The Lucky Country's Luck Running Out?

Following our negative comments on Australia’s banks, the rating agency Standard & Poor’s has just downgraded all the big four – Westpac, Commonwealth Bank, ANZ and National Australia Bank by one notch and investment bank Macquarie by two to BBB. But so self-satisfied are the punters on Australian assets that they took this as a compliment and the shares rose.

The reason for their nonchalance was that S&P has been (belatedly) downgrading lots of banks notably in Europe and the US as part of a broader-risk reassessment policy. So Australia did not look so bad. S&P described Australian banks as having a “very low risk appetite” even though their ratings are now on a par with some stressed European ones.

This was a bizarre statement given that they rely on wholesale lenders from overseas for 40 percent of their funding. This has fallen from a peak of around 50 percent but it is still very high. Imagine what the western commentators would be saying if Korean or Thai banks had this level of vulnerability to cross border money! It says a considerable amount about the Anglo bias of the financial world that it was ever allowed to get so high without alarm bells ringing. Australia may be a soundly managed, developed country but it has very small foreign reserves compared with Korea or Thailand.

How this can be viewed as “low risk” is anyone’s guess given that most of this money has gone into the house price boom which has made Australian households at 154 percent the most indebted among OECD countries -- few of which are shining examples of thrift. That financed a housing bubble which has made them among the most expensive in the world relative relative to incomes – at 6.1 times median income which is higher than even the UK now and the US before 2008. S&P seems to have forgotten the US lesson – that home mortgages are not always safe. The average price of a house in Australia is now 80 percent above that in the US – Australian houses are also bigger, in fact the biggest in the world. High land prices in the major metropolitan areas are forcing developers to build smaller houses, but that will mean an increase in supply and give a further downward push to prices now off about 4 percent from their peak. Thus banks face long as well as short-term potential problems.

For sure there are probably more local funds which could be tapped, most of the banks’ foreign exchange risk is hedged and there is always the Reserve Bank to ride to the rescue should global conditions squeeze access to funds. Much bank borrowing is for three years, though some 25 percent of a total of A$300 billion is for less than 90 days However, the banks are going to have to be much more cautious about future lending which will mean insufficient fuel to keep property prices at today’s elevated levels. Any major decline in the Australian dollar from today’s elevated levels may also make it harder for Australia to cut interest rates for fear of precipitating further currency decline.

The commodity boom is surely ending. Iron ore prices have fallen 25 percent over the past three months yet new project developments are in full swing. The problem is not simply a downturn in short term expectations of the Chinese economy. It is that the nature of Chinese growth must change. Demographics alone is slowing the rate of urbanization as the number of 15-25 year old falls and as the percentage of young people in rural areas declines especially fast.

The Australia dollar bounced 5 percent last week after falling nearly 10 percent during the November global bank liquidity freeze. But its extreme volatility suggests there are plenty of worries in the marketplace and Mrs. Watanabe in Japan may be getting nervous about whether the high interest rate on her Australian dollar deposit is any long worth the risk of currency decline.