will return to in a later post.

Data Source: Reserve Bank of Australia.

Thanks to @Magpie for the link to this piece by Christopher Joye which has a detailed discussion of the issue of interest rates for businesses, a topic which generated a lot of discussion in the comments here on this post.

When will Australia’s coal run out?

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Coal exports are a growth industry for Australia. A lot is being invested in infrastructure for coal production and transport to keep this growth going. But how long will this bonanza last? After all, there is only a finite amount of the stuff in the ground.

Earlier this year, the Australian Bureau of Agricultural and Resource Economics (ABARE) released an extensive report on Australia’s energy resources. The chapter on coal included the following observation about black coal:

At the 2008 rate of production of around 490 Mt [mega-tonnes] per year the EDR are adequate to support about 90 years of production.

For those unfamiliar with the jargon of the industry, “EDR” stands for “Economic Demonstrated Resources” which means an estimate of the total amount of coal in the ground that we could feasibly dig up.

Now some of you may already be thinking that 90 years does not sound all that long, but there’s a problem. The authors of the report do not understand exponential growth! The catch is hidden in the apparently innocuous phrase “at the 2008 rate of production”. In other words, to come up with the 90 year figure they are assuming that production levels do not grow at all for the next 90 years. Is that reasonable?

A quick look at coal production over almost 50 years would indicate that it is far from a reasonable assumption.

Australian Coal Production 1961-2008

Even to the untrained eye, a growth trend is evident in this chart, a fact which is confirmed by looking at year-on-year growth, which has averaged around 5% and has only been negative three times over the whole period.

Annual Growth in Australian Coal Production 1961-2008

So, where does the 90 year figure come from? According to the ABARE report, Economic Demonstrated Resources are 39.2 giga-tonnes (Gt). Add to this another 8.3 Gt of “Sub-economic Demonstrated Resources”, or SDR, (i.e. reserves that are really hard to get) gives an estimate total of 47.5 Gt for Australia’s coal reserves. Now 90 × 490 Mt (the 2008 production rate) gives 44.1 Gt, which is somewhere between EDR and the combined total of EDR and SDR. Presumably the ABARE authors are allowing for the possibility that over time it will become economically feasible to mine some of the coal that is currently classified as sub-economic.

But there is no way that 2008 production rates will be kept steady for the next 90 years. Apart from anything else, there are plenty of stakeholders in the coal industry doing their best right now to see their export business grow.

To come up with a better estimate of how long the coal might last, rather than assuming zero production growth, I will assume a constant growth rate. While the annual growth rate from 1961 to 2008 averaged 5% per annum, growth has been a little slower more recently. The last 5 years have seen growth average only 3.1% (presumably the global financial crisis did not help). Working with the ABARE estimate that viable coal reserves are 90 times 2008 production levels and assuming 3.1% annual growth in production, the reserves will in fact only last for 43 years! That is less than half the 90 year figure in the ABARE report and it starts to seem like an awfully short period of time. Since the working life of coal-fired power stations is typically around 40 years, this means any new power stations built today would still work out their useful life, but they could be the last ones we build and extract the full value of their potential productivity.

Of course, if the growth rate is higher, the time to deplete the reserves will be lower, as is illustrated in the table below. In fact, if production growth returns a long run average of 5%, then reserves would only last 34 years.

Growth Rate	Years Left
5%	34
4%	38
3%	44
2%	51
1%	64
0%	90

Reserves 90 times 2008 production

Optimists may counter that the ABARE estimates of the available reserves might be far too conservative. Perhaps there are coal fields out there just waiting to be discovered. Surely that would give us room to have coal export growth go gangbusters, wouldn’t it? Let’s see. I’ll be generous and assume that coal reserves are in fact twice as big (EDR has not changed much over the last 30 years). Running the figures again assuming reserves total 180 times 2008 production levels still means that with 3.1% annual production growth, the coal will all be gone in 60 years and if growth is 5%, it will only last 46 years.

Growth Rate	Years Left
5%	46
4%	53
3%	62
2%	76
1%	103
0%	180

Reserves 180 times 2008 production

Now it may be the case that climate change will trigger disasters on such as scale that in 40 years time we are not too worried about coal production, nevertheless, these basic calculations mean that some or all of the following must be true.

Australian coal is going to run out in around 40 years
The coal industry cannot continue to grow at the rate it has done over the last 50 years
Australian energy will be turning to coal alternatives sooner that we may expect (with or without a carbon price)
There is a significant expansion in EDR in the future (much greater than we’ve seen over the last 30 years)

If we are going to stretch coal supplies beyond 40 years, what can slow down the need for production? With a price on carbon not looking likely to slow Australian energy consumption in the near future, one possibility would be to reduce the share of coal production that is exported and keep more of it for our own energy needs. After all, the export share has been growing quite rapidly.

