Why Australia’s Economic Policy Is Simply Dumb

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With not much going on in markets overnight, today’s Daily Reckoning will focus on the Aussie economy.

As I’ve written often, thanks to low interest rates and a tax system that encourages capital to flow into property, Australia has a very warped economic ‘structure’. That is, the foundations of economic growth (interest rates, tax policy, etc.) support an unstable structure that is susceptible to shocks, large or small.

I was reminded of this again yesterday after reading Robert Gottliebsen’s somewhat sensational article in The Australian. Here’s the opening salvo:

The ingredients for the next banking “scandal” are now sitting on the table ready to be mixed. It will be a scandal like none other in Australian history because it will involve Chinese rather than Australian residents as the victims.

And therefore it may involve the Treasurer Scott Morrison, firstly because the “scandal” could create a severe Australian downturn, greatly damage Australia’s education industry/international reputation and complicate Morrison’s involvement in the proposed Chinese purchase of the NSW electricity distributor Ausgrid.

Wow…there’s a lot going on there…

The ‘scandal’ Gottliebsen refers to is the fact that there are 230,000 apartments under construction in Australia, mostly along the east coast centres of Melbourne, Sydney and Brisbane. The ‘vast majority’ have been bought by Chinese and Asian investors with a 10–20% deposit.

Now, these investments are at risk from a lending clampdown by the banks, which is in turn driven by tighter regulatory rules imposed by the bank regulator, APRA. The RBA asked APRA to impose tougher rules to allow them to keep cutting rates without setting off a destabilising house boom. Too late for that, methinks…

If this clampdown is too successful, it risks a ‘national catastrophe’ according to Gottliebsen, as builders and developers go to the wall.

Now, I should point out that apartment developer Harry Triguboff has been the source behind most of Gottliebsen’s property related articles this year. Harry was obviously feeling the pinch when the banks first started to tighten credit on apartment buyers back in March/April.

So he enlisted the help of Gottliebsen the get the word out. That is, unless the banks ‘lay off a bit’, the Aussie economy would be in trouble. The warnings haven’t worked. Now the banks are asking for much larger deposits from Chinese and Asian investors. If they don’t get them, the banks won’t lend the required funds.

This could cause a glut of unsold apartments, and lead to recession as the housing industry goes into a downturn. And the banks will be to blame…

If the Reserve Bank is right and there is to be an apartment glut causing severe damage to the building industry, our education industry and our international reputation, it may require a royal commission or a Senate inquiry to find out what really happened in the banking industry.

A Royal Commission? Let me save you the wait and tell you what really happened right now.

The Aussie economy was facing a sharp, mining led downturn in 2011. The terms of trade and mining investment had peaked, and the RBA needed to find another source of growth, quickly.

So they began cutting rates aggressively, in an attempt to get housing investment to replace the dwindling mining investment.

And guess what? It worked!

Low interest rates set off a house price and construction boom. However, the construction part of it was mainly confined to apartments. Now, surprise, surprise, we have a glut of apartments! And who is to blame?

Everyone is complicit. The RBA and APRA are most to blame, as they watched lower interest rates in action for years before belatedly asking the banks to tighten their lending requirements.

And when the banks did tighten, they went after the easiest political target…Chinese investors. In the lead up to an election, it wouldn’t have been a good look to tighten housing credit across the board. This would’ve threatened the wealth of ‘ordinary Australians’.

It was much easier to tighten the screws on ‘foreigners’.

Why do we need to sell such a large chunk of the housing stock under construction to foreigners anyway, you might ask?

Well, it comes back to what I’ve been banging on about in The Daily Reckoning for a long time now. Australia is hugely dependent on foreign capital. Without it, we’ll go into a recession. Foreign capital inflows support our standard of living.

In June, Australia recorded a massive trade deficit of more than $3 billion. To finance this deficit, and to stop the dollar from collapsing, we need foreign capital to flow into the country.

And like it or not, one of our biggest export industries is selling apartments off the plan — and selling assets in general. Go back to the first quote from Gottliebsen’s article above. He mentions the proposed sale of NSW energy infrastructure, Ausgrid, being at risk.

This is all part of Australia’s flawed economic structure. That is, we consume more than we produce and have to sell off assets to make up the difference. Even after the largest resource investment boom in our history, we are still running massive trade deficits.

So don’t be confused any longer. We sell apartments to Chinese and Asian investors because that is what our economic model calls for. It’s all part of the plan. We overconsume and must, therefore, borrow and sell assets to plug the gap.

The problem is, the economic model that we run is self-reinforcing. The RBA lowered rates to offset the resources investment slump. This created a house price and construction boom. With rising housing prices comes a rising ‘wealth effect’. This means we spend more on the consumption of goods.

For example, in June, a $588 million rise in imported consumption goods contributed to the trade deficit. My guess is that this increased spending came from the wealth effect of higher house prices, which we borrow against in order to increase consumption.

The borrowed funds come from foreign capital, which increases our reliance on offshore debt even more! Pretty dumb, huh?

It might be an effective way to run an economy in the short term, but it’s a highly risky long term strategy. Thankfully for the politicians, the banks and the various regulators, the RBA has managed to keep the long term risks at bay by constantly lowering interest rates. They can probably keep on doing so for some time.

But it will only make the eventual day of reckoning that much worse.

Regards,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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