This next year will be interesting for many reasons. First, it’s the next year, and that is always interesting. Second, China plays host to the world at the summer Olympics. Though this date doesn’t have any official importance in China’s rise, it is kind of a “coming out” party for China. But why is the next year interesting for Australia?
No one mentioned it during the campaign, but there’s a strange anomaly in Australia’s economic success. During the midst of the greatest resource boom of all time, Australia runs a trade deficit. The country imports more than it exports.
Export volumes, in fact, have been fairly flat for the last five years. The rise in commodity prices has kept export earnings high. But none of the business investment in new production capacity seems to have led to higher export volumes. This is somewhat alarming, especially for state governments that have committed to new spending projects based on projected royalties from resource exports. Have export volumes already peaked?
While export volumes have plateaued, imports continue to grow. After all, you build all those houses, you have to fill them up with things. And thus, the current account deficit – a large part of which stems from Australia’s trade deficit – continues to grow both in real terms and as percentage of GDP.
Australia’s current account deficit is around AU$9 billion, or about 6% of GDP according the latest RBA figures. That probably means nothing to you. So what does it mean?
Well, maybe it DOES mean nothing. Australia has run consistent current account deficits for nearly 50 years. In fact, it’s run one each and every quarter of the economic year…since 1973. Australia imports capital to invest in capital goods. Those capital goods generate a return on investment that exceeds the cost of the imported capital, and everyone is happy, right?
Perhaps not happy. But yes, less confused. The existence of a current account deficit is not some fundamentally unsustainable economic evil. Yet it does tell us something about the Australian economy and the risks it may face ahead. If there’s no inherent “badness” to a current account deficit, what’s all the fuss about?
To balance the current account deficit (without a decline in imports/increase in saving) Australia runs a capital account surplus. Roughly speaking, the current account deficit is balanced out by the capital account surplus. However, this is not your everyday healthy kind of surplus.
To say Australia has a surplus in the capital account is the same as saying it imports foreign capital. Or, you could just say Australia borrows from foreign lenders. And who knows, maybe foreign lenders like loaning to Australians? Maybe that explains the persistent current account deficit.
Here’s the trouble. As long as the borrowed money builds new capital – assets that generate income – it’s a good trade. But what has Australia borrowed from abroad to spend on at home? The investment in minerals and energy hasn’t yielded a huge new boom, as export volumes clearly show. So all that borrowed money must’ve gone somewhere else. Where did it go?
Ahh yes. The housing boom. Australia borrowed from the world to finance a housing boom. And is a house the kind of asset that generates a return on investment greater than the cost of servicing the debt?
Well, that’s an interesting question which gets to the dual nature of housing on the personal balance sheet. On the one hand, the house is an asset – often the largest component of individual net worth.
On the other hand – in the liability column – is the mortgage. A house is both, then. It’s a liability when the cost of servicing the mortgage exceeds the market value of the home, or what you could pay in rent. It’s an asset when you intend to pay off the mortgage and, perhaps, use the equity to finance your consumption, or just live in the house (which we admit is old fashioned and reflects a lazy personal balance sheet).
Here’s the question, though; has Australia borrowed foreign capital to finance a housing boom that’s about to bust? It looks to us like the answer is “yes” and this is very bad news if interest rates keep going up.
Though Australia’s public debt is gone, the debt owed to foreigners is about 60% of GDP and rising. When rates rise, so does the cost of servicing this debt. Rising rates strike the economy at both the macroeconomic and microeconomic level then.
At the microeconomic level, Aussie borrowers typically pay mortgage rates somewhere between 1% to 2% higher than the cash rate. The current cash rate – after 5 increases in the last 19 months – is 6.75%. Let’s call that 7%, in anticipation of a rate rise at the next RBA meeting. That means homeowners are a quarter or two away from double digit mortgage rates, if the RBA continues on its current path.
That will likely take some steam out of the housing boom – which is not so good for people who’ve bought in over the last two years. But what can you do? The only way to keep a lid on inflation is to keep raising interest rates (and stop printing money).
The global bear market in credit, and a growing aversion to risky assets, does not bode well for the direction of Aussie interest rates either. The bear market in credit is driving rates up everywhere. Higher yields would normally be good news for commodity currencies like Australia’s. But recent yen strength suggests that the carry trades behind demand for the Aussie dollar are…off the boil.
Yeesh. It’s an awful lot for a new government to consider on a Monday. But Australia’s lack of a truly diverse manufacturing base could be exposed most painfully in the next few years. And at just the wrong time, during a global currency and credit crisis – where borrowing money and attracting capital to finance deficits gets even harder. Good luck Labor. It turns out that 11-year boom had some big holes in it after all.
As for BHP (ASX:BHP) and RIO, their proposed marriage looks a lot more interesting in light of Australia’s poor export performance, doesn’t it? It now seems clearer that if Australia – or shareholders in Rio and BHP – want to maximise the benefit of China’s growth (while it lasts) they’ll need to do more to increase export volumes while prices remain high.
Does that mean a merger? It probably does. And more than just BHP and Rio.
The Daily Reckoning Australia