Tag Archives: economics

When is a bet a derivative?

Almost 6 months ago, the Australian Securities and Investments Commission (ASIC) was rattling its sabre, threatening to “shut down” online betting agency Centrebet if they continued to allow punters to bet on stock market and interest rate moves.

Peter Martin reported at the time in the Sydney Morning Herald that ASIC had written to Centerbet saying:

it has come to the attention of the Australian Securities and Investments Commission that you may be carrying on a financial services business without holding a financial services licence.

In particular we believe the financial bets you offer over the ASX 200 share index and RBA interest rate changes may be ‘derivatives’, as defined in the Corporations Act.

It seems that anyone in Australia in the business of offering financial derivatives is required to hold an Australian Financial Services Licence (AFSL) and adhere to a raft of regulatory responsibilities. Centerbet, apparently, did not have such a licence.

It was a little bit surprising, therefore, to see an article about the soaring Australian dollar in today’s Herald feature the following commentary from another online betting agency, Sportsbet:

Sportsbet.com.au, which has taken bets on US dollar parity of up to $2000, says there has also been a plunge on the Reserve Bank raising interest rates next week.

So what has changed? A quick call to ASIC confirmed that a business offering bets on financial instruments would be required to hold an AFSL and that their records indicated that Sportsbet did not in fact hold such a licence. I asked them how this requirement was enforced and they told me that if they received a complaint, they would investigate it. They could neither confirm nor deny whether they had received any complaints about Sportsbet.

I will be listening out very carefully for the sound of ASIC’s sabre!

UPDATE: further digging revealed that even while ASIC was clamping down on Centrebet back in April, Sportsbet were taking financial bets. The difference in treatment is quite mysterious.

FURTHER UPDATE: Sportsbet have now taken down their pages for betting on interest rates and the Australian dollar. It may be temporary, or it may be that ASIC are investigating them…It’s now back up, so it appears to have only been a temporary suspension.

Purchasing Power Parity postponed

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The Australian dollar has been going for a bit of a run over the last few weeks and many commentators are concerned that it has become over-valued. A widely quoted Bloomberg article published yesterday argued that the Aussie is 27% over fair value compared to the US dollar.

Australian Dollar vs US Dollar (Jun 2009 – Sep 2010)

Their case rests on the theory of “purchasing power parity” (PPP). According to this centuries-old idea, exchange rates should be such that identical goods in different countries should, in the long run at least, cost the same amount. If prevailing exchange rates make it cheaper to buy the same goods overseas than in Australia, then the buying power of the Australian dollar is too high and the currency is over-valued.

The rationale behind PPP is that if there is a big price difference, it becomes worthwhile for enterprising souls to export goods from the cheap country to Australia. Not only would this put upward pressure on prices in the cheap country, but the entrepreneurs would be buying the cheap country’s currency and selling the Australian dollar, thereby putting downward pressure on the Australian dollar. Both of these effects would tend to correct the over-valuation implied by PPP.

For years now The Economist has, famously, been publishing league tables of over- and under-valued currencies based on the price of a Big Mac at McDonalds. Their most recent report suggested that the Australian dollar was over-valued by almost 4%. At the time of publication, the Australian dollar was trading in currency markets at around US$0.88. Since then it has increased in value by another 9%, suggesting the over-valuation is now 13% (assuming Big Mac prices are about the same). However, the Big Mac index has come in for some criticism: last year various News Corporation organs broke the alarming story that Australian Big Macs are in fact smaller than Big Macs around the world, which suggests they are not as cheap in Australia as the Economist believes.

Perhaps aware of this problem, CBA economists have instead constructed an iPod index, based on the price of iPod Nanos around the world. Now I know that Apple only recently brought out their new Nano, but my Apple gadget of choice is the iPhone. Phone prices are tricky though, as they are distorted by the plethora of phone plan deals. So instead, I have constructed a PPP index based on the iPod Touch to illustrate the workings of PPP exchange rate indices. After all, the Touch is just an iPhone without the phone.

The table below has iPod Touch 32G prices from five countries around the world. For each of the non-US countries, the local price has been converted to an effective US dollar price using current currency market exchange rates. The PPP rate shows what the exchange rate would have to be to ensure that the local currency price would convert to the US dollar price of $299. Intriguingly, on this basis all four currencies appear to be over-valued relative to the US dollar. Indeed, the 13% over-valuation of the Australian dollar appears modest compared to a 23% over-valuation of the euro and the Pound. Even the Japanese Yen appears to be very slightly expensive.

