Surveys in the Economic History of AustraliaCAPITAL MARKET.docx

Surveys in the Economic History of Australia
CAPITAL MARKETS AND CAPITAL FORMATION IN
AUSTRALIA, 1890–1945
By D.T. Merrett
University of Melbourne
This survey article examines the interaction between the
domestic
capital markets and capital formation in Australia from the
1890s
up to the end of World War II. The disenchantment of the City
of
London with Australian securities in the 1890s opened a
window for
the development of domestic capital markets. It was the
demands of
the government for funds, especially during both wars, that
transformed the scale and character of local markets. Local
deposit
taking institutions and stock exchanges handled a sufficient
volume
of domestic savings to fund the lion's share of both public and
private sector capital formation.
INTRODUCTION
This survey is the first of two that explores the dynamics and
interaction of
domestic capital formation and the evolution of Australian
capital markets.

Over the 100 years separating the depression of the 1890s and
the deep
recession of the early 1990s, a large and rising share of
Australia's resources
was devoted to capital formation. This investment was both a
cause and a
consequence of a process of economic development that came to
rely
increasingly on urban-based manufacturing and service sectors
that required
large capital inputs. The volume and direction of this
investment was largely
driven by responses of the public sector and private businesses
to two powerful
forces, the speed of population growth, particularly net
immigration, and the
erection and subsequent subsidence of trade barriers.
Furthermore, the share
of investment undertaken by the private sector came to
overshadow that of the
once dominant government sector.
Somewhat surprisingly, in view of contemporary concerns about
the
nation's low rates of saving and high external debt, domestic
savings paid for
the greater part of capital formation undertaken within
Australia. However,
there have been shorter periods, most notably in the 1920s and
1980s, when
Australian Economic History Review, Vol. 37, No. 3 November
1997
ISSN 0004-8992
ß Blackwell Publishers Ltd and the Economic History Society of

Australia and New Zealand 1997.
Published by Blackwell Publishers Ltd, 108 Cowley Road,
Oxford OX4 1JF, UK
and 350 Main Street, Malden, MA 02148, USA. 181
foreign savings were of particular importance. Yet even in these
atypical
decades, foreign savings did not amount to more than 30 per
cent of total
savings in the 1920s or reach even 10 per cent in the 1980s.1
Funding
investments from domestic savings placed new demands on
local capital
markets; responses to these demands were generally positive. In
the process,
Australian capital markets underwent very significant changes
in terms of
the range of services they provided and the manner in which
they operated.
By the 1980s these markets were considerably more mature than
had been
the case a century earlier. However, for all the innovation that
had taken
place, capital markets played a passive role of simply
accommodating the
demands of investors.
This survey will cover the period from the 1890s up to 1945. It
will begin
with a brief overview of the period before discussing
developments from the
1890s to World War I, and the years from 1918 to the end of
World War II.

Poor investment decisions by both governments and private
business in the
1880s, and widespread collapses among overstretched financial
institutions in
the 1890s, contributed to the depth and duration of the
subsequent depression.
That long period of economic expansion after the gold rushes of
the 1850s left a
legacy in terms of a stock of capital skewed towards a narrow
range of
activities and a set of financial institutions and capital markets
that, although
shaped by British experience, were uniquely Australian. Despite
the
developments that had taken place in the financial and capital
markets in the
decades before the bank crashes, the narrow range of services
provided by
banks and other financial intermediaries, together with the
underdeveloped
character of colonial stock exchanges, were indicative of a
relatively immature
economy that was still in many respects an appendage of the
United
Kingdom.
The experience of the 1890s had very important long-term
implications for
the subsequent development of antipodean capital markets. The
depression of
the 1890s dampened the demand for new large-scale investment
for nearly two
decades. In brief, recovery took place without substantial
increases in
investment. However, the loss of reputation by Australian
borrowers in the

London market in the early 1890s, and subsequent downgrading
of credit
ratings, set in train a series of developments which were to
transform local
capital markets. Australian borrowers in the London market
came to rely on
British intermediaries, so ending the investment banking
function undertaken
in the late nineteenth century by Australian banks. Commercial
banking and
investment banking were effectively separated without the
impress of a US-
style Glass Steagall Act, a specialization of function which gave
Australian
capital markets an unusual twist.
The growth of the Australian capital market over the half
century after
1890 was driven first and foremost by the demands placed upon
it by the
public sector. Before the depression of the 1930s, Australian
governments still
182 Merrett
Australia and New Zealand 1997
looked abroad, primarily to London, for long-term development
capital.
However, there were two critical episodes when the financial
needs of the
Australian government rose dramatically at a time when
overseas capital

markets were closed: both were during the two world wars. The
sheer volume
of war-related government debt transformed the Australian
financial system,
and ensured that the primary business of local capital markets
remained in the
issuance and trading of government fixed-interest securities up
until the 1960s
or 1970s. Furthermore, it thrust two federal government
institutions – the
Loan Council and the Commonwealth Bank of Australia – into a
central
position in the workings of the market.
Australian stock exchanges, which were established in the
various colonies
from the 1860s onwards, initially owed their existence to the
flourishing
market for shares in mines. Mining had a voracious demand for
capital to
finance the exploration and development of new ore bodies.
Money had to be
spent before the size of the ore body or its quality could be
known with any
certainty. The risks and rewards were high. Speculative mining
shares were
more important to the operations of the market than `industrial'
stocks until
well after World War II. The preponderance of mining stocks on
the boards of
the stock exchanges gave a peculiar flavour to their operations
and the type of
clientele using the services of the brokers. The stock market
was a place for
gamblers, not the faint-hearted, and a place for individual rather
than

