Australia’s Capital Crisis and its Chinese Future

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Is there a way out? That is the question today’s Daily Reckoning takes up. A way out of what? Why a severe, prolonged, and painful Australian recession of course.

In the “no” corner, weighing in with some theatrically negative comments, is IMF managing director Dominique Strauss-Kahn. He told reporters yesterday that, “2009 will almost certainly be an awful year – we expect global growth to enter deeply negative territory. This is a truly global crisis, and nobody is escaping.”

Nobody Wayne Swan. Did you hear that? Nobody! That means YOU!

Before we get to Australia’s capital crisis and its Chinese future, just a quick note to say we won’t be taking up the question we left you with at the end of yesterday’s Daily Reckoning. It’s the “what should we do” part of a world where the fiat money system cracks up, leading to a hyperinflationary/deflationary depression.

It’s an important question-probably the most important you can ask these days. So we’re going to collect and write up our thoughts over the weekend. Stay tuned! And if you want to send us your plan, don’t be shy. dr@dailyreckoning.com.au

Meanwhile, what about the present? The IMF issues its World Economic Outlook twice a year. When times are good, the forecasts are too optimistic. When times are bad, the forecasts tend to be too pessimistic. And when times are really bad??

There is a problem for Australia buried in the IMF’s comments we want to explore today. The problem is capital. Where is it going to come from over the next five years? Will Australia have a capital crisis?

The report says that one big consequence of the GFC is declining capital flows to emerging markets. With banks not lending at home in Europe and America, they certainly aren’t lending abroad. The IMF said the decline in these capital flows, “may be protracted, given the solvency problems facing advanced economy banks that provide significant financing to emerging economies.”

You could argue that Australia is not an emerging economy but an advanced, developed economy with two (and perhaps only two) world class industries (finance and resources). But what you cannot argue is that Australia is a net importer of capital and has been so for two hundred years. We didn’t make that up. It’s what the Australian Office of Financial Management told investors in a slide show in Dubai late last month (see slide 14). The AOFM hit the road-an investment road show-to entice investors to buy Aussie bonds. More on that in a second.

But first a question: would a prolonged credit depression choke of the capital imports that are the lifeblood of Australia’s modern economy? After all, the Aussie housing boom was financed with a great deal of money borrowed from abroad. And the resource boom continues to depend on foreign capital (especially China) to expand. So is there a risk that Australia will experience a capital shortage in the coming years if the GFC drags out as the IMF expects?

We may surprise you and say the answer is “no.” It’s a qualified “no,” though. First off, the banks are the largest importers of capital. If they have trouble importing capital, it’s going to affect the Australian property market, both residential and commercial. But the government has already promised to fill this gap in two ways.

First, the AOFM was told by the Treasurer late last year to begin buying Residential Mortgage Backed Securities (RMBS) from non-bank lenders. It’s been doing just that. And one interesting question is how much of the nearly $4 billion in RMBs the AOFM has already bought represent new loans made by non-bank lenders to First Home Buyers taking advantage of the big government grant.

If that doesn’t sound like Fannie and Freddie buying subprime loans originated by Countrywide, we don’t know what does. And we suspect that if the government wants to keep the housing market propped up, it will have to extend the first home buyer’s grant past June 30th AND increase the role of the AOFM in buying securitised mortgages. After all, who else is going to buy them?

But while the government essentially underwrites residential property values via the AOFM, you can expect it to get busier providing capital to the commercial property sector too, via Ruddbank. You may have noticed that General Growth Properties, the second largest mall owner in America, filed for bankruptcy overnight. But even if you didn’t notice it, we think this means the other shoe to drop in the second half of this year is major trouble in the Australian commercial property market. Why?

The Australian consumer is not much better off (by some measures he’s worse off) than his American counterpart. Australians are growing their credit card balances, but paying off less and less each month, according to data published this week by the Reserve Bank. Credit card debt grew by 1.7% to $45.4 billion. But Aussies cut their repayments on that debt by 7.1%.

You’d have to expect major reverberations in the commercial property sector later this year if the Aussie consumer reaches his limit or loses his job. We expect that will lead to increased government borrowing and lending to prop the sector up in the same way it’s propping the housing market up. It won’t be cheap, either.