Country	iPod Price	Effective US$ Price	Market Rate	PPP Rate	Over-valuation
Australia	A$378	$357	0.94	0.84	13%
UK	£249	$388	1.56	1.27	23%
Germany	€299	$391	1.31	1.06	23%
Japan	¥27,800	$324	85.7	97.7	2%
USA*	$317	$317	–	–	–

iPod Touch (32G) PPP Index

There is another possibility here though. Perhaps it is not so much that these currencies are all over-valued (or that the US dollar is under-valued), but simply that Apple rips off all its non-US customers! Mind you, as most Australians would know, Apple are far from alone in charging us more for electronic consumer goods than they charge Americans (although Europeans seem to get an even worse deal). So, sadly, the iPod index may not be very useful. The analysis does, however, highlight the challenges of using PPP to assess fair value of currencies.

Economists would caution against using a single product and would instead use a “basket” of consumer goods to compare currencies, which is what most of those arguing that the Australian dollar is over-valued would have done. But the real problem with the PPP analysis is that prices of consumer goods are not nearly as relevant to currency markets at the moment as interest rates are. Compared to the rest of the world, investors see Australian interest rates as attractively high. Here is a comparison of the interest rates you would earn by buying government bonds rather than iPods in the same five countries.

Country	2 Year	5 Year	10 Year
Australia	4.82%	4.97%	5.14%
UK	0.73%	1.82%	3.15%
Germany	0.81%	1.47%	2.47%
Japan	0.14%	0.30%	1.05%
USA	0.46%	1.40%	2.69%

Government Bond Rates (Sep 2010)

Depending on the “term” of the bond you buy (i.e. how many years before you get your money back), the rate you earn will differ. Typically, longer-dated bonds will generate higher returns, but regardless of the term an investor chooses, at the moment they can earn significantly more by investing in Australia than in any of the other four countries. Now Australia is certainly not the only country in the world with higher interest rates than the US, Europe or Japan, but most of the countries with high interest rates are developing countries which investors would consider a much riskier proposition than Australia. Furthemore, the noises coming from Australia’s central bankers suggest that interest rates here are only heading higher. In order to invest in Australia, offshore investors have to buy Australian dollars, and this goes a long way to explaining why the currency keeps getting stronger.

The practice of switching investments from low interest rate countries to high interest rate countries is known as the “carry trade” and it is not without risks. In fact, the Economist has compared the carry trade to picking up nickels in front of a steam roller. Where is the steam roller? It is the exchange rate. A US investor may be drawn to the extra 4.36% that a 2 year Australian government bond offers compared to a US government bond, but if the Australian dollar falls back as far as it has risen over recent months that investor would lose that 4.36% and more. On the other hand, if investors think that the Australian dollar is only going to keep going up as long as everyone is jumping on the carry trade, they may not see depreciation as much of a risk. Everybody wins, until the music stops… and Reserve Bank governor Glenn Stevens seems to be promising to keep that music playing.

So where does that leave the theory of Purchasing Power Parity? Most economists would take refuge in the caveat “in the long run”. It’s not that Purchasing Power Parity is wrong, it’s just taking a back seat to the carry trade for now. Eventually it will re-assert itself. Perhaps. In the meantime, Australians travelling abroad will be making the most of their buying power.

Data sources: exchange rates from OANDA, iPod Touch prices from Apple, bond rates from Bloomberg.

* The US price excludes tax, while the other countries include GST/VAT etc. To provide a fair comparison, the US price has been grossed up by 6%, a mid-range sales tax rate.

UPDATE: Thanks to Andrew for the comment about sales tax. The post has been updated accordingly.

Keynes on Economics

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I have always enjoyed the way John Maynard Keynes had with words. He was responsible for many a bon mot, such as “in the long run we are dead” (skewering the idea of long-run equilibrium in economics), “It is better to be roughly right than precisely wrong”, “Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone” and (my favourite) “Markets can remain irrational a lot longer than you and I can remain solvent”.

Today I read a rather scathing piece on the performance of economists in the lead up to and throughout the financial crisis, which included this rather longer but nevertheless brilliant quotation from Keynes.