institutional investors. Discoveries of new fields, particularly
gold in Western
Australia in the 1890s, spawned wild booms followed by busts.
Fortunes were
won and lost in markets where a few unscrupulous promoters,
stockbrokers
and dishonest geologists fleeced gullible investors. Foreign
investors were as
ready to chance their arm as the locals, and mining shares
attracted the lion's
share of foreign money coming on to Australian exchanges.
The development of a market for the issue of the shares,
debentures and
bonds of private non-mining businesses grew slowly and in a
more sedate
fashion. A small market for `industrials' had emerged by the
1890s, consisting
largely of the issues of banks, gas companies, shipping
companies, and
breweries. The list grew slowly before World War I as
Australian businesses
were slow to incorporate and even slower to take advantage of
listing on an
exchange to raise new equity. Firms continued to finance their
day-to-day
operations and their long-term expansion using a combination of
their own
financial resources and short-term debt from banks and trade
creditors. The
domestic stock exchanges, comprising a smallish number of
broking firms
whose partners operated with minimal capital resources and
unlimited
liability, managed to meet, and underwrite, the modestly
expanding demands

of the new issue market in the interwar years.
The most immediate effect of the events of the 1890s was on the
perception
of the safety of the trading banks, the country's premier
financial institutions.
Directors and managers of trading banks reacted to the closures
and
Capital Markets and Capital Formation 183
reconstructions of the 1890s by behaving in a very conservative
fashion up to
the outbreak of World War II. These privately-owned banks
steadily lost
market share to government-owned competitors, and non-bank
financial
intermediaries. Private banks became embroiled in political
issues and public
controversy in the 1930s and 1940s. They gradually became
enmeshed in the
web of regulations spun by the federal government and put into
effect by the
Commonwealth Bank of Australia and later by the Reserve Bank
of Australia.
The regulations flowing from the wartime legislation were
primarily
concerned with controlling the volume of bank lending. The
idea was that
rather than amplify the cycle of boom and bust – a charge
levelled against

the banks by their critics at the royal commission held in the
mid-1930s –
changes in the volume of bank lending should be used to offset
cyclical
movements.
DEPRESSION AND RECOVERY, 1890–1918
During the second half of the nineteenth century the needs of
borrowers, both
government and private businesses, had exerted a powerful
influence on the
structural form and behaviour of Australian financial
institutions and capital
markets. An abrupt end to a long period of sustained economic
expansion from
the gold rushes onwards placed severe strains on the financial
system, and
some sections collapsed leaving a trail of anger and suspicion
towards financial
institutions that remained long after the settlement of the
outstanding
financial claims. By the outbreak of World War I, Australia's
capital markets
and financial institutions were different in many respects to
what they had
been a quarter of a century earlier. The wreckage of the 1890s
had been
cleared away, leaving the private banks with repaired and
strengthened
balance sheets. However, they would never again dominate the
financial
markets as they had before 1890. A much reduced and different
set of demands
for investment funds provided opportunities to other types of
financial

institutions to play a larger role.
In 1890 the private commercial banks, known colloquially as
`trading
banks', bore a distinctively Scottish stamp, having established
far-flung
branch networks decades before the growth of branch networks
by British
clearing houses. In many other respects, however, these banks
reflected their
British heritage. A number were British-owned and managed
from London,
while the majority were domiciled locally. All were heavily
engaged in
financing international trade, and the transfer of funds to and
from Australia,
as well as accepting deposits, making loans and issuing notes.
British banking
principles and precepts were highly influential, although –
contrary to British
orthodoxy – landed property, livestock and other illiquid
securities, were
gradually accepted as collateral for loans. They differed from
their British
184 Merrett
cousins, who operated in the most sophisticated and highly
specialized
financial centre in the world, the City of London, in one
important respect:

Australian banks spread their wings into capital-market
activities because
there were no local equivalents of merchant banks. Consortia of
Australian
banks had acted as agents to raise loans for colonial
governments in London
since the 1860s.
The two dozen trading banks dominated the domestic financial
markets as
they held more than two-thirds of the assets of all financial
institutions (Pope,
1986). They were followed at a distance by a number of smaller
deposit-taking
institutions of whom savings banks were the most important.
Savings banks,
operated by trustees or, more generally, by colonial
governments, had taken
root with the express purpose of encouraging thrift amongst the
poorer classes.
Colonial governments soon came to appreciate the usefulness of
this deposit
base as a means of funding government debt issue. Savings
banks were to play
a far more important role after the crash. A number of other
private non-bank
financial intermediaries, such as building societies, land and
mortgage
societies, and so on, operated on the margins of the system, and
were
particularly active in the boom and crash. Pastoral companies,
whose
principal business was as commission agents, had also become
bankers to
many of their clients. While life companies also lent to their
customers, most

of the lending of all the non-bank financial intermediaries was
related to
property, either directly or indirectly.
The volume of business done on the local stock exchanges was
dwarfed by
the operations of financial intermediaries. These exchanges2
served colonial
rather than national markets. The largest, Melbourne and
Sydney, could
support no more than three or four dozen brokers. These
individuals or small
partnerships dealt in a narrow range of thinly-traded `industrial'
securities.
However, their main business was in mining scrip, a trade
facilitated by the
passage of a bill in Victoria in 1871 which allowed the creation
of a no-liability
mining company. Investors could forfeit their partly paid shares
rather than
pay calls in failing ventures. The stock exchanges were touched
by the `land
boom' of the 1880s: a number of land companies floated new
securities, and
other businesses sought to capitalize on the optimism of the
time by
incorporating themselves and issuing shares. However, it was
the discovery
and working of the rich mining fields at Broken Hill and in
northern Tasmania
that captivated the stock exchanges in the late 1880s.
While the exact causes of the 1890s depression are still a matter
of dispute,3
the link between the end of the speculative bubble in the

property market and
the distress suffered by financial intermediaries is clear cut.
Much of the
trading in property, whether in large sheep runs, broad acre sub-
division on
the outskirts of Melbourne, or suburban housing, had been
financed by
lending by pastoral companies, building societies, land
mortgage companies
and trading banks.4 Property owned by defaulting borrowers
found its way
on to the balance sheets of financial institutions. Many of the
fringe
institutions had been trading in property on their own account
and were swept
away. The trading banks held out longest, but as bankers to the
other financial
intermediaries a secondary flood of depreciated property,
offered to them as
collateral, led to large losses and the writing down of their
capital. After a
small number of bank failures in 1892, the dam broke in late
January of 1893.
By May of that year, 13 of the 22 banks which issued their own
notes had shut
their doors, either permanently or temporarily.
While the land boom was driven by greed and tinged with fraud,

