Australia’s Debt Dreamtime

18 Dec

Mark McGovern of the Queensland University of Technology’s Business School recently had a paper published in the peer-reviewed free online journal Economic Analysis and Policy.

It is entitled Beyond the Australian Debt Dreamtime: Recognising Imbalances, and is well worth a read. Only 24 pages.

For those not sufficiently motivated, here’s the Abstract (emphasis added)

Sadly, all the efforts of a generation of Australian men and women have only made them more indebted to the rest of the world. Australia’s external net wealth is negative, soon passing minus $900b on an accelerating downward trajectory. This ongoing dissipation of national resources is unsustainable. Australians live in a debt dreamtime, one from which the rest of the world has been rudely awakened. After years of inadequate policies, the nation has a large external debt and significant government exposures. Servicing pressures are growing as rising uncertainties permeate global credit markets. Reserve Bank policies are worsening Australia’s external position and needlessly driving up internal costs. Major policy rethinking is warranted. Relevant issues are still little considered, crowded out of dialogues by comforting myths that accompany the Australian Debt Dreamtime. Imbalances need proper recognition with new approaches and strategies developed. Automatic corrections will not occur as history and current overseas experiences demonstrate. A real awakening, improved positioning and a touch of luck are required if Australians are to avoid being seriously impoverished by world events and their own confused Dreaming.

Got your attention now?

Good.

Here’s some more selected quotations (bold emphasis is mine, italics and underline in author’s original):

Rising problems have gone addressed because current preferences ignore them. Australians and their policy makers need to wake from their economic and financial dreams before they stumble into an economic crisis.

The net external wealth of Australia has deteriorated across the generation (McGovern 2010b, from which Figure 1 is drawn). Calculation of external wealth is based upon cumulative financial surpluses from an essentially zero basis in 1960. As is evident, Australia has been increasingly building external liabilities. A particularly marked decline has occurred over the last decade resulting in a total external exposure of $820b as at June 2010 with an annual deterioration of over $50b.

Click to enlarge

The central conclusion is stark: all the efforts of a generation of Australian men and women have only made them more obligated to the rest of the world. All that reform, all those industry and government initiatives, all those strategies, all that talk of productivity, all the promises of a previous boom in mining – all have come to naught. Today, we stride the world stage with external debts and other net liabilities above seventy percent of GDP, and increasing. Unaddressed, this is a precursor for crisis…

Manasse and Roubini (2005) empirically explore past crisis experiences to investigate “the set of economic and political conditions that are associated with a likely occurrence of a sovereign debt crisis”. They derive rules of thumb for likely default. Their schema is applied to Australia as shown in Figure 2. Importantly, Australian external obligations are largely held privately so at face value the sovereign appears little exposed externally. Importantly also, these are held in Australian dollars. However, the sheer bulk of obligations held by banks deemed “too big to fail” in the Australian context, the sizeable Commonwealth, State and local government debts (Section IV), the uncertainties of currency regimes, the indirect sourcing of some monies and the existence of various guarantees and understandings drive de facto and potential de jure exposures.

It is just this uncertainty about “who bears which risks” and “who guarantees whom” that has made resolution of existing crises so difficult, and the escalation of some crises so rapid and devastating. Just ask the Indonesians, Icelanders, Irish and Italians – amongst many. In the long history of defaults, there were 48 sovereign defaults between 1976 and 1989 and 16 more from 1998 to 2002 (Feenstra and Taylor 2011, p. 864) but virtually none between 1950 and 1970…

This is precisely what your humble blogger has long argued.

That for all the reassuring rhetoric from Goose (and assorted singing-for-their-supper, vested-interest economists) about how our debt is nothing to worry about, the truth is this. Their constant references to our “comparatively” “low” public debt “as a percentage of GDP”, is a red herring to distract our attention.  The real risk lies hidden just below the surface.

The real risk is in the liabilities of our banking system.

Which the Labor government has guaranteed.

From this perspective the Australian governments are currently not crisis prone. They do have three vulnerabilities. External financing and public external debt to revenue ratios currently appear well under posited trigger points but this could change rapidly with adverse global conditions, unsupportable interest positions or local bank fund-raising failures

Events in Europe have shown how quickly and broadly crises can build. It was only two years ago that the European Commission praised Italy, including its “greater resilience to external shocks”. Now Italy is under administration with no politician in the new cabinet (Squires 2011) as, in PM Monti’s words, this “will remove one ground for disagreement”. How the government of Italy is for Italy will be revealed in the days to come. There is much to ponder in current developments, and lessons for Australia.

