ASX and the GFC

In an opinion piece in The Age today I discuss the positive impact that capital raising in the ASX has had on the Australian economy in the GFC, and the importance of dividend imputation and superannuation contributions in maintaining that capital flow.  Here is slightly expanded version of the text of the article. 

A combination of good luck and good management has kept Australia relatively unscathed thus far in the global economic crisis.  Our economy crept along at 0.4% growth over the last 12 months, versus declines of 4% in the US and a savage 10% in Japan.  Our unemployment rate is still only 5.5%, versus 9.2 % and rising in the US. 

In the good luck column is the resilience of property prices, which are underwritten by Australia’s rapid population growth, and the persistently high terms of trade, which are down from a peak of 120 but still much higher than their 2004 level of 75.

The good management column records the soundness of our banks, the high government surplus at the outset of the crisis and the high level of interest rates in early 2008, which has allowed a 4.25% cut in rates, with more cuts in reserve. 

Another positive factor has received less attention — the amount of new capital that has been raised in Australia’s stock market.  The ability of Australian firms to raise cash by issuing new shares has been very helpful in taking Australia through the crisis. 

Australia’s banks have been able to replace capital lost through bad loans and top up their Tier 1 capital from 7.5% to 8.3%.  The four majors have maintained their coveted AA rating status without the injection of any capital from the Federal Government.  Beside the major banks, Suncorp and Macquarie have been able to access the deep pockets of Australia’s institutional investors through the ASX. 

Australian industrial firms have also drawn from the stock market well.  Wesfarmers ($4.5 billion), Santos ($3 billion) and Qantas ($600 million) are among many firms that found the corporate bond market closed to them or prohibitively expensive and turned to shareholders instead. 

The listed property trust sector has been savaged in the financial crisis, but at least most firms have been able to smooth their transition to a world of lower leverage by bringing more equity capital onto their balance sheets through the issuance of shares.  The ability of property trusts to raise large licks of equity capital belies the need for a Ruddbank to intervene in the de-leveraging process in the commercial property industry. 

Equity capital raisings in Australia are much higher, as a proportion of GDP, than many other developed countries, including the US and the UK.  This has been true for many years and has two principal causes.  The first cause is Australia’s dividend imputation system which creates demand for new equity capital, as explained below.  The second is Australia’s superannuation system which generates a large supply of equity capital. 

The importance of dividend imputation, in this context, is that imputation causes Australian firms to pay higher dividend yields.  In the decade before the financial crisis started the dividend yield on listed Australian firms, at 3.8%, was twice that of the US at 1.9%.  Yields had been about the same in both countries until the introduction of dividend imputation in Australia in 1987.  Dividend imputation leads to higher dividends because firms can only get the valuable corporate tax credits out of the firm by stapling them to dividends.   

Because Australian firms pay much higher dividends than their US counterparts, they have lower retained earnings with which to finance new projects.  So, Australian firms must raise more new equity capital in the stock market than US firms.  It is good that firms have to convince the market to give them new capital.  Otherwise, if firms can finance their new project purely from retained earnings, then the firm’s management only needs to convince itself that it is investing shareholder funds wisely. 

It is better that cash is paid out of firms in high dividends and then only reallocated for investment to those firms that can convince the market that they have the best investment projects.  The high dividend, high capital raising model of a dividend imputation system leads to a more efficient allocation of capital in the economy. 

The second reason for Australia’s high equity issuance is the flood of savings into superannuation funds.  The volume of savings of Australian households which cannot be accessed before retirement is $1.1 trillion and growing rapidly.  Only the US, Japan and the UK have higher volumes of private retirement savings.  Most of these savings are managed by investment management firms.  It is these institutional investors that have a constant inflow of new cash through the 9% compulsory superannuation contributions and salary sacrifice contributions. 

Most of the $55 billion of new equity issuance by Australian firms this financial year has been placements with institutional investors.  In some capital raising there has been no allocation to retail investors, which has evinced the complaint that retail share holdings are being diluted by issuance to institutional investors at large discounts to the prevailing share price. 

Equity placements are a actually a mixed blessing for retail shareholders.  Institutional investors may get a higher proportion of the shares issued.  But, if retail shareholders do get an allocation, then they may be able to decide whether to take up the retail offer after they have seen what has happened to the share price.

In some ways the poor treatment of retail shareholders in recent equity capital raising is the flip side of the benefits to retail shareholders when firms were doing large, discounted share repurchases in 2004-2007 (which have come to an end in the GFC).

The benefits of a an efficient market for new equity capital in Australia should not be taken for granted.  The Henry tax review is considering changes to the Australian tax system which would substantially reduce the issuance of new equity. 

An end to dividend imputation has been suggested.  That would lead to the low dividend, low equity issuance model of the US, which is inefficient in the best of times and has served the US poorly in the financial crisis.  A further reduction in the tax benefits of retirement savings has also been suggested.  That would reduce the flow of new capital to institutional investors and hence their demand for new share placements.

So far, tax policy goes in the good management column of the Australia’s GFC experience, but that will change if the Government eliminates dividend imputation or the favoured tax status of retirement saving.