the bank
crashes cannot be explained in similarly simple terms. Most
Australian
bankers were upright men who would not knowingly place their
shareholders,
customers or depositors at risk. Only a handful used the bank's
money to
finance their own or their associates' speculations. One or two
institutions
did try to disguise their true financial position by issuing
fraudulent accounts.
Two salient facts help to explain the magnitude of the crash
(Merrett, 1989:
60–85). First, the prudential strength of the banking system as a
whole had
been progressively weakened over the preceding two decades.
Fierce
competition for market share from new entrants drove all banks
to cut margins
between lending and deposit rates, and to accept higher lending
risks. Some
bankers did not foresee the dangers of concentrating their
lending on a
smallish number of very large customers or having most of their
loans tied up
in a single industry or geographic region. While the risks
carried in the balance
sheets grew through the 1870s and particularly the 1880s,
bankers weakened
their ability to meet bad times by allowing both their ratio of
gold and cash to
deposits, and of capital plus reserves to loans, to fall. These
developments
reduced the banks' capacity to meet any sudden withdrawal of
depositors'

funds, and to absorb losses rather than go into liquidation.
Second, once the
bank crashes were under way, an action triggered by the failure
of Victoria's
largest bank, the Commercial Bank of Australia, shareholders
and depositors
panicked. Shareholders were better informed about the
likelihood of failure
than depositors. The latter rushed to withdraw their funds from
strong and
weak alike.
The crisis was brought to an end without any appropriate
intervention by
the colonial governments. Governments in New South Wales
and Queensland
took action to avert a liquidity crisis by passing legislation
making privately-
issued bank notes legal tender – a temporary and unnecessary
measure – while
the Queensland government, also unnecessarily, replaced
private issues with
its own notes. This latter government also `rescued' that
colony's largest bank,
the National Bank of Queensland. In Victoria, where the crisis
was most
severe, government action was the least effective. The
government urged the
local banks to give financial support to one another, blissfully
unaware of the
consequences that would have followed had they done so
(Merrett, 1993: 122–
42), and proclaimed a bank holiday that brought the crisis to a
head.
186 Merrett

The action taken by the Commercial Bank after its closure
provided the
mechanism that brought the sorry episode to an end. The
directors of the
Commercial Bank put a proposal to its shareholders and its
creditors that the
bank be `reconstructed', a procedure made possible by an
innovation in
British company law in the 1870s. The reconstruction schemes
were subject
to the scrutiny of the courts, and creditors were particularly
active in
defending their position. In essence, the way they operated was
as follows:
the depositors agreed to convert their term deposits into
debentures –
although some part was converted into preference shares in a
minority of
cases, and only the Commercial made it compulsory – while the
shareholders
agreed to put additional capital into the banks to meet the
existing losses and
to allow the businesses to continue. In the end, the depositors in
all the
reconstructed banks were repaid in full, with interest. They
were also able to
get cash for their claims before the agreed dates of maturity as a
market sprang
up in bank deposit receipts in 1893. It was the bank
shareholders who lost most

heavily, suffering paper losses as share prices crashed, putting
up new capital,
and receiving no dividends for many years.
Once the Commercial had shown the way, other banks opted for
reconstruction rather than waiting out the panic withdrawals
which might
render them insolvent. Reconstruction was a superior outcome
for all parties
than liquidation and the realization of bank assets in the
depressed asset
markets of the 1890s. A negotiated settlement offered the
prospect of a known
minimized loss for both parties. Shareholders were not anxious
for the banks to
be liquidated as, in many cases, a double liability on shares
would arise in these
circumstances. Australian banks converted »57 million of
deposits into
deferred deposits receipts and inscribed deposit stock in 1893,
»38 million of
which was due to residents in Australia (Merrett, 1993: table 3:
10). This
latter figure was 40 per cent of all trading bank deposits in
Australia. By
1914, only »5 million was still outstanding.
While the reconstruction schemes solved the immediate crisis
facing banks,
they did the banks incalculable harm in the longer term. The
legal
complexities surrounding the schemes, the litigation associated
with some
and the renegotiation of a number of schemes in 1895 and 1896,
gave rise to
widespread misunderstandings. It came to be commonly

believed that the
banks, particularly their directors and most senior managers,
had used this
device to escape the inevitable exposure, trial and convictions
that they richly
deserved, had they been wound up as insolvent.5 Greed and
fraud, it was
alleged, resulted in the banks' collapse, and widespread loss by
depositors,
and those responsible had used a legal device for their own
protection. Banks
lost their reputation and standing with the community, neither
of which they
have been able to regain.
Government banks were the main beneficiaries of the tarnished
image of the
commercial banks. In the darkest days of the banking crisis, the
Victorian
government had propped up its state bank by pledging
taxpayers' money to
guarantee its solvency. State banks, and later the
Commonwealth Bank of
Australia's savings and trading bank arms, offered riskless bank
deposits. In
1890, savings bank deposits amounted to 16 per cent of those in
trading banks.
By 1914, savings bank deposits had risen to 55 per cent (Pope,

1986: table 1).
Insurance companies also moved to tap the savings of the
working man by
offering `industrial' life policies sold by a small weekly
payment. The number
of policies sold by 1914 was approaching 600,000 (Gray, 1956:
table 10: 80–
81). Trading banks slowly rebuilt their balance sheets by
strengthening their
capital position and maintaining higher levels of liquidity.
However, the long-
suffering shareholders were offered little reward in terms of
higher dividends
or share prices, even when profits were eventually restored.
After decades of
adventurous growth, Australia's banks became staid and
cautious. Savings
banks and insurance companies were to be their new
competitors for deposits,
as the depression of the 1890s had effectively ended the
challenge of property-
related institutions, such as land banks and building societies,
and the pastoral
companies.
The recovery of the economy from the depression was largely
the result of a
marked upswing in commodity prices over the two decades
before the war, the
discovery of gold in Western Australia, and the end of one of
the worst
droughts on record in eastern Australia in 1902. Unlike the
period of
prosperity before 1890, this economic expansion did not rely on
heavy
investments (Sinclair, 1970: 15–16), at least until around 1910.

