FIN203 Relationship Between Foreign Currency Liabilities of Australian Banks Assessment 2 Answer

Executive Summary

This report is based on the internationalization of business in Australia. Specific reference is given to the big 4 commercial banks of the country about the sources of fund that it procures to continue its operational services. In the situation of internationalization of business, the foreign exchange currency translation reserve pays an important role in determining the risk of foreign exchange transaction. Other significant factors involve interest rates, inflation rate and exchange rate. A comparative analysis has been conducted between USA inflation, interest and exchange rates with that of Australia. The four big commercial banks, Westpac, NAB, CommBank and ANZ has been selected to verify and summaries how these companies have dealt with foreign exchange currency translation risk using hedging from 2006 to 2018.

Introduction

From the viewpoint of economics, internationalisation of financial markets is defined as the steps undertaken to increase the market share of the business outside the domestic country of the domicile business. It is possible through various strategic alliances like joint ventures, franchising, branches into international markets. These strategies greatly impact each of the other business activities as well as economic well-being. As opined by Nassios et al. (2016), the main sources of funds for Australian commercial banks for the big 4s are from the commercial deposits with other major funding sources like LT and ST wholesale debt. Securitization and equity funding form ancillary part of sources of funding for such business. This report is about an in-depth understanding of how the commercial banks of Australia are receiving funds from both domestic as well as international markets in responding to the internationalisation of financial markets of Australia. 

Literature Review

Inflation Rates

The inflation rate in Australia is reported between 2009 to 2019 with the projections made until 2021. The inflation rate of the country is computed using the general price level of the product basket. This product basket comprises products and services on which the average consumer makes a consumption expenditure throughout the year. These include the purchase of consumer goods, rent, power, telecom expenses, recreational activities and raw materials like gas and oil. The inflation rate involves a payment made by the consumer to the federal government in the form of tariffs, fees and taxes. In 2019, the inflation rate in Australia was 1.61% as compared to 2018 of 1.93% (Statista.com, 2020).

Figure 1: Inflation Rate in Australia

(Source: Statista.com, 2020)

The annual inflation rate in the US shows the statistical figures from 2010 to 2019 with a projection up to 2021. The inflation rate is based on the city averages in the country. The base country for computing inflation in the country was 1982-84. As said by Bell & Hindmoor (2019), inflation rate is the measurement of the rate of increase in the general price level of goods and services which is denoted as CPI. In other words, it is the % of the change in prices over time. This causes the value of money or the purchasing power to decrease significantly. As per the forecasted report prepared by the IMF, the inflation rate in the USA for 2020 will increase by 0.62% in 2020 (Statista.com, 2020). Moreover, it is projected that there will be an annual rise of 2.24% at the general level of the price until 2021.

Figure 2: Inflation Rate in the USA

(Source: Statista.com, 2020)

Interest Rates

The interest rates in Australia between 1990 until 2020 was an average of 4.19% where it reached the highest of 17.50% in 1990 January and recorded the lowest interest rate as 0.25% in March 2020 Tradingeconomics.com, 2020). The official current cash rate as determined by RBA is 0.25%. This indicator is the expected market rate of the change in the OCR that is fixed by the RBA. 

Figure 3: Interest Rate in Australia

(Source: Tradingeconomics.com, 2020)

The USA has recently decreased its interest rates by 1% and therefore, the annual rate has come down to 0%. It is one of the most effective monetary policies by the Central Bank to implement control of monetary supply and demand of money in the economy. A reduction in the interest rates results in weakening of prices of goods and services with a possible situation of deflation in the economy. It also supports the improvement of the economy and an increase in exports. As on 29th July 2020, the Federal Funds rates are targeted to lie between 0% and 0.25% to revive the business sector throughout the pandemic (Tradingeconomics.com, 2020). The interest rates in the US lied at an average of 5.59% between 1971 until 2020 with the all-time highest as 20% in March 1980 and a recorded lowest in December 2008 of 0.25%.

Figure 4: Interest Rate in USA

(Source: Tradingeconomics.com, 2020)

Exchange Rate

AUD/USD is one of the most traded currency pairs in the world. Currently, it is traded as 0.7172 USD which is 0.0011 higher or 0.15% as on 24th August 2020 (Tradingeconomics.com, 2020).

Figure 5: Exchange Rate AUD/USD

(Source: Marketwatch.com, 2020)

Analysis

Review and summarization of the bank’s foreign currency liabilities

The annual reports of the four big banks of Australia- ANZ, Commonwealth Bank, NAB and Westpac are evaluated for the years 2006 to 2018 particularly on the bank’s currency liabilities.