The completeness of the [orthodox] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, [with] the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority. But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists…were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation—a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists…

John Maynard Keynes, The General Theory of Employment, Interest and Money (1936; London: Macmillan, 1964) 32–3

I have a copy of the General Theory, which I have only skimmed. One day I really should read the whole thing. In fact, there’s even a Kindle edition for $3, so maybe that day is not too far away…

Photo credit: Wikimedia Commons.

Infrastructure Bonds

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With Australia’s Federal election looming, the opposition has today proudly announced a new policy to fund infrastructure without actually increasing Government debt! What are we to make of this?

It’s hard to determine the details from a media announcement, but based on the text posted by Peter Martin on his blog, it would seem that the idea is to provide tax incentives for entities other than the Federal Government to borrow to fund infrastructure:

Private infrastructure operators and State and Local Governments will be eligible to apply for the concessional treatment.

The way the scheme would seem to work is that eligible projects could issue bonds and investors would receive a tax rebate amounting to 10% of the interest on the bond. So, if you received a $100 interest payment and your earning put you in the top marginal tax bracket, you would pay $45 in tax. Under this scheme, you would only pay $35 in tax.

So, the cost to the Federal Government would simply be forgone tax revenue (and this would be capped at $150 million per annum) and the Opposition believes that the program could support up to $20 billion in infrastructure financing. Presumably, investors currently buying plasma TVs would rush to buy these bonds instead.

Seems like a neat trick, but I have a number of reservations about the scheme.

First, I have argued in the past that the near-hysterical concern about Government debt is overdone. For a start, Government debt in Australia is far lower than in other developed countries around the world. More importantly, the facile analogy that compares Government finance to that of a household budget does not stand up for one very important reason: unlike you or me, the Government is the monopoly issuer of Australian dollars. This changes the game and breaks the analogy utterly.

Second, the opposition’s policy would still involve raising significant amounts of debt, just not issued by the Federal Government. If that debt is all incurred instead by State Governments, should that really be a cause for celebration? After all, unlike the Commonwealth, State Governments do not control issuance of currency, so they really could go bankrupt and indeed, recent history has shown that many of the State Governments are loath to increase their debt levels too significantly for fear of having their credit rating downgraded. What if the borrowers are in the private sector? Well, that would be worse still! Back in March I updated my chart showing private and government sector debt. The debt level we should all be worried about in Australia is private sector debt, which is far higher than government sector debt.

Third, infrastructure bonds have form. Back in the 90s, the then Labor government introduced an infrastructure bond scheme which also featured tax incentives. Of course, it did not take long for clever investment bankers to work out how to surgically isolate the tax benefit so that wealthy individuals could take advantage of the concession without actually taking on any investment risk. In the end, the whole scheme was shut down, although some of the transactions that were done still survive today. I would expect exactly the same thing to happen with this policy. Any special tax treatment is always a red rag to the tax expert bull.

So, it may sound clever, but to me it does not seem to be sound policy.

Labor’s National Broadband Network – Less than $10/month

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Our regular guest contributor James Glover (aka @zebra) returns today with a look at the numbers behind the National Broadband Network. He asks: do you think it would be value for money?

The Labor Government’s proposed National Broadband Network (NBN) has many things to recommend it, not least speeds of up to 1GB/s (currently I am on 10Mb/s for ADSL; theoretical speeds of 24MB/s on ADSL2+ and 100MB/s on VDSL are also soon to be widely available, though the reality is dependent on many variables such as distance from an exchange). It would revolutionise the way we communicate as the higher bandwidth would allow not just interactive entertainment and fast downloads, but genuinely accessible cloud applications that really felt like they sat on your computer…and of course dishwashers waking up at 3.00am to negotiate the best electricity price. I doubt whether anybody on either side of politics would disagree that, in a perfect world, this is all desirable. But like all utopias, it comes at a cost and that is where the real divergence between the Labor Party and the Coalition’s broadband policies exists. I hope to cast some light on this cost argument using the power of the Time Value of Money, in particular calculating the real cost to you on a monthly basis so you can compare it with your existing broadband cost.

