by Peter Brain
The second indicator of exposure to overseas debt cumulates current-account deficits into the stock of external financial obligations, measured in relation to GDP. This provides a broad assessment of the vulnerability of an economy to the willingness of its creditors to continue their support. Financial crises have often been precipitated by fluctuations in such willingness.
These two indicators of the debt burden are complemented by a single price indicator, the real exchange rate. The EC includes this indicator because the capacity of an economy to meet its external obligations depends, in part, on the price-competitiveness of its exports and of import-competing production, which diminishes when the real exchange rate rises. The EC notes that periods of high real effective exchange rates often precede economic crises by generating current-account deficits.
We will take the same approach to these three indicators of overseas debt as we took for the indicators of private domestic debt. We now concentrate on the relationship between the crisis levels being flagged by the indicator and financial deregulation.
Exchange-rate volatility
The European Commission assesses exchange-rate volatility using the three-year percentage change in the real effective exchange rate. This is an index of the exchange rate for each European country vis a vis 35 other industrial countries, weighted by the importance of each partner country in the European country’s trade. The change in the real exchange rate is calculated after removal of the effects of price inflation in each country. The equivalent for Australia is the real trade-weighted exchange rate, as calculated since 1992.
This indicator is related to the terms of trade (the ratio of import and export prices), but allows for the failure of exchange rates to reflect the terms of trade either for market reasons (movements in capital and speculative funds) or for policy reasons (changes in regulation that affect movements in capital and speculative funds). An appreciation means that, overall, a country’s exporting and import-competing industries are becoming less competitive with overseas producers. This has been shown to be a frequent precursor of crisis.1 The EC also regards a rapid depreciation of the exchange rate as a precursor of crisis because it generates ‘potential problems related to domestic demand or the potential of harmful future price convergence’.2 The commission has set its threshold of alarm at a variation of more than 11 per cent, up or down. Either way, a rapidly fluctuating exchange rate hinders long-term economic planning by governments and, more importantly, by investors in exporting and import-competing industries.
Estimates of Australia’s real exchange rate are only available on a consistent basis from 1992, so statements about the behaviour of the indicator before this time must be tentative. With this caveat, it would seem that Australia’s real exchange rate was reasonably stable during the post-war decades, with the probable exception of the Korean War boom years in the early 1950s, during which the nominal exchange rate was maintained despite a burst of inflation that would have increased the real exchange rate. However, for Australia as for the rest of the world, this period of stability ended in the early 1970s. Inflation rates went haywire, real exchange rates diverged from nominal rates, and the United States put paid to the Bretton Woods system of fixed exchange rates anchored in the US dollar when it suspended the relationship between the dollar and gold. Since 1972, three-year changes in the Australian real exchange rate have exceeded the EC alarm point as often as they have been within it.
The fact that the Australian dollar exchange rate has fluctuated much more than would be acceptable in a European country draws attention to Australia’s fate as a commodity exporter and hence to its exposure to fluctuating commodity prices. It is arguable, too, that Australian businesses have become inured to this, at least during the 1970s, 1980s, and 1990s, when the real exchange rate cycled between over-valued and under-valued every few years. However, the decade from 2003 to 2012 was marked by increases of 11 per cent or more in all years bar two (the three-year moving average removes the downwards blip that occurred in 2009). These sustained increases, brought about by the mining boom, were disastrous for import-competing industries, many of which are beyond revival, even though in 2015 the real exchange rate started to head downwards.
Because high volatility struck the real Australian exchange rate in the early 1970s, rather than waiting for the floating of the exchange rate as part of financial deregulation in 1983, it is arguable that the volatility of the exchange rate is not due to financial deregulation but instead reflects the general instability of the world economy and of commodity prices, which are unstable even though they are anchored in the cost of production of rural products and minerals. In most cases, resources are reasonably abundant, or at least abundant after a minor rise in their price, so the expectation would be for prices to remain stable. However, price spikes can easily result from unexpected failures of supply (typically due to bad weather) or unexpected spikes in demand. (For example, the recent minerals boom reflected the failure of mineral companies around the world to anticipate a spike in Chinese demand for steel, and it took years to increase productive capacity.) Australia seems fated to endure fluctuating exchange rates, but could certainly manage this fate far better than it has over recent decades.
Though the real Australian dollar exchange rate became unstable a decade before the rate was officially floated, financial deregulation denied the authorities the use of quantitative controls, and required that interest rates be targeted on preventing inflation rather than on dampening fluctuations in the exchange rate. Both of these reforms limited the extent to which the authorities could act to stabilise the exchange rate. Similarly, other neo-liberal reforms that accompanied financial deregulation prevented the authorities from assisting industries in temporary difficulties due to an over-valued exchange rate, and also prevented them from capturing a share of the windfall profits generated by the commodity-price fluctuations that underlay the movements in the real exchange rate. These limitations were highlighted by the destruction of import-competing industries during the minerals boom of 2005–12.