Indeed, it
could be argued that the earlier construction boom had created
an excess
supply of physical assets – in transport and communications, the
pastoral
industry, and residential housing – that was only gradually
worked off.
Output grew most rapidly in agriculture, mining and
manufacturing, none
of which required capital on the scale provided in the decades
prior to 1890.
However, the financing needs of each sector came to shape the
evolution of the
domestic capital market.
Australian colonial governments had been larger borrowers in
the London
market than any private concern in the 1870s and 1880s.
However, the
London market turned against Australian government loans
from the early
1890s until the end of the first decade of the new century. The
restoration of
their standing was due not only to `sound finance' policies
followed by colonial
Treasurers, but by their use of the house of Nivison, a London
stockbroker,
who came to control the applications of Australian governments
to the
London market.6 Colonial governments had ceased to use
Australian banks
as their London agents even before the depression, for they
could obtain better
terms using the Bank of England and the London and
Westminster Bank.
Nivison provided even better service in two ways. As agent to

all governments,
the problem of competing issues was eliminated. Second,
Nivison provided an
underwriting service which was far more successful than the
previous system of
188 Merrett
having investors' tender for issues. Australian governments
returned to the
market in the early 1900s to make a series of modest conversion
loans. It was
not until around 1910, when the expenditures on a series of new
large-scale
construction projects outstripped the capacity of the domestic
market, that
the state governments returned to the London market on a large
scale.
Most of the state governments' projects were designed to
facilitate the
settlement of a larger population in rural areas. From the 1880s,
many
colonial governments had been implementing a policy of `closer
settlement'
through compulsory acquisition and subdivision of private
freehold, the
resumption of leasehold and the sale of crown land. Access to
small blocks of
land, together with new farming practices – particularly in
irrigation areas,

wheat farming and dairying – did lead to the sorts of
developments that
governments wanted. Governments, however, were drawn
increasingly into
financing much of Australia's farming, while the trading banks
continued
their association with the pastoral industry. State banks
established credit
fonciers, and Treasury departments spawned agricultural banks
in some
states. These ventures, so appealing in the decades of rising
commodity prices
before 1914, were to have an unhappy sequel in the interwar
period.
Local government authorities required large amounts of money
to finance
their construction works in the 1890s when London was
unreceptive to any
new Australian loans. Bodies such as the newly created
Melbourne and
Metropolitan Board of Works, raised millions of pounds on the
local stock
exchange. State governments, local governments and semi-
government
bodies tapped domestic capital markets in the 1890s and 1900s.
Loans
outstanding on Australian stock registers rose from »26 million
in 1899 to
»114 million in 1913 (Nash, 1899; 1914). The issuance and
trade in fixed
interest securities altered the character of the market in
important ways, and
laid the foundations for the ease with which governments turned
to the market
after 1914.

It was the mining industry that kept Australia in the eyes of
British investors
in the 1890s and 1900s. Those speculating in mining shares
were very different
from the conservative investors and trustees who purchased safe
colonial
government stock. The discovery of gold in Western Australia
in the early
1890s attracted the interest of British investors (Appleyard and
Davies, 1988:
160–89), many of whom had lost money in South Africa.
Thousands of leases
were registered in Western Australia and hundreds of companies
were floated
on the London exchange. An estimated »70 million pounds was
raised by
these companies, however, the lion's share, possibly more than
»60 million,
stayed in the pockets of promoters and speculators in London.
The
development of one of the world's most productive gold fields
was helped by
the modest amounts actually employed.
On the other hand, development of the base metal mines at
Broken Hill in
New South Wales and Mount Lyell in northern Tasmania, did
involve a

substantial involvement by Australian stock exchanges
(Salsbury and
Sweeney, 1988: 133–8; Hall, 1968: 133–47). Despite the wild
speculation in
the original shares of the Broken Hill Proprietary Limited, the
long-life base
metal mines soon came to be regarded as `blue chip' rather than
speculative
investments. A group of mines and smelting companies
operating on the
Broken Hill field, known as the Collins House group, became
expert at raising
finance for the exploration and development of mines, and for
associated
industrial ventures. Men such as E. L. Baillieu, W.S. Robinson
and Francis
Govett developed the capacity, partly through associates on
both the
Melbourne and London exchanges, to act as an in-house
merchant bank for
a large and powerful group of mining companies (Richardson,
1988: 226–53).
The field of potential business for the exchanges was
considerably enlarged
by the widespread business failures of the 1890s, for these had
demonstrated
the dangers of unlimited liability in sole proprietorship or
partnerships, the
most common form of business arrangement. Subsequently,
many businesses
sought to take advantage of limited liability which had been
available since
the 1860s by virtue of the company acts. The number of
incorporated

businesses rose, in broad terms, from less than 500 in 1899 to
nearly 2500 by
1913 (Nash, 1899; 1914). While few of these companies had
chosen to list on
the local stock exchanges, their existence did widen the market
for non-mining
stock as brokers became involved in private placements of
shares of these
tightly held companies.
Capital formation fell sharply as a proportion of gross domestic
product
(GDP) during the 1890s but recovered to nearly match its 1891
peak by
1914.7 The upswing in aggregate investment was underpinned
by government
spending on public works. The depression had not deflected
colonial and state
governments from their long-term development programs that
combined
large-scale public works to assist rural industries and
immigration. By 1910,
state governments' public works, primarily railway construction,
were in full
swing, and they were actively boosting migration. Renewed
flows of migrants
stimulated residential construction outlays. The latter were
already showing a
modest increase, for the excess stock of dwellings built in the
1880s had been
absorbed by the early 1900s. Private non-dwelling investment
also recovered
after 1900, although it was dominated by public sector outlays
up to the war.
The composition of private capital formation shifted decisively
after 1890 as

