The structural foundations of State debt: Part 1

 

Why the Federation’s Financial Architecture Leaves States Exposed

Australia’s public debate about government debt is dominated by household analogies and moral framing. We speak as if governments “borrow too much”, “live beyond their means”, or “burden future generations”. But the accounting tells a different story. The Commonwealth and the States operate with fundamentally different liability structures. They face different risks, different constraints, and different opportunities. If we ignore those differences, we misdiagnose State fiscal pressures as behavioural rather than structural.

Tasmania is a case in point. Its fiscal challenges are not simply the result of overspending or poor discipline. They arise from the architecture of the federation itself — from the fact that the Commonwealth can issue liabilities that behave like equity, while States can issue only liabilities that behave like debt. Once that asymmetry is understood, the entire debate looks different.

This blog sets out the structural foundations of State debt. It is a more complete explanation of the points raised in the last blog – the presentation given to the Economiccs Society on State Debt. It explains why States are trapped in market‑linked liabilities, why the Commonwealth’s balance sheet is uniquely flexible, and why the federation needs a sovereign equity mechanism to restore balance. Part II will develop that mechanism — the Federal Development Facility — in full.

1. The Commonwealth’s Unique Liability Toolkit

The Commonwealth’s Consolidated Financial Statements reveal a liability structure unlike any other in the federation. The Commonwealth issues two distinct classes of liabilities:

1.1 Policy‑controllable liabilities

These include:

• settlement balances, and
• currency on issue.

They share four defining characteristics:

1.     No maturity — they do not need to be refinanced.

2.     No rollover risk — they cannot trigger a liquidity crisis.

3.     Policy‑determined pricing — the cost is set by the cash rate, not markets.

4.     Extinguishable through taxation — they disappear when taxes are paid.

These liabilities behave more like perpetual equity claims than like debt. They are created when the Commonwealth spends. They exist because private banks act as intermediaries in the settlement system. If every Australian had an account at the RBA, those accounts would appear on the Commonwealth’s balance sheet as perpetual, policy‑priced claims — essentially non‑redeemable preference shares.

1.2 Market‑linked liabilities

These are Commonwealth bonds. They:

• are created by swapping settlement balances
• mature,
• must be refinanced,
• are priced by markets, and
• expose the issuer to interest‑rate cycles.

The Commonwealth can choose the mix. It can shift between equity‑like liabilities and market‑linked liabilities depending on policy needs. This is sovereign flexibility.

States cannot do this. They have only one class of liability: market‑linked debt.

This asymmetry is the foundation of the federation’s structural imbalance.

2. States Are Trapped in Market‑Linked Liabilities

States can issue only liabilities that behave like debt. Every dollar they borrow:

• matures,
• must be refinanced,
• is priced by markets,
• exposes them to interest‑rate cycles, and
• carries rollover risk.

This constraint is structural, not behavioural. It exists regardless of how disciplined or prudent a State may be.

2.1 Rising capital needs

States build and maintain the infrastructure that underpins national productivity:

• water systems,
• transmission lines,
• hospitals,
• schools,
• ports,
• transport networks.

These are capital‑intensive assets with long lives and high renewal costs.

2.2 Regulated revenue streams

State‑owned businesses — TasWater, TasNetworks, TTLine — operate in regulated markets. Their revenue streams cannot rise fast enough to service modern infrastructure debt. They cannot price their way out of capital constraints.

2.3 Dividend extraction

In Tasmania, the Government drains 90% of after‑tax profits from government businesses. This leaves them unable to fund capital renewal from operating cash flows. They must borrow — at market rates — to maintain assets.

2.4 The result

States face rising capital needs but have only market‑linked liabilities to meet them. They are structurally exposed to interest‑rate cycles and rollover risk. No amount of discipline can change this.

3. The RBA’s Term Funding Facility: A Demonstration of Sovereign Flexibility

The RBA’s post‑COVID operations made the Commonwealth’s flexibility visible. The Term Funding Facility (TFF) provided $186 billion in loans to banks at 0.1%. Banks delivered bonds as collateral; the RBA credited their settlement balances.