ANZ

From the CF statement of the bank, it can be seen that the foreign currency translation opening balance was recorded as $2627 million for the year 2006 as compared to ($2479) million in 2007 as consolidated Group and $929 million and ($1169) millions for 2007 specific to the company. The FCTR was created by ANZ for 2006 worth $3 million as the consolidated entity and no provision was created for the company independently with no balances in 2007 (Anz.com,2020). 

The foreign currency translation for the years 2009 and 2008 was ($294) million and $75 respectively as Group and for Company, the values were ($486) million and $440 million for 2009 and 2008 respectively (Anz.com,2020).  ANZ created an FCTR to meet the exchange difference that arises on account of the translation of the assets and liabilities of all the Group that is reflected on account of the FCTR. The effect of offset of such foreign exchange difference causes a profit or losses on hedging of this balance along with a tax effect that is shown in the form of the reserve as $27 million for 2009 and $15 million for 2008. 

For the accounting years, the FCTR accounted for $330 million and ($1006) million for 2011 and 2010 respectively. The effect of the foreign exchange rate is illustrated on the cash and cash equivalents of ANZ for the years 2011 and 2010 as $566 million and ($576) million. For 2013 and 2012, the translation reserves of foreign currency were $1712 million and ($416) million respectively (Anz.com,2020).  The balance recorded at the beginning of the year where ($2831) million and ($2418) million for 2013 and 2012 respectively. The adjustments took place for currency translation inclusive of hedges after taxes were $1706 million for 2013 and ($413) million for 2013 and 2012. The reserve and retained earnings included FCTR for the years 2015 and 2014 as balances in the beginning of the year to be ($605) million and ($1125) million respectively. 

During the year, there has been transferring to P/L account and adjustments of net hedging resulting in the total currency translation reserve to be $1119 million for 2015 and ($605) million in 2014. Out of all the reserves included within the shareholder’s equity, the foreign currency liability for 2018 was $12 million, 2017 was ($196) million and $544 million for 2016 (Anz.com,2020). The fluctuation of share price taken on account of difference in the shareholders’ equity was ascertained as ($748) million in 2017 and ($456) million in 2016. The FCTR included $222 million for 2018 and ($748) million in 2017 (Anz.com,2020). 

Commonwealth Bank

CBA recorded its foreign currency liabilities under reserves and surplus carrying an opening balance of ($141) million. During the years, adjustments took place in the form of IFRS transitional adjustments, restated opening balance, currency translation adjustments, transfer to I/S and tax adjustments. Therefore, the closing balance of foreign currency reserves for 2006 was ($241) million. In the years 2008 and 2007, the liabilities for FCTR were ($795) million and ($200) million respectively (Commbank.com, 2020). The closing balances of foreign currency reserves for 2010 and 2009 were ($553) million and ($533) million as compared to ($533) million and ($795) million in 2010 and 2009. There has been a fall in the liabilities for 2009 due to adjustments of foreign operations for CommBank, however, for there has been an increase in the transfer or disposal of foreign operations to the I/S in 2010 for $26 million (Commbank.com, 2020). 

The liabilities held by CBA in the form of foreign currency were recorded as ($1083) million in 2012 and ($563) million in 2011. With given adjustments taking place during the year, the closing balances of the FCTR were ($893) million and ($1083) million for 2012 and 2011 as the CBA Group. From the annual report of CBA, the following figures are recorded as the shareholders’ equity included an FCTR having an opening balance of ($427) million in 2014 and ($803) million in 2013 (Commbank.com, 2020). The tax adjustments made during the year was ($14) million in 2014 and ($10) million. 

The liability of foreign currency is reduced through investment reserves of ($6) million and ($13) million respectively for 2014 and 2013. Therefore, the closing balances were ($42) million and ($427) million in 2014 and 2013. The foreign currency liabilities recorded for CBA were recorded as $739 million in 2016 and $358 million in 2015 indicating a favourable balance for the bank. It means the bank holds sufficient amounts of foreign currency with itself to hedge against the risk of translation under foreign currency transactions (Commbank.com, 2020). For the year 2017 and 2018, the FCTR accounted for $457 million and $448 million respectively for CBA. 

NAB

For the year 2006, under AASB 1, NAB Group has created an FCTR to be 0 as on 1.10. 2004 resulting in an increase of retained earnings for the Group to be $166 million or $23 million for the Company. The FCTR was valued as ($135) million in 2006 as Group and ($26) million as Company in the same year. For the years 2007 and 2008, the FTCR comprised ($860) million and ($1040) million against the adjustments made during the year for current translation risk of ($180) million in 2008 and ($725) million in 2007 (Nab.com, 2020).