Ahmed Fahour is the man designated to run the Australian Business and Investment Partnership (ABIP aka Ruddbank). He is already expanding the mission of the bank beyond the backstopping of commercial real estate. He told the Australian Financial Review earlier this week that, “Right now, we’re focusing on commercial real estate, but it does have the potential with all five shareholders to go beyond commercial real estate” (the five shareholders are the Big Four banks and the government).

Fahour has said the Ruddbank is a “backup plan” and not a bailout. But if things go to form in Australia-if capital remains scarce and the global economy continues to contract-Ruddbank will be a conduit between government money borrowed in the global bond market and Australian businesses that can’t get capital any other way.

So how much is all this going to cost? A lot more than anyone expects, that’s for sure. In its road show in Dubai last month, the AOFM produced a few slides that showed that Australia’s net debt and debt-to-GDP ratios are quite favourable to other countries. And then it showed the chart below which projects the government’s borrowing needs over the next few years. Have a look.

Australia to borrow over $40 billion each of the next three years

Click to enlarge

Source: Australian Office of Financial Management

So the Rudd government, through the AOFM, is hitting the road to hawk Australian government debt in order to pay for…well…for a lot of things. For the stimulus. For infrastructure. And, we reckon, for the funds to keep commercial property developers from going up and residential home prices from falling.

Of course there’s no sin in being a net importer of capital. It means foreign investors are attracted to the rate of return on Aussie investments. But this is a trend that should worry any Australian who’s had a chance to see what America has done to itself. It makes the country’s economic growth dependent on foreign creditors.

A society that thinks it owes itself cash payouts and all sorts of other projects it can’t pay for will happily borrow from the future to pay for the present. This is not so good for the future, though. What starts out as a temporary dip into debt to ride out a recession becomes a chronic habit of living above your means with borrowed money. Politicians support it because it’s a way to keep the promises flowing without having to find ways to pay for them with current revenues.

The question we began with, however, is will foreign creditors like the Chinese and Japanese or the Petrol States simply cut Australia off and invest their money elsewhere (or in their own economies)? Right now the Federal Government enjoys a triple A credit rating from Standard and Poor’s. But if the Federal government steps in to guarantee the borrowings of State governments (the same way it’s guaranteed the borrowing of the big four) then the credit rating might not be so gold plated.

This means rising borrowing costs for the AOFM. This means the habit of paying for your projects with money borrowed from the future gets even more expensive (even if you call it ‘investment’ rather than say, ‘plundering from the future’). This also means your taxes are probably going up (GST).

But it does not mean China will not be interested in Australian resources. And this brings us to the “yes” part of the question we set out to answer at the beginning of today’s journey. Australia can mitigate the effects of severe recession, perhaps, by opening its arms wide to embrace its Chinese investors. Very wide.

Even though it was at a ten-year low, Chinese GDP grew by 6.1%, according to data released yesterday. That’s good news. But as Michael Pascoe writes in today’s Age, the better news is that the GFC is accelerating China’s exit from its huge U.S. dollar reserves…and into tangible assets.

Pascoe points out that the commodities bubble has definitely popped, but that the boom is still on trend. Base metals and bulk commodity prices are lower than they were in 2008…but a lot higher than 2006 and mid-2007. He says prices have reverted to the rising trend, not crashed.

He also quotes Nobu Su, the head of a Taiwanese commodity firm, “China has woken up,” Nobu says. “The West is a black hole with all this money being printed. The Chinese are buying raw materials because it is a much better way to use their $1.9 trillion of reserves. They get ten times the impact and can cover their infrastructure for 50 years. The next industrial revolution is going to be led by hybrid cars, and that needs copper. You can see the subtle way that China is moving into 30 or 40 countries with resources.”

We hope Nobu is right. Over at the Australian Small Cap Investigator, Kris Sayce has tipped two Aussie rare-earth metal companies that could benefit from a boom in hybrid cars. That would be welcome news indeed.