When the cash rate rose, banks earned 4% on those settlement balances while paying only 0.1% on the loans that created them. It was a windfall for banks and a loss‑making exercise for the RBA.

The RBA went into negative equity. Nothing happened. A sovereign cannot be insolvent in its own currency.

3.1 Why States could not access the TFF

The RBA Act prohibits the RBA from lending directly to States. The constitutional structure reinforces this. The RBA can lend to:

• banks,
• the Commonwealth,
• Commonwealth‑owned corporations.

It cannot lend to States.

3.2 The implication

If the federation wants to replicate the TFF for States, it must create a Commonwealth‑owned intermediary — a statutory corporation that can borrow from the RBA and lend to States.

Part II will develop that intermediary.

4. Debt Held by Third Parties vs. Policy‑Controllable Liabilities

Interest paid on market debt is extraction. It flows to private and foreign bondholders. It leaves the State economy.

Interest paid on policy‑controllable liabilities is different. It can be structured as a national equity dividend — a deliberate, policy‑priced distribution of the national pie. It can be directed to super funds, embedding sovereign equity into the retirement system.

This reframes government debt. From the outside‑in view — the only view that makes sense for a public institution — government liabilities are the community’s equity. They are the financial expression of the public assets we collectively own.

States cannot issue equity‑like liabilities. The Commonwealth can. That difference shapes everything.

5. Reintroducing a Modern 30/20 Rule for Super Funds

Australia’s compulsory superannuation system now holds more than $4 trillion in assets — a pool of capital larger than the nation’s GDP. Yet it is structurally disconnected from sovereign balance‑sheet strategy. The system was designed to provide retirement income, but it has evolved into something much larger: the dominant investor in Australia’s financial markets. And despite the rhetoric of “building a better Australia”, much of the time super funds are not investing in productive assets at all. They are participating in asset speculation — bidding up the price of existing assets rather than financing new ones.

This is not the fault of super members. It is the architecture of the system. And it is why the history of the 30/20 rule matters.

5.1 The original 30/20 rule: a forgotten nation‑building tool

For decades, Australian super funds were required to hold a portion of their assets in Commonwealth bonds. The rule was simple:

• 30% of assets had to be held in prescribed government and semi-government investments.
• 20% of assets had to be held in Commonwealth bonds.

In other words 20% had to be in Commonwealth bonds but the remaining 10% could be semi-government bonds like Telecom or Hydro bonds for instance. It was a nation‑building mechanism. It ensured that compulsory savings were aligned with sovereign development. It created a stable investor base for Commonwealth liabilities. It embedded national equity into retirement savings.

The rule was abandoned in the 1980s and 1990s as part of financial deregulation. The argument was that markets should allocate capital more efficiently than governments. But the result was predictable: super funds shifted into equities, property, and private markets. The connection between compulsory savings and national development was severed.

5.2 Why the 30/20 rule has a place in modern Australia

Today, the case for a modern version of the 30/20 rule is stronger than ever.

First, the cost of super tax concessions now exceeds the cost of the age pension — the very system super was designed to relieve pressure on. This raises a legitimate public question: if taxpayers subsidise super so heavily, should super funds contribute more directly to national development?

Second, super members would overwhelmingly support it. When asked, most Australians believe their super is already helping build a better Australia. They are told this constantly in advertising. But in reality, super funds often invest in existing assets — airports, toll roads, shopping centres — not new productive capacity. A modern 30/20 rule would make that promise real.

Third, it is in everyone’s interest to ensure sustainable States. States build the infrastructure that underpins national productivity. If States cannot renew assets, the nation cannot renew assets. A modern 30/20 rule would provide a stable, long‑term investor base for State‑linked sovereign instruments.

Fourth, super funds need long‑duration, low‑risk assets. Commonwealth‑guaranteed bonds — including bonds issued by a statutory corporation like the FDF — are ideal for matching long‑term liabilities. They provide predictable returns, low capital charges, and regulatory certainty.