Of particular interest to your humble blogger is the following excerpt concerning the long run effects of so-called trade “liberalisation” on Australia’s ever-deteriorating external wealth situation.

Mr McGovern’s words here, along with his chart above, should be slapped in the face of every “free trade” spruiking clown who arrogantly criticises Barnaby Joyce (and indeed, Bob Katter), for their so-called “protectionist” views on trade. In so doing, they act as blissfully ignorant mouthpieces and sloganeers for the internationalist banksters behind the “globalisation” movement:

… the stunning thing about Australian External Wealth (Figure 1) is that we have now being waiting for some thirty year for payoffs from hosting visiting funds and investments yet the position is, if anything, deteriorating more rapidly. More tellingly, the most optimistic figures about the current boom do not adequately address Australia’s External Wealth/Obligations problem… Dreaming of resurrecting Doha or of Trans-Pacific Partnerships introduces nothing new, and some fundamental changes are now of the essence. While political exaggerations from “delighted” and “excited” Ministers are understandable, the proper response by the governments of Australia is to demonstrate how mooted changes will be good for Australia, specifically in rectifying Australian external imbalances.

Put bluntly, Australia’s external position deteriorated as trade liberalisation advanced so any net opportunities that may have been on offer were not realised. Why should the impacts of any further liberalisations been any different? When Finance Ministers agree that across APEC “growth and job creation have weakened, inflation remains elevated [and] Capital flow volatility has intensified in response to heightened risk aversion” (APEC 2011), proponents need to demonstrate with convincing evidence how proposals will reduce risks and rectify problems in the current environment and going forward. More of the same is not an answer.

Indeed.

McGovern has an entire section devoted to interest rates, and their real impacts on investment, growth, and imbalances in our economy. It’s excellent.

In a nutshell, he demonstrates that compared with the rest of the world Australians are being shafted; that RBA interest rate policy not only does not achieve its purported aims (inflation targeting, stable currency) but actually contributes to the further impoverishing of Australians through their paying higher than necessary interest rates on loans, and, the encouragement of the international currency “carry trade” which results in windfall profits for bankers through financing asset bubbles here … like the housing bubble … which must eventually burst:

Australians have been paying historically high real interest rates for some decades now. The interest-only component of a 30-year loan has been steadily rising, from zero in real terms for loans terminating around 1980 to five-and-a-half percent for those terminating today (McGovern 2010a). Meanwhile, real growth rates in Australia and around the world have been declining.

Indeed … just as we saw in our recent debunking of Wayne’s/Treasury’s still ridiculous “growth” forecasts in the MYEFO:

Click to enlarge

Back to McGovern:

Arguably, in recent decades the reliance on interest rate movements in inflation targeting along with an insensitive allocation of rates across investment classes have compounded problems and raised investment risk while doing little for inflation objectives. Clearly this challenges current conventions in Australia, and elsewhere, but an argument needs to be had. Reserve Bank of Australia decisions of interest rates may be well be worsening not only Australian competitiveness (since investment becomes markedly more expensive and unattractive as next discussed) but also its external position (as then discussed).

High Australian interest rates also impact on Australia via the carry trade. While the potential profits from this are recognised (making even the textbooks, Feenstra and Taylor 2008), the impacts on domestic monies are less appreciated. Monies that flow into a nation’s currency pool may well be utilised within the nation by eager lenders sitting on these substantial deposits… there is a marked and little monitored (let alone regulated) increase in the quantity of money in circulation. It is then but a short step to an asset bubble, particularly in investments such as housing which are deemed “prime” by distant institutions.

The possibility that actions by the Reserve Bank in Australia may be worsening the external situation in a variety of ways needs to be investigated further.

I’ve said it before. It bears repeating.

Abolish the RBA!

And with it, the $1 million salaries of “public servants” like RBA Governor Stevens.