But the larger argument and question is if Australia will ride out the GFC on China’s foreign investment coat tails. Even that is no sure thing. It’s one thing to sell Aussie resource firms to Chinese partners. But how will that halt rising unemployment? How will it save the retail economy? What will it do for house prices and commercial real estate?

Despite the “glimmers of hope” and “signs of stability” alluded to by talking heads and politicians, we see nothing of the sort. This kind of talk is just self delusion. It wouldn’t surprise us at all if the people saying these things are in the meantime burying gold in the backyard and hoarding bottled water in the spare bedroom. More on survival strategies for the rest of the year next week!

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Queue Ned S.

    Reply
  2. Joe – Yes, the article looks pretty spot on to me. Unfortunately. It would seem we just might have been rather silly billies to squander our boom year opportunities on lots of bigger and nicer houses, or bigger and nicer TV screens, or whatever other bigger and nicer things were within our particular personal credit limits. It’s a worry that Australian’s are still wracking up more credit card debt though? Wonder if that means that they think everything is good or that things are so bad that they have to? Me – I’ve gone for living within my means. But it is not easy! It is good news that we can sell off bits of the farm to the cashed up Chinese though. But while we are buying time doing that, I’d like to see Mr Rudd and co putting together a long term plan for maybe rebuilding some viable export industries apart from natural resources. Just saying we can’t compete doesn’t sound like a very good answer. I reckon we should be asking what changes we to make to be able to compete. And maybe looking at capitalising on a few of our natural advantages. We do have lots of land that we can produce food on if we can get water to it maybe? And I’ve never for the life of me been able to figure why we send all our coal and iron ore overseas and let someone else turn it into steel? Surely we are clever enough to do that ourselves? Or is it simply that our labour costs are too high for us to compete? Honestly dunno – But I do reckon we have a right to expect people who reckon they are clever enough to lead us and who have access to lots more info than us to be thinking about it and presenting us with some possible options. And this last one will undoubtedly wind a few people up but one of our natural advantages is that as a nation, we are nowhere near “full” yet – So bring in the immigrants – The smart hard working cashed up ones I mean (providing they aren’t real full on absolute fundamentalist Jihad types perhaps???) – Sure it was nice as a boy to walk along maybe half a mile or so of beach and be the only one there. But there are a few luxuries we just obviously can’t afford anymore. And if existing Aussies are terrified about not being able to compete with “them”, then we just might have to think about what we need to do to make ourselves more competitive on an individual basis as well as on a national one.

    Reply
  3. Joe – One more – If my take on it is right Mr Rudd reckons Autralia’s soltion to the GFC is to put some Pink Batts in rooves. And Mr Turnbull’s opinion is that we just might be putting a few more Pink Batts in rooves than are really required. (An overly simplistic and shallow and cynical analysis of their positions – But accurate “enough” in a very basic fundamental sort of way.)
    Because comparing that to China; Their policymakers think that it is a good idea to sign up 30 year contracts with Russia for long term guarenteed cheap oil supplies. And to buy big chunks of Oz resource companies that will see them sitting pretty for coal and iron ore supplies to make steel out of for maybe 50 years? Plus buy some copper suppliers and some good agricultural land outside of China. ETC, ETC, ETC presumably?
    There is a truly amazing disparity here – Oz policymakers think in terms of 2 years. Chinese policymakers think in terms of 30 or even 50 years.
    Sweet Jesus preserve us! (As they say.) I know that under democracy people get the government they deserve. And I know we’ve been bad – But I just don’t think we’ve been at all bad enough to deserve either Rudd or Turnbull???
    Surely there must be at least one person in Oz who genuinely cares enough about the country and its future to think beyond their next election date. And who ALSO has enough savvy to figure out that as a nation we should at least be trying to think in terms of several decades rather than several years???
    ENOUGH FROM ME – I’ve got to “retire” from DR for at least a week and go and try and make some money … Things are definitely a bit tight out in the real world as I think some of us have realised.
    SMILE!

    Reply
  4. Here is a great link Dan, I really enjoy your writings and site.

    http://www.youtube.com/watch?v=tfa_SNkDCCI

    This is a very clean and dynamic representation of the amount america is spending.

    Kind regards,

    Rudderless clueless
    April 20, 2009
    Reply

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