In today's analog-inspired edition of the Daily Reckoning, we take a big step back and question some of our key arguments over the last three months. Is Australia's banking sector at risk from foreign borrowing? Will Japanese sovereign debt be the first to run into higher rates, triggering a rise in the cost of global capital? And are we wrong about China's fixed asset investment boom? Is it a bubble...or is it paving the way to decades of prosperity?

It's a lot of heavy lifting today. And we did have a quick glance at the markets at home before heading into the office. It doesn't look like anything important happened. So we're going to get tucked into some of these weightier issues and see how they taste.

First, for the last few weeks we've been making the point that Australia's banking sector is vulnerable because it's a large importer of capital. All the booms in the local market - in shares, housing, or commercial real estate - are, to some extent, financed by foreign lenders. Like most foreigners, overseas bankers like what they see from Australia.

Capital flows are good now. The sun is shining and the country is lucky. But if we're right and the strong Aussie dollar is mostly a function of the U.S. dollar carry trade, capital flows can reverse just as quickly. Currency traders probably love this because of the volatility. But the question is: how risky is it for Australia's economy to source so much of its borrowing needs overseas?

Well, until today we've neglected one aspect of that question. When you borrow, you can theoretically borrow in your own currency - a loan denominated in Aussie dollars - or in another currency, say, American dollars. There are risks and advantages to both. America has been able to issue debt in its own currency for years, always paying it back in the same currency. It's been a huge economic advantage (that's probably going away slowly).

The big risk to borrowing in a foreign currency is that you must pay the loan back in the foreign currency too. That's all well and good when exchange rates are stable. Let's say you're an Australian business and you borrow $100,000 in US dollars while the exchange rate is at .94 cents. If the rate stays there, you'll pay back US$100,000 plus interest, but neither nor more nor less in principal.

In fact, if the Aussie dollar appreciates even more against the U.S. dollar (say it goes to parity, or one Aussie dollar buys you one U.S. dollar) then the loan gets cheaper for you pay off. The nominal amount (US$100k) is the same. But because of the exchange rate move, you can buy more U.S. dollars with your stronger Aussie. A move to parity from here, for example, could make your $100k loan about six percent cheaper than you first planned.

But if you borrow in a foreign currency and your own currency weakens against the currency in which you have borrowed, look out! This is what happened in many Eastern European countries over the last five years. The local banks borrowed from larger bank lenders in Western Europe (Austria especially) in order to finance local housing booms (yes, this DOES sound familiar).

When the local currency depreciates against the one in which you've borrowed, paying back the borrowed money gets a lot more expensive. You must somehow raise money in the borrowed currency to pay it back. You can sell things, give up equity, or default altogether in which case the collateral posted for the loan is transferred to the lender. And there's always the possibility that you just throw your hands up in the air, shrug, and say, "Sorry. We're all out of money! Go screw yourself."

That's why having a large percentage of your borrowing denominated in foreign currencies is dangerous. But the larger your demands for capital are (and Australia's are large) and the less you can source new lending from existing deposits (for regulatory and other reasons), then the further abroad you must look to borrow, even if it IS in someone else's currency.

A recent study by the Australian Bureau of Statistics concluded that Australia's total foreign currency debts grew by 130% between 2005 and now. The ABS says the banks have $548 billion in foreign currency debts while "other financial institutions" have $117 billion.

If these borrowings weren't properly hedged, a fall in the Australian dollar would make repaying them more expensive. But, according to the ABS, 95% of the foreign currency borrowings ARE hedged. According to Geoff Winestock in today's Australian Financial Review, "The share of unhedged foreign currency debt is roughly the same as four years ago, even though the total volume of debt has increased."

Whew!

"In many cases," Winestock reports, "the debts are naturally hedged because they have been used to buy income producing assets of shore. Taking this into account, Australia had a large net-positive foreign currency exposure."

How about that? Not only is the rise in foreign currency debt not a problem, it's a good thing! Aussie borrowers have taken that money, the ABS reports, and bought foreign assets that produce income. It's a win-win! What could possibly go wrong?

Well, one interesting fact from the ABS report is that while the debts appear to be properly hedged, the assets are not. For example, Australia has $456.7 billion in foreign equity assets, half of which are denominated in U.S. dollars. The ABS concludes that, "Overall, the reported net exposure of $388.1b appears largely due to equity assets and net foreign currency receipts that are largely unhedged."

Hmm. The only thing we can think of that might go wrong is that assets can fall in value while debts generally do not. Take, for example, collateralised debt obligations and other securitised assets. They are bundles of debt whose value is based on the regular income and principal payments of borrowers. And they never fall in value at all, do they?

Oh wait. Yes. Sometimes assets DO fall in value. Like U.S. houses...and all the securities that derived their value from those houses.

So it comes down to the quality of the assets you get with your borrowed money and how regular the income is. And frankly, we haven't given the assets that much scrutiny yet. It could be that a U.S. dollar rally raises the value of Australia's dollar-denominated stocks, even as it makes paying debts more expensive. That would be the hedging.

But you can colour us a tad skeptical. We've heard plenty of people claim debt was not a problem. We've heard very few claim it was "net positive." And we're not hearing many people show that assets denominated in U.S. dollars and that are unhedged are risky assets.

But maybe we're just being old-fashioned. Is debt really that big a deal? Isn't a bit hysterical to claim, for example, that a sovereign debt crisis is unfolding in the Western Welfare states?

Well, maybe not. Yields on 10-year Japanese government bonds are up 12% since the start of the year. According to Brendon Lau in today's AFR, "The fall in prices and the subsequent rise in yields may reflect worries about the country's deteriorating fiscal position, as government spending is tipped to surpass tax revenue this financial year for the first time since World War II."

Japan's public sector debt-to-GDP ratio is approaching 200%. But the Japanese are no longer saving at the same rate they used to. Granted, the pool of national savings remains high. And the government is hoping the ageing Japanese population will transfer its pension assets to government bonds and continue financing large deficits.

But Lau reports that the Japanese saving rate has fallen from 15% in 1991 to just 2% today. That rainy day everyone was saving up for - or that retirement - is finally here. Japan's own people may not be able to finance the government's large Keynesian deficit. So the country will have to find the money from somewhere else.

