by Peter Brain
As the vulnerability of the Australian economy increases, we expect that the hedging ratio, both measured and unmeasured, will decline back to its historical norm. By 2021, we assume that it will fall back to 25 per cent, even if the ratio of short-term foreign lending to total foreign lending remains close to its current level.
The year-ahead foreign-exchange-cover ratio
These data on the borrowing requirement can, alternatively, be presented as the year-ahead foreign-exchange-cover ratio, defined as the ratio of effective reserves to short-term obligations. The numerator of this ratio, effective reserves, is defined as total official foreign-exchange reserves, plus short-term foreign lending multiplied by the national hedging ratio. The denominator, short-term obligations, comprises gross short-term foreign debt plus the year-ahead current account deficit (taken to be four times the current quarter current-account deficit). This ratio is also profiled in Figure 2. In 2015, it averaged 0.33, implying that if foreign investors refused to roll over any short-term debt and lend any new debt to finance the current account deficit, Australia would last four months before being forced to default. This represents a considerable improvement from the value of 0.18 (two months) experienced in the immediate aftermath of the 2008 GFC. Indeed, the values of 0.17 to 0.19 experienced in 2000–01 and again in 2008 identify periods when the Australian exchange rate came under considerable downward pressure.
Australia has been able to improve its foreign-exchange-cover ratio over recent years because relatively low current-account deficits have been accompanied by a reduction in capital outflow relative to GDP. An influx of foreign funds to purchase Australian dwelling and farm assets may also have played a role. However, the end of the mining boom and the recent adverse movement in the terms of trade are likely to bring a return to high current-account deficits and capital outflows, which will push the foreign-exchange-cover ratio back towards 0.20 by 2018. If high current-account deficits and capital outflows continue after this (as they will, if policies remain unchanged), the ratio will keep on declining and so increasingly warn of economic crisis.
We now turn to the other side of crisis prediction, that reflecting the capacity of an economy to generate macroeconomic indicators that maintain confidence in its ability to repay its creditors. Though defensive reserves are important, the fundamental causes of financial crises go deeper. We have already summarised the recent work by the European Commission on the antecedents of national financial catastrophes. Similar studies have been published by the IMF and others, generating a literature on the indicators of impending catastrophe that is of compelling interest to international lenders.
Because each crisis is a tumultuous, unique event, there is no set path to calamity. There is no combination of indicator values that guarantees a catastrophe — just as no combination short of the complete avoidance of overseas borrowing guarantees immunity. However, based on recent experience, it is possible to estimate the probability that a crisis will occur. In our work, we have developed a summary indicator of Australia’s vulnerability to a crisis arising from excess debt. This crisis-risk indicator extends the EC approach; it is an index of macroeconomic indicators with a proven relationship to the risk of catastrophe. It provides a second indicator of vulnerability, alongside the year-ahead foreign-exchange-cover ratio.
Crisis risk assessed from macroeconomic indicators
We have already considered the EC list of macroeconomic indicators of vulnerability to crisis and concluded that, for Australia, the risk arises chiefly because of its excessive overseas borrowing. We accordingly concentrate on this aspect of macroeconomic risk, building on a model developed by Luis Catao and Gian Milesi-Ferretti of the IMF.2 We have applied this reasoning to Australia’s position, developing the model documented in the report Carbon crisis: systemic risk of carbon emission liabilities, prepared by National Economics for Beyond Zero Emissions, and published in December 2014. This report includes the impact of an externally imposed carbon price shock along with other negative shocks on the Australian economy, including the shocks considered below. The model was developed to summarise the experience of medium-sized economies with significant overseas debt, including all such countries that have experienced economic catastrophe over the past four decades. Our analysis excludes small economies since they are not likely to be relevant to the Australian case.
Harkening back to the European Commission scorecard, the IMF identified seven indicators that influence the probability of an economic conflagration. They were:
The stock of gross foreign debt to GDP;
The flow of gross foreign borrowing to GDP;
The balance-of-payments current-account deficit as a percentage of GDP;
Nominal GDP per capita in US dollars relative to the United States;
World financial-market volatility as measured by the VIX index of the Chicago Board Options Exchange;
The stock of foreign-exchange reserves as a percentage of GDP; and
The market exchange rate relative to the purchasing-power-parity (PPP) rate.
We have incorporated these indicators into an index of the risk of an Australian economic crisis using weights estimated from data for all relevant countries over the period from 1970 to 2011. The higher the indicator value, the greater the level of risk. As shown in Figure 3, the average risk-indicator value for the period was 0.52, with the years of highest risk being 1986 at 0.74 and 2000 to 2001 at around 0.72. In 2011, the risk of crisis abated to a low level. However, after 2013, with the winding down of the mining boom, the fall in commodity prices, and a downward adjustment in the exchange rate, the risk indicator increased rapidly and is now back to its average value for the period since 1970.
Figure 3: Australian systemic crisis risk indicator from 1970 to 2015
The critical question is: what is the threshold value of this risk indicator at which a crisis is likely?