outlays on assets in the pastoral industry declined sharply.
Investment was
more broadly based: mining, farming, manufacturing and
service industries
led the process of recovery and renewed economic expansion.
This upswing in capital formation before 1914 was financed
almost
completely by domestic savings. As noted above, Australian
governments
were unwelcome borrowers in London in the 1890s and early
1900s. Many
British investors in Australian banks, pastoral companies, mines
and other
businesses suffered heavy losses as security prices crashed or,
worse, businesses
190 Merrett
failed. Australia was a net exporter of capital from the mid-
1890s until around
1910. Local capital markets and financial institutions met the
demands placed
upon them by local investors without undue strain. Domestic
interest rates,
measured by trading bank deposit rates and the yield on
government
securities, were marginally lower in the 1890s and 1900s than
they had been
in the 1880s when British capital flooded the country. The local
stock

exchanges, in particular, proved themselves capable of meeting
the
requirements of governments and local companies for new
issues.
Despite the developments that had taken place in the domestic
financial
system and capital market before 1914, both remained immature
in many
respects. This is demonstrated by the fact that in 1914 more
than a half of all
outstanding financial claims were generated by the banks in the
form of
currency and demand deposits, term deposits and bank loans.
Non-bank
financial intermediaries' deposits and loans, and the reserves of
life offices,
made up less than 15 per cent, while capital market instruments,
such as
government securities and shares, made up the balance of a
little more than a
third. In the USA in 1900, by contrast, claims against financial
institutions
comprised only 21 per cent of outstanding financial instruments,
claims
against non-financial institutions 56 per cent, and corporate
stock 23 per cent
(Goldsmith, 1969: table 1.1: 10–11).
The Australian financial system still revolved around banks
with a modest
fringeofotherfinancialintermediariesandarelativelyunderdevelop
edcapital
market. This situation reflected the exceptional position
occupied by the
trading banks in the second half of the nineteenth century. At

this time most
businesses were still small family affairs that did not use capital
intensive
techniques of production. Their demands for capital funds were
modest. The
bigger banks possessed the resources to provide what was in
effect long-term
capital to just about any of their customers. Bank lending on
this scale had
blunted the development of a substitute domestic capital market
to service
businesses. However, new large-scale capital intensive
companies began to
emerge with increasing frequency in mining and smelting,
brewing, food
processingandmetalworking.Thegrowthofthesenewindustrialandr
etailing
giants would come to tax the resources of the banks in the
twentieth century.
The development of the domestic capital market had been
retarded further
by the ease with which Australian borrowers, particularly
governments, could
raise large sums in London. The City of London offered many
advantages in
terms of the size of issues it could absorb, and lower fees. The
depth of trading
in the secondary markets provided much higher levels of
marketability and
liquidity for holders of securities than was possible in
provincial exchanges.
London also possessed a set of specialized institutions, such as
merchant banks,
that increased the efficiency of origination and distribution of
new issues.

Australian capital markets, by contrast, were significantly
smaller and less
specialized, and lacked the services of investment bankers.
WORLD WAR I TO WORLD WAR II
The 30 years spanning the two world wars saw a number of
significant changes
in the aggregate level of capital formation and its composition,
Australia's
reliance on foreign savings, and in the scope and maturity of
domestic capital
markets. Expenditures on capital formation became remarkably
volatile and
added an element of instability to the economy. Investment as a
proportion of
GDP fell sharply during World War I, plunging below the
trough of the 1890s,
before rebounding quickly in the early 1920s where it remained
on a plateau
before sliding down in the late 1920s into another steep trough
by 1931. The
renewed investment associated with recovery from the
depression of the 1930s
did not match the ratios of capital formation to GDP achieved in
the 1920s.
However, this modest growth disguises the fact that private
sector investment
in dwellings and machinery and other structures increased far

faster than
public sector investment outlays. From this point on, the public
sector
relinquished its position as the most important source of
investment
expenditures. Capital formation fell precipitously during World
War II,
reaching a trough far lower than that experienced in either
World War I or
the 1930s depression. The majority of funds used to finance
these investments
continued to come from local savings. In the 1920s, when
governments raised
very large sums abroad, foreign savings played a more
important role.
However, the costs of servicing the large foreign debt in the
1930s were to have
important consequences for the financing of government capital
formation.
World War I had a profound short-term and long-term impact on
Australian capital formation and its capital markets. Australian
governments
put aside their long-term concerns to promote economic
development and
concentrated on waging war. British authorities made it plain
that the
Australian government should not expect to approach the
London market
for funds. Public works projects that had picked up from around
1910 quickly
ran down, dragging the ratio of investment spending to GDP in
their wake,
despite state governments' borrowing what they could on local
markets.
However, it was soaring government military expenditures that

transformed
domestic capital markets. Large armies were raised, equipped
and sent
abroad. Most of the monies needed were raised by loans, with
higher taxes
and an increased supply of Commonwealth government issued
paper money
making up the balance.
Between the first war loan of 1915 and the War Gratuity
Redemption and
Conversion Loan of 1924, »274 million had been subscribed by
876,000
applicants.8 Most of the loans were taken up by individuals
rather than by
financial institutions such as banks and insurance companies. In
a wave of
patriotic fervour, men and women drew on bank deposits, took
out bank loans
and sold shares, to buy war bonds. At the end of the process,
many of
Australia's one million households owned a financial asset that
was traded on
192 Merrett
the stock exchanges. The legacy of this wartime financing was
to convert
Australian stock exchanges to a primarily fixed-interest market
for another
generation. While war financing transformed and democratized

capital
markets, it also thrust a new institution forward. The issue and
management
of these ten war loans was in the hands of the Commonwealth
Bank of
Australia, an institution established by the federal government
in 1912. The
private banks, which had raised loans for governments in the
City of London
before 1890, were bypassed.
The 1920s saw state governments returning in force to
international capital
markets, particularly London. The motives and the patterns of
expenditures
were broadly similar to those of the 1870s and 1880s, and the
five years prior to
the war. Governments were actively promoting population
growth via
assisted immigration and the construction of infrastructure for
farming
activities.9 Railway building took the lion's share of the funds,
with
telephones, irrigation, roads, water and sewerage, and so on,
also requiring
large-scale funding. The British government accepted that such
policies would
strengthen the Empire, and committed funds on a pro rata basis
for migrants
received.
The wisdom of such a development strategy had come under
question by the
end of the decade. The economic conditions that underpinned
the idea ^ a
buoyant international economy and high commodity prices ^ did