Labor wants an all-connecting fibre optic network (with subsidised satellite to cover really remote areas) that will cost an estimated $46bn. The Coalition wants a more modest effort: a fibre optic “backbone” network that uses existing copper wiring in urban areas and relies on market competition to pay for further improvements. It is estimated to cost about $8bn plus later commercial costs. Both of these figures seem extraordinarily high. How to decide if it is really worth it? Well if I told you that Labor’s NBN would cost you $10 per month would that sound too high? After all that only includes the infrastructure cost, not the access cost via an ISP. But most of us don’t pay upfront for our broadband or mobile (cell) phone bills, we pay monthly. The Coalition’s figure of $8bn works out at less than $2/month each (for those so inclined, you can read the details behind these figures). But it doesn’t include any additional costs charged by commercial companies building additional infrastructure. It also only claims to provide “peak speeds” of 10Mb/s which I already get on my ADSL+.

Is $10/month a lot of money? Or $2/month for that matter? It obviously depends on what your income is and how much you are currently prepared to pay for broadband. My broadband plan costs $50 for 120GB/month. I also live in a one-person household. It doesn’t sound much to me, but all those $10/month costs add up to the thousands we pay in tax each year. There’s no point paying more for little for no benefit. Of course it’s not going to be charged directly, but through increased taxes (or decreased services). I estimate $10/month to represent an average increase in the tax rate of about 0.5%. This seems reasonable to me. After all, if in 2020 a businessperson (or BusinessBot2020) came to Australia and found our broadband to be the equivalent of dial-up today, they’d hardly be impressed enough to invest in a technology business. Of course, by 2020 with super-fast broadband we should really be able to do most business remotely, right? But we’ve been saying that since the invention of the telephone.

So I’m for the Government’s NBN plan…but what do you think?

Update: I have since writing this post changed my mind based on readers’ comments and some research. It appears that many of the benefits of the NBN are available already on ADSL2+, VDSL and 4G and the Coalition’s more modest plan to build a fibre-optic network backbone might be sufficient. There is also the question of whether a Government entity is best placed to oversee such a large scale project – it’s not like Peter Garrett is going to personally project manage the NBN but Governments in general are not (IMO) best placed to predict and respond to consumer demand. But I accept there are strong feelings on both sides. Sometimes that bright shiny thing in your vision is a light on a hill and sometimes it’s a white elephant blocking your view.

UPDATE: Let us know what you think by voting in this broadband poll.

RSPT RIP – Long Live the MRRT

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In the third in a series of guest posts on the subject of Australian mining tax, Zebra (James Glover) considers the changes to the proposed tax the new prime minister, Julia Gillard, has negotiated with miners.

The Govt has announced a replacement for the RSPT discussed in earlier posts to a Mineral Resources Rent Tax (MRRT). The principle differences are the tax rate – 30% and a change in the deduction. For established mines it is now based on market value depreciated over 25 years and the uplift rate is 12% not 5%. In addition there is a 25% deduction from earnings upfront which makes the base rate of tax 22.5% rather than 40%.

This post replaces an earlier one I put up about the MRRT in which I erroneously assumed that the opt-in about using the market value of assets applied in the way I proposed in my second post. The key statement here is:

“Miners may elect to use the book or market value as the starting base for project assets, with depreciation accelerated over 5 years when book value, excluding mining rights, is used; or effective life (up to 25 years) when market value at 1 May 2010, including mining rights, is used. All post 1 May 2010 capital expenditure will be added to the starting base.”

In the case where the mining company opts to use a market value approach I take it to mean the depreciation takes place before the MRRT is calculated. This means the formula is:

MRRT = 30% x (75% x Earnings – Price(2010)/25)

Currently the mining industry average for P/E (price to earnings ratio) is 14, though in the case of BHP-Billiton it is 19. For an average miner then Price(2010)/25 = Earnings x 14/25 = 56% Earnings so the actual MRRT is based on 19% of Earnings. However the Price is fixed at the May 1 2010 value so this will not increase over time even though earnings will. Should earnings continue to rise at the dramatic rate we have seen in the past decade then the MRRT will eventually look more like the 22.5% base rate.

It appears that the Govt and the mining industry’s compromise is to push the revenue from the tax windfall out from today to later years. In a sense the mining industry has also removed the contentious “retrospectivity” of the tax by using the current high price and choice of 25 years depreciation to ensure the current value of the MRRT is minimised but will rise at 22.5% of increased earnings going forward.

Thanks to an observant reader who pointed out my error. Mea culpa.