The warning codes
Our two indicators — the year-ahead foreign-exchange-cover ratio and the macroeconomic crisis-risk indicator — are not independent, if only because reserves of foreign exchange fluctuate with macroeconomic flows across the balance of payments. However, the two indicators are sufficiently different in derivation and implication to justify separate treatment. Both should be treated as warnings. It is therefore appropriate that they should be interpreted in a way similar to bushfire warnings.
Bushfires are similar to financial catastrophes, not only because they are highly destructive. For both, it is possible on the basis of past experience to estimate the imminence of catastrophe, whether or not it actually occurs in any particular case. Like the indicators of the danger of bushfire (temperature, wind speed, and the like), the signals of impending financial collapse can be summarised into numerical values that can in turn be converted into warning codes such as those issued by the Victorian Country Fire Authority (CFA). The major difference is that fire warnings refer to the need to take action to escape from wildfire any time within the next few hours or days, whereas our alerts refer to the need to take drastic action to escape from financial conflagration within the next few months or years.
The CFA codes range from low through moderate to high, very high, severe, and extreme, to Code Red. These same codes can be applied to describe the risk of financial collapse as measured by our two indicators. Like bushfire warnings, the ratings are strongly based in historical experience — in this case, the historical record of the events leading up to economic conflagrations overseas, coupled with the historical record of Australia in avoiding such conflagrations since the 1930s. However, again like bushfire warnings, they are subject to uncertainty. It is inevitable that an element of personal judgement will enter into the assessments of probability, though we have tried to be conservative.
The codes have been calibrated so that Code Red status means that, unless immediate evasive action is undertaken, the probability of an economi
c catastrophe within the next five years is 50 per cent or more. As with bushfires that, due to carelessness or unusual circumstances, can still occur at times of low or moderate danger, so also with economic catastrophes: a low or moderate warning code means that catastrophe is still possible within the next five years, but its likelihood is rated at 15 per cent or less.
Calibrating the year-ahead foreign-exchange-cover indicator
Armed with this rating system, we now provide a more detailed description of the two summary crisis-predictor indicators, starting with the capacity to ward off a crisis.
The year-ahead foreign-exchange-cover ratio incorporates the same data as the net annual borrowing-requirement ratio, but is expressed in a way that allows easier interpretation. In this form, it provides the basis for bushfire-code warnings. The codes allocated are based on evidence from the historical record that the exchange rate comes under particular pressure (relative to its purchasing-power-parity value, which in 2016 was 69 cents to the US dollar) when the year-ahead foreign-exchange-cover ratio is in the 0.16 to 0.20 range. Code Red status, when a crisis should be expected with a 50 per cent probability or more, is set at a cover ratio of less than 0.12, or less than six weeks of annual cover in the event of a total refusal by overseas investors to finance Australia’s short-term debt rollover requirements, plus the new debt required to finance the current-account deficit. Those familiar with the bushfire warning system will know that Code Red means ‘Get away, and fast.’ In the present context, it means that economic conflagration is not far short of unavoidable, so hold on tight for a crisis that will destroy the financial structure of the economy and much else besides. After the conflagration, the country may be given a period of grace to reconstruct from whatever foundations it has left, or may be effectively taken over by administrators acting in the interests of financial institutions overseas.
Short of Code Red, the bushfire warnings include various options to ‘stay and defend’. The analogy in the present context is that at high or even severe levels of warning, there is room for disaster-avoidance policies. The worse the assessment, the greater is the need for such policies.
At the 2016 value of the ratio of 0.33, we categorise the risk as moderate; that is, we judge that Australia is not seriously at risk of an economic crisis within the next five years. However, the historical record shows that such a risk can increase sharply. During 2000, the risk was classified as severe, as it was again in 2008. It remained very high during 2009 and to the end of 2011. The present respite from risk may prove to be merely temporary — a matter to be considered below.
Calibrating the macroeconomic-crisis indicator
We have calibrated the macroeconomic-crisis indicator by analysing the impact of different threshold levels, offsetting the cases where the indicator correctly predicted a crisis against the cases where a crisis was predicted and did not eventuate, taking the experience of all indebted medium-sized countries into account. Historical experience thus analysed indicated that Code Red status is reached when the crisis-risk indicator attains a value of 0.84. The historic record provides instances of countries where the crisis-risk indicator has exceeded this value for a year or so without disaster ensuing, and similarly there have been instances where disaster has occurred at lower levels of the indicator, but 0.84 represents the value where economic conflagration becomes more likely than not.
More technically, at a threshold of 0.84 the number of crises correctly called is 26 out of the 39 crises that occurred in the estimation database, so that the estimated model correctly called two-thirds of the total. However, at this probability threshold the model incorrectly called 101 crises that did not occur, in many cases because the government concerned took evasive action. Higher threshold levels would increase not only the correct call rate but also the incorrect call rate, and vice versa. The 0.84 threshold is accordingly a compromise that produces similar performance standards to those found in other crisis-prediction models. Code Red status occurs when the crisis-risk indicator exceeds this threshold level for more than four consecutive quarters.