not
materialize after the war. Export prices peaked in 1925, while
Australian cost
levels continued to rise. The terms of trade, the ratio of export
to import prices,
moved sharply against Australia and other primary producing
economies.
Rising trade barriers in European economies, a slower growth in
demand for
foodstuffs and raw materials, and an expansion of supply from
around the
world signalled that trouble lay ahead for Australia in servicing
her growing
foreign debt.
A matter of more immediate concern was the losses being made
on
completed infrastructure works that were operated as
government-owned
utilities (Sinclair, 1970). Poorly planned investments and bad
management
of key areas, such as the railways, were placing burdens on state
budgets well
before the end of the decade. A major problem was that the
public sector had
been constructing infrastructure ahead of private-sector
settlement or
complementary investments in the rural sector. Many of the
public-sector
investments were viable only if more settlers arrived who would
increase
patronage. Falling export prices and steadily rising
unemployment deterred
migrants, and the losses continued to rise.
Australian governments continued to seek funds abroad in the

1920s ^
despite an informal rationing of funds for overseas investment
by British
authorities prior to that country's return to the gold standard in
1925 ^
because there was a concern that further heavy borrowing on
local markets
would drive up domestic interest rates. Competition among the
states for
funds in London became so intense that a mechanism more
powerful than the
informal advice of Nivison and Co. was needed to restore order.
In 1923, the
federal and state governments agreed to arrange all borrowings
through a
voluntary Loan Council.10 This body assumed statutory powers
in 1929 as a
result of the amendment to the federal constitution following
the Financial
Agreement of 1927. The federal government was able to impress
its views on
the rest of the states as it needed the support of only two to
have a majority.
From the early 1920s, it was the federal government, and no
longer the states,
that effectively decided the amount of public-sector borrowing
and debt
management. The Loan Council was to become an even more

important
institution in the operation of Australian capital markets than
the
Commonwealth Bank of Australia.
While state governments sought the bulk of their funds abroad,
the
demands on the domestic capital market rose considerably.
Local
governments and semi-government authorities, such as gas and
electricity
utilities, increasingly used the local share markets to raise
funds. Businesses
sought fresh capital to increase capacity in the brief period of
postwar
prosperity. Manufacturers, enjoying higher levels of protection
against
competition from imports, busily built additional factories and
upgraded their
equipment. More companies listed their securities on the stock
exchanges. The
new issue market for non-mining companies was active in the
1920s, with
more than »75 million worth of shares and debentures being
offered to
investors between 1924 and 1929.11 The local stock exchanges
received
another fillip due to the federal government's active engagement
in a series of
conversion loans as part of its debt management
responsibilities, all of which
provided fees and commissions for brokers.
In the nineteenth century most foreign capital coming to
Australia had
been raised by Australian borrowers by issuing bonds, shares or

debentures
on the London capital market. Australian banks had also briefly
sought
deposits in the United Kingdom. On the other hand, direct
investment by
foreign companies in Australian operations was rare before
1890, although
not unknown. However, the 1920s marked a sharp upturn in this
type of
transfer of capital to Australia. British firms ^ which made
significant moves
into confectionery, textiles, chemicals, and engineering ^ were
joined by large
numbers of American companies in automobiles, rubber, food
products, and
textiles. It has been estimated that foreign direct investment
accounted for
roughly a quarter of capital formation in Australian
manufacturing in the
1920s (Forster, 1964: 200^2).
Investments in farming and housing were funded by financial
institutions
rather than the capital market. Government-owned banks, the
state savings
banks and the Commonwealth Bank of Australia, took a leading
role in
lending to both industries. Advancing money to farmers had
been an integral
part of state banking since the late nineteenth century. Policies
to promote
194 Merrett

closer settlement, soldier settlement after World War I, and
Empire
Settlement in the 1920s, drew state banks and government
departments into
a closer embrace with small-scale farmers. Many of these new
settlers fell
victim to falling export prices and rising wage and material
costs in the mid-
to late-1920s. It was the government banks, including the Rural
Credits
Department of the Commonwealth Bank that opened in 1925,
which took
the risks and absorbed the losses from farmers in the 1920s and
1930s (Murray
and White, 1992), just as the private trading banks had done
with the pastoral
industry in the 1880s and 1890s.
The demand for housing rose strongly in the 1920s, pushed
along by higher
levels of immigration and a backlog of unsatisfied demand held
over from the
war. Building societies had been the main provider of funds to
the residential
construction industry in the 1880s but most of them had been
swept away in
the maelstrom of the 1890s. Private trading banks were not
willing providers
of funds for housing before they established their own savings
bank
subsidiaries in the late 1950s, so the field was left to state
banks and the
savings-bank arm of the Commonwealth Bank of Australia. The

Commonwealth government also entered the arena of providing
funds for
housing through its establishment of a War Service Homes
Commission which
was to provide homes for ex-servicemen. Commonwealth
monies flowed
through the state savings banks which acted as agents for the
Commission.
These state banks also lent large sums from their own resources
(Hill, 1959).
The State Savings Bank of Victoria was the major provider of
funds for new
houses in that state by the mid-1920s. The close connection
between
government-owned banks and the residential construction
industry was
indicative of an increasingly segmented financial system where
funds were
`trapped' in serving particular markets. Sometimes, as in the
case of rural
lending, the rates of interest did not reflect the risks involved.
The authority and position of the private trading banks in the
financial
system had been seriously diminished before the onset of the
1930s depression.
Both the Commonwealth and state banks continued to win an
increasing share
of deposits away from the trading banks throughout the 1920s.
While no
legislation had emerged as a result of the 1890s bank crashes
that limited their
autonomy, the private banks were increasingly forced to do the
bidding of
government. They had lost their right to issue bank notes in
1910, and had