Share of Australian coal production exported (1961-2008)

With around 66% going offshore, there is quite a bit that could be clawed back there. But who would dare suggest slowing export growth? Maybe we will just wake up one morning and discover, with a shock, that the coal is all gone and, since it is estimated that Australia has about 6% of the world’s coal reserves, the rest of the world may face the same realisation even sooner.

Data source: ABARE (note that the 2007-08 production figures in this data set look a little lower than the 490 Mt figure quoted in the report, this is because the chart shows saleable coal which is lower than total coal extracted).

UPDATE: there was initially an error on the export share chart. Thanks to @paulwallbank for pointing it out!

Getting caught in the traffic

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Guest author @pfh007 returns today to the Stubborn Mule. Staying on the theme of Sydney transport, but moving from train lines to motorways, he once again pulls out his beer coaster calculator (perhaps one day I’ll get him onto R).

QUICK SUMMARY: The proposal to widen the M2 motorway in Sydney recently received government in principle agreement. This post examines the risk that due to a provision in the original motorway deed the widening proposal may put at risk the completion a rail link to North West Sydney until after 2046!

UPDATE – 26 October 2010 – Government announces it has now signed the deal with the operators to widen the M2!

The recent post “Playing with trains” took a stab at a cost-benefit analysis for a North-West rail link in Sydney. In the comments on the post, the question arose as to whether the construction of a rail link would require compensation payments to be made to the operators of the Hills M2 motorway, since the original agreement to build the M2 included a provision that provided protection from any government action that undermined the viability of the toll road. In this post I will dig into this “no-prejudice” provision.

Naturally, any compensation payment(s) would be an additional cost in building and/or operating the North-West rail link and thus might be a factor in decisions to build it and where to locate it.

Last week the NSW government announced that an in-principle agreement had been reached with the operators of the M2 motorway to widen certain sections of the motorway. The ASX announcement by Transurban stated that the costs of widening the road were $550 million and provided for the extension of the original concession period by 4 years to 2046.

The announcement was, however, silent as to how the no-prejudice provision in the original M2 agreement would apply to the road-widening proposal. This was surprising as the no-prejudice provision had been very controversial when first revealed in the 1990’s and it seems relevant to the recent discussions about rail or metro links to the North West.

Time for some more Google-assisted beer coaster calculations!

First stop is to find out what the original M2 no-prejudice provision actually said. Google could not produce the actual deed but it did produce this interesting old report from the NSW Auditor General.

The M2 Deed and the “no-prejudice” provision.

The Auditor General report sets out the no-prejudice provision. In summary, the provision provides that if the NSW government takes action relating to the servicing of the transport requirements of the North West of Sydney which prejudices the operational results of the M2, then it will negotiate with the trustees so that the investors in the M2 will get the lower of the base-case equity return or the equity return they would have received if the prejudicial event had not occurred.

Of great interest to rail fans is the content of a letter from the Chairman of the Hills Motorway that the Auditor General included in the report. This “side letter”, which pre-dated the M2 deed, stated:

The Hills Motorway acknowledges the announcement of the New South Wales Government proposing a mass transit route connecting Parramatta to Hornsby via Epping, utilising the Carlingford line alignment in part.

The Hills Motorway proposes to execute the M2 Motorway Project Deed, having taken into account the above proposal and its likely impact on the M2 Motorway. As a consequence, the development of the Parramatta to Hornsby Mass Transit Route would not constitute grounds for negotiation under the M2 Motorway Project Deed.

The Auditor-General noted that the letter appeared to mitigate claims by the operators for at least the Parramatta-Epping section of any Chatswood to Parramatta rail link.

On the face of it, the no-prejudice provision would therefore appear to be directly relevant to action by the government to

introduce or increase bus services to the North West
build a heavy rail link to the North West
build a metro line to the North West
improve other roads servicing the North West

if those actions might reduce the number of toll payers using the M2 and thereby “prejudice the operating results from the M2 motorway”.

There is nothing really remarkable about having a provision like the no-prejudice provision. If you were an investor and had just stumped up a lot of money to build a toll road, you would not be too happy if the government then decided to undermine your business model by providing an alternative transport option to your potential toll payers.

The question is whether the current no-prejudice provision is too wide and should, for example, be limited to certain types of government action (such as selling another competing toll road concession) and whether, while negotiating to widen the M2, now is a good time to clip its wings.

Has the “no-prejudice” provision ever flapped its wings?

The 1994 letter concerning the Parramatta to Epping rail proposal suggests that both Hills Motorway and the government of the day considered the no-prejudice provision to be a serious issue, but I have been unable to locate any information that confirms whether the existence of the provision has been a significant factor in any government decision or in the resolution of any issue relating to the M2 motorway since then.

It would be interesting to know whether there was any correspondence or discussion between the government and Hills Motorway about the Chatswood to Epping rail link before it was completed as the Auditor General notes it does not appear to be covered by the 1994 side letter to the M2 deed.