5.3 A modern rule: up to 10% in Commonwealth‑guaranteed instruments

A contemporary version of the rule could require super funds to hold up to 10% of assets in Commonwealth‑guaranteed bonds. These could be:

• Commonwealth bonds, or
• bonds issued by a Commonwealth statutory corporation such as the FDF.

This would:

• stabilise State refinancing,
• embed sovereign equity into retirement savings,
• redirect interest flows into Australian households,
• reduce reliance on foreign capital, and
• create a long‑term investor base for national development.

5.4 Super funds and housing: a natural fit

Super funds have long wanted to invest in housing — particularly community and social housing — but they face a structural barrier: the returns are too low for private capital. The Commonwealth can solve this by:

• providing interest subsidies to States, or
• guaranteeing minimum returns on FDF‑issued housing bonds.

And crucially, those subsidies can be structured inside the GST pool:

• assessable amounts reduce GST shares, or
• quarantined amounts leave GST shares unchanged.

This gives the Commonwealth a powerful policy lever: it can channel super savings into housing without distorting relativities or increasing No Worse Off payments.

The FDF becomes the natural vehicle for this. It can:

• issue Commonwealth‑guaranteed housing bonds,
• borrow from the RBA if needed,
• lend to States or community housing providers, and
• structure returns to suit super funds.

This is nation‑building in the literal sense.

6. The Commonwealth’s Policy Role in GST and Grants Commission Adjustments

The Commonwealth has tools that can support States without distorting GST relativities. Loan forgiveness, interest subsidies, and equity‑like transfers can be:

• assessed by the Grants Commission, reducing GST shares, or
• quarantined, leaving GST shares unchanged.

The choice determines whether the Commonwealth’s No Worse Off payments rise or fall.

6.1 Why this matters

The GST pool is the primary mechanism for equalising fiscal capacity across the federation. But it is blunt. It cannot distinguish between:

• structural constraints, and
• behavioural choices.

By using assessable and quarantined amounts, the Commonwealth can:

• support States facing structural pressures,
• avoid penalising them through relativities, and
• manage its own fiscal exposure.

Part II will show how the FDF can use this lever.

7. The Structural Consequences of State‑Only Debt

The consequences of States relying solely on market‑linked liabilities are structural, not behavioural. They arise from the architecture of the federation, not from overspending or poor discipline.

7.1 Surpluses shrink the State; deficits build it

Surpluses reduce public assets. Deficits accumulate into infrastructure. The annual deficit/surplus debate hides the long‑term balance sheet story.

7.2 Competitive neutrality and dividend extraction drain renewal capacity

Government businesses must behave like private firms. They borrow at market rates, pay Income Tax Equivalents, and lose most of their profits to dividends. They cannot renew assets under this model.

7.3 Sectoral balances limit the ability to “pay down debt”

Public surpluses require private deficits. Households are already over‑leveraged. Paying down government debt forces private borrowing or foreign ownership.

7.4 Deferred maintenance compounds into structural decay

Deferred maintenance compounds. Infrastructure decay becomes structural. States cannot “save their way” to capital renewal.

These pressures are not separate. They are symptoms of one underlying constraint: States can issue only market‑linked liabilities.

8. The Federation’s Structural Asymmetry — and the Need for a Sovereign Equity Mechanism

The Commonwealth can issue equity‑like liabilities. States cannot. Yet States do most of the capital spending. They build the water systems, transmission lines, hospitals, schools, ports, and transport networks that define the nation’s productive capacity.

The federation is structurally unbalanced. It asks the level of government with the weakest liability toolkit to carry the largest capital burden.

If the Commonwealth is the only issuer of equity‑like liabilities, and States are the primary builders of public assets, then the federation requires a mechanism that converts sovereign equity into State‑level capital capacity.

That mechanism is the Federal Development Facility.

Part II will develop it in full.