The Lucky Country's Burning Fuse
Australia is living high on hubris. In delivering his budget for 2010-2011 this week Treasurer Wayne Swan boasted that the nation had "defied economic gravity not by accident but by choice" with 1.4 percent expansion in 2009 and 2 percent growth expected in the year ending June at a time when other developed economies are only just struggling out of recession.
Canberra assumes that the good times, driven primarily by high resource prices, will continue into the foreseeable future, enabling both strong growth and a rapid rise in government revenues. Having outperformed every other OECD economy over the past year thanks to a mix of government stimulus and the rapid rebound in commodity prices, it now expects real growth of 3.5 percent in 2010-11 rising to 4 percent in the following year. At the same time as it expects the budget to return to surplus in 2012-13 after an A$57 billion deficit this year and projected A$40 billion one next year.
Much of this is based on rosy assumptions about continued massive growth in mining investment even in the face of the threat of a 40 percent excess profits tax on resources being promised by the government following the Henry Report into the taxation system.
The assumption that Australia can play tax games with its resources sector reminds some observers of the damage done by a 1970s Labor government and minerals and energy minister RFX Connor in playing a nationalist resources card when commodity markets were already peaking out.
Now the Australian Treasury remains convinced that demand from China and India will pull Australia's economy along and enable a huge rise in revenues. It assumes that China will grow 10 percent in 2010 and 9.5 percent next year and that the resource component of its growth will be as strong as ever.
For sure there is a case for a resources tax which captures price booms much better than the present fixed royalties on production, which are charged at state level. However, the details and timing will determine not only how much revenue it produces at given levels of resources prices but how much new investment is put on hold till companies know the future. Already several projects are known to have been postponed.
Australia seems to assume that the extraordinary good fortune it has enjoyed over the past six years from its terms of trade, thanks to the huge rises in most commodity prices, is destined to be sustained. They have risen by 50 percent from 2002 lows. After peaking in the third quarter of 2008, terms of trade plunged 20 percent in the first half of 2009 before rebounding. Although they have yet to regain their 2008 peaks they are now well above 2007 levels and forecast to improve by another 14 percent in 2010-2011.
The treasury also assumes that Australia will continue to attract huge amounts of capital to finance additional resource production, sustain a consumption boom and keep property prices at the astronomic level to which they have recently risen thanks to a mix of cheap credit and pressure from immigration.
In contrast to the rosy picture painted by the treasury, however, Australia faces what could be a hugely troubling combination of foreign debt exposure, potential for collapse in its terms of trade, and rising foreign resistance to its persistently very high current account deficit.
Thanks to the Greeks, Portuguese, Argentines, etc, markets have come to believe that the only debt that really matters is government debt, and particularly if it is in foreign currencies. In the case of the Eurozone's problem countries, the currency may in theory not be foreign but is actually mainly controlled by the Germans and other north Europeans so it is not a sovereign currency from the point of view of small southern EU states. But these commentators seem to have forgotten that the Asian crisis had nothing to do with government debt. It was almost entirely private sector foreign debt driven.
Australia's net foreign debt now stands at A$647 billion, or roughly (depending on exchange rates) 50 percent of GDP. As the government has only a tiny amount of foreign debt, almost all of this is private sector debt. And most of it is owed by the financial institutions – A$426 billion of the total – compared with just A$155 billion by non-financial corporations.
Nor is there any sign of it slowing. The Treasury's forecast is for the current account deficit to return to 5 percent of GDP this year and stay there next year. Few Australians bother to notice it, just as few Greeks or their lenders bothered about Greek debt until a few weeks ago.
These Australian borrowers are the very same financial institutions which have been fuelling the housing and household debt binges which recently forced the Reserve Bank into a belated series of interest rate hikes. For sure, Australian banks avoided the derivative disasters of US and European banks and now enjoy stellar credit ratings. They may be hedged. But there are some big hits to be taken if the Aussie plunges again, global interest rates rise and foreigners start to worry about Australia's predilection for a fancy lifestyle and high growth based more on debt than on a sunny climate.
Australia has one cushion. About 45 percent of its net debt is in its own currency so that the foreign exchange risks for its borrowers are mitigated. If the Aussie falls out of bed as it did in late 2008 and early 2009 when it fell to 54 to the US dollar or to the 48 cents it hit in 2001, half the brunt will be borne by Japanese pensioners and the various sovereign wealth funds which have been picking up Aussie debt as they attempt to diversify away from US dollars.
On a trade weighted basis the Aussie is now 33 percent above its January 2009 level. But somewhere down the line there are probably going to be big bills to be paid by those who ended up on the wrong side of an Aussie dollar slump back to, say, 60 US cents or 50 yen.
There could be a double terms of trade whammy. Just as a commodity price plunge would take the Aussie with it, so a general rise in Asian currencies such as the yuan and won would raise prices of its consumer imports, most of which are from Asia and deliver a big hit to consumption.
Between 2003 and 2008 Australia was able to be close to the top of the OECD growth table partly because of an extraordinary gain – cumulative almost 50 percent -- in its terms of trade after more than a decade of weakness. But instead of using this as a base for building its net asset position it also simultaneously indulged in a borrowing binge, with its current account deficit persistently being around 4 percent of GDP. Net foreign debt has gone from 35 percent to 50 percent of GDP over a decade.
For sure, some of this deficit was associated with a revival in mining investment, primarily to meet the China demand. But the debt burden, which has gone unnoticed in an era of easy and cheap money, may bite hard before long. As it is, even at today's very low interest rates, net interest payments amount to some 2.3 percent of GDP and net equity payments to another 1.3 percent. So even if Australia gets back to trade balance it will still have a current account deficit of 3.5 percent of GDP. That is likely to rise if interest rates return to more normal levels even if equity payments fall if commodity prices weaken.
A mostly complacent Australia argues that the 3.5 percent of GDP level of payment on debt and equity has been the case for many years so there is nothing to worry about. But in reality the debt proportion has been rising even though interest rates have been at historically low levels. Thus Australia is particularly vulnerable to an end in easy money conditions, particularly if this is accompanied by a commodity price retreat.
The trade account looks unlikely to improve unless either domestic demand slumps or commodity prices regain the peaks of early 2008. As it is, though the latter have recovered a long way from the end 2008 bottom and terms of trade are back to 2007 levels, the Australian trade deficit is still running at about 2 percent of GDP. A sharp improvement in early 2009 was not sustained.
So if ever there was a sell in sight it is the Aussie at 90 cents, and shares in the self-congratulatory Aussie banks.