Moving on from trade and interest rates, what does McGovern have to say about The Situations Of Australian Governments? His opening paragraph is a beauty:

It is fascinating that Government financial situations were not assessed in either Henry (2010) or in the lead up to the Tax Forum (Commonwealth Treasury 2011). Instead the focus has essentially settled on who to tax more, and the purported efficiencies of different ways to do it. Why there is a need for governments to raise more tax goes unaddressed, as do other relevant considerations. Such myopia appears to be risky and, probably, dangerous.

Indeed. His comments about the state governments are particularly interesting:

The Commonwealth has a stated net exposure of $124b as at June 30 2010 (with an additional $67b in liabilities taken on in the following year). The States generally appear close to financial balance. However, those States using Treasury Corporation are on-lending to their various agencies with high interest repayments expected in return. Rising utility service prices, for example, appear influenced by high bond servicing costs, an issue not commonly recognized. Inflationary effects result.

There you have it folks. State government borrowings, on-lent at high interest rates to state government “agencies”, are driving up your electricity and water charges.

Again these figures need further elaboration but observations include:

•    the singularly high net exposure of the Commonwealth;
•    that bonds and notes totaled around $340b or over 25 percent of current GDP across all governments with an annual interest expense of $17.6b;
•    that the net exposure (Assets less Liabilities) is around 10 percent of GDP;
•    that the liquidity of underlying Assets is unclear, as is the appropriateness of booked valuations;
•    the stated interest repayments for Queensland and NSW are particularly high (with deducible interest rates of 6.9 and 5.3 percent respectively) compared to Victoria (around 4.7 percent) and the Commonwealth (4.0 percent);
•    Queensland has assets (and liabilities) valued markedly more than those of New South Wales and Victoria;
•    that more adequate, consistent and complete reports are needed.

Queensland which is not projecting a surplus (of $0.1b) across the general government sector until 2015- 16 increased its debt by $4.2b in the last year. It is planning to continue capital investments of over $10b annually for some years (Queensland Treasury Corporation 2011a). Why State debt more than doubled in four years, from $32.1b in 2006-07 to $73.1b in 2010-11, despite around $15b from asset sales (ibid) is an unexplained mystery, as is the lack of discussion of such a significant increase in exposure while global conditions were deteriorating markedly.

Queensland state debt only doubled in four years?

Amateurs.

Federal Labor have more than quadrupled Commonwealth government debt in four years.  From just over $50b when they came to office in Nov 2007, to over $223b today.

Back to McGovern:

Which of the challenges raised by Moody’s in 2009 have been adequately addressed, in Queensland and elsewhere?

The [Queensland] downgrade reflects the state’s deteriorating financial and debt performance and the absence of a medium-term strategy that would over time restore budgetary performance and financial flexibility… the state is expected to produce a series of very large, recurring deficits. The widening budget gaps and the resulting additional borrowing that is being projected place the state on a debt trajectory that is no longer consistent with Aaa debt metrics. Additional budgetary pressures could emerge should economic growth be slower than currently anticipated. Queensland’s financial performance is also expected to be challenged by the difficulties in reducing operating spending following a period of accelerated growth.” (Moody’s Investor Services 2009).

It is clear that not only are liabilities, specifically debts, high. In terms of the presented accounts, assets appear to reasonably match liabilities given current valuations. If so, any anticipated problems would be ones of liquidity rather than solvency. That is, the central problem is one of achieving appropriate flows of revenues and payments while maintaining (or perhaps improving upon) the stock situation.

If however, assets were not realizable at the stated values then solvency problems can arise. As evident in Europe, one response is partial or full default on obligations.

If interest rates rise (strongly), then liabilities may escalate (markedly) due to the exposures and linkages demonstrated earlier…

If a debt-deflation were to occur then the States could be quickly squeezed as asset values fall while liabilities at least remain.

Note that well.

What McGovern is arguing is that it is the state government balance sheets that pose a risk. That’s important, as you will see in a moment.

Finally, some pertinent remarks from the paper’s conclusion, entitled Up A Gumtree In A Bushfire? The Australian Dilemma:

As the fires feeding on years of lush credit growth rage in many parts of the world, Australia has been so far only a little affected. Significant exposures exist, however, and these need to be assessed and redressed. While no one can know just what blazes will break out next or where, prudence mandates risk assessments, readiness, firebreaks and controlled burns. Recovery is much more expensive after an unanticipated fire, and some losses are never really replaced. As even Kunbul knows, this is not a time to be dreaming up a gum tree.

