by Peter Brain
# 4: A home-grown implosion of the banking sector
The risk of a home-grown implosion is reflected in Australia’s sustained violation of several of the EC indicators, notably private sector debt as a percentage of GDP. This weakness reflects decades of debt-based growth during which a large part of the new debt was used to finance house price increases and consumption.
Consider the following scenario. Currently, Australia is experiencing an apartment construction boom, with many of the apartments being bought by foreigners. The Australian banks are financing the developers who are building the dwellings. What will happen if the apartment building boom turns out to be a bubble, and apartment prices start to fall? There are plenty of precedents in other jurisdictions that have experienced over-heated property markets. If a substantial share of borrowers, foreign or domestic, fail to complete their purchases, either because they cannot arrange finance or because they face a capital loss of (say) 25–30 per cent on the original off-the-plan price, developer cash flow will dry up, and the Australian banks will face a serious bad-debt problem. In addition, falling apartment prices will generalise into falling house prices, forcing at least some recent buyers of new or established homes, including negatively geared investors, into loan default, with the possibility that the banks will not be able to recoup their loan from sale of the property at the new lower prices.
All this will undermine bank share prices. Given that bank shares are a major component of household wealth (particularly superannuation wealth), there will be a loss of consumer and business confidence, triggering a recession. The Reserve Bank will not be able to counter this recession by reducing interest rates as it has when similar threats have appeared in the past, due to the need to place a floor under the currency.
If the sequence of events stopped at this point, the resulting substantial reduction in the economic growth rate would take pressure off the current account and reduce the risk of a crisis. However, if the domestic loss of confidence widened into a general loss of foreign-investor confidence in the Australian economy and particularly in the banks (which collectively hold a significant share of Australia’s short-term international debt), catastrophe would ensue.
At this stage, we consider the risk of a home-grown banking-sector implosion to be restricted to that of a recession — indeed, a ‘recession we have to have’ to reduce the risk of a worse economic crisis.
# 5: A home-grown implosion from inappropriate domestic policies
The baseline projection assumes that the domestic policies which encourage debt accumulation and equity withdrawal by the household sector are continued, subject to the capacity of the household sector to absorb additional debt. During the hectic years of the urban land boom, 2001–07, Australia’s banks enlarged their balance sheets by lending to households and borrowing from overseas. This generated a boom in house prices, which increased household wealth and encouraged equity withdrawal and consumption. This consumption, whether directly debt-financed or financed simply by dipping into savings, reduced the household savings rate.
The land boom quietened after the GFC, and the average rate of growth of land prices declined to a mere 4.5 per cent a year. However, in 2014–15 it flipped upwards to 12.5 per cent (with the Sydney market much higher), reviving the folk memory of rapid capital gains on urban property. In the absence of deliberate policies to control this appetite, the current apartment boom can be interpreted as a revival, despite dangerously high household debt, of the land boom that did so much to weaken Australia’s financial position. The deregulation policies that permitted this boom remain in place.
Figure 4 shows that, over recent quarters, equity withdrawal by the household sector has trended back to 8 per cent of net household disposable income.2 This revival of equity withdrawal pushed the discretionary household-savings ratio below zero during the last two quarters of 2015.3 It can be seen from Figure 4 that in the early years of this century the discretionary-savings ratio reached significant negative levels that almost offset the compulsory savings made under national superannuation, so that the overall household-savings ratio fell nearly to zero. Over this period, the net stock of household debt rose rapidly to finance high housing prices and consumption expenditure. Our baseline scenario assumes that equity withdrawal as a percentage of net household disposable income will continue at close to current levels until stopped by a recession, which may be either policy-induced or market-driven.
Given that equity withdrawal is already included in the baseline scenario, what is the additional risk? The risk is that Australia’s monetary authorities, unhappy at the rise in unemployment as the mining boom subsides, will join their European and Japanese confrères, and reduce interest rates significantly below the levels prevailing in the baseline scenario in the hope of increasing the economic growth rate. This would be defensible policy in countries such as Germany and Japan, which have strong balances of payments, but if applied in Australia would encourage further equity withdrawal and a resulting increase in overseas debt. Such a policy move would be very dangerous.
Between the September quarter of 2013 and the December quarter of 2015, Australian household debt increased by 1.3 percentage points of GDP per quarter. On current trends, incorporated into the baseline projection, this results by the end of three years in the ratio of household debt to GDP increasing by a further 15 percentage points, with corresponding increases in the ratio of household-equity-withdrawal debt to GDP and the ratio of short-term foreign debt to GDP. The baseline scenario is already flagging disaster by showing a reduction in the year-ahead foreign-exchange-cover ratio, and interest-rate cuts would accelerate the process. At some point, either the international economic institutions, such as the IMF, or the rating agencies are going to declare this growth dynamic to be unsustainable and economically reckless.
