Australia’s Ticking Time Bomb

--With the release of yesterday’s economic growth data, you’re finally starting to see a clearer picture for the Aussie economy. It explains why growth is strong but the economy ‘feels’ weak.

--The headline GDP number showed Australia grew a very healthy 1.1% in the three months to 31 March, and 3.1% over the past year. Given what else is happening in the world’s developed economies, that is exceptional.

--And yet the RBA saw fit to cut interest rates in May, not long after this powerful economic performance. So what is going on with the Aussie economy? If it’s strong, why the interest rate cut and concerns about growth? Or is the economy really weaker than the numbers suggest?

--Here’s my take…

--The Aussie economy is indeed growing at a decent clip. But it’s quite a fragile form of growth. Let’s have a look at the numbers to show you what I mean…

--First of all, understand that GDP is a measure of gross domesticproduct. It measures the amount of production in an economy. Right now, the economy’s production numbers are very healthy.

--That’s mostly due to a big pick up in exports of iron ore, coal and natural gas. Combined with a slight fall in imports (which adds to economic growth) ‘net exports’ contributed 1.2% to the overall quarterly growth figure of 1.1%.

--The only other decent contributor to growth was household consumption. It accounted for 0.4%, while the winding down of the mining boom continued to detract from growth.

--That’s the good news. But the problem for the Aussie economy is that the prices we receive for this increased production keep falling. The terms of trade, which measure this, fell 1.9% in the quarter, and a whopping 11.5% over the year.

--Taking this into account, along with a few other things, produces a more accurate measure of growth called ‘real net national disposable income’. For the March quarter, growth in this measure was just 0.2%; over the past year, it actually contracted 1.3%.

--This is why the RBA cut interest rates in May. Despite the strong headline economic growth numbers, they know there is considerable underlying weakness in the economy.

--To see this more clearly, just have a look at the current account data for the March quarter, which came out on Monday.

--The current account measures the trade balance as well as the balance of Australia’s income payments to the rest of the world. Because Australia has a large net foreign debt (over $1 trillion), we must pay interest on it. The current account measures this, netting it off against the interest payments coming into Australia. It’s called the ‘net income deficit’.

--Right then. Given the big contribution that exports made to economic growth, you’d probably think Australia runs a trade surplus, right? That is, we export more than we import.

--Not at all. In the March quarter, Australia still managed to produce a trade deficit of $8.1 billion. It was an improvement on the December quarter’s $10 billion trade deficit shocker, but it’s still ugly given our apparent ‘export boom’.

--This tells you that, despite the big increase in export production, thanks to falling prices for that production, it’s not improving our trade situation at all.

--And because our trade deficits don’t improve, we need to keep borrowing to make up the difference. That’s why our net foreign debt is now at $1.028 trillion. In the March quarter, the net interest bill on this debt was a whopping $12.1 billion.

--Add the net interest bill and the trade deficit together and you get the current account deficit. For the 12 months to 31 March, Australia’s current account deficit was $84.7 billion.

--That’s $84.7 billion dollars flowing out of this country to maintain a standard of living we can’t actually afford.

--This is not a new development. It’s been going on for decades. And for years it’s never really bothered financial markets.

--But I don’t think this happy state of affairs will continue. Here’s why:

--For a long time, the build-up of debt in Australia was all about households. Because incomes were on the rise too, this debt build up was manageable. In addition, government debt was low for a long time too. That gave financial markets confidence in Australia.

--But ever since the crisis of 2008, government debt has increased. It’s coming off a low base, but the growth trajectory is worrying, and there is no credible plan to get the budget deficit down anytime soon. That means government debt will continue to grow as a percentage of economic growth.

--And since 2011, when the prices for our main commodities like iron ore and coal peaked, income growth has been in decline. Yet we have continued to borrow at a rapid clip.

--At 31 March 2011, Australia’s net foreign debt was $636 billion. It’s now $1.028 trillion. That’s a 62% increase in five years. Over the same timeframe, national incomes have barely grown.

--This big increase in debt hasn’t posed a problem so far because the RBA keeps lowering interest rates, which makes it easier to manage.

--But that also encourages more debt accumulation. In the short term, everything looks OK as it translates into strong household consumption.   

--But make no mistake; it’s a ticking bomb for Australia. Both household and government debt is growing rapidly, while income growth is stagnant. That means the economy is more and more leveraged, and ever more susceptible to an external shock.

--When that day comes — and it always does — the real shock will be felt inside Australia. Most Australians, including our leaders (but not you, dear reader), have no idea just how fragile our economy is.

Cheers,

Greg Canavan,
For The Daily Reckoning

Australia’s Debt Build-up Is Even Worse than China’s!
  