It should be noted that the data in Figure 3 is in annual terms and, therefore, the 2008 estimate of 0.6 is affected by quarterly averaging. There were days during the December quarter of 2008 when the exchange rate was very low compared to the rest of the year and the crisis-risk indicator would have been approaching its threshold value of 0.84. The high-risk years during the period for which data is available were 1986–1987 and 2000–2001, both occasions when the exchange rate was low.
Unlike our other indicator, the year-ahead foreign-exchange-cover ratio, a fall in the exchange rate directly increases the value of the cash-flow crisis-risk indicator, because it reduces the US dollar value of Australian GDP. A fall in the exchange rate also indirectly increases risk via its impact on the value of foreign debt and any negative so-called J-curve effects on the balance-of-payments current-account deficit.
From this perspective, the two indicators complement each other, with each emphasising a different set of factors critical in determining whether or not a crisis will occur. The crisis-risk indicator captures the risk of a crisis from an uncontrollable fall in the exchange rate such as can result from a sudden loss of confidence. The cover-ratio indicator simply measures the obvious: if a country does not have sufficient resources to meet its obligations, a crisis will occur unless its resources are somehow augmented.
According to the crisis-risk indicator, from 2010 to 2014, when the Australian exchange rate was significantly over-valued compared to its PPP value, the risk of a crisis was low. Given the value of the indicator at the end of 2015 of 0.51, the Australian crisis-risk ratio had risen to high, having been low in the December quarter of 2014. These ratings concur with the year-ahead foreign-exchange-cover ratio in concluding that in 2016 the chance of economic crisis was high but not yet severe, but the trend was adverse. As the bushfire warning system indicates, Australia has the opportunity to take evasive action, and the breathing-time to do so.
But how much breathing-time? This raises the question of the values of the indicators over the next five years.
6
Crisis vulnerability over the next decade
To answer the question of how long Australia has to set its house in order so as to avoid catastrophe, we first developed a baseline projection of the Australian economy closely related to current official projections, and then adjusted this projection to incorporate plausible additional risk factors omitted from the official forecasts. We have set this out in the course of two chapters: in this chapter, we describe the position around September 2016, and in Chapter 7 we update the outlook as of November 2016. We then re-calculate the vulnerability indicators to the values implied by the revised projections.
The baseline (no shocks) projection
Our baseline projection with no (negative) shocks is a little more pessimistic than the projection outlined in the Commonwealth budget of 2016–17. (The projection may be viewed on the National Institute of Economic and Industry Research’s website.) In this scenario, world growth is maintained at near-current low (by historical standards) levels of just under 3 per cent per annum. Domestic interest rates rise and the gap with United States interest rates widens. Debt constraints are projected to limit private consumption growth. The terms of trade outcomes, at least to 2018–19, are similar, with little change from current levels. However, contra to the federal government’s budget projection, in the baseline projection the balance-of-payments current-account deficit fails to fall below 4 per cent of GDP in 2018–19. This is because our baseline projection incorporates a more pessimistic outlook for import growth that takes into account the continuing impact of the hollowing-out of the manufacturing sector due to the high exchange rates of 2011–14, including the full closure of the motor vehicle industry. This divergence removes a little optimism from the official projection, but not much; the two projections are similar.
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The federal government budget projection does not include debt indicators, but these are not difficult to fill in. The ratio of gross foreign debt to GDP has been rising rapidly since 2013 as the exchange rate has fallen. In fiscal year 2013, it was 96 per cent of GDP, and in 2016 it was estimated to reach 131 per cent. The return of high current-account deficits and further falls in the currency will push the gross-foreign-debt-to-GDP ratio to 144 per cent of GDP by 2018. With capital outflow stable and the $A/$US exchange rate stable at 66 cents after 2018, the gross-foreign-debt-to-GDP ratio rises in line with the current-account deficit to reach 154 per cent of GDP by 2021. (A reminder: the current-account deficit arises from the balance of payments, and is not to be confused with a budget deficit.)
These sustained high current-account deficits increase the risk premium of lending to the Australian economy, which increases Australian interest rates relative to the rest of the world, reduces the average period before loans mature, and also reduces the proportion of lending denominated in Australian currency. These adverse trends are temporarily offset by a number of factors that are at present working to reduce the deficit, which is accordingly less than might have been expected from the recent plunge in the terms of trade. These factors include:
The fall-off in imports associated with the fall in mining investment (the import content of mining projects such as liquefied natural gas (LNG) plants was particularly high);
The increased quantity of exports over the next two years associated with the completion of mining projects (particularly LNG projects); and
A substantial build-up of net-foreign-equity assets.
Reinforcing these factors, at the end of 2016 the Australian terms of trade revived due to a rally in commodity prices. However, the rally was expected to be temporary — at the beginning of 2017, the forward price of iron ore for the early 2020s was US$46 a tonne, which was not much more than half its current level.