Hmm. Britain and America are already shaking down the world's saving nations for more money. Japan may find lenders. But you can be sure that it will cost more money to borrow. Rates will keep rising. Already the five-year credit default swap spread on Japanese bonds has risen 0.75 percentage points.

In other words, the cost of insuring Japanese sovereign debt against default is rising. Japan's CDS spreads now put in the same neighbourhood as Chile and the Czech Republic. By all accounts, Chile and the Czech Republic are nice places to visit and live. Chile sounds like a great place to visit and the Czechs have great beer.

But Japan is the second-largest economy in the world. Its cost of capital is going up. This could be the first sign that the cost of capital is going up all over the world. Higher interest rates are on the way.

That would be a major change. As we showed earlier this week, the cost of capital (like the cost of energy) has been in a long-term downtrend. Cheap money and cheap energy have both fuelled a global boom - a boom in which 2 billion people have been lifted out of poverty and brought into the industrial economy. Nowhere has this been truer than China.

Which brings us to reconsider what we wrote about China yesterday. We wrote that its rates of fixed asset investment were largely driven by political and not economic considerations. China's central planners value stability, and full employment brings stability. Even if factories are cranking out goods Americans can no longer afford (or want) to buy, it keeps people working.

Idle hands do the revolutionary's work.

But Glenn Mumford tells us not to worry. He quotes from a report by Mingchun Sun, the China economist for Nomura International. Sun says that China's current investment boom will prove, "a major milestone in China's economic development." The main claim, though, is China is paving the way for decades of new growth, greater consumption, and more developed domestic economy with rising per capita incomes.

In fact, China might actually be UNDER-investing in fixed assets. "Sun warns that investment demand for capital goods, raw materials and energy could be so strong that some upstream sectors now facing overcapacity may soon experience shortages...[Sun] is forecasting fixed-asset investment in the first-half of 2010 to rise 40%, year-on-year. This would be great news for Australian exporters."

Anything is possible. It certainly IS possible that the China boom is sustainable and getting larger. But it's also possible that the Super Cycle in fiat money is reaching a thunderous climax. And after the boom?

Dan Denning
for The Daily Reckoning Australia

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And counter to our prediction of an imminent, counter-trend U.S. dollar rally, the dollar is most definitely not surging. Take a look at the chart below. We've been writing about the decline of the dollar for nigh on ten years. So we looked at a ten year chart to tally up the damage. It is considerable.

Click to enlarge

What's at stake with the interpretation of this chart? If the dollar rallies on short covering from the dollar carry trade (a BIG if), then other "risk" assets like gold, stocks, and emerging markets would probably sell off. And yes Australian stocks, that includes you. As well as the Aussie dollar.

The chart shows that the index's 50-week moving average is set to cross below its 200-week moving average. That is mixed news. The first time it happened on this chart was back in early 2003. That was the early days of a long decline in the index. The second time, though the move failed to confirm the "flight to safety" rally of 2008 had staying power in 2009.

Once the fear that gripped markets in 2008 went away, the investment world sold the dollar and started borrowing en masse to buy other, higher-yielding currencies and assets (like the Aussie dollar and resource stocks). That's where we are now.

But based on the chart, is the next move down in the dollar index a new low, which the crossing of the long-term MA by the short-term MA would suggest? Or is it a false move? Will the dollar quickly and violently rally for some reason (geopolitical perhaps) that currently remains unknown to the human beings of this world?

"It's an interesting chart," said our technical analyst Murray Dawes. "But it is not useful for timing your moves out of or into trades related to the dollar's movement."

"So you're saying our chart doesn't have any useful information from a trader's perspective?"

"Not really."

Murray promised to show us HIS dollar index chart tomorrow. We'll bring it to you, live and in colour. But in the meantime, we think the one piece of important information communicated by our chart is that the dollar's trend is down. But there IS a catch.

The catch is that when this many people are this uniformly bearish, everyone is probably wrong. Consider this a warning then, that a dollar rally is just the sort of thing that will lead to a correction in the gold price and the stock market. We won't speculate on the sort of things that could lead to a dollar rally. But surely they're out there and sooner or later they'll come.

The other possibility is that the dollar is in its death throes and that this is the big one, in currency terms. That is such a momentous and disastrous event that people consider it both kooky and unlikely, not to mention undesirable to a predictable and comfortable world. But it IS possible.

And do you get the feeling that this kind of manic melt up rally is the sort of irrational frenzy that comes just before everything goes haywire? Haywire is not a precise financial term. So what do we mean?

We meant that the world enjoyed a 20-year economic relationship based on a fundamentally unbalanced global economy. Manufacturing capacity migrated to Asia where wages were lower. For awhile, this was mostly good news in Western countries. Goods got cheaper but jobs didn't vanish.

Now the situation is not so pleasant. The world is awash in manufacturing over-capacity, especially in China. Wage deflation (in the Western world) looks like a long-term trend, leading to a lower standard of living. This wage deflation is occurring at exactly the same time that Western governments are encountering demographic crises of ageing populations.

We all knew the ageing of the Boomers would put pressure on public finances right around now. But no one reckoned on a global financial crisis further saddling the public balance sheet with debt. And no one reckoned that Western wages and incomes would be falling at just the time people needed them most. And no one reckoned that savers would lose the most from low interest rates on fixed income - even though those low rates are keeping the American housing sector on life support.

It's a bit of global impasse. America's needed structural adjustment has come. Households and businesses are reducing debt, trying to live within their means. But the net adjustment to the American balance sheet is not happening because public sector debt is growing so fast.

Meanwhile, the other obvious adjustment is that the Chinese currency ought to be allowed to strengthen. For political and social reasons though, China will not allow this. It means China is actually adding to its industrial over capacity. It is conjuring up the world's largest ever bubble in fixed asset investment, including commercial real estate.

It is easy to see why China is reluctant to allow a stronger Yuan. Exports account for 39% of Chinese GDP. The Chinese economy, and probably the Communist Party itself, cannot survive on unleashed Chinese domestic demand. They need American markets. But American consumers - in addition to reducing debt - are now realising that the focus on finance over manufacturing from American policy makers has worked out for Washington and Wall Street, but not terribly well for the average American worker.