From the annual reports of NAB for the years 2008 and 2009, the FCTR for the group were ($1040) million and ($2525) million respectively whereas for the Company the value was ($178) million and ($180) million respectively (Nab.com, 2020). This shows that in both the years, there was a high translation risk borne by the NAB which could not be mitigated through hedging risk instruments. The reserves for NAB for the year 2010 and 2011 included FCTR worth of ($3404) million and ($3667) million respectively which is the closing balance. 

Westpac

From the annual report of the company for the year 2016, the opening balance of FCTR was ($175) million. Amidst the exchange difference on foreign currency, the associated hedge during the years was ($238) million that resulted in increased in the foreign currency liability up to ($413) million. The FCTR for the years 2015 and 2014 were recorded as ($354) million and ($251) million respectively. There has been a tax adjustment of foreign currency in 2014 worth of ($11) million causing the end balance to be adjusted for the year to be ($251) million (Westpac.com, 2020). However, for 2015, a favourable exchange or hedging of risk was carried out by Westpac for $61 million resulting in a decrease of liabilities up to ($190) million. 

The financial statements (consolidated) recorded the FCTR for 2011 was ($32) million in 2011, $6 million in 2010 and $4 million in 2012. These liabilities were paid from the provisions or reserves created by Westpac out of the profits for the year that included ($171) million in 2010, ($287) million in 2011 and ($294) million in 2012 (Westpac.com, 2020). Cumulative adjustments of FCT and tax paid on foreign currency transaction resulted in the closing balance of the FCTR to be ($287) million, ($294) million and ($354) million for the year 2010, 2011 and 2012 respectively. 

Graphically depict the following

(i) % change in foreign currency liabilities and exchange rate

Figure 6: Increase in foreign exchange

 (Source: Economiconline.uk, 2020)

(ii) % change in inflation rates (US) and inflation rate (AUS)

Figure 7: Inflation of USA and Australia

 (Source: Au.investing.com, 2020)

% change in interest rates (US) and interest rate (AUS)

Figure 8: Australia and US Interest Rates

(Source: Rba.gov.au, 2020)

Critically analyse the relationship between bank’s growth rate and exchange rate, inflation rates and interest rates

The monetary policy of a country is used as a tool by the central bank to exercise and manipulate the overall economic growth level of the money supply and interest rates. As said by Afza & Alam (2016), if every other factor is maintained, the high cost of financing increases the state's money, and vice versa. Higher borrowing costs generally attract unknown firms interested in the nation's money, while lower premiums reduce speculation of the unknown (Rba.gov.au, 2020). However, borrowing costs alone cannot determine the value of money. A nation must also be financially and politically stable. This is one of the key components when financial professionals think about the allure of having money.

Inflation rate can also significantly affect the valuation of money and the rate at which it trades against the standard currency of other countries (Rba.gov.au, 2020). The impact is usually unfavourable - low inflation rates do not provide an adequate benchmark for a country's exchange rate, while very high rates of expansion have great potential to negatively affect the value of national trade. For this reason, these countries depart at night to cut spending and credit for greater financial development (Robertsson, 2016).

Recommendation

Based on the above analysis, it is recommended to the Australian government to pass banking regulations to compel banks to adopt an exchange rate in terms of FCTR as per the RBA’s cash rate. The RBA should use currency exchange rates to revive or stop financial movements with the aim of keeping swelling within the target range in the medium term. In case of inflation, it is likely to be too high for a very long time, the RBA will regularly raise the exchange rate to bring the expansion back on target (Rba.gov.au, 2020). A lower cash rate encourages household spending and speculation, including through expanding family wealth and income. When the RBA lowers the money rate, it leads to a reduction in other borrowing costs in the economy. 

As explained by Tripathi (2018), lower borrowing costs turn on costs. The value of money is the percentage that banks lend to one another within the transitional currency window, but it still has a large impact on contract values in the economy, the rates people use to use their reserve funds, and resource costs and exchange rates. So this is a significant financial expense (Mishler, 2017). When the RBA cuts interest rates at this point, finance costs go down: this is useful for upfront household payments and very bad for bank accounts (Rba.gov.au, 2020). Reserve banks will cut interest rates again in March 2020 as part of the COVID-19 pandemic crisis response.

Conclusion

It can be concluded that Australia has seen significant changes in its monetary framework over the last few decades. The net impact represents a shift in Australia's budget framework from the generally closed oligopolistic structure of the 1950s and 1960s of standard banking intermediation to a more open and serious framework that offers much broader governance than many different suppliers. The process of developing this monetary framework, although led largely by advertising forces, has been facilitated by the creation of administrative and administrative game plans. Storage of marine materials (limiting budgetary institutions) accounts for a little over 10 % of total financing for large bank funds. About 60% of this is obtained from unknown supporting banks for private customers and small and medium enterprises (SMEs). Other businesses not connected to money (NFC), usually in Australian specialty operations and foreign branches.