--With trading on Wall Street closed overnight due to the Memorial Day holiday (the US version of ANZAC Day), there’s not much for the Aussie market to go on today.

--As I pointed out yesterday, the move above 4,500 points on the ASX 200 wasn’t at all convincing. Yesterday the index put on a measly two points. It will be lucky to hold that level today.

--There just isn’t a lot of momentum to push stocks sustainably higher from here.

--I mentioned last week that any major mover higher would probably need to come from the banks. While you’re not seeing it yet, underlying conditions are improving for the big four.

--That is, the flood of easy money around the world is pushing down their borrowing costs. As the Australian reports:

‘Improving global debt markets are providing major banks with cheaper funds, limiting the big four’s ability to blame higher ­financing costs for further mortgage and business loan ­repricing.

‘The fall has pulled banks’ credit default swap spreads down to 93 basis points, significantly lower than the year’s high of about 145 basis points, according to Deutsche Bank.

‘Record low official interest rates around the world, including negative interest rates in Europe and Japan, are pushing funds into commercial financing markets to seek improved yields.’

--With net foreign debt levels now over $1 trillion, this is not a good thing. But in the short term, it’s beneficial for banks because it lowers their borrowing costs. If they don’t pass the lower costs on, it improves their margins.

--Longer term it’s anything but good. The interest bill on the debt is over $40 billion per annum. That’s money that flows back to our foreign creditors every year. Along with the trade deficit, the capital outflow from Australia (based on December quarter data) is around $125 billion per annum.

--We’ll get March quarter data today. You might see an improvement on those numbers thanks to a rebound in the iron ore price, but not by much.

--The reality of the situation is that, with such a large amount of capital flowing out of the country each year, we need to offset it with capital inflows to maintain our living standards.

--The balancing mechanism is the price of the currency. Capital outflows must equal inflows. But the real issue is at what exchange rate do the outflows and inflows meet?

--As a general rule, a rising exchange rate means more capital is coming into Australia than is leaving. When the exchange rate falls, it’s the opposite.

--Given the Aussie dollar has been reasonably stable lately, you can assume that capital inflows are broadly matching the capital outflows.

--What does this capital inflow actually represent?

--A big chunk of it is offshore borrowing by the big banks — borrowing to fund the property boom.

--But it’s more than that. It also involves the outright selling of assets. In other words, we’re selling assets to maintain current spending levels. We’re selling agricultural land, listed assets (a Chinese firm just bought a 13% stake in Virgin Airlines) and residential land and property.

--Everyone knows the Chinese have been huge buyers of Australian residential housing and apartments over the past few years. It’s a contentious issue. But the reality is that this is Australia’s economic policy. We simply must continue to borrow and sell assets in order to keep the current economic structure going.

--In an enlightened country, this short term and unsustainable economic model might come up for some serious debate in an election campaign. But we haven’t heard a whisper of it.

--My guess is that most politicians don’t get it. And the ones that do think the electorate are too dumb to comprehend it. So the elephant in the room becomes a non-issue.

--And because it’s a non-issue, Australia continues with the same dumb economic policies that are putting us deeper and deeper into debt. That just increases our ‘riskiness’ for when the next global downturn arrives.

--Have you noticed that whenever there is a bout of ‘global risk aversion’ (market panic) the Aussie dollar plunges? It happened last year when China got the wobbles. The Aussie dollar sank to 68 US cents.

--That reflected the slowdown of capital flowing into Australia. As a result, the Aussie dollar had to fall sharply to entice capital in and match it with the ongoing capital outflows. Remember, inflows and outflows must always match. A sharply falling dollar tells you foreign creditors are pulling back on their willingness to lend to us.

--This is what happens when you have a lot of debt. When times get tough, our creditors become nervous.

--Recent research by Morgan Stanley, published in the Financial Review, showed that ‘total household, corporate and government debt has reached a staggering 243 per cent, a level that has increased the nation's vulnerability to a deep downturn or even recession.’

--According to the research, the problem with the debt is that it is incredibly unproductive.

‘Calculations by the investment bank show Australia last year used up more than $9 of debt for every $1 of extra gross domestic product, which is around three times more than the debt needed to produce the same amount of growth in the US economy.

‘Even more concerning, according to Morgan Stanley, is the comparison to China — where a so-called "debt productivity ratio" of $6 has stoked deep-seated global financial market fears this year about the sustainability of the world's second-largest economy.’

--Geez. So our borrowing is even less productive than China’s, our largest trading partner?

--And Australia is still the wonder of the developed economic world?

Regards,

Greg Canavan,
Editor, The Daily Reckoning