That the Australian economy may be in trouble will not be news to FT Alphaville readers.
We’ve been warning for a good while that the country is uniquely exposed to the commodity super-cycle, an overvalued currency, a real-estate bubble, not to mention the Chinese slowdown.
Yet what we may have overlooked is the remarkable similarity between Australia’s external finance position and that of the European periphery, a point now being made the analyst team at Variant Perception — a boutique research analysis shop.
It should be noted that Variant Perception believes a country’s external debt ratio and net international investment position (NIIP) are incredibly important, not to mention major factors in determining overall economic sustainability.
As they noted in a report entitled Australia: The Unlucky Country this week, the current metrics could leave the RBA with little choice but to go down the ECB route and cut interest rates, if not engage in liquidity operations outright:
The Australian banking system is highly reliant on external funding and will likely become dependent on the RBA for liquidity in the near future. Our view is that the RBA will have to become much more activist in supporting its major banks as the structural slowdown in China and the housing market continues.
We believe the RBA will ultimately be forced to take similar action to developed market central banks either by aggressively cutting interest rates or propping up banks through domestic open market operations akin to the liquidity injections seen by the ECB.
Quantitative easing is also a possibility if the RBA is forced to buy bank debt to try to stave off a financial crisis. Under such a scenario, the AUD would fall considerably.
The crisis-stricken economies along the eurozone periphery share one key characteristic: their external debt is too high and their net international investment position (NIIP) – measuring the difference in stock value between assets held abroad and asset held domestically by foreigners – is deeply negative. Yet, a closer look and you will find Australia and its neighbour New Zealand in the same company, with negative NIIP well above countries such as Turkey and Brazil.
Here’s the chart that emphasizes the NIIP point:
In short, Australia’s key Achilles heel may be its over-reliance on external funding — its total funding need from external sources currently standing at an “extraordinarily high” 40 per cent, according to VP.
All that said, it’s important to note that even if the metrics imply that Australia is in the same boat as some of the European periphery when it comes to external debt and exposure — there’s no denying that in reality it actually isn’t.
Unlike the ECB, the RBA still has full control of its balance sheet and currency, and has all the tools it needs to inject liquidity as well as to devalue the Australian dollar. More so, says VP, if there was a sudden shortage of dollar funding for Australian banks it is likely the Fed would step in with dollar swap lines, as it has done with the BoE and ECB.
Nevertheless, if the RBA does move to ease aggressively, there may be hugely important implications for global flows… best highlighted by the following chart which shows just how much money the country has managed to attract into its government debt market in the last few years alone:
In this scenario the government’s budget surplus kinda becomes irrelevant, largely because it does little to offset the wider real debt burden. As VP notes, it’s exactly the sort of situation we have seen in Spain:
But, even though the situation looks good optically, the fact of the matter is Australia would have to backstop its banks in the event of a crisis, and this low number masks the real debt burden. This is exactly what we have seen and are seeing with Spain, which is in the process socializing its financial sector’s debts. We remain of the view that rates in Australia will converge to the lower bound currently set by the rest of major central banks. This process has been progressing for the last 6m-12m and in our view it will continue.
And to sum up, this is why the country’s current account deficit makes a currency devaluation strategy in Australia an entirely different ball game to one in somewhere like Switzerland:
The strong AUD has raised the possibility that the RBA would follow in the footsteps of the Swiss National Bank (SNB) and enforce a ceiling on the currency to prevent it appreciating. This is very unlikely in our view.
Although the RBA is starting to show some concern over the strength of the currency – and while Australian government assets may certainly have been buoyed by global diversification out of euro assets (see below) – the situation in Switzerland is materially different. Switzerland has the biggest net foreign asset position in the world and a current account surplus at 14.3% of GDP. This represents a tremendous fundamental force for currency appreciation and it is no surprise that the SNB is having to pedal hard against the grain.
Conversely, Australia’s current account deficit coupled with a deeply negative net external debt position both provide strong fundamental impetus for currency weakening. Should the RBA want to engineer currency depreciation, lower interest rates are likely to be more than enough. Indeed, even if interest rates decline only gradually to reflect a structurally slowing economy there are plenty of fundamental reasons for the Australian dollar to weaken.
For more on Australia’s external debt plight, see the full report here.
BHP’s untimely dilemma – shrinking cash flows – FT Alphaville
Australia’s capex cliff – FT Alphaville
The Aussie dollar – from South Pacific peso to Southern franc – FT Alphaville
An AUD tale of correlation lost – FT Alphaville