Where do we go from here? How about the blame game. U.S. Treasury Secretary Tim Geithner once blamed the Chinese for being currency manipulators. He back-tracked later. And yesterday, Liu Mingkang, the chairman of the China Banking Regulatory Commission, had a go at America.

"The continuous depreciation in the dollar, and the US government's indication that, in order to resume growth and maintain public confidence, it basically won't raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation." He is blaming the U.S. for fuelling a destabilising global bubble.

Of course that bubble is felt most acutely because China pegs its currency to the dollar. China is right to blame the U.S. for manipulating its currency to try and improve its competitive position. And China is right to worry about the value of its dollar-denominated assets in a world of exploding U.S. debt supply.

But China has put itself in this position. And here we are at the end of 2009 with a world still fundamentally un-adjusted to a new, workable currency arrangement. The world remains burdened by trillions in assets purchased with debt. Those assets linger on bank balance sheets, on government life support but fundamentally lifeless at fictitious book value prices.

And meanwhile, the China-US currency arrangement has fuelled a global bubble. Australia is part of this bubble, too. The question is how it will end. In the U.S., the housing market looms as the Achilles heel of the economy. It could strike households, banks, and the government again in the next 12 months are more mortgages reset at higher rates (with lower home values).

If the event that pops this bubble comes from America, look for the supply of credit to the emerging world to dry up again. And though Australia is not a developing economy, we saw last time what happened when U.S. credit markets imploded. Australian banks had to get a government guarantee to borrow money in the wholesale market.

We'd suggest that lending for residential housing and commercial real estate would take a real dip in Australia on another U.S. housing crisis (even if Aussie banks aren't exposed to actual U.S. housing-backed RMBS and CDOs. You don't have to own toxic debt to be impacted by it.

If the bubble pricking comes from China, what then? Well, China does everything big. So a Chinese bust would be world-class. It's a subject that requires its own Daily Reckoning. More tomorrow.

Dan Denning
for The Daily Reckoning Australia

• CRB Index Correction Likely to Go Further
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• The Aussie Dollar as a Measure of Global Risk Appetite
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike

Why this three part thought experiment? Well, just because our analysts are in agreement that the cautious way forward is to surf the liquidity in the markets higher, your editor is, at heart, a massive worry wart. Plus, all these disaster movies about the end of the world must be affecting our state of mind, or amplifying its natural tendencies.

We're always worried about the worst-case scenario, always thinking of the things that could go wrong. This just seems like a prudent way to prepare. It will be better if these things don't happen. But let's just assume they will and work backward from there. And then let's figure out what you can do - if anything - to avoid getting wiped out again, and maybe even making a buck or two on it.

First cab off the rank is the total implosion of the Chinese economy. This might be bearish for Aussie resource stocks. But how likely is it to happen?

Well, not very likely if all you were looking at is the raft of official data released this week. Retail sales in China were up 16.2%. Industrial output was up 16.1%. And exports, even though they were down 13.8% in October, decreased at the lowest rate in ten months. Fixed asset investment for the year is up 33.1% over last year's pace.

You could take all of these as signs that China is leading the world to recovery and managing itself quite well. It should achieve 8% GDP growth. That's the growth rate that China's economic planners reckon the country must achieve to maintain high unemployment. And high employment rates promote political stability - valued above all else by a regime that makes free market gestures but still is run by old school communists.

What's more, if you take up the question we asked a few weeks ago - when is it in China's interests to allow its currency to strengthen - the answer is starting to emerge: when a stronger currency keeps inflation in check. China's currency managers are making noise about letting the Yuan strengthen against the dollar.

But it's not to please Barack Obama, who visits Beijing this month. A stronger Yuan, among other things, gives Chinese consumers more purchasing power. That might slowly reduce the contribution exports make to Chinese GDP (and to forex reserves which are then recycled into U.S. Treasuries.

Or it could all fall apart more quickly than anyone expected. Why?

China has massive over capacity in steel and cement. Granted, these two materials are quite literally the building blocks of industrial society. But according to Bill Powell in Fortune Magazine, China has enough spare production capacity in the cement industry to meet annual cement demand from India, Japan, and the U.S....combined!

This fact would be consistent with a country that's massively over-investing in fixed assets to achieve high rates of employment. And then there's steel. China's own National Development and Reform Commission says the country will have 250 million tonnes of excess steel production capacity by the end of next year.

Chinese steel production is approaching 600 million tonnes per year. But its current demand is around 350 million tonnes. That means it's either planning to put the rest of the world's steel makers out of business by dumping cheap steel on to global markets...or there is massive overcapacity and inefficiency in the steel sector.

Either way, it's probably a good idea to consider the possibility that China's investment binge is more fragile than it looks. In short, the bear case on China is that, "the Chinese have dangerously overheated their economy, building malls, luxury stores and infrastructure for which there is almost no demand, and that the entire system is teetering toward collapse."

Naturally this would be bad for Australia, whose economy is lately coupled with China's prosperity. It would argue for reducing your allocation to common stocks, raising your cash position, and not taking the China growth story at face value.

Next cab off the rank is global rush to refinance debt while interest rates low. Moody's reports that there is $10 trillion of bank debt maturing between now and the end of 2015. What's more, the average maturity of bank debt fell from 7.2 years to 4.7 years over the last five years.

This means bank debt (like sovereign debt, especially in the U.S.) is getting more interest rate sensitive. Not only do banks have to roll over a lot of debt in the coming years, they may have to do so at higher rates (assuming they can find takers for it.) Moody's is not confident.

In a research note published to clients, and also on the FT's Alphaville blog, Moody's analysts wrote that, "credit costs should continue to put banks' earnings and profitability under considerable pressure, which might cause investors to seek additional risk premia, as governments gradually exit from the direct support they have so far provided. In other words, we see weaknesses on both sides of the balance sheet, and we are concerned that the risks associated with both assets and liabilities may fuel each other, cause losses and undermine investor confidence."