I have a hazy recollection that the initial introduction of bus services on the M2 was not all plain sailing. I think there may have been an argument at some stage between the government, the M2 operator and Hills buses about the terms of commuter bus access to the M2. As that debate occurred in the era of human history now known as the pre-Googlassic, I was unable to locate any online references. It would be interesting to find out if, in the course of those negotiations, there were discussions about the extent to which public bus services might prejudice the operating results of the M2.

One immediate question that comes to mind is whether the public bus services that use the M2 pay a special toll or whether the government pays the M2 operator some sort of compensatory payment that reflects the fact that 17,000 public bus trips each day might be considered to result in a certain number of individual M2 car/toll trips avoided.

Presumably, there was some discussion about the provision before the Metro link was announced but as the link was initially only going as far as Rozelle perhaps not.

Missing in Action – The “no-prejudice” provision

Despite its relevance to both a proposal to widen the M2 and to building a metro line or heavy rail link to the North West of Sydney, the no-prejudice provision has been keeping a low profile lately.

I am more than happy to be directed to some information on discussion of the application of the no-prejudice provision to the M2 widening proposal, but I was unable to find any reference or discussion of it on the RTA website, the Hills Motorway website or the 277 page RTA “Submissions and Preferred Project Report (August 2010)”.

The closest I found were some submission questions on pages 123‒133 of that document, but the responses to those questions did not touch on the no-prejudice provisions in the original M2 Deed.

Does it really matter?

If you read the RTA Submissions and Preferred Project Report (August 2010), the impression given is that the North West region of Sydney is generating a swelling sea of cars and that buses and new rail links do not reduce the need to increase the capacity of the M2. This might suggest that we can sleep easily and not worry about dusty old provisions from 1994 that require the government to guarantee the returns of investors.

But it might also suggest that there is no good reason to retain the no-prejudice provision in its present form. At the very least, it might suggest that in coming to an in-principle agreement with the M2 operator to widen the current motorway, now is a good time to modify the provision to explicitly exclude the impact of new bus services, new rail links and other public transport options as events that may trigger the no-prejudice provision.

Finally, one last reason for caution. Traffic forecasting appears to be a very challenging science. The history of Sydney’s toll road projects has been remarkable in the regular disconnect between the estimates of traffic flow contained in the glossy prospectus documents and the number of toll payers who actually turn up when the red ribbon has been snipped and they have to start paying.

I am no expert in this area and the forecasts underpinning the M2 widening proposal may prove 100% accurate, but I would feel more comfortable if the tax payer was not exposed to the risk that they do not.

On page 129 of the RTA document, response (b) notes that the tolls from the increase in usage after widening would not be sufficient to fund the project and that is why the widening deal involves an increase in the toll of 8% and an extension of the concession period by 4 years. That suggests that a failure to hit usage targets will readily prejudice the operating results of the M2.

Finally, it is also worth noting that a large chunk of the Auditor General report on the M2 that I referred to earlier was concerned with the forecasts of traffic numbers contained in the original prospectus. More on that below.

Calculating the Prejudice

Leaving to one side what a flock of lawyers and judges might decide the words of the no-prejudice provision actually mean, how might we go about calculating the prejudice?

Time to turn over the beer coaster!

According to the RTA, approximately 100,000 vehicles currently use the M2 every day. That is an interesting figure because the Auditor-General’s report in 2000 set out the original base case projection of traffic numbers by 2010 to be 94,659, but only 76,289 under the then proposed financial restructuring. Transurban’s figures report that in the Sept 2010 quarter 96,983 trips per day were made on average, or 105,068 trips on the average workday.

The vehicle figures (whichever you prefer) suggest that the M2 is currently going gang-busters and exceeding the traffic projections made when the original deed was entered in 1994. That, of course, is entirely consistent with a proposal to widen the roadway.

If the M2 is currently at or exceeding capacity, minor government action would seem unlikely to prejudice the operating results of the M2. A few additional bus services to the North West are unlikely to trigger the no-prejudice provision.

The Transurban ASX announcement states that one of the objectives of the M2 widening project return is to achieve by 2016 an increase in average daily trips of 17,300.

Current toll revenue

Currently the toll on the M2 is $4.95 for a Class 2 vehicle (cars and motorcycles) and $14.50 for everything else (trucks, etc) for the full route, or less to Pennant Hills Road ($2.20 and $7.10 respectively).

According to Transurban figures for the Sept 2010 quarter they earned approximately $36.7 million net of GST which is about $40.37 million inclusive of GST.

That equals $161.48 million per annum including GST.

Their daily average figure of approximately 97,000 trips amounts to about about 35.4 million trips per annum.

That suggests an average toll per trip inclusive of GST of $4.56.