been unable to prevent the establishment of the Commonwealth
Bank of
Australia in 1912. During the war it was the government who
suspended the
operation of the gold standard, while the banks negotiated with
the
Commonwealth Bank for a share of the financing of bulk
purchases of rural
produce. Business that the trading banks would once have called
their own,
and matters of policy such as those concerning the monetary
backing for the
note issue, were passing into the hands of the federal
government or the
Commonwealth Bank.12
Trading banks behaved in an increasingly conservative fashion
in the
1920s. A wave of mergers between 1917 and 1931 reduced their
number from
twenty-two to nine. The larger banks, with a nationwide
network of branches,
were now better able to spread risks. A smaller number of banks
found it easier
to agree on a common set of interest rates and fees. They
became a cartel,
discouraging competition from existing members and driving
off foreign
challengers. They did not innovate in ways that reduced their

operating costs,
nor did they introduce new services to their customers. This
lack of drive,
together with an extreme conservatism in lending, drove
disappointed
borrowers to find other sources of funds. However, these
institutions remained
at the heart of the financial system not only because they still
commanded a
very large share of the deposit base, but because they alone
could operate the
domestic chequing system, arrange for international payments
and receipts,
and buy and sell foreign exchange.
Capital formation, especially that undertaken by the private
sector, was
declining even before the collapse of security prices on Wall
Street in October
1929 signalled the onset of the 1930s depression. Australian
governments,
whose public works programs had sustained aggregate
investment outlays,
faced very serious problems in raising additional funding once
international
capital markets effectively closed to new issues, especially to
those from
heavily indebted primary producing economies. In such
circumstances, it
was not surprising that capital formation fell away sharply from
a peak of
around 18 per cent of GDP in 1927/8 to a trough of around 10
per cent of
GDP in 1931/2. The climate for private sector investment
worsened as profits
fell, and as the list of business failures rose.

Australia faced a number of acute economic and social problems
during the
depression. There was little consensus among the conservatives
and the Labor
Party sides of politics about how these problems could best be
solved
(Schedvin, 1970). The trading banks were drawn into the
political debate on
the side of the conservative groupings, earning themselves the
undying enmity
of the Labor Party and its trade union supporters. The
Commonwealth Bank,
which was independent of the federal parliament, emerged as a
central bank
that acted in defiance of the wishes of the Australian Labor
Party government.
It was the Bank and the Loan Council that emerged as the key
policy-making
institutions that enforced reductions in government borrowing
and spending
as agreed upon in the Premiers' Plan of 1931. The federal Labor
Party, which
held office from 1929 to1931, was itself divided. It split into
warring factions,
one of which joined with the conservatives to form a new
government. The
labour movement never forgave either the Commonwealth Bank
or the
trading banks for their part in the formulation of conservative
economic
policies. These policies, it believed, caused unnecessary
hardship to the more
than a quarter of the workforce who lost their jobs. The strength
of feeling
against the banks was so strong that the conservative

government set up a
196 Merrett
royal commission to inquire into the banking system in 1935. Its
recommendations were to legitimate the far-reaching and
sudden regulation
of banking seven years later.
The simultaneous collapse of commodity prices and the closure
of
international capital markets in late 1929 generated a crisis in
Australia's
balance-of-payments position. Export income shrank while
import spending
continued to run at high levels. A strong flow of external
earnings or new
borrowings was needed to service its very large outstanding
foreign debt.
Australia chose to bow to the pressures from Britain, the
country's largest
creditor, and service the debt rather than take the path of
repudiation
followed by a number of Latin American countries.The decision
to honour
the debt made the defence of the balance of payments, and the
maintenance
of the parity of the Australian and British currencies, of
paramount
importance. The Commonwealth Bank and the trading banks
haggled over

the extent to which the former had priority access to those
reserves of foreign
currency, which were held as `London funds' or short-term
sterling balances
by the trading banks. They also argued about whether the
Commonwealth
Bank had any right to be informed of the size of balances held
by the banks.
More importantly, policies designed to reduce imports ^ such as
import
quotas, surcharges and higher tariffs ^ had the unintended
consequence of
sowing the seeds of economic revival, as did the belated
devaluation of the
Australian pound. It was higher trade barriers and a depreciated
currency
which did most to stimulate the expansion of manufacturing
output,
employment, and investment.
Private-sector capital formation recovered strongly from around
1932 up
until the outbreak of war in 1939. Most of the expansion came
from new
investment in manufacturing industries that were benefiting
from the
heightened trade barriers. Increased output placed pressure on
existing plant,
for this had not been expanded since the early and mid-1920s.
Apart from
renewed interest in gold mining, particularly in Western
Australia,
investment in the depressed rural sector shrank. It was a
decisive moment in
Australian economic development in a number of respects. The
thrust of

capital formation was henceforth set by the private, rather than
the public,
sector (see Sinclair, 1970; and Butlin, Barnard and Pincus,
1982). Private
businesses made investment decisions in the light of anticipated
profits, and
they had decided that the bulk of new capital would be allocated
to urban-
based industries. Reluctantly, governments came to abandon
their traditional
policies of promoting rural development by taking a leading
role in
constructing and operating a range of publicly-owned business
enterprises.
Public-sector investment was to follow the lead of private-
sector decisions,
and accommodate the growing demands for urban infrastructure.
Investment in dwellings also recovered strongly in the 1930s.
Unlike earlier
periods of high levels of residential construction, this upswing
was not driven
by high levels of immigration. It was a response, in part, to the
relocation of
population, due in large part to the growth of the regional iron
and steel
centres at Newcastle and Port Kembla in New South Wales, and
in South