No move expected by the Reserve Bank

Following one link too few…a mea culpa

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My last post, Are Australia’s banks about to collapse?, took Steve Keen to task for a presentation on the dire outlook for Australia’s property market and its banks. However, a commenter has pointed out that it was not Steve’s presentation! Moreover, the final slide of the presentation, which is in very poor taste, appears to have been added by Business Insider.

How did I get that wrong? By following one link too few. Here is a quote from the Business Insider article where I found the presentation:

according to this presentation from economist Steve Keen, courtesy of Mish’s Global Economic Analysis

Following the link to Mish’s Global Economic Analysis gets a bit closer to the truth (“on his blog” not “by him”):

Australian economist Steve Keen addresses that question and more in a presentation on his blog How to Profit From the Coming Aussie Property Crash (and Banking Crisis)

At that point I made the mistake of not following the final link to Steve’s blog and instead read the presentation. Slide 3 was a familiar one I had seen in various forms and by then the notion that Steve had written the presentation was firmly implanted. The style should have given me pause for thought as it is extraordinarily hyperbolic.

If I had followed the final link, as indeed I should have done, I would have found a post entitled “Excellent presentation on Scribd on Australian housing” the following on Steve’s blog:

This presentation was noted by a blog member today. Take particular note of slides 21-20 which compare the balance sheets of US and UK banks to that of one Australian bank, the Commonwealth.

How to Profit From the Coming Aussie Property Crash (and Banking Crisis)

So who did write the presentation? Who knows, but it was uploaded to Scribd by someone called Karenina Fay.

In any event, while Steve may think it is an excellent presentation and I clearly do not, he did not write it and hence this a mea culpa. I apologise for following others in incorrectly attributing this presentation to Steve and I have edited the original post. I will also be endeavouring to click that last link in future!

Are Australia’s banks about to collapse?

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UPDATE: In this post I repeated Business Insider’s mistake of attributing the presentation I criticise to Steve Keen. While Steve considers it an excellent presentation, he did not write it and I apologise for not confirming the source before publishing this post. I have now struck out the incorrect attributions. My criticisms of the presentation itself still hold, which is why I am leaving the post up in its edited form.

Steve Keen and his forecasts of a property market collapse have received plenty of local media coverage over the years. Now he has come to the attention of the international press as well.

In April, Keen hiked to the top of Mount Kosciuszko after losing a bet about the direction of property prices with Macquarie Bank strategist Rory Robertson. This event was enough to prompt an extensive review of Keen’s concerns in the New York Times. Curiously, Robertson himself did not receive a mention, despite winning the bet.

Now the US business site Business Insider, which has a penchant for drama, has published one of Keen’s presentations a presentation, incorrectly attributed to Keen, under the headline “Here’s What You Need To Know About The Major Property, Debt, And Banking Crisis Brewing In Australia”.

One of Keen’s central concerns is the size of private sector debt in Australia. This is a legitimate concern and should receive more focus than misguided fears about Australian government debt. However, I am far less pessimistic than Keen about the outlook for Australian property prices.

As for the Business Insider presentation, Keen takes his concerns it goes too far, to the point of unsupportable alarmism. The final slide of the presentation is evidence enough of this, not to mention being in extremely poor taste. This slide appears to have been added by Business Insider! If that is not enough to convince you, I will consider just one of the arguments offered by the anonymous author Keen.

On slide 22 of the presentation, he writes:¹

Look at CBA 2009 annual report—Leverage ratio is almost 20 times (total assets of $620.4 billion against $31.4 billion of equity). Of $620.4 billion of assets, $473.7 billion are loan assets. If around 6.6% of CBA’s loans go bad (any loans not just mortgages), 100% of its shareholder equity will be wiped out!!

(the bold italics are not mine, they appear in the presentation). Here the implication is something like “6.6% is not very much. Wow! CBA could easily collapse!”. But, that line of thinking does not stand up to even moderate reflection.

Crucially, we must understand what “going bad” means for a loan. It does not mean losing everything, which is in fact very rare for most types of bank loans.

Over half of CBA’s are home loans and these are secured by the property that has been mortgaged. According to their half-year presentation², based on current market valuations, the average loan-to-value ratio (LVR) for CBA’s portfolio is 42%. This means that, on average, the value of the property is more than twice the loan amount. This gives the bank an enormous buffer against falls in property prices. Of course, this average conceals a mix of high and very-low LVR loans. Even assuming that loan defaults occurred on a higher LVR section of the portfolio, say with an average LVR of 70%, and allowing for Keen’s oft-quoted figure of a 40% decline in house prices, CBA would still only lose 14% on their defaulting loans³. Even then, this does not take into account the fact that, like other lenders, CBA takes out mortgage insurance on loans with an LVR of more than 80%.