Toll revenue in 2016

Assuming that an 8% increase in toll is applied, the average toll per trip stays constant (plus the 8%) and the 17,300 extra trips are occurring by 2016, then the toll revenue figures will have increased substantially.

114,300 car trips per day at $4.92 (the average toll per trip $4.56 + 8%) = $562,356 per day or $205.3 million per year.

That’s a tidy revenue increase of $43.8 million per annum (inclusive of GST) per year for the remainder of the now longer concession period (2016 to 2046, 30 years) for the $550 million investment to widen the road.

Needless to say the above figures are beer coaster calculations.

Could the M2 experience train pain?

How much pain could a heavy rail link to the North West cause?

As beer coaster fanciers would recall from the “Playing with trains” post, a modestly efficient heavy rail link to the North West with 15 train stations could move approximately 30,000 passengers on 25 services (at 6 minute intervals) during the morning peak period of 6.15 am‒8.45 am, or 60,000 trips assuming every person returned to their home each night.

Assuming that only 10 of the stations proposed are likely to compete with the M2, that would mean that competing stations on the North West rail link could service 40,520 commuter trips each day (once again assuming that the stations have equal passenger loads of 2,026 people per morning peak period).

As discussed in the rail post, securing that many commuters will not be easy and may require substantial re-zoning to increase population densities and perhaps other policies to build patronage on the new rail link, such as building extensive commuter car parks and connecting bus services throughout the catchment. The actions are also likely to decrease the appeal of a daily return trip on the M2.

Let’s assume that the rail link was built (and, conveniently for this exercise, that it is done by 2016—yes, optimism is good for the soul) and succeeded in achieving only 66% of capacity—attracting only 20,000 passengers each morning peak period to its 25 comfortable air-conditioned Waratah carriage (only a few months away now, fingers crossed) equipped services.

Let’s also assume that 40% of those 20,000 passengers are car users who have been attracted by the thought of relaxing and reading their iPads on the train rather than listening to honking horns and breakfast radio on the M2. Those 8,000 train converts represent 16,000 lost trips each day on the M2.

The value each day of those lost trips is 16,000 × $4.92 = $78,700 per day or $18.1 million per annum (assuming they work 230 = 46 × 5 days per year) .

Considering that the business case for the widening of the M2 has a target of 17,300 extra trips by 2016, there could be some unhappiness if the majority of those 17,300 exciting motorway trips vanished into a railway tunnel.

That unhappiness would only increase if the railway hit its target capacity of 30,000 passengers per peak period (60,000 trips) and 50% of them were lost trips on the M2. A loss of 30,000 $4.92 toll payments per day would represent an annual loss of toll revenue on the M2 of $33.95 million per annum (again assuming those train commuters only turn up to work 230 days per year).

OUCH!

That would mean that the tidy toll revenue increase of $43.8 million per year under the widening proposal might shrink to $9.85 million if there was a North West rail link that could attract 15,000 people who would otherwise be paying a toll to travel on the M2.

DOUBLE OUCH!!

As the estimated ticket revenue in my train post from approx 30,000 people paying $50 for a weekly ticket was only $70 million, it would be a nasty sting if $33.95 million of that had to be handed over to the M2 operators as compensation for loss of toll revenue.

It seems highly likely that a moderately well-patronised and well-designed new rail link to the North West (that interconnects with the Chatswood-Parramatta railway) would have the potential to prejudice, perhaps significantly, the operating results of an M2 that is widened and has a daily trip capacity increase from 97,000 trips to 114,300 trips per day. It is even possible that a well-designed and run North-West rail link could prejudice the operating results of the M2 without any widening taking place, but that is less likely as the M2 is already exceeding the capacity that formed part of the original base case for the road.

Summary

The absence of any substantial public discussion of the application of the no-prejudice provision in 1994 Deed to the M2 widening proposal and a North-West rail link and the potential for possible compensation payments to the operators of the M2 is surprising.

No doubt people with much bigger beer coasters than I have available will have performed much more sophisticated modeling of the potential impact of governments actions like a North West rail line or significantly expanded public bus services on the number of vehicles using the M2 per day. But even with my little beer coaster, it seems that there is real potential for government action servicing the transport requirements of North West Sydney to prejudice the operating results of a widened M2.

The problem is clear.

If the agreement to widen the M2 is likely to expose the government (and therefore the residents of NSW) to even greater risk of compensation should a North-West rail link go ahead, then the likelihood of a North-West rail link being approved for construction is reduced as those compensation costs would weigh heavily on the decision. Furthermore, every action taken to improve patronage by creating bus links to train stations, or commuter parking or expanding the number of services will only worsen the problem and understandably meet some resistance from the M2 operator.

Of course if the sophisticated modeling, that I am sure is on a laptop somewhere in Sydney, shows that future public transport by rail and bus to the North West will not prejudice the operating results of the M2, because the M2 when widened will have no trouble attracting 114,300 trips per day, then the agreement to widen the M2 should include a modification of the original no-prejudice provision to exclude future public transport services to North West Sydney as potential triggers for the operation of the provision.