The risk of additional inappropriate policy moves adds to the risks already present in the baseline scenario. Policies that ignore the balance-of-payments constraint to growth could so undermine international confidence in the competence of Australian government agencies as to trigger an uncontrollable fall in the Australian dollar, even if our two risk indicators remain below Code Red status. In this context, it could be argued that the Reserve Bank’s decision to lower interest rates in early May 2016 was an inappropriate policy response that increased the risk of crisis. The alternative assessment would regard it as a reasonable attempt to lower the exchange rate in the context of low inflation and low foreign interest rates.
Perhaps Australia’s monetary authorities are assuming that a continued tightening of macro prudential regulation will offset the encouragement this interest-rate cut gives to equity withdrawal. Maybe. However, if the Reserve Bank continues to cut interest rates, it will no longer be appropriate to ignore the risk of disaster due to additional equity withdrawal. Interest-rate announcements by the bank, federal budgets, and other policy responses will be important in determining how this risk is incorporated into our analysis over the next few quarters. At this stage, we have made no allowance for this risk.
Figure 4: Household equity withdrawal and discretionary net savings
# 6: A drought
A severe drought has the potential to increase the Australian balance-of-payments current-account deficit by between one and two percentage points of GDP. Although this would be a temporary impact, if it came at the wrong time it might prove to be the straw that broke the camel’s back, and tip the economy into catastrophe. The 2016 El Niño did not, as would be normally be expected, create a severe drought, thanks to offsetting changes in the Indian Ocean and the Southern Ocean. However, a severe drought is quite likely some time over the next five years, and in all probability will come at the wrong time, closer to 2021 than 2016. At this stage, no allowance has been made for this risk.
# 7: An additional negative terms-of-trade shock
The strategic risk of a second GFC (risk # 2, above) ha
s negative implications for Australia, since any increase in financial volatility will reduce commodity prices and the terms of trade. This is not the only risk to Australia’s terms of trade, which are by no means guaranteed even if the world avoids further generalised financial crises. Is it likely that, even if financial stability is maintained, trends in the world economy will depress Australia’s terms of trade to crisis point? The answer is that a decline in the Australian terms of trade by a further 15 to 20 per cent from the current level (which is assumed in the baseline projection) is far from inconceivable, since it would merely return trade to its level before the mining boom. If a decline of this magnitude were to be sustained over a number of quarters during the early 2020s, the exchange rate would fall to around 55 US cents to the Australian dollar on a sustained basis, with similar falls in the weighted average exchange rate against other currencies. We have published an analysis of this possibility for the early 2020s. In this scenario, the crisis-risk indicator would take on Code Red values.2
A return of the terms of trade to its level before the mining boom would put the Australian economy on a knife edge. More generally, any additional risks beyond those incorporated into the baseline scenario that would have adverse consequences for the world economic growth rate or direct commodity-price impacts would have the potential to upset the Australian economy. Such items include threats such as an accelerated coal-market slump related to climate-change policies, an LNG export slump related to accelerated expansion of the United States LNG industry, and general export sluggishness due to protectionist trends in the world economy. There are also, of course, upside risks. It is, for example, possible that the major countries will get together to implement a co-ordinated fiscal expansion that will raise the world growth rate; it is also possible that they may get together to implement polices to attain the goals agreed at the 2015 Paris conference on climate change in a way that creates opportunities for Australia.
Ultimately, the way in which the risks and opportunities arising in the world economy affect Australia depends on whether the national leadership is able to give plausible answers to two questions: where will Australian net trade growth come from after 2020?; and will it enable Australia’s foreign-debt obligations and interest costs to be serviced at economic-growth rates that satisfy the aspirations of the Australian people?
The answers to these questions will depend partly on the international environment, but also on the credibility of Australian economic policy as it evolves over the next three years.
The revised baseline scenario incorporating strategic risks
Our list of strategic risks omitted from the baseline scenario leaves the most serious to a further chapter, assigns probabilities of occurrence to two of them, and recommends a watching brief for the rest. The two to which we have assigned probabilities are the risk of world economic instability and the risk of a decline in Australian sales to China. We have revised the baseline scenario to incorporate these two risks and made consequent adjustments to Australia’s risk rating.