Even if you concede that Moody's might be overly-dire now to make up for its non-existent warnings about the risk of sub-prime related debt, you have to take the warning seriously. In fact, in a report released last weekend, the IMF said banks were not out of the woods yet at all and remained at risk.

Its analysts wrote that, "Banking systems remain undercapitalized, suffering from impaired legacy assets and, increasingly, non-performing loans. Deleveraging pressures will likely remain a constraint on bank credit for some time. Activity in securitization markets remains dependent on public sector support. Moreover, large public interventions have transferred risk to sovereign balance sheets, raising market concerns that have abated somewhat recently."

We'll get to the sovereign balance sheets in a second. But in your financial disaster preparations, spare a thought for the banks. Serious problems remain. And if you're looking for where risk resides in the financial system today - the next AIG, or Mrs. O'Leary's cow if you prefer - you might not have to look any further than the banks.

But as the IMF noted, a great deal of private sector risk has been transferred to the public sector via bailouts, loan guarantees, and other schemes. This exposes sovereign borrowers like the U.S. and the UK to interest rate shocks (increased borrowing and debt service costs). But more importantly, these countries already faced fiscal dilemmas with ageing populations.

There is not much detail to add to this point. We've covered it before. But it's the best reason to own gold and tangible assets (your house, vodka, cigarettes). All the world's paper currencies are drowning under a sea of public sector debt that's becoming increasingly unsustainable. And this has happened at just the point where the Western welfare states will begin spending more money on caring for ageing populations.

Where will the money come from? Between a China meltdown, a bank implosion, and the rising risk of sovereign debt default, there are at least three known unknowns that worry us right now. And don't even get us started on the unknown unknowns.

Dan Denning
for The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Chinese Economy Seems to be Growing
• Australian Iron Ore Shares on China’s Menu
• Chinese Surge in Construction Explains Pickup in Base Metals Stocks
• China Performs a Kind of Financial Alchemy

Australian baby boomers have never experienced a "rainy day" - so they've never planned for one.

But then why would you?

Over the last 20 years, virtually everything has gone up... and up...

A generational bull market has lifted the stock market, property values and commodity prices to dizzying heights. Most of us have felt the benefit of this in some way or other.

It's certainly made us feel a lot wealthier than we are. And when you feel wealthy, you tend to act wealthy.

And that's just what we've been doing - in some style... We've bought bigger houses, newer cars, nicer TV sets - and in the process, we've racked up more personal debt than the Americans were in just before the U.S. sub-prime crisis hit.

How deep in debt are we?

According to the Bank of International Settlements (BIS), during the 1980s, the ratio of household debt to disposable income for Australian households was around 45%. For every dollar an Aussie earned he owed 45 cents. Not ideal - but manageable.

Since 1990, the BIS reports that this ratio has risen rapidly, reaching an incredible 157% in December 2007. That means for every dollar the average Aussie earns, he owes $1.57.

In an October 2008 article, The Australian reported:

"By 2008, Australian households carried 35 per cent more debt relative to their income than Americans. The great Australian middle class has become more addicted to credit and more spendthrift than the US, the home of consumer capitalism."

We all know what happened in America after their debt bubble exploded...

But despite that warning, and despite debt far in excess of their incomes, Aussies are STILL spending money like it's going out of fashion.

In June 2009 the government handed out $900-a-piece to low and middle-income earners as part of a $23 billion stimulus package. By August, Australian National University economist Professor Andrew Leigh found that 40 per cent of those who'd received that cash had spent the lot. That's some stimulus for the economy!

"This is approximately twice as high as the share of United States residents who reported that they spent the tax rebates handed out in 2001 and 2008," noted Professor Leigh.

We all love spending free cash - who doesn't? - But every dollar you fritter away now is a dollar your future self will have to find when there's no regular money coming in.

The fact is, despite the overwhelming warnings, many of us spend more than we earn without any thought to the consequences... we believe that house prices will always rise... that high asset values equate to "true" wealth... and that we don't have to save any of our income because our super will provide us with a comfortable retirement.

But hang on a second - How often do you audit your super?

How regularly do you check to see whether your nest egg is still growing... or, at the very least, well protected against the economic downturn? Every month? Once a year? Never?

Have you checked it recently? Maybe you should...

Many Aussies opt for their company approved super fund and then forget about it, expecting to be handed a huge cheque at the end of their working life.

Granted, it's convenient: no research, no hassle, no worries. There's usually a big name behind the fund, and the glossy brochure your HR Manager hands you makes you feel cosseted and reassured.

It's the easy choice so you take it. And you stick with it - because you never physically see the money... it's just another deduction on your pay slip. It's not as if you're actually handing over piles of notes to someone to safeguard and nurture for you.

According to a recent report by superannuation research firm Chant West, the majority of retail super funds (i.e. yours) are classed as "growth" funds; defined as containing between 61 and 80 per cent of their allocation in assets such as shares. Even if you're invested primarily in a "balanced" fund, 40-61 per cent of your retirement cash will still be held in "growth" assets, says Chant West.

Growth assets are great when the market is going UP... but you want to limit your exposure to these assets when the market goes DOWN. And that's the problem: in the same report Chant West states that the average 'growth' super fund fell by 13% in 2008/09.

This is the worst return since the introduction of compulsory superannuation in 1992.

The worst return in the history of super.

That's a real kick in the teeth.

And the thing is, unless you've been paying attention, you may not have even noticed it. Rest assured, it'll smart pretty badly when you're still doing that early morning commute five... or even ten years after you'd planned to retire.

Please understand: sticking with the 'default option' of your company super allows someone you don't know to make all the crucial decisions that affect your financial future.

In terms of committing crimes against your future self, this is just about the worst thing you can do. Believe me - you may as well jump forward in time to the day you retire and punch yourself square in the face.

Kris Sayce
for The Daily Reckoning Australia

• Your Average Australian Super Fund
• World of Super Collides With World of Credit Crunch
• Is Kevin Rudd Planning to Steal Your Superannuation and Bankrupt Your Retirement?
• European Governments of the Eurozone are Separately Responsible for Their Euro-debt
• Your Actively Managed Superannuation Fund Cannot Beat the Market

But here is where the world of super collides with the world of the credit crunch. Aussie corporate bond issuance has increased as access to foreign bank loans tightened up in the last two years. Domestic savings (in the banks) may be inadequate to fund the country's credit requirements. But if borrowers could siphon off a bit of the super money...that would be the ticket.