At the very least there can be no harm in releasing the modeling that has been done on this issue so that the context of the in-principle agreement to widen the M2 and its potential implications on future public transport to North West Sydney can be fully understood by the community.

Forget the wisdom of crowds!

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Congratulations to all you insightful Stubborn Mule readers! Despite the fact that pricing in the financial markets was indicating around a 60% probability of the Reserve Bank hiking the official interest rates, participants in a poll here on the blog put the chances of no move at 60%. Even the fact that Sportsbet punters* were tipping a rate rise did not sway Mule readers. And it turns out that they had a better read of the RBA tea-leaves than the so-called experts. Today the RBA announced they were leaving the official cash rate unchanged. Well done, all of you!

* Interestingly, Sportsbet have pulled financial bets from their website. Perhaps the Mule post on the topic had some repercussions. UPDATE: their financial bets are up and running again.

Playing with trains – a North-West rail link

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Not content with scrutinising the plan for a National Broadband Network in Australia, guest contributor @pfh007 has now turned his analytical beer coaster to a network of a different sort: a railway network.

There is a Ph.D. for the taking by any researcher who is able to unlock the evolutionary origins of the propensity of young children (and many older people) to be mesmerised by trains, even the generic suburban variety. You can see the rush of endorphins on the faces of weary commuters as an express service roars past within a metre or two of their aching feet. People seem to have a railway gene.

During the 1970s and early 1980s, the annual model train exhibition held in the Willoughby Town Hall in Chatswood was a highlight for the local kids. It took a full day to observe every detail of the elaborate models complete with green fuzz trees, fields of tiny cows and platforms full of frozen people and Hornby OO gauge recreations of famous rolling stock clattering around and around. Although remarkable as demonstrations of what can be achieved in a backyard shed, those models and their kin were probably responsible for turning large measures of the population into armchair rail network designers.

Consider this a contribution from one such Backyard Bradfield.

One of the striking features of the recent federal election was the ferocious response to the promise to complete the Epping to Parramatta section of the Chatswood to Parramatta line even though new (or finally completed) rail should be of immense appeal to residents of the area. It seems clear that the strength of the reaction was largely due to the failed rail promises of recent NSW political history. In short people were tired of having their railway gene tweaked for short term political advantage.

At one level it is hard to understand why building a new railway in Sydney is so difficult. Unlike the technological challenges facing the early railway builders in Sydney (see the ponies and pick axes in the photos at Museum Station) we have access to marvellous mole-like machines that can bore tunnels right through the Sydney sandstone. We also have advanced administrative systems for compensating people whose houses must give way to new surface track. Shanghai has been laying a new subway at a great rate over the last 15 years, so why can’t Sydney?

Could the problem be cost, even though modern technology and construction methods should have caused construction costs to fall over the last 100 years? Perhaps it is not so much the cost as the complexity of the financing arrangements, which have become too ‘elegant’. The Waratah train deal seems remarkably ‘elegant’ and yet, according to the press, it is poised for implosion.

I think the real problem is that these days we are spending too much time thinking about what we want rather than what a railway needs to be viable. That is we should decide to build a railway and then shape that part of the city to suit the railway. After all, if the majority of Sydney’s suburbs were designed around the car it is highly unlikely that they will be suited to a rail line without substantial modifications.

As the National Broadbank Network (NBN) has established back of the beer coaster calculations as a valid method of policy analysis, I will adopt that technique for some rough calculations of the North-West rail line viewed from the perspective of the needs of the railway.

Route

Using Google Maps, the following route seems reasonable in terms of not going too close to existing rail lines. The precise route is not critical as the demographics and structure of the suburbs will change to suit the new rail line by way of changes to zoning requirements.

Number of Stations: 15

Balmain, Drummoyne, Gladesville, Top Ryde, Denistone East, Eastwood (interchange with Northern Line), Carlingford (interchange with Chatswood-Parramatta Line), North Rocks, West Pennant Hills, Castle Hill, Kellyville, Rousehill, Box Hill, McGrath’s Hill and ending at Windsor.

Train Capacity

Capacity of the new Waratah trains is 896 seated (8 carriages) and, say, another 320 standing (20 in each vestibule) = 1,216 people in total per train

Peak Hour Capacity

The beer coaster is not very big so I will stick with peak hour only and peak “hour” is taken to extend from 6.15 am to 8.45 am, so 2.5 hours. We want a well-signaled, well-designed speedy network that can handle trains at 6 minute intervals. This means we can run 10 trains per hour. Thus the number of peak hour trains is limited to 25 trains.

25 trains in 2.5 hours can carry between 22,400 people (all seated) and 30,400 people (40 standing in each carriage) into the CBD.