But we can be more conservative still. In their prudential standards, the banking regulator APRA considers a severely stressed loss rate on defaulting home loans to be 20%. To suffer actual losses of 6.6% in their mortgage portfolio, CBA would have to suffer a default rate of at least 33%! This would be astonishingly unprecedented. Currently, the number of CBA borrowers late on their mortgage payments by 90 days or more is running at around 1%. Most of these borrowers will end up getting their finances back in order, so for actual defaults to reach 33% is inconceivable. A default rate of a “mere” 2% would be extraordinary enough for CBA.

As for the rest of the $473.7 billion, it includes personal loans, credit card loans, business loans and corporate loans. The loss rates on some of these loans can be higher than for mortgage portfolios, but losing everything on every defaulting loan is still highly unlikely. So to suffer 6.6% in actual losses on these loans, defaults would have to run at a far higher rate. Furthermore, since the dire prognosis for the banks is rooted in the view that the property “bubble” is about to burst, presumably the argument would not simply be based on everything other than the home loan portfolio collapsing.

If property prices do fall sharply and our economy has another downturn, will bank earnings be affected? Of course. Are they teetering on the brink of collapse? Of course not.

¹ While there is a footnote on the slide referencing this post, what is not made clear is that the whole paragraph is a direct quote rather than Keen’s own words. Presumably he agrees with it though!

² Page 84.

³ If property prices fall to 60% of the original value, the loss on a 70% LVR loan would be (70% – 60%)/70% = 14.3%.

Resource Super Profit Tax Everything Correctly Explained (R.S.P.T.E.C.E.)

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This guest post from Mule Stable regular Zebra (James Glover) delves into the details of the proposed Resources Super Profits Tax.

The Australian Government (hereby known as the Govt) has proposed a Resources Super Profits Tax (RSPT) for mining companies. Superficially it appears to be a 40% tax on all profits (measured by Return On Investment or ROI) in excess of the Govt Bond Rate (or GBR, the interest rate at which the Govt borrows money, over the long-term).

The key points of this article are:

1. The GBR is the correct threshold level for RSPT,

2. If the Govt increases the threshold above GBR this will represent a subsidy of miners by taxpayers,

3. The RSPT will benefit small and marginal mining projects to get finance through partial Govt backing of risks.

So for example suppose miner Mineral Wealth of Australia (MWA) invests $1bn in the Mt Koalaroo Iron-Ore mine. MWA is a wholly owned subsidiary of Silver Back Mining (SBM). In the year following they make $200m profit or a return on investment (ROI) of 20%. If the GBR = 5.5% then the 40% RSPT means a tax revenue to the Govt of Tax = 40% x (20%-5.5%) x $1000m = $58m.

This seems very straight forward. It appears that the Govt is saying that GBR represents some “fair” level of return and anything in excess of this is a “super profit” to be taxed accordingly. Not at the normal company tax rate of 30% but a “super tax” rate of 40%. This is how it has been presented by both sides in the media. Arguments against the RSPT have focused on whether the GBR as a “risk-free” rate is the appropriate benchmark for a risky profit stream. Indeed it is not but in fact this isn’t what the RSPT is about. For example normally taxes on profits have no negative impact on the Govt if the company loses money. In the case of the RSPT though the Govt has stated that 40% of any losses can either be claimed back from the Govt (as a refund) or carried over to other projects.

So what is the RSPT? A good way to consider it is if the Govt took a 40% stake in MWA as a “silent partner”, leaving SBM with a 60% stake. In this case we would expect the Govt to contribute $400m of the investment costs (raised presumably through issuing bonds at the GBR or equivalent). In return it would get 40% of the profit. The Govt return would therefore be 40% of the profit less the cost of funding its 40% investment ie Tax = ROI x 40% x I – GBR x 40% x I = 40% x (ROI – GBR) x I.