It's this whole issue of Australia still being a net importer of capital. It's a major economic vulnerability. And there are some bankers who are already looking for a way around it. In today's Age we read that, "Commonwealth Bank of Australia Ltd (CBA) group treasurer Lyn Cobley said there was a place for the government to mandate more superannuation savings to stay in Australia to fund some of the lending that was now funded from offshore."

Let us deconstruct. Super is compulsory. Now CBA (or one of its officers) has broached the idea that compulsory super money be compelled to invest in corporate bonds." Not much choice there for you, is there? Your money being taken away and being made to invest in assets not of your choosing.

All of that as a solution to the worst two years of super performance in memory? In today's essay, Kris Sayce shows why now is not the time to be complacent about super. Even if this year's rally has erased some of the sting from the last two years, there are a lot of good reasons to fundamentally reconsider your relationship to super.

Or you could take up Texas Hold 'Em poker. Joe Cada, a 21-year old college dropout from Detroit won the World Series of Poker (and $8.5 million) yesterday...with a pair of nines! A pair of nines?!

Cada's story is a great American vignette. News reports say he is the son of an out of work auto-parts design engineer. His mother deals black jack at the Motor City Casino in Detroit. Cada is the youngest winner in the history of the tournament, and beat a logger from Maryland and a Frenchman in a fourteen and a half hour final session. He went all in on the last hand.

It's great for Cada. It sounds like he's a pretty good poker player. But it may not be so great for America that the only way a young man from Detroit can make it big in the United States is to win a poker tournament in Las Vegas.

Dan Denning
for The Daily Reckoning Australia

• Your Average Australian Super Fund
• Is Kevin Rudd Planning to Steal Your Superannuation and Bankrupt Your Retirement?
• A Look at Debt and Super
• Actively Managed Superannuation Funds Have Not Had a Stellar Few Years
• Attention Dr. Ken Henry: Government Could Make Employee Voluntary Contributions Compulsory

Stocks rallied on this news.

Employment is said to be a lagging indicator. Economists tell you it's the last thing to recover from a recession. Businesses don't begin hiring until after they are sure the worm has turned in the economy. But right now, there is a pretty big decoupling between the stock market's verdict on the economy (it's all good, man) and the employment market's verdict (it sucks, man).

But there's no doubt the rising market has lifted a lot of spirits...and superannuation balances. Aussie Super data firm Rainmaker says the average super is now down just -0.8% as of the end of September. To be honest though, we found this data incomprehensible.

Is it down 0.8% for the year (since January) or in the last twelve months? Or is the average super fund down 0.8% from its all-time high? The average super fund fell 21% from its heights to its lows during the GFC. But the Aussie market has rallied 55% this year.

So does this mean super has done well? Average? Above average?

In today's Age, Eric Johnston reports that for the last three years, the average super fund is down 0.3%. Over five years, the average fund performance is a bit better at 5.2%. And over ten years, a 6% average super return just means boring old government bonds at 5.6%.

To us, this suggests that the equity premium in stocks really is collapsing. What's the point of getting average super returns if you're better off in bonds? Or, if all you can get in the average super is a performance that barely beats bonds, wouldn't it make more sense to stick half your money in bonds, 30% cash, and actively manage the other 20% in your own self-managed super?

You could do worse, of course. Maybe it's a lousy idea. So we asked the man with the wealth gampelan, Kris Sayce, what he made of the enigmatic super figures. He's on the super beat full time. It's a sensible complement to the growth-stock tipping he does at the Australian Small Cap Investigator.

"I think what this research shows you," Kris writes, "is the utter failure of the funds management industry. The research claims the S&P/ASX200 is up nearly 55%, yet the best performing fund manager has only managed a 9.9% return. Something doesn't quite add up for investors.

"But still they're charging you between 1% and 3% for underperforming the market! That's just bizarre. Then again, I've always thought you're better off investing in the shares of a fund manager rather than in their funds."

Australia's super annuation industry is often trumpeted by the government (and the industry) as one of the best pension schemes in the world. And there's a lot of talk now about raising compulsory contributions from 9% of salary to 12%. This would be a real gift to the funds management industry.

But according to a report from Boston Consulting, the GFC hit Australian investors about as hard as anyone in the world. The report says the GFC wiped out 27% of Australian pension "wealth." That was the third-worse wipe-out of 62 countries surveyed. Only Britain (-32%) and Sweden (-28%) were worse off.

If you're having a hard time reconciling that fact with the rosy picture routinely painted by the media and the funds industry and the government, you need to dig a bit deeper and see how your fund is investing your money. At the very least, you ought to know whether your super fund is underperforming the market and over-exposing you to a certain class of stocks.

If it's your average Australian super fund, odds are it's doing both. According to an OECD report released earlier this month, "Australian superannuation funds had the highest exposure to equities last year and were the third worst performing group of pension funds in the world." The default Aussie super has 60% of its assets invested in shares and 70% of those shares are growth stocks.

Not only does this mean the average Aussie super investor is over-exposed to equities, he's way over-exposed to growth stocks. Granted, that might be exactly the sort of asset allocation you wanted if you were a young investor with time on his side, investing at the beginning of secular bull market.

But now? And let's not forget that the half of the total average return for stocks over time comes from reinvested dividends, not capital gains. That means that Aussie investors probably have too few income producing stocks in their portfolio, and too many stocks period.

If you have an asset allocation plan already (some percentage of your assets in stocks, property, bonds, cash, and gold, respectively), it may not be a bad time to revisit your percentages (rebalance). And if you don't have a plan - if you're leaving it to your super fund to make your asset allocation decisions for you - the odds are THEY don't have a plan either. They're just chucking your money into growth stocks and clipping your ticket.

That's not a plan at all. But it's probably a better plan than stick all your money into bonds willy nilly. That's not a plan either. Or, if it is a plan, and those bonds are U.S. bonds, it's a really bad plan. Worse than no plan at all (owning equities blindly).