The revised projection upgrades Australia’s projected risk rating as assessed by the year-ahead foreign-exchange cover to a 60 per cent chance of extreme status for four or more quarters over the five years from 2016 to 2021. However, the probability that the warning will reach Code Red status is only 10 per cent. The level of warning as assessed by the crisis-risk indicator likewise rises to a 66 per cent chance of a severe rating over four or more quarters, with an approximately 25 per cent chance that an extreme rating will be awarded over four or more quarters.
It is clear from this analysis that, while neither indicator reaches Code Red status in our revised projection, the economy will be teetering on the edge of Code Red, particularly in 2020 and 2021 — and, on unchanged policies, thereafter. The danger of economic crisis in these years will be heightened if the upward adjustment of United States’ interest rates is delayed and the implications of this for world economic stability are likewise delayed. It would therefore be wise to plan on the basis that Australia has about two years to implement the policy measures required to avoid catastrophe.
Such planning is particularly important in an economy that is approaching Code Red status, because international assessment of the quality of public administration and planning contributes to investor willingness to finance debt. As noted above, economic policies that are judged to threaten the capacity to service overseas debt are likely to hasten a crisis. On the other hand, even if the crisis indicator deteriorates sharply towards Code Red status, a crisis could still be avoided if foreign investors believed that policies were in place to substantially reduce the threat of default by rapidly increasing the contribution of net trade to Australia’s economic growth on a sustained basis.
Conclusion
To summarise, based on recent studies of the antecedents of economic catastrophes related to over-borrowing, we have identified two key warning indicators: the year-ahead foreign-exchange-cover ratio and a compound macroeconomic-crisis indicator. These indicators can be treated like bushfire warnings. The risk of economic conflagration arising from over-borrowing overseas can be rated, and alerts can be issued based on the estimated probability that a crisis will occur within the next five years. In October 2016, assuming that the world economy would follow existing trends, we calculated four values for each indicator. These were:
The current value;
The expected value in five years’ time, according to current official projections of the Australian economy (slightly adjusted downwards to adjust for what National Economics regards as undue optimism about export growth);
The expected value in five years’ time if the official projections are further adjusted downwards to take major risks into account (which we regard as the most likely and prudent projection); and
An assessment of the effect of current policies on indicator values.
The results are provided in Table A. We intend to publish quarterly updates of this table on the National Economics website, nieir.com.au.
Table A: National Economics Catastrophe Alert indicators, values at mid-2016
Indicator
Current alert value
Alert value in 2021: official projection
Alert value in 2021, prudent projection
Policy alert
Year-ahead foreign exchange cover
Moderate
Severe
Extreme
Code Red
Crisis indicator
High
High
Severe
Code Red
Political events overseas during the latter part of 2016 have changed these assessments, and their repercussions will cause further changes as they unfold. In the next chapter we assess the effects of the political events of 2016 as they affect National Economics’ catastrophe-alert indicator values for mid-2017.
7
Neo-liberalism comes full circle
In democracies, the quality of political leadership has two main components: the quality of the policy platforms endorsed by the electorate when it elects a national government, and the personal characteristics of the leadership group elected to national government, such as their competence, experience, and capacity for rational and competent judgement when negotiating trade-offs and deciding complex policy issues. Above all, it is important for the government to avoid corruption and to have the capacity and the willingness to act in the national interest, as distinct from the interests of those who contribute to its political funding, whether by way of bribes or party contributions.
In this chapter, we
address the first component. In particular, we consider the party platforms put before the American electorate in November 2016, and argue that the Washington Consensus, which was implemented in the 1980s in both the United States and the United Kingdom, has now generated political dysfunction as true believers in the neo-liberal faith face an unco-ordinated array of critics.
More than three decades have passed since Washington Consensus policies were implemented with great elan in the United States by Ronald Reagan, a Republican president, and in the United Kingdom by Margaret Thatcher, a Conservative prime minister. Over the following three decades, disposable incomes at the top end of the income scale surged upwards, but the incomes of the majority of the population stagnated. As a Republican, the new United States president, Donald Trump, finds himself suspended between a party establishment that has greatly benefited from the Washington Consensus and a public that has not.
There is a cynicism abroad, related to the increase in economic inequality, or at least to the gulf between promises of economic growth and the actual experience of people of average income. Three decades of neo-liberalism have generated a social malaise that is not yet fully understood. Is it simply disappointed economic expectations — underemployment, unaffordable housing? Or does it go deeper, to the loss of egalitarianism as the economic elite retreat behind their sense of superior entitlement and condescend to all the rest? Is it the loss of trust as people realise that their bank manager has become a salesman? Or is it, maybe, a loss of identity as traditional social institutions such as churches, general stores, and country pubs close, each in their own way losing out to market competition?