I have assumed that during peak hour everyone gets on and travels to the city and everyone comes home by train at the end of the day. I have also assumed that every train going in the opposite direction during peak hour is empty

Station Capacity at Peak Hour

With a capacity at 30,400 people between 6.15 and 8.45 am and assuming that the load is spread equally between all 15 stations, each station will process 2,026 passengers during peak hour. Assuming they all arrive evenly spaced during peak hour, there would be no more than about 80 people on the platform at any one time.

Ticket revenue generated by Peak Hour Capacity

Assuming that everyone works about 46 weeks per year and no one uses the train for any other purpose the revenue generated by the new line (at $50 per week for a weekly ticket) is 30,400 × 46 × 50 = $69,920,000 (roughly $70 million per year)

Certainly people will use the rail line outside of peak hour, but as they will often be concession fares, etc. it is probably safer to do the sums on the basis of the peak hour capacity.

Out of that $70 million you will need to remove operating costs (say $25 million) leaving you with $45 million to pay down the debt used to construct the rail line. As $45 million would only produce a 6% return on $750 million worth of bonds and building the line would cost a lot more than that, there is quite a large shortfall to be found.

To give you an idea of how much that shortfall might be, the price tag for completing the Epping–Parramatta line is estimated at $2 billion. It seems likely that the cost for the full North-Western rail line would be well in excess of $5 billion. How do we cover the shortfall?

Remodeling the suburbs along the route

The beer coaster calculations make it quite clear that the finances of our beloved new railway are marginal even if we squeeze 1,200 people on trains running every 6 minutes non-stop between 6.15 am and 8.45 am.

That means we need a nice steady supply of warm bodies arriving at the station. Where will they come from? This is what demands the remodeling of the suburbs along the route. Unless there are sufficient people who can use the rail line we will not even get to the stage of trying to convince them to use it.

Finding 30,400 people in a Sydney of 4 million during peak hour can’t be that hard, can it?

Well yes it can.

It is worth keeping in mind that, currently, the inner West line in Sydney only runs about 4 services per hour in peak time and you can usually get a seat at Petersham, which is one of the closer stops to the city. That means that, even in the relatively densely-populated inner Western suburbs of Sydney, it would be a struggle to get anywhere near 30,400 people.

Walkers are unlikely to want to walk more than 15 minutes to the station. It may be that most people will only be willing to walk a shorter distance. A 15 minute walk at a brisk pace is only 1.5 km. That means that the walker catchment for each railway station will be a circle of radius 1.5 km.

Bus links and commuter car parks can help extend the catchment for each station, but when you are trying to get an average of 2,026 people to each station during the peak hour, that means a lot of buses or a rather large commuter car park for each station.

The only practical solution is to permit or, better still, encourage medium-high density housing for a 1.5 km radius around each of the 15 stations. Ideally this would be mixed office/housing/retail construction so that the inhabitants of the 1.5 km zone might get away without having a car at all.

On the assumption that only 20% of the people living in the 1.5 km radius will be daily commuters, we will need about 10,000 inhabitants in each 1.5 km radius to generate the 2026 passengers. That is quite a lot of houses or, more likely, apartments (say 5,000–2 people per dwelling).

The re-modeling will not require an army of town planners. Simply change the zoning rules for the 1.5 km radius around each station to allow medium-to-high density construction of approximately 5,000 dwellings and let the builders and developers of Sydney do the rest.

If this approach was applied to the other rail lines in Sydney we may find that we can deliver an enormous supply of new dwellings (apartments) over the years ahead without any increase in the area occupied by Sydney. This would allow the preservation of the market gardens on the outskirts, which currently supply much of Sydney’s vegetables.

Needless to say, an increased supply of dwellings where people want to live will go a long way to making housing more affordable in Sydney.

What about the shortfall between construction costs and ticket revenue?

It might be possible to increase the weekly ticket price, but I think $50 is probably a price that will not cause too much “sticker shock”.

It is hard to justify making people outside the railway catchment pay the cost as they will probably have their own rail link developments to fund. It seems reasonable that the shortfall between ticket revenue and paying the construction cost should be recovered from all the property owners in the railway catchment as the rail line will increase the value of their properties.

This could be done by imposing an annual State “infrastructure” tax on houses in the catchment for as long as it takes to retire the bonds issued to raise the construction capital (perhaps 20 years). The rate of the tax could vary depending on the benefit to the taxed property of the rail line.

For example: the 75,000 dwellings (15 × 5,000) within the 1.5 km radius of each of the 15 stations might pay $3,000 per year for 20 years and the 300,000 dwellings (I have no idea how many there are!) outside the 1.5km radius but still within the railway catchment might pay $750 per year for 20 years. This ‘infrastructure’ tax would raise $450 million per year. Add in the $45 million from ticket sales and the annual total of $495 million would pay 6% interest on about $8.2 billion worth of government bonds (or less for a non-government borrower). Taking into account repayment of principal as well over, say, a 20 year period, the debt $450 million could support would be closer to $5 billion.

