By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
Your Excellency, I am pleased to present the requested report on the economic outlook for the Great Southern Province of China, currently referred to by the local population as “Australia”. For convenience I will refer to the country by this older name.
Deep dependence on our great nation means Australia’s future is inextricably linked to China. Given that the white European colonisers historically feared the “yellow peril”, the irony of the situation will be not lost on the Politburo. Despite recent engagement with us and the rest of Asia, Australia’s focus seems confused. The country’s head of state remains an octogenarian British Queen. Australia also believes its security is guaranteed by the United States of America with whom it has extensive defence links.
The locals continue to believe in both in its sovereignty and also its bright economic prospects.
The popular narrative is that Australia escaped the GFC (global financial crisis – the locals are acronymic) through their own planning.
The country was certainly in a better position to cope with the problems. The Federal government did not have much debt. However, some State governments have significant borrowing. Governments also systematically shifted some of their debt into public private partnerships (“PPP”). Because of the strategic nature of this infrastructure, these projects de facto enjoy the indirect support of governments. Private household debt is also high.
At the start of the crisis, Australian interest rates were relatively high, providing greater flexibility.
But Australia did not escape the crisis unscathed. One major bank lost nearly a billion Aussies (colloquial term for the Australian dollar, the local version of the Renminbi). Investors, including a number of charities and local councils, suffered significant losses from investments in various financial products. A number of highly leveraged infrastructure and commercial real-estate investors failed.
Local banks escaped the problems of their overseas counterparts. The near death experiences in the recession of the early 1990s encouraged them to stay home eschewing overseas adventures and complex financial structures. That said, another year or so, they would not have been so lucky.
The local banking regulator, APRA (Australian Prudential Regulation Authority), and politicians take credit for the banks being relatively unaffected. This is curious given that banking regulations are largely uniform around the world. One can only assume that Australia has superior regulators and politicians to the rest of the world – an example of “Australian exceptionalism”.
In reality, Australia’s swift recovery was driven by large cuts in interest rates, government guarantees for banks, government stimulus and a commodity boom.
The central bank reduced interest rates (from 7.25% per annum to 3.00% per annum). The fall of 4.25% per annum translates into a fall in monthly mortgage repayments of nearly 30 % or around $7,000 per year on a 20-year mortgage of $250,000. A government guarantee on bank deposits and borrowing ensured that financial institutions were insulated from many of the problems.
Government spending minimised the effects on the real economy. Cleverly directed cash transfers to lower income households rapidly stimulated the economy. As part of the ESP (Economic Stimulus Package), government spending on education, housing and infrastructure was also increased. Some of the spending was not well directed. Environmental initiatives, subsidies for home insulation to reduce energy consumption, have proved less than successful.
The long-term benefit of some spending is questionable. Your Excellency, the school across from my office has been refurbished with new gold signage and a brand new fence replacing the aluminium one that was perfectly serviceable. The economic return on this investment is unknown.
The main driver of the recovery has been a commodity boom. This is not a new phenomenon in Australian history. It can be traced back to the famous gold rush of the 19th century when many of our countrymen travelled to Australia in search of their fortunes.
Former Prime Minister of Australia Paul Keating, a prominent Sino-phile, recently remarked that Australians were luckier than most races having been give an entire continent. He might have added that it was also remarkably rich in mineral wealth.
Australia has benefited from a substantial increase in demand for and prices for its mineral products. The country is enjoying its best terms of trade (measured as Price of Exports divided by Price of Imports, showing the quantity of imports that can be purchased theoretically from the sale of a fixed amount of exports) in 140 years. Australia’s terms of trade have improved by 42%, just since 2004.
The commodity boom is driven by a sharp increase in demand, supply constraints because of under-investment in mineral production and associated infrastructure and some unexpected effects of the GFC.
In the 1990s, as a result of persistently low prices, mining companies did not invest sufficiently in expanding production capacity or infrastructure, such as transport, refining or processing capacity. The increase in demand from purchasers, particularly emerging economies, quickly created bottlenecks and shortages. This led to sharply higher prices as well as improved volumes for many commodities.
