Euromonia Infects Australia

This column has repeatedly warned of Australia’s vulnerability due to its high level of foreign debt. No one took much notice when commodity prices were booming and Australians saw themselves as beneficiaries for many years to come of the China and other BRIC demand for raw materials. But all of a sudden the music has stopped.

Not only has the Aussie dollar fallen 10 percent to US$0.97 in little more than a week. More dangerous is the situation of international banking. Money flows have been drying up thanks in large part to the mess in Europe where banks are sitting on huge sovereign bond losses, prompting them to preserve cash and discouraging cash-rich banks elsewhere, such as Japan, from lending either to them or to those in emerging market who had been financing themselves in the wholesale international lending market.

Australia may not be an emerging market and its banks were largely untouched by the 2008 financial turmoil. However, in many ways it is worse off than many countries other than peripheral euro area ones. There are two very simple reasons for this. The first is the reliance of their banks on these wholesale markets due to the shortage of domestic savings relative to loans. The second, and perhaps more serious, is the quality of some of the lending.

Australia has one of the world’s highest household debt ratios, in large part due to a long-lived house price boom. By some measures prices in the main cities are further out of line with the long-term mean than those in US hot spots prior to 2008. Ideally the Reserve Bank should be thinking of an interest rate cut which would reduce the threat of mortgage delinquencies. A further fall in the A$ would also be of benefit to the non-mining sector – unless the banks had not hedged their foreign currency borrowings.

However, easing rates at home is not going to be possible if the cost of foreign funds is now to rise as a result of the global conditions. Some foreign bankers who have long viewed Australia through rose-tinted spectacles may even close the access window altogether. Net foreign debt in foreign currency of Australian financial institutions is around US$300 billion of which about 25 percent is 90 days or less. Hedging of currency risk could also become much more difficult and other banks run shy of counter-party risk or the local currency appears headed for a further major decline – in the panic of 2008 it fell to 65 US cents.

Australia’s problem is that though its government has almost zero foreign debt it also has very limited foreign exchange reserves. A flexible, often volatile, currency is an advantage but only so long as borrowers of foreign currency have protected themselves against a major fall in the local currency and hedging costs are not too high. The overall economy is still being supported by the mining investment boom which is still in full flood. But the rest of the economy, which is where most of the debt resides, is less healthy.

Global conditions can only make the latter worse in the short term and thus make it more likely that non-performing loans rise, putting pressure on the banks and giving cause for concern for the banks’ foreign creditors. For the longer term, the sheer volume of new production potential in mining in Australia and elsewhere, particularly for iron ore and coal, will at some point collapse Australia’s terms of trade which are still running close to record levels. Even without a cooling in Chinese demand, the future supply outlook is ominous for some miners. While miners are cash rich at present thanks to high prices, that situation will not last as projects requiring rail and port facilities as well as mine development continue to eat cash at a huge rate.

An early return to normalcy in Europe would enable Australia to manage a gradual adjustment. But so long as international bank lending remains in a semi-frozen state the greater the danger that Australia will find that the golden era comes to a very sudden halt.