Dan Denning
for The Daily Reckoning Australia

• Your Actively Managed Superannuation Fund Cannot Beat the Market
• A Look at Debt and Super
• World of Super Collides With World of Credit Crunch
• The Problem With a Well-Diversified Portfolio
• Pension Plans are Selling Stocks

Maybe it's the end of the dollar carry trade (where speculators sell risk assets). Or maybe not. Whether that little thesis turns out to be correct we'll know in due time.

In the meantime, there are some other things we might learn this week. First up is the TD Securities - Melbourne Institute Inflation Gauge. This will probably show that except for food, fuel, energy, healthcare, and housing, prices in the economy are stable and inflation is contained.

One quick note about this: there is obviously plenty of inflation in the prices you pay every day. But most consumer price indices are rigged to understate inflation, as our colleague David Evans pointed out yesterday in Canberra at the Gold Standard Institute conference in Canberra. Trimmed medians...hedonic adjustments...there's quite a bit of statistical hocus pocus going on.

Inflation is evident if you just follow the money. The returns on wealth (rent, capital gains, income from bonds) are accruing to that group that's benefitted the most from low rates. Dr. Michael Hudson called them the 'financial oligarchy' in his recent trip to Australia. This group has benefitted from inflation in the form of higher asset prices. And meanwhile, the Fed and other central banks have been able to say their policies are not inflationary because consumer prices and, more importantly, wages, aren't moving up.

Duh.

Is it really a surprise that there's no inflation in wages in a world where tens of millions of workers in emerging market economies are willing to do the same work as those in Western economies, but at much lower prices? Wage deflation is the order of the decade. Maybe the century. You generally won't find inflation in consumer prices or wages. But that doesn't mean it isn't there.

So what will the Fed and the Reserve Bank do this week? The RBA meets tomorrow and everyone is expecting another rate rise. The Aussie dollar has all but priced it in. The RBA also puts out its commodity price index week and its always exciting quarterly statement on monetary policy which we just can't wait to pore over for signs of continued credit and debt growth in the Australian economy.

Westpac will also post results this week. If it follows the lead of NAB and ANZ, it will report higher-than-expected bad debts, but claim the bad debt cycle has peaked. Don't be so sure, though. And why not?

Well, over the weekend, CIT Group Inc. (NYSE:CIT), with US$71 billion in assets, filed for the fifth-largest bankruptcy in American history. CIT is the latest victim of the credit crunch, which obviously still isn't over. It's a commercial lender to small businesses that's been unable to refinance its debt. As a non-deposit taking bank holding company, it has to finance asset growth through securitisation and borrowing, both of which are still pretty hard to do these days.

CIT's Chapter 11 allows it to restructure under the protection of the courts. Bondholders might make out okay. The U.S. Treasury, though, has already lost $2.3 billion in TARP money it put into the firm. And the biggest losers are the small businesses who will no longer have financing. That's bad news for the real economy.

As deposit taking institutions, the Big Four Aussie banks are not nearly as vulnerable to this kind of crisis as CIT obviously was. But as we showed last week, Aussie banks still rely on quite a bit of short-term borrowing in the wholesale funds market abroad, borrowing money from foreigners to financing lending here. That's always going to be a weakness.

Hold everything!

Last week we warned that a result of the Fed's low rates is that U.S. banks have stocked up on U.S. Treasury bonds and notes to stabilise their balance sheets. We warned that this could put the banks at risk again, IF the value of those bonds was slashed by market forces. You'd get another bank collateral wipe-out which could, if large enough, wipe out equity. Insolvency becomes an issue again.

But don't underestimate the ability of the bond bubble to go on longer than anyone thinks. The Feds meet this week and will probably not change a thing. Its formal program to buy Treasury bonds and mortgage backed securities with newly created central bank reserves (quantitative easing) can always be extended. So should bond bears like your editor (who agrees that U.S. Treasury bonds are a great short) be wary?

Yes!

The reason is a new regulation passed by Britain's Financial Services Authority which lays out new liquidity rules for bank assets. Rolfe Winkler has the story in his blog. The short version is that the FSA may require banks to own a certain percentage of assets that can quickly be liquidated to raise cash if need be. Lower credit quality assets (junk bonds or lower rated corporate bonds) might not qualify.

What that means - if you read between the lines - is that the only assets which would meet the new liquidity requirements from the FSA are sovereign government bonds. Now maybe this does make bank assets more liquid. But we wouldn't say owning more government bonds makes bank assets any safer, or improves the capital position of the financial sector.

What it DOES do is give the government a way to force new bond issues down the throats of banks. Rather than having to find creditors among the high-saving emerging market nations, governments in the UK and the US would have a captive market in their own financial sector. The banks would gradually gorge themselves on sovereign government debt, provided Moody's or Fitch or Standard and Poor's didn't downgrade the credit ratings of the US and the UK.

It sure looks like another move toward the nationalisation of the financial sector, although in a very clever way. And the banks probably don't mind that much right now. Trading government bonds with new Fed money was a virtually risk-free trade that propped up bank profits in the first half of the year. It's a good trade.

But in the bigger picture, as Nial Ferguson and Ken Rogoff mentioned this weekend, this means that the financial crisis may soon become a sovereign debt crisis. So far, the liabilities of financial firms have been transferred to the public sector balance sheet. But this has not solved the problem. It's merely moved it to a larger stage on which it must play out.

As we mentioned in our remarks yesterday at the gold show, we believe this marks the beginning of the end of the Super Cycle in paper money. A sovereign debt crisis is the same as saying that the funding model for the fiscal welfare state is broken. Only in this case, there is no organisation large enough to bail out the fiscal welfare state. What does that mean? More on the consequences, and the opportunities tomorrow.

"This is the first time I've been in Canberra," we began our remarks yesterday. "I spent most of last night trying to figure out what it reminded me of. And then it came to me. It reminded me of Washington D.C., and not in a good way. I spent four years in college living in DC. Both cities make you feel like you've stepped onto a very orderly and sterile brothel."