The alternative to the neo-liberal reforms, the path that Australia rejected when it transferred power from government to the finance sector, is to govern the markets. Countries that adopt this alternative use qualitative financial controls — including, as regards the exchange rate, selective financing of exporting and import-competing industries, the utilisation of foreign investment to strengthen competitiveness, and the dampening of speculative activity by the neutralisation of hot-money flows. These controls have turned out to be so effective that the countries that govern the market are regularly tempted into maintaining highly competitive real exchange rates that result in them accumulating excessive current-account surpluses, which they can get away with because the neo-liberal countries are willing to run the corresponding deficits.
As regards the real exchange rate, we conclude that financial deregulation was not in itself the cause of the rise in volatility. During the 1970s, using their remaining quantitative controls, but without resorting to the more sophisticated qualitative controls then under development in continental Europe, Australian governments attempted to stabilise exchange rates as they had during the post-war period, but failed, and in the process delivered substantial profits to speculators. The floating of the exchange rate recognised this reality. By deregulating rather than switching to qualitative controls, Australian governments left the country exposed to unproductive and indeed dangerous fluctuations in the real exchange rate.
Australian overseas debt
The two other EC indicators of vulnerability to crisis due to overseas debt — the current-account balance and the stock of private overseas debt — are so closely related that they can be considered together. Neither indicator is very sophisticated. They both lump together financial obligations of all kinds, ranging from demand deposits through short-term and medium-term loans to equity shares, and they both offset Australian lending overseas against Australi
an borrowing overseas. Each of these subdivisions of debt contributes differently to the danger of crisis. However, as the EC points out, the two indicators make useful starting points for analysis of the dangers of overseas debt, and can readily be calculated from the national accounts.
In Australia, the two EC indicators of overseas debt are closely related to the EC indicators of private-sector domestic debt. This reflects the role of the deregulated banks, which hold loans to domestic private-sector borrowers on the asset side of their balance sheets, and loans from overseas lenders on the liability side. This relationship does not hold in all countries. For example, Japan combines a high level of domestic government debt with substantial overseas assets, while a large proportion of American overseas debt has no domestic counterpart, since it is issued directly to overseas lenders by the United States government.
During the post-war period, the Australian annual current-account deficit rose above the EC’s alarm level of 4 per cent of GDP on several occasions, notably in 1951–52 in the aftermath of the Korean War boom, and also in 1981–82. However, on these occasions, and on several others when the deficit threatened to get out of control, the authorities took action to reduce it by cutting imports. Their methods were blunt but effective. They risked full employment by reducing demand overall — both demand for imports and demand for domestic production. The instruments used included both fiscal policy (by raising taxes and curbing government expenditure) and monetary policy (by reducing the banks’ capacity to borrow and lend, and raising interest rates). In 1951–52, when the three-year current-account deficit touched what we now know is the EC alarm level, the drastic corrective action included import restrictions. Over the whole of the post-war period till the early 1980s, the current-account deficit was kept under control, and from 1960 to 1984 it averaged 1.8 per cent of GDP.
As measured by the EC over a three-year period, the current-account deficit first rose above the alarm level of 4 per cent in 1983 — the year of financial deregulation. It remained above this level for nearly a decade, but eventually responded to the 1990 recession and fell just below 4 per cent for a few years. However, it soon bounced back, and over the fifteen years from 1996 to 2010 went above 4 per cent of GDP in all bar three years, peaking at 6.2 per cent in 2008. During the recent mining boom it fell marginally below 4 per cent, but is now poised to increase once again to levels that the EC regards as dangerous.
The average current-account deficit of 4.3 per cent of GDP recorded from 1985 to 2015 contrasts with the pre-deregulation level of 1.8 per cent. The difference of 2.5 percentage points can be interpreted as an estimate that financial deregulation more than doubled the current-account deficit and seriously raised the likelihood of crisis.
It is not so easy to follow the course of the second EC indicator of overseas indebtedness, because data for this indicator do not run far back into the pre-deregulation period. The Parliamentary Library has collated estimates going back to 1980, in which year Australia’s net overseas indebtedness, including equity debt, was estimated at 20 per cent of GDP.3 The ratio rose above the EC danger level of 35 per cent in 1986, and has remained there ever since. It reached 50 per cent in 1994 and stabilised for a while, then went up to 55 per cent in 2007, where it has again stabilised with a 2015 estimate of 56 per cent.4 Not surprisingly, these estimates also associate financial deregulation with a rise in the likelihood of crisis.
These EC indicators home in on a broad measure of overseas borrowing, partly as a matter of statistical convenience — the current-account deficit is readily and reasonably accurately available from balance-of-payments data. However, as already noted, they fail to distinguish the riskiness of different patterns of borrowing. For example, a country whose residents and institutions have incurred overseas loans in order to buy overseas equities may report zero net borrowing, yet be exposed to financial collapse if the value of its overseas equities falls while the value of its borrowings remains constant.