This appears to be the formula that the Govt has presented to calculate the RSPT and in this derivation it is quite straightforward. However the Govt appears to be getting something for nothing since it isn’t actually stumping up the $400m in investment capital. So what’s going on? A clever piece of financial engineering that’s what. The Govt avoids raising the capital itself (and hence have it be counted as Govt debt) by getting the project to raise it on the Govt’s behalf.

(You can easily skip the next paragraph if you aren’t interested in the details of mine financing costs)

Whilst MWA raises 100% of the $1bn in capital the Govt appears to get the upside (and potential downside) as if it has contributed $400m without doing so. Money for old rope you say. However consider MWA not to be the stand-alone mining company SBM, but the joint venture beween the Govt and SBM. Suppose MWA borrows $1bn in capital at its Project Funding Cost (or PFC). This PFC will be lower than the SBM’s Miner’s Funding Cost (or MFC) as the Govt is now backing 40% of all liabilities. In fact in an efficient market we deduce PFC = 60% x MFC + 40% x GBR. If MWA then allocated these funding costs accordingly it would charge the Govt its share, risk-weighted, not PFC, but GBR. If the GBR = 5% and MFC = 8% then we expect PFC = 6.8% not the 8% if SBM was the sole investor. Under this arrangment SBM’s cost of funding (in % terms) its effective 60% share of the joint project is the same as its stand alone cost of funds, as it should be.

An argument against raising the threshold above GBR is that this will effectively lower the miners’ cost of funds, the difference being borne by the Govt and hence us taxpayers. No wonder miners are arguing so vehemently for the threshold to be raised. In fact it can be shown that raising the threshold to 11%, as some propose, and using a GBR of 5.5% would effectively reduce the miners’ cost of funds by a whopping 3.67%! If you want a formula for the Miners’ Taxpayer Subsidy(MTS) it is: MTS = 2/3 x (Threshold – GBR) in terms of the miners’ funding cost discount (paid for by the taxpayers remember); or MTS = 40% x I x (Threshold – GBR) in $ terms. For the Koalaroo mine this would represent $22m of funding cost transferred from the mining company SBM to the taxpayer. That’s you and me. You don’t see that in their ads.

From the Govts perspective the advantage to them is that the investment does not sit on their balance sheet but the project company MWA’s and in effect SBM’s balance sheet. From a financial engineering point of view all this makes perfect sense. Having said that, it was precisely this sort of clever off-balance sheet flim-flammary that got Greece (and Lehman’s et al) in trouble. We need to make absolutely sure it is properly accounted for.

Update: Several commenters have pointed out the effect on mine financing of the RSPT. Specifically with the Govt backing 40% of any losses smaller stand-alone projects will find it easier to get project finance. As discussed above the funding cost will be lower with the Govt’s partial backing. The operating profit (so called EBITDA) of the project is unchanged so this makes them more, not less, viable. This is at odds with what the miners have been saying. Even existing projects with refinancing clauses in their loans should find it easy to convince their lenders to reduce their interest payments. For large global miners such as BHP-Billiton, who issue bonds, it will be harder to disentangle the Australian RSPT benefit to their overall cost of funds and hence spreads. But the market should over time price this in with lower spreads on their bonds. With a reduced cost of funds miners will be able to leverage their existing equity across more projects and make up for the 40% the Govt now takes out of individual profits (and losses) through the RSPT.

Update: Tom Albanese, CEO of Rio Tinto was on Inside Business on ABC on Sunday May 30. It is interesting that in arguing against the RSPT he referred to the unfairness of the Govt coming in as a 40% “silent partner”, and not about the GBR threshold. He clearly understands the true nature of the RSPT. While it was self-serving he emphasised (in my terminology) the determination of Investment or “I” for existing projects. Depreciation comes into it but some of these projects are decades old and it would an accountant’s dream/nightmare to work out the correct value of I to base the Govt’s GBR deduction on. He also questioned the “principle” (his word) of the Govt forcibly coming in as a “silent partner” on projects which are clearly profitable going forward, having survived to this point. After all they are not compensating mining companies for mining projects that failed in the past. I’m afraid I have to agree with this point, though I think it is more complex than I currently comprehend. It is good to see the RSPT being debated for once without the disinformation we have seen from less eloquent opponents. After all the Govt did say at the beginning that it was these sort of aspects of the RSPT they were prepared to negotiate on, not the 40% and not the GBR threshold.

UPDATE: Zebra looks at a fair value approach to the RSPT.

Stubborn Mule

Obstinately objective