Dan Denning
for The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Hyperinflation and the Dollar’s Monetary Destiny
• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• The Asian Banks Have Finally Been Heard From
• Australia to Borrow as Much as $300 billion

"Okay."

"Why so serious? I mean, all you do every day is write about the worst-case scenario. It's depressing. Who died and made you the harbinger of financial doom? How about something positive for a change?"

"Is that code for, 'buy me another beer?'"

"No, seriously. It's not all bad all the time is it?"

We'll tell you how we answered our friend's question below. But first up, the markets. It was another red day in New York, with Dow stocks down over one percent. Tech stocks on the Nasdaq - the ones enjoying a bit of euphoria renaissance - were down 2.67%. September new home sales in the U.S. fell 3.6% from the month before. The Aussie dollar shed 1.44% against the greenback.

Is that all just noise? Or is there a melody building in the markets? The chorus chanted by Ken Henry, Wayne Swann, and most of the media is that the strong Aussie dollar, the strong market, and the strong(ish) economy are all factors of Australia's great policymaking and unique relationship to the China boom.

But the alternative tune - the one which we've been humming - is that most of the rally in stocks since March and most of the 30% rise in the Aussie dollar is a result of the carry trade. Yes, Aussie assets are relatively more attractive when the cost of capital in the U.S. is zero. But this can change in a flash when foreign speculators change their trading minds.

That's just what happened last year. Only then, it was both a dollar and yen carry trade that led to a rise in Aussie assets. Once the credit crisis set in, the yen carry got dropped and investors fled risk assets and piled right back into the greenback and U.S. Treasuries. Stocks fell, commodities fell, and the Aussie dollar plummeted to nearly 60 cents against the USD.

It doesn't have to happen that way now just because it happened that way then. But since our main job here is to question conventional wisdom and offer you an alternative explanation, that's the one we're offering you. Beware carry trades promising false permanent prosperity!

But what about today's earnings? ANZ followed up yesterday's bad debts bonanza from NAB with one of its own. ANZ reported an 11% fall in net profits (to $2.94 billion) and a 46% rise in bad debts to $3 billion. But both banks hinted that the end of the "bad debt cycle" is over and that things can only get better.

Let's take the other side of that trade. Again we'll focus on two risks: access to foreign funding and asset values on the balance sheet. ANZ sourced more of its funding from domestic savers and less from short-term whole sale funding, according to its report. Aussie savers funded 55% of ANZ new loans for the year (up from 50%) while the company reduced its reliance on short-term whole sale funding by 17% (now just 17% of all funding).

What does that mean? It means the company is making plenty of new loans (you'd want to, especially to the housing market, to prop up the value of your real estate portfolio). But it means the company is relying a lot less on short-term borrowed money from overseas in order to boost lending to Aussie homes and businesses.

Whether it is doing this by necessity or by choice is big question. But all we want to point out is that if your economy relies on imported capital to finance investment (or consumer spending, or new mortgage lending) you're vulnerable if that capital is not forthcoming. It's great when the dollar is high and capital is flowing. But if those capital flows reverse, the banks may find themselves in a jam that even a government guarantee makes it hard to escape.

It's not just us saying this, by the way. "We need to figure out how we can become less dependent on wholesale funding to finance our economic growth," said Commonwealth Bank of Australia chairman John Schubert in last Friday's Australian Financial Review. "It is not assured that we will get the funding into the future."

No foreign funding, no continued housing boom. In fact, we'd be willing to say that a cut off from short-term wholesale foreign funding is just the sort of thing that could lead to a major correction in Aussie house values. Naturally, the government here would step into the mortgage finance market in a big way, and not just for non-bank lenders, as it's done with the Australian Office of Financial Management buying securitised residential mortgage backed securities.

The U.S. government has done everything it can to keep the mortgage credit flowing and household net worth from imploding. Australia would do the same if it had to. But like in the U.S., this means more government borrowing to prop up the property market. More debt, higher interest payments, less capital available for lending to the rest of the economy.

But let's assume for now the public sector does not enlarge again to Depression-era levels of debt. Let's assume that Aussie banks have access to overseas credit. There is still the issue of asset values. ANZ says it is leveraged about 17 to 1. With $476 billion assets, that leaves it with about $28 billion in equity (according to how it calculates both assets and equity). And like yesterday, it's fair to say that a few billion in loan losses and bad debts are hardly the sort of thing to wipe out that much equity.

That's not where the real risk is, though. The real risk is to the asset portfolio. Twenty eight billion in equity capital is just under 6% of total assets. Or, put another way, a 6% loss in assets wipes out the equity.

A six percent loss in assets? Is that possible? The IMF and APRA have stress tested Aussie banks for scenarios in which large chunks of homeowners can't pay their mortgages. They chuck in large corporate bond default rates just to make things more stressful. And after all that, they've concluded that most of the banks' assets are solid and safe and unlikely to incur mammoth losses that would jeopardise the equity capital (solvency).

And maybe they are right. But we're just saying...in a world dominated by massive credit write downs...where we have just seen six months of re-leveraging...and where house values here in Australia have managed (thus far) to escape massive deflation...is a six percent loss on assets totally unimaginable?

We can imagine it, although we don't relish it. Either way, we wouldn't buy the banks just now.

But if you're looking for the most over-valued asset class in the world - the one worth a punt for going short - it has to be U.S. government bonds. Paolo Pelligrini, the man who helped John Paulson make a mint shorting the U.S. housing market, told Bloomberg that shorting long-term U.S. debt is the "only attractive bet" going at the moment.

"I always like to think about assets that are likely to experience a breakdown; the only thing I'm pretty comfortable with right now is U.S. Treasury securities and U.S. agency mortgage-backed securities...I think that those are overpriced so they are attractive shorts."

If you're not going to short the U.S. long-term bond market any time soon, the take away from this is to look for assets that go up when U.S. bond prices fall. If U.S. bond prices fall it means U.S. interest rates go up. That might, for a bit anyway, lead to a stronger USD and a weaker AUD.

For a trader - other than cash and gold - we'd look to see which of those Aussie stocks hammered by the stronger Aussie dollar have been beaten down the most. They might be due for a quick rebound - although they will be fighting the general trend in the market. We'll ask Murray what he thinks and get back to you.