The GFC also boosted investment in commodities. As traditional investments fared poorly (stocks, interest rates and property prices all fell), investors switched to hard assets, like commodities. The underlying logic was that these were real assets with genuine underlying uses rather than the fictions created through financial engineering.
Low interest rates also assisted demand and prices as it cost less than before to buy and hold commodities, which paid no return.
As central banks commenced printing money in an effort to restart growth, investment in commodities increased further as investors sought a hedge against the risk of inflation. Former Board member of the Reserve Bank of Australia, Professor Russell McKibbin suggested that perhaps as much as 40% of the improvement in Australia’s terms of trade was driven by US and European monetary expansion.
As your Excellency knows, one of China’s priorities is to preserve the value of its foreign exchange reserves, currently around US$3.2 trillion. The bulk of these funds are invested in US dollar, Euro and Yen denominated securities. To reduce the risk of losses as these securities lose value due to the actions of governments to devalue the currency against the Renminbi, we have executed your instruction to purchase and stockpile large amounts of strategic commodities.
The economists, who failed to forecast the rise in commodity prices or the GFC, now speak of a “super” boom lasting decades. The boom is more fragile than currently understood.
As growth in China and other emerging countries decelerates, demand for commodities is likely to slow. High prices have encouraged investment in expanding existing mines, building new mines and additional infrastructure as well as exploration. As new capacity and supply comes on stream, there will be pressure on prices.
At your Excellency’s suggestion, we have extensively studied the commodity purchasing strategies of Japan in the 1980s. Based on this analysis, we have actively cultivated new sources of supply of essential commodities. This will enable us to play suppliers off against each other to achieve more favourable prices in the long term. Westerners place great store in contracts, such as long term agreements to purchase minerals at agreed prices. In the Chinese way, these are, at best, statements of intention based on conditions existing at the time of agreement. If conditions change, then we will, like the Japanese, renegotiate the arrangements in our favour.
Australian mining entrepreneurs and politicians point to a massive pipeline of projects, which will underpin Australian prosperity. The Australian Mines and Metals Association estimate that there is A$427 billion of resources in train, including A$146 billion in Liquid Natural Gas alone. A$236 billion of projects are current under way with a further A$191 billion awaiting approval.
There is also A$770 billion of infrastructure spending required to renew and develop Australia’s economic and social infrastructure. This will compete with commodity projects for funding. Chairman of Infrastructure Australia Rod Eddington has warned that financing will not be available for many projects. Infrastructure Australia has identified a smaller list of priority project totalling A$86 billion.
Commodity projects depend on demand for the product and also on the ability to finance it. Deterioration in money market conditions and also problems in the banking system mean that the availability of funding is becoming more restricted and expensive. If previous commodity booms are a guide, then many of these projects may not eventuate.
Around 23 % of Australian exports now go to China. The real quantum is higher as some Australian exports to Asia are then re-exported to China.
China currently faces significant challenges. Our two major trading partner – Europe and America – face serious problem which will lead to a slow down in our own exports. Recent statistics, such as the volatile Purchasing Managers Index that measures manufacturing activity, suggest a sharp slowdown. In turn, this will affect our suppliers such as Australia by way of lower demand and also lower prices for commodities.
Unlike 2008, our capacity to respond to any slowdown is reduced. Then, we increased lending through our policy banks to boost demand. In 2009 and 2010, we were able to grow loans by around 30-40% of our GDP to drive growth. Unfortunately, party cadres have not used the money wisely in all cases, resulting in some unproductive investment and bad debts for the banks. The need to support our banks and cover their bad debts will restrict our ability to support the economy.
As your excellency is also aware, around US$ 800 billion or 25% of our US$3.2 trillion in foreign exchange reserves is invested in “risk free” European government bonds. Continued losses in these investments and on investments in US government bonds also further restrict our flexibility. Our economic growth will be slower then widely anticipated.
Australians believe that physical distance from Europe and proximity to China and Asia affords protection from European debt problems.
Despite record terms of trade and high export volumes, Australia continues to run a current account deficit with the rest of the world of around 2-3% of GDP, around US$30-40 billion per year. This must be financed overseas. Sovereign debt problems and the resultant problems in the banking system will affect international money markets for some time to come. Australian borrowers will face reduced availability of funding and increased borrowing cost.