Not quite there, as the construction cost is probably a lot more than $5 billion but at least in the ball park!

Is it all too hard?

The numbers above are all beer coaster figures, but they do suggest that better public transport has a real cost and involves changes that cannot be imagined away.

Survey after survey reports that Sydney is sick of congestion and wants better public transport, and yet I cannot recall too many attempts by our politicians (of any shades of the political rainbow) to lead the debate as to what better public transport may require of us in terms of contributing to its cost and accepting some changes to the car-flavoured landscape of Sydney.

Perhaps that is the real obstacle to improving public transport in Sydney.

Conclusions

If we want new rail lines, we need to think more about what they require of us rather than what we require of them.
If we are serious about better public transport, we need to be serious about increasing the density of Sydney’s population (although not necessarily increasing the total population).
The main obstacle to building new rail lines in Sydney is low population density.
Building a new rail line will require substantial remodelling/re-zoning of the areas within a 1.5 km radius of each station, preferably a mix of medium-high density housing/offices and retail.
One way of funding the cost of better public transport is a state infrastructure tax on the properties that benefit from better public transport services.
The next time you catch a train in Sydney, take along a beer coaster and count the people on the platform, the density of housing around the station, the frequency of services and the price of the ticket and then start designing your own preferred extension to the City Rail network
Some suggestions—Bondi Junction to Cronulla via Kurnell (tunnel under the mouth of Botany Bay), Northern Beaches, Parramatta to Hurstville, Chatswood to Dee Why, Hornsby to Mona Vale.
It the context of the above discussion, it is perhaps unsurprising that people are raising questions about the rationale for an expenditure of $43 billion on the NBN.

Photo credit: coverling (copyright Creative Commons)

Will the Reserve Bank hike rates next week?

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Over the last few months, the Reserve Bank of Australia (RBA) board meetings have not provided any real surprises, but coming up next week is the most interesting meeting in a while. The cash rate is currently 4.5%, but there have been enough noises from the bank’s governor and other RBA board members about the strength of the Australian economy, that consensus is leaning towards a rate hike next week. Financial market pricing is currently indicating a 62% probability of a 0.25% rate rise. Interestingly, the online betting agency Sportsbet offers bets on possible RBA actions (somewhat controversially) and its odds are indicating an even higher chance of a rate hike.

Reserve Bank move	Payout	Probability
Rise Between 0.01 and 0.25%	1.33	75%
Stay The Same	3.40	29%
Rise Between 0.26 and 0.5%	4.50	22%
Rise 0.51% or More	21.00	5%
Any Decrease	101.00	1%

Sportsbet Odds (as at 1 October 2010)

My own contacts in the markets (you know who you are) tell me that the HSBC economist Paul Bloxham, who recently joined the firm after 12 years at the RBA, is calling for no move until November. So, perhaps a hike is not as sure a thing as Sportsbet punters believe.

What do you think? Here is another chance to pit the collective wisdom of Stubborn Mule readers against both the financial markets and online gamblers!

If you need more information to help you make up your mind, you could read Christopher Joye’s arguments as to why the RBA should just be getting a move on in the fight against inflation. It might help tame property prices in the process. Then again, perhaps not.

UPDATE: there was an error with the calculation of probabilities, which has been corrected. By the way, the fact that the probabilities add up to well over 100% gives an insight into Sportzbet’s profit margin, which looks to be around 25%.

FURTHER UPDATE: Sportsbet’s pages of financial markets bets are down…I wonder if ASIC are on to them now.

Is this the stupidest provision of the U.S. Tax Code?

6 Replies

Two guest posts in one week! On this occasion, the Mule is yielding the soapbox to an anonymous and unqualified cynic who wants to talk about tax (his own words).

“Decline in housing affordability relentless“. So screams the Real Estate Institute of Australia in its latest Deposit Power Housing Affordability Report, and they’re not the only ones. Of course, what they’re really screaming about is the (in)ability of people to purchase their own home – private renters, constituting a mere 25% of households, or social housing tenants at a mere 5%, only very rarely rate a mention. Why? The answer, in part, lies in just how beneficial it is to be part of that home-owning majority. The Australian tax system provides many advantages to the home-owner. The holy trinity of exemptions, in order of their estimated value in 2005-06 Australian dollars, are shown in the table below.