So what did we tell our drunk friend when he asked us why were so critical, sceptical, negative, and gloomy all the time?

"Relax dude. It's my job to plan for the worst case scenario. It makes me happy to have a purpose in life. If you want the best case, turn the TV on and turn your brain off. And I object to your overly negative characterisation of my work."

"Huh?"

"My work isn't negative. It only seems that way because we live in a period of wealth destruction. I wish it were a world of wealth creation. But in a world of wealth destruction, you have to focus on preserving your wealth and maybe, when you can, growing it if you've got the big picture sorted out correctly."

"But you make it sound like the end of the world every day."

"It is the end of the world every day. But it starts all over the next day. And it is just the end of the financial world as we know it. Not the end of the world world...Besides, it's a lot less scary when you face up to what is really going on and make a plan for it. Uncertainty is scarier than risk because with uncertainty, you have no idea what to expect. Risk you can at least manage."

"But how can you be so sure you're right about the big picture? Everyone else I talk to says there's no way the dollar is going down as a reserve currency and that only kooks believe that. Are you a kook?"

"Certified. But that doesn't mean I'm wrong. You can't keep adding debt forever to fund your way of life. Debts have to be repaid. And interest has to be paid on the money you've borrowed. The politicians in America keep making new promises they aim to keep with borrowed money. This borrowed money is massively interest rate sensitive. And it's in addition to a huge amount of money they've already borrowed. It's the end-game for the whole financial/fiscal/political model."

"But so what? Isn't everyone else doing the same thing?"

"Well yeah. All fiat money is a scam. It's a way for the government to run perpetual debts and steal savings through inflation. It's an immoral living arrangement in that respect. But more importantly, from a financial perspective, it's a way of funding a political arrangement. And that way of funding it - borrowing more and raising taxes on a small productive class to pay for a larger public sector - is every bit as dead as the funding model for investment banks."

"But the government bailed out the investment banks. Who is going to bail out the government?"

"No one. Nothing. It will try inflation. But that doesn't work. Printing more money to pay off your debts just destroys wealth. That's where we're headed. That's what you should plan for. Sooner, not later."

"I would like to begin my plan with another beer, if it's all the same to you."

"No worries."

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Fed Now the Middle Man in Interbank Lending Market
• Corporate Debt is Just One Aspect of the National Debt Problem

Daily Reckoning,

Mick.

Mick, you can read all about the history of the RBA here.

Dear Dan,

Colin B.

---"But if you're forwarding copyrighted material, you're breaking the law."

Peter

Peter, just because we don't like the State making rules doesn't there aren't rules for voluntary transactions that protect property rights and guarantee the terms of an exchange. The free e-mail is free. The paid services are not free. When you give them away you're giving away our intellecutal property. It's theft. Plus, it's just bad faith.

We can tell when an e-mail sent to a given address is forwarded and how many times, although we can't tell to whom (and wouldn't bother to find out.) We're not interested in getting in a fight with anyone over the issue. But we do think it's fair to ask you to quit giving away copyrighted material.

And if you don't, we'll reserve the right to terminate your subscription. We're within our rights to do that, although we'd issue a pro-rata refund as well. It's not a problem at all if you forward material from your work address to your home address. But serial offenders...

Dan Denning
for The Daily Reckoning Australia

• Diggers & Drillers and Australian Small Cap Investigator Being Republished
• E-mail Update for Paid-up Subscribers Only
• Bigpond Blocking e-Mail from the Daily Reckoning Australia
• Rare Coins as an Informal Way of Estate Planning
• Daily Reckoning Reader Mail

Much will be revealed this week in the Aussie market, although a lot will probably remain obscure too. Producer price data for the September quarter comes out from the Australian Bureau of Statistics. Inflation anyone? Maybe not in wages. But certainly in raw materials (energy).

And speaking of inflation, the Housing Industry Association will report new homes sales data for September later this week too. What do you reckon it will show? Our prediction: how prices in Australia are outrageous and getting more so with each passing month, as the banks double down on home lending.

You may even see a move in the Aussie gold price this week. It could come if the U.S. dollar pulls itself together for a bit of a rally, as we're expecting. But the other reason Aussie gold may go up is a small item on the front pages of today's Australian Financial Review. "Big Banks gear up to lend again," reports the AFR. Uh oh.

No one's been too terribly worried about consumer price inflation lately, mostly because it's been masked - until recently - by cheaper oil prices. Of course the biggest factor affecting consumer price inflation is the growth in bank credit. The RBA reports on that later this week. But bank lending is the main engine for new money creation in the economy...and new money creation is the main engine for inflation.

"The Big Four banks are keen to lend more aggressively to large businesses as the economy recovers and competition for assets intensifies, in a development that is likely to drive down corporate borrowing costs," Katja Buhrer writes. "The major banks are seeking to take advantage of surplus capital and improving corporate growth prospects."

Hang on! Surplus capital? Just last week we were under the impression that Aussie banks were having to import capital from foreign lenders in order to fuel the housing bubble. Now there's surplus capital? And now the banks are eager to loan it out and build up the asset side of the balance sheet again?

So much for deleveraging in the financial economy! This sounds like re-leveraging. It also sounds like exactly the sort of thing - a fresh new wave of bank lending into the real economy - that could trigger much larger inflation. This is the sort of thing the RBA is trying to prevent by raising rates. But if banks start expanding the asset to capital ratio again, watch out! You could see higher Aussie interest rates AND a higher Aussie gold price.

"West Africa beckons as Aussies go for gold," reports Barry Fitzgerald in today's Brisbane Times. This answers a basic investment question: which Aussie gold producers benefit most from a rising gold price and a strong Aussie dollar? ASX-listed firms with greenfield West African gold assets generally have their costs in U.S. dollars. That's a big advantage over domestic gold producers.

Dan Denning
for The Daily Reckoning Australia

• RBA Rate Cut Does Little to Unlock Credit Market
• Global Credit Shortage is Over According to European Central Bank
• Australian Recession in the Works? Ask the Sharemarket
• Foreign Investment in Australia, How Much is Too Much?
• Banks or BHP?