Of all the acronyms coined in the financial crisis, “QE” is certainly one of the most elegant. Its genesis may be traced to 2010, when press commentators dubbed the second round of quantitative easing by the Federal Reserve “QE2”.
Since then, press references to easing by central banks in the US, Japan, UK and the Eurozone have often adopted the regal QE moniker. Use of the term QE seems to suggest an ease and perhaps even affection for quantitative easing. Yet QE comes with a number of, as it were, “risks-in-waiting”. Key among these is inflation.
China's central bank governor Zhou Xiaochuan recently warned that QE policies worldwide could cause inflationary risks, a concern reportedly shared by central banks across Asia. HSBC economist Wellian Wiranto is more forthright, labelling inflation the “elephant in the room” at this stage of the global recovery. So as the Fed’s QE3 gets underway, it is perhaps not surprising that products like inflation-linked bonds, inflation funds and inflation derivatives are coming into the spotlight.
Against this backdrop, the recent re-referencing of Australia’s Consumer Price Index (CPI) will be of more than passing interest to many market participants. This Alert summarises what has happened and considers some of the consequences.
What has happened?
In a process known as “re-referencing”, all Australian CPI numbers are to be calculated by the Australian Bureau of Statistics (ABS) on a new index reference period of 2011-12 from the September quarter. This has resulted in the index numbers for each index series being reset to 100.0 for the financial year 2011-12. For comparison, the June 2012 All Groups CPI level was 180.4.
Re-referencing is not a frequent occurrence, the previous CPI rebasing was in 1990. Re-referencing is not to be confused with re-weighting. Re-weighting refers to changing the weight attached to items in the consumer price index. Re-referencing refers to changing the base reference year of the index.
What does this mean for me?
The ABS will produce historical index numbers using the new base, so generally there is no need for users to do their own calculations. However those involved or invested in Australian CPI linked products should consider how the re-referencing impacts them.
To assist the market in preparing for the re-referencing, the Australian Financial Markets Association (AFMA) Inflation Products Committee published a guidance note on 26 September 2012 titled “Re-referencing/Rebasing of the Australian Headline CPI”. The guidance note recommends that in general:
- issuers of capital indexed bonds should use the new index for coupon dates following 24 October 2012
- issuers of indexed annuity bonds should use the new index following 24 October 2012
- the Calculation Agent for inflation swaps confirmed under the 2005, 2006 or 2008 ISDA Inflation Definitions should follow the “Rebasing of the Index” provision in the definitions
The majority of market participants should be able to follow the AFMA recommendations without difficulty since these will be consistent with transaction documentation. Many inflation derivatives are confirmed using the ISDA Inflation Definitions which, as noted above, have rebasing provisions. The Australian inflation bond market primarily consists of sovereign issuers with documentation which contemplates CPI re-referencing. For example the prospectus for Treasury Indexed Bonds issued by the Australian Office of Financial Management provides:
“If the reference base of the CPI is changed after Treasury Indexed Bonds are issued, the index which shall be used for the purposes of this prospectus shall be the CPI numbers expressed on the new base as published by the Australian Bureau of Statistics.”
However, there could be transactions which fall outside the AFMA guidance due to the drafting of specific documentation. This documentation should be reviewed to identify relevant requirements. A particular issue to look out for relates to fixed CPI definitions.
The case of fixed CPI definitions
A drafting approach which is sometimes encountered in transaction documents is CPI defined as a fixed value without an allowance for re-referencing. For example: “CPI(0) means 150”.
If the documents do not include a re-referencing provision then an amendment to the fixed value definition could be considered, unless the parties are able to get comfortable with a solution through a process of contractual construction.
If parties are uncomfortable with re-referencing based on the principles of contractual construction alone, then CPI references in the transaction documents may need to be amended. In the case of bilateral inflation derivatives which do not incorporate the ISDA Inflation Definitions, it may be relatively straightforward for the parties to agree to an amendment. However for widely held inflation-linked instruments the position could be more complicated. Much will depend on the terms of the instrument, for example the power of a note trustee to vary bond terms without noteholder consent in order to make “technical changes” or variations which are “not materially prejudicial to noteholders”. Whether a note trustee could form the view that re-referencing is a “technical change” or “not materially prejudicial” will depend on all the circumstances.
The key message is that those involved with Australian CPI linked products should:
- be aware that a re-referencing has occurred; and
- consider how re-referencing impacts them.