Tax	Exemption	Value
Land tax	Owner occupiers are exempt from state-based land taxes	$3.5 billion
Tax on imputed rent*	Imputed rent is not taxed, nor is it captured by GST	$11.7 billion
Capital gains tax	Owner occupiers are exempt	$29.8 billion

Table 1: Tax concessions to homeowners

These benefits are designed to encourage home ownership, which is seen as a social good. This argument is typically justified either on cultural grounds (the importance of home ownership to our society, or the centrality of home ownership to the “Australian Dream”) or occasionally on economic grounds, in that home ownership is said to produce positive externalities (for example, children of homeowners may have a higher likelihood of finishing school, or a lower likelihood of criminal behaviour). However, others argue that any social good which is intended by these benefits is undermined by the fact that the concessions are distributed inequitably, with high income households receiving a much greater advantage than low income households. In particular, the capital gains tax exemptions are worth seven times as much to the top income quintile as they are to households in the lowest income quintile. But Australians concerned about efficiency and equity in the tax system might take some heart from the fact that the grand-daddy of all tax concession to homeowners is missing from Table 1: home mortgage interest deduction.

In the United States, mortgage interest repayments are fully tax deductible on up to two homes, capped to a debt level of $1 million. Historically, this deduction was available across all interest repayments. Rising levels of household debt in the United States throughout the 1970s, associated with the rising popularity of credit cards, led to a rethink of the wisdom of interest deductibility. However, the deductibility of housing mortgages remained, ostensibly to facilitate ever increasing rates of home ownership, but perhaps more honestly as a nod to the middle class who had come to think of this deductibility provision as a birthright, as the keystone to the “American Dream” (a dream which is eerily similar, it seems, to the aforementioned Australian Dream). While it is true that home ownership rates in the United States have increased over the past fifty years, it is not clear that this is as a result of this particular tax benefit. Indeed, home ownership rates in the United States are comparable to those in Australia, which has no such concession (although both countries offer similar capital gains exemptions).**

Country	1961	1990	2007-08
Australia	70%	69%	68%
United States	62%	64%	68%

Table 2: Home ownership rates

Many argue that home ownership rates have increased far more substantially as a result of financial innovation and the deregulation of the mortgage industry – although, of course, the net benefits of these innovations are still being debated. In fact, many economists argue that, far from enfranchising aspiring homeowners, tax deductibility of interest is a regressive policy measure which affords a much more substantial benefit to the wealthy than the poor. There are three main reasons for this.

Firstly, the size of the concession is obviously related to the size of the mortgage, and as such wealthier households accrue a greater benefit, in absolute terms. Secondly, the deduction is more valuable to taxpayers in the highest income tax band. Thirdly, the deduction can only be claimed if an itemised tax return is submitted. However, lower income households overwhelmingly fill out a so-called standard deduction, not an itemised one. In fact, while 98% of households with incomes above $125,000 itemise, the figure is only 24% for households with incomes below $40,000, and therefore the remaining 76% would not be eligible to receive the benefit. One model estimates that in 2009, 68% of the total tax change associated with mortgage interest deductions went to the top income quintile, while nearly 90% of the total tax change went to the top two income quintiles.

Even more economists argue most against the mortgage interest deductibility provision on the grounds of its being so expensive. The 2010 United States Federal Budget calculates the cost of the mortgage interest deduction at US$131.2 billion. By comparison, the next largest housing tax expenditure was attributed to capital gains exemptions, which came in at US$49.6 billion. Another potential side effect of this concession is to encourage leveraging at the household level. In its latest Economic Survey of the United States, the OECD argues that increased preponderance of interest-only mortgages was a symptom (if not a cause) of the housing crisis. Interest only mortgages are particularly attractive in terms of the mortgage deductibility, as it makes repayments deductible in their entirety.

The Bush administration convened an expert panel to develop tax reforms, one of which was a proposal to change the home mortgage deduction to a 15 percent credit and making it available to all filers, regardless of itemization status. This was immediately rejected out of hand. The Obama administration more recently suggested that home mortgage interest deductions would be capped at 28%. However, commentary on this proposal suggests it has failed, although everyone appears more focused on the politics of such a measure, not the economics.

It seems that this is yet another example of “Murphy’s Law of Economics” – the overwhelming weight of expert opinion is no match for the American Dream. Must we, then, accept that this is an instance of the truism of tax concessions, which is all too apt when one is talking about the family home: that they are easy to introduce, and near impossible to repeal?

* A renter has to pay rent from income that is taxed, but the homeowner does not. It can be argued that the homeowner effectively earns an income from their property, in that they pay an “imputed rent” – to themselves. This effective income is not taxed, although some would argue that it should be.

** A limited home mortgage deductibility scheme was part of Gough Whitlam’s “It’s Time” package. It was designed as a response to rising interest rates, and was specifically targeted at the lower end of the income scale. As he said in his 1974 policy speech: “All taxpayers whose actual income is $4,000 or below will be entitled to deduct 100% of their interest rate payments. The percentage of total interest payments which is deductible will be reduced by 1% for every $100 of income in excess of $4,000.”

Data Sources: J. Yates, Tax expenditures and housing, AHURI, September 2009; U.S. Census data; Australian Census of Population and Housing

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