Before the crisis, Australian bank deposits totalled 50-60% of loans made. The difference was funded in wholesale markets, generally from institutional investors.
In 2007, deposits made up around 20% of bank borrowing down from 34% a decade earlier. Domestic wholesale borrowing and foreign wholesale borrowing were 53% and 27% of bank balance sheets. Following the GFC, increases in the cost of overseas funding and regulatory pressure, Australian banks significantly reduced their loan to deposit ratios, with deposits now around 70% of loans. They also reduced their dependence on international borrowings.
Nevertheless, Australian banks face significantly international re-financing pressures, needing around A$80 billion in 2012. Around A$35 billion are AAA rated government guaranteed bonds which will need to be financed without government support, unless the policy changes. In addition, the banks have a further A$28 billion worth of bonds that mature in the domestic markets
In the period before the GFC, Australian banks relied on securitisation to raise cheap funding from overseas. When these markets closed, Australian banks used debt guaranteed by the Federal Government to raise funds. With the guarantee now not available, Australian banks are increasingly using covered bonds to raise funds.
Covered bonds are secured over specified assets such as a pool of mortgages, giving investors priority over depositors. Regulators have limited the quantum of covered bonds permitted to a maximum of 8% of assets, limiting the ability of banks to use this form of financing.
To date, covered bonds have not proved a cheap source of finance for banks, as originally envisaged. Inaugural international issues by ANZ and Wespac have cost around 1.50% over inter-bank rates. In early 2012, the Commonwealth Bank issued at around 1.75% over interbank rates in the domestic markets. Given that the covered bonds enjoyed the highest rating of AAA, the funding cost for Australian banks for unsecured borrowings would be around 2.00-2.50% over inter-bank rates, a sharp increase over the last 6 months. This higher cost will be passed on to customers at some stage.
In testimony to a parliamentary committee, John Laker, the head of APRA, acknowledged the funding challenge. He hoped that improvements in market conditions would allow the Australian banks to access the overseas funding required.
Money Too Tight To Mention …
Facing reduced availability and higher cost of funding, Australian banks may reduce loan volumes and increase rates to customers.
The problems of international banks, especially European banks, previously active in financing local businesses, will compound the problem. These banks are required to increase capital to cover losses, including those on their sovereign bond investment. As they can’t or do not want to issue equity at deeply discounted prices and the limited investor appetite for such issues, the banks may sell assets or reduce lending to raise the required capital. Estimates suggest that these banks could have to sell (up to) $2.5-3.0 trillion in assets, resulting in a sharp contraction in availability of credit.
Before the GFC, European banks provided around 35% of loans to Australian corporations. This has fallen to around 16% in 2011 and is likely to decline further as a result of losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.
The reduced participation reflects losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.
Given that Australian companies will need to re-finance around A$80 billion of maturing loans in 2012, these pressures are not welcome. The problems of European banks, active in commodity financing, may reduce the supply of credit to the sector by about 25-30%, which would impact Australia’s resources businesses.
The contraction of credit will also affect Australia indirectly. The withdrawal of European banks from Asia and other emerging markets is affecting the ability of companies to finance trade and investment projects. This affects Australian exports.
In 2007, European banks and US banks accounted for 30% and 10% of loan in Asia-Pacific. This has fallen by around half to 15-16% for European banks and 5-6% for US banks. The level of participation is likely to shrink further as a result of the problems of these banks. Troubled French banks account for about 11% of maturing loans in Asia Pacific. It is unlikely that these banks will maintain their level of commitment. Asia-Pacific banks have taken up the slack but are not sizeable enough to fill the gap completely.
Australian companies overseas earnings also face significant pressure due to economic weakness in Europe and its affect on the other markets. A proportion of Australian retirement savings are invested overseas. These will also be affected by the problems in Europe and internationally.
The European crisis has affected Australian public finances. Falls in income and capital gains have reduced tax revenue. The government is cutting expenditure and tightening taxes to offset the reduction in revenue. Falls in income on retirement savings, reduced business investment and general loss of confidence is likely to adversely affect the domestic economy. Australia may not escape the possible European tsunami.