More importantly, a country whose businesses have borrowed on equities is generally considered as being less at risk of financial crisis than one where business or government has borrowed on a short-term basis. The cost of servicing equity investments depends on the performance of the equity assets, which depends on medium-term to long-term prospects, generally in a wide range of industries. On the other hand, a country burdened with short-term debt faces creditor judgement every time it rolls over its debts. The EC recommends that, once a country has been identified as vulnerable to crisis by the broad indicators of overseas debt, a detailed assessment should be conducted that takes the composition of the debt into account.
Unfortunately, the Australian national balance sheet, which includes estimates of the composition of Australian overseas assets and liabilities, was first prepared in 1989, some years after financial deregulation. Changes in the composition of Australia’s net overseas debt during the post-war period are not particularly well recorded, but those that have occurred since deregulation are well documented. Between 1989 and 2016, Australia’s net overseas borrowing increased by 21.7 per cent of GDP, beginning close to the EC danger level and worsening from there. This resulted from an increase in overseas financial liabilities of 125 per cent of GDP, offset by an increase in overseas financial assets of 104 per cent of GDP — globalisation with a vengeance.
As Australian superannuation funds increased their holdings of overseas financial assets, they acquired a balanced portfolio of debt and equity; however, the banks borrowed overseas by issuing debt. As a result, the overseas debt of the Australian financial sector is now roughly equal to its overseas assets (debt plus equity), and its overseas debt liabilities considerably exceed its overseas debt assets. Offsetting the two, Australia’s net overseas debt increased from 32 per cent of GDP to 63 per cent in 2016. We note, in passing, that the four countries that were at the epicentre of the Asian Economic Crisis of 1997 all reported net foreign-debt ratios less than this in 1996: Indonesia (52 per cent), Thailand (53 per cent), Malaysia (25 per cent), and South Korea (13 per cent).
Some of these trends were intended at deregulation. It was intended that Australian lending overseas should increase, to allow Australian investors and superannuation funds to spread their risks over world markets instead of being penned into the Australian market. However, the increase in the current-account deficit, and hence the finance of Australian lending overseas by borrowing, was not intended — it was thought that increased household saving through National Superannuation would allow the new overseas investments to be financed from domestic sources. As we have seen, bank mortgage lending negated the increase in saving expected from National Superannuation, resulting in values for overseas debt net of equity investment that are even more alarming than the EC indicator for net overseas borrowing. The indicator signals danger; we now find that the nation’s vulnerability has been enhanced by concentrating borrowing in the dangerous form of debt.
Official complacency (and panic)
The fact that the Australian authorities (chiefly the Commonwealth Treasury and the Reserve Bank) permitted the current-account deficit and the level of overseas indebtedness to rise to levels considered dangerous — not only by ageing Keynesian economists, but by the young post-Global Financial Crisis economists of the EC — does not mean that the authorities were totally unconcerned. In 1989, the Reserve Bank became so worried about the increase in overseas debt that it activated the one relevant power still in its hands following the neo-liberal reforms. It bolstered the increase in interest rates that was already underway as a market response to an increase in the current-account deficit, and so took responsibility for a recession that, after a couple of years, curbed imports sufficiently to reduce the three-year deficit to less than 4 per cent of GDP.
The recession ‘we had to have’ incidentally caused a plague of business failures, and the banks incurred such serious bad debts that two state banks received emergency assistance from their gov
ernments, and were in due course amalgamated with stronger banks. Two of the big four banks admitted to serious losses and, in the subsequent words of the then Commonwealth treasurer, were placed in a ‘sort of humidicrib for three or four years’ till they ‘got their balance sheets back together again’.5 Although some banks found themselves more seriously affected than others, all the banks rebuilt their balance sheets by exercising their deregulated freedom to increase transaction fees and widen the spread between borrowing and lending interest rates.6
If neo-liberal theory applied in the real world, the banks’ revenue from increased fees and widened interest-rate differentials would have been rapidly competed away by an inrush of new banks offering services at cost, but this simply did not happen. Banking in Australia, as elsewhere, is at best imperfectly competitive, if only because customers are locked in by the cost and inconvenience of transferring accounts from one bank to another. In the upshot, the banks survived the 1990 recession with the privileges of deregulation unchanged. The government of the day took the blame for the recession rather than the banks, which, by their over-lending and the related over-borrowing, had made the recession necessary.
The 1990 experience indicates that raising interest rates to bring on a recession is a blunt but effective mechanism, closely related to the increase in interest rates that accompanies a financial crisis; indeed, it is like control burning in the path of a bushfire, and amounts to fighting fire with fire in the hope that a precautionary recession will prove less costly than an uncontrolled Depression. It also constitutes an admission that the neo-liberal adjustment to balance-of-payments problems, via responses to changes in relative prices and the exchange rate, does not adequately control situations where a country’s banks have over-borrowed overseas. The 1990 recession was undeniably costly, and the fact that the government of the day bore the blame while the banks strengthened their political position will make future governments wary of taking similar action.