This Dynamic Doesn’t Bode Well for Australia

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While we’re still on themes for 2016, how about it being the year of the broken peg? More on that in a moment…

Firstly, in related news, stock markets continue to lose ground in the first trading week of the year. According to Bloomberg it’s the worst start to the year since 2000. I hope that’s not an omen. 2000 was the year the dotcom bubble finally burst.

Will 2016 be the year the global (reinflated) credit bubble pops?

Who knows? It could be. Whatever the year brings, it certainly hasn’t started well. Last night, the Dow lost another 250 points. Crude oil plunged 6% to just over US$34 a barrel. Global asset markets are deflating.

Gold was one of the few standouts. It jumped more than 1% to over US$1,090. Gold rose because it’s a safe haven currency, along with the US dollar and the Japanese yen. It comes back to the theme of the broken peg.

Before I explain what I mean by that, let’s look at the source of all the problems: China. More specifically, it’s China’s attempt to devalue its currency that is unsettling global markets.

And China is devaluing its currency because it has an insane debt problem. Here’s how I explained it to Crisis & Opportunity readers yesterday:

The bottom line is that China continues to struggle with its huge debt load. This makes the economy and financial system extremely fragile.

Let me show you what I mean. The following chart comes from Bank of America-Merrill Lynch (BAML), via Business Insider:

[click to open in new window]

It shows the growth in private sector credit relative to GDP. China and Hong Kong are the standouts. As the analysts at BAML write (their emphasis):

“China’s private debt to GDP ratio rose by 75 percentage points between 2009 and 2014, by far the highest among the 40 economies with data (together with HK). At the peak speed, over the 4 years from 2009 to 2012, the ratio in China rose by 49 percentage points. Historically, any country that grew debt this fast inevitably ran into financial system problems, including currency devaluation, banking recap, and high inflation, and we do not expect China to be an exception. We believe that the government had maintained system stability over the past few years by allowing various implicit guarantees to get firmly entrenched, which has made the financial system fragile. This is a classic case of short term stability breeding long term instability, in our view.”

That’s a crazy rate of debt growth. Now, as China’s economic growth rate continues to slow, it’s finding it increasingly difficult to service that debt. Leaks (debt defaults) are springing up everywhere.

So far, Chinese authorities are doing a good job at plugging the gaps. But if growth continues to slow, the leaks will continue.

One way of trying to manage its debt problem is to devalue the currency. The problem for China is that the yuan is loosely pegged to the US dollar. That means as the US dollar rises, China loses competitiveness.

Given that China still manages to generate huge trade surpluses, you’d think a loss of competitiveness wouldn’t be such a bad thing. But it is. The trade surplus represents a lot of employment. Social stability, via high levels of employment, is China’s number one policy aim.

Therefore, a loss of export competitiveness is a worry for China. This is why they are devaluing against the US dollar. They want to loosen the currency peg further. And because the trading world now knows this is a policy aim, they’re taking a punt on more devaluation, which in turn puts more pressure on the authorities.

The big question is whether China will decide on a one-off major devaluation, and effectively break the peg with the US dollar.

That might prove too risky. Even now, these one-off currency adjustments are causing major problems across global stock markets. There are a couple of reasons for this.

Firstly, it’s a sign that all is not well with the Chinese economy. For years, consensus opinion was that China had the tools to manage its economic slowdown and rebalancing. Now, that assumption is under question. The market is losing faith in China’s policy makers.

Second, currency adjustments have an impact on ‘carry trades’. This is where speculators borrowed in yuan to invest in other assets, including commodities. Now, this trade is slowly unwinding, leading to selling off ‘risk assets’, including commodities and stocks in general.

Clearly, this dynamic doesn’t bode well for Australia. So far, we’ve managed to avoid a major slump (unlike other commodity producer, Brazil) by loading up on debt, speculating on property, and setting off a building boom.

That’s added to the wealth effect and created enough demand to offset the big drop off in mining investment. The question for Australia is whether we can continue relying on strong household consumption to pull us through another year.

The drop-off in mining investment still has some way to go. In addition, it looks like the building boom peaked last year so it won’t add to economic growth in a meaningful way in 2016.

It’s going to be another year of weak growth for Australia. But if China slows down more than expected and its debt chickens come home to roost, then we’ll be looking at the prospect of a recession later this year.

As a result, you can expect to see more interest rate cuts and a weaker dollar as 2016 unfolds. Be prepared for it.

Greg Canavan,

For The Daily Reckoning

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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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