Australia (Sinclair, 1970: 44). The rise in real incomes of those
still in
employment in the 1930s gave rise to an increased demand for
new housing,
while governments in a number of states embarked on the
destruction and
replacement of old, poor-quality, housing stock in inner
suburbs.
This recovery in the level of private sector capital formation
was financed
almost entirely from domestic savings. Australian governments
approached
the London market in the 1930s but to refund existing debt
rather than to raise
new money. Public-sector borrowing on local markets was quite
substantial,
exceeding the amount raised in the 1920s. However, a
significant part of this
increase in public sector debt was in the form of short-term
Treasury bills
which were funded by financial institutions. Indeed, trading
banks and
particularly savings banks took up the majority of all short- and
long-term
debt issued by the Loan Council in the 1930s. The non-bank
public increased
their holdings of government securities by only »90 million
between 1931 and
1939, compared to an increase of »134 million in the 1920s.
While the issuance and trading in fixed interest securities
continued to
provide the bread and butter of the stock exchanges, the market
in equities
developed strongly as the economy recovered. Financial

institutions were less
willing to extend credit in the depths of the depression. For
instance, lending
by trading banks did not regain its 1930 peak until 1937.
Consequently, many
companies sought to supplement their internal sources of
finance by making
new issues on the stock exchange. The number of new issues
noted in the
financial press between 1930 and 1939 numbered more than
700, and offered
securities of more than »70 million to investors. The
marketability of equities
rose steadily as leading stockbrokers, such as J. B. Were of
Melbourne, built up
large lists of clients who were provided with a regular flow of
high quality
information concerning listed and unlisted companies (Ellis,
1954). Stock
exchange listing requirements were more onerous than the
company laws,
and listed companies were compelled to make fuller disclosure
of their affairs
(see Salsbury and Sweeney, 1988: 202^8). While some shady
company
promoters and less than scrupulously honest brokers did exist,
the exchanges
operated in a fashion that warranted the confidence given them
by the large
number of individual investors. The depth of trading was
enhanced further as
a number of broking houses established unit trusts in the late
1920s that
allowed small investors to acquire a diversified portfolio.
World War II had significant short- and long-term effects on

Australian
capital formation and capital markets.13 In the early phase of
the war, before
the Japanese assault on Pearl Harbour in December 1941, the
Australian
government diverted a fairly modest proportion of the nation's
resources to
military ends. As the war effort built up, one of the first areas
of civilian
198 Merrett
activity to be squeezed was public and private capital
formation.
Governments could control their own non-war investment
spending, and the
federal government constrained the levels of private spending
by a
combination of capital issues controls and the licensing of
construction
activities. The deterioration of the military situation in both
Europe and the
Pacific in early 1942 led the newly elected Labor government to
impose a
sweeping set of direct controls over all parts of the economy.
Labour was
conscripted for military and civilian duties, non-essential
industries were run
down, and their surplus resources transferred to war work.
Wages, prices
(including security prices), and rents were fixed. Private sector

investment in
`non-essential' areas fell to very low levels for the duration of
the conflict. Vital
areas such as the engineering and munitions sectors received
little in the way of
additional plant and equipment. On the other hand, public
investment in
roads and aerodromes for military usage rose sharply.
Financing the rapidly expanding war effort, which peaked at the
equivalent
of nearly 37 per cent of GDP in 1942/3, had other sorts of
effects on Australian
capital markets. Unlike World War I, the bulk of the additional
revenues
came from higher taxes. The Commonwealth became the sole
collector of
taxes on personal and company incomes from June 1942, and
raised tax rates.
However, the federal government did raise very large loans,
which amounted
to the equivalent of a quarter of GDP in 1942/3, on the domestic
capital
market. Once again, it was the Commonwealth Bank which had
responsibility
for the management of the 17 loans that raised over »1 billion
(Mobbs, 1947).
The amount of Australian government securities on issue rose
nearly one and a
half times between 1939 and 1945. While more than a half of
this increase was
absorbed by banks, the holdings of the non-bank public doubled
over the
period. Applications to subscribe to the loans, which numbered
3.8 million,
came from most Australian families. Government war loans had

further
democratized Australian capital markets in a similar fashion to
the earlier
conflict.
The flow of government securities on to domestic capital
markets during the
war presaged a fundamental shift in behaviour by Australian
governments.
Sales of foodstuffs and war material to its Allies during the war
brought about
a dramatic transformation in Australia's balance-of-payments
position. An
accumulation of external reserves, now under the direct control
of the
Commonwealth Bank, allowed a retirement of part of Australia's
external
debt. Memories of the costs of fixed interest obligations abroad
in the 1930s
persuaded successive governments to utilize domestic rather
than
international capital markets. No future Australian government
would echo
the actions of their predecessors of the 1880s and 1920s when
new issues by
Australian states made up a significant share of international
capital
movements.

NOTES
1 These data, together with other references to rates of savings
in this chapter, are taken from
McLean (1991).
2 There are a number of useful histories of stock exchanges and
broking firms. The most
comprehensive of these is Salsbury and Sweeney (1986).
3 For an account of the depression and the issues still
outstanding, see Sinclair (1976: 47^151,
158^9, and 160^1).
4 Financing investment in property has been dealt with, from
very different perspectives, by
Butlin (1964) and Cannon (1972).
5 This view of the changed public perception of banks is put
most eloquently in Butlin (1961:
302).
6 The changing relationship between Australian governments
and the London market is
discussed in Hall (1963); Butlin (1964); Davenport-Hines
(1988: 190^205); and Gilbert
(1971).
7 Data relating to aggregate and sectorial estimates of gross
domestic capital formation up to
1939 are drawn from Butlin (1962) and as revised Butlin
(1977).
8 War finance is discussed most fully in Scott (1936: ch. 9) and
Faulkner (1923: ch. 9).
9 The motivation for developmental expenditures and the

pattern of investment spending is
discussed by Sinclair (1970).
10 The most authoritative account of the Australian economy in
the inter-war period, and
economic policy matters, is Schedvin (1970). See also Gilbert
(1973).
11 Details of new issues offered by Australian companies were
taken from the monthly issues of
Jobson's Investment Digest, and The `Wild Cat' Monthly.
12 The best accounts of this complex change in the relationship
between the trading banks, the
Commonwealth Bank and the federal government are Schedvin
(1970); Butlin (1961); and
Giblin (1951).
13 The definitive account of the economy during the war is
found in Butlin (1955), and Butlin and
Schedvin (1977).
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The `Wild Cat' Monthly (Sydney).

Surveys in the Economic History of AustraliaCAPITAL MARKET.docx

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