Current external policies favour a major expansion of mining to lead export growth. However, the current mining sector would need to roughly double its exports for Australia to stand still externally. It is not only the trade balance that has to be rectified but also the net factor income outflows. Given that mining is focused in three States that already have high public liabilities, funding further infrastructure becomes even more problematic.

Superficially the Governments of Australia appear in a reasonable position when compared to much of the world. Servicing of obligations appear problematic, however, even under optimistic scenarios. Closer investigations of positions is clearly warranted. This initial review has revealed significant potential vulnerabilities. Adverse conditions externally could lead to a rapid deterioration due to refinancing risks while recession would reduce the ability to raise sufficient net revenues to service existing obligations.

Reduced ability to “service existing obligations”, eh?

What was it exactly that Senator Joyce warned of in 2009-10?

What was it that unleashed all the verbal fire and brimstone that cost Barnaby his new job?

What exactly did he say that so angered the Labor government, then Treasury secretary Ken Henry, and all the “leading” talking head economists in the land?

No, it was not just his warning about the dangers of the ever rising US debt level.

It was his warning about Australia, and the vulnerability of the state governments’ finances, that really fired them up.

From the Sydney Morning Herald, 11 December 2009:

Senator Joyce told the Herald yesterday he did not mean to alarm the public but there needed to be a debate about Australia’s ”contingency plan” for a sovereign debt default by the US or even by a local state government

He said the Federal Government’s debt would push up interest rates and predicted that some state Labor governments would not be able to repay their borrowings.

”The Federal Government has $115.7 billion in debt, Australian government securities, notes and bonds on issue, and the states have another $170 billion in debt.

We have to ask whether the states have the capacity to repay that. I would say in some instances they do not, particularly Queensland.”

And from The Age, 11 December 2009:

Senior government figures have taken aim at Barnaby Joyce’s dire warning about a global financial meltdown if the United States government defaults on its debt. Mr Joyce also came under fire for comments about the financial health of Australian states.

”That’s shooting from the lip, making it up on the run,” Prime Minister Kevin Rudd said of the new opposition finance spokesman’s comments.

Senator Joyce is concerned that demand for Australia’s resources would ”go through the floor” if the US was not able to pay off its burgeoning foreign debt.

Mr Rudd dismissed the senator’s comments, describing them as ”not responsible economic policy”.

Assistant Treasurer Chris Bowen went further saying Senator Joyce’s comments were extremist.

”His comments on the United States need to be taken with a grain of salt,” he said, adding the vast majority of economists believed US debt levels were manageable.

He accused Senator Joyce of engaging in a series of thought bubbles that were unbecoming of a senior economics spokesman from either government or opposition.

”Senator Joyce adopts very extreme positions, he is an extremist.”

States ‘rock solid’

Separately, Mr Rudd criticised comments made by Senator Joyce that some Australian state governments might not be able to repay billions of dollars in debt.

The states were carrying $170 billion in debt and rising interest rates were affecting their capacity to make repayments, Mr Joyce said.

”I would say in some instances they do not, particularly Queensland,” he told Fairfax Media.

The Prime Minister said such ”erratic and ill-considered” comments should not be made by a senior opposition spokesman.

Mr Rudd described as the ”most serious charge” the coalition’s view that state governments could default on their debt.

In light of Mr McGovern’s paper, and the reality of world events over the past 2 years, the truth is clear.

Barnaby was right.

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5 Responses to “Australia’s Debt Dreamtime”

  1. Barry December 18, 2011 at 3:55 pm #

    Like 99% of economist McGovern thinks it is all to do with money.
    The real crux of the matter is the peaking of oil production and the escalating cost of energy.
    While energy is busy eating GDP how can loans & interest be paid ?
    Without energy there is no growth.
    Welcome to the zero growth world !

  2. Mark McGovern March 10, 2012 at 6:30 pm #

    Thanks for the comments on my article. Interest is much appreciated, and yes it is an important but neglected issue. Came across your site while searching for my Courier Mail opinion piece of March 9th 2012 (pp 34-5) which discusses Queensland State debt quadrupling between 2004 and 2012. Link to the subsequent QUT media release is

    News release at
    http://www.qut.edu.au/about/news/news?news-id=40695

    Graph at
    http://www.flickr.com/photos/66214080@N04/6965939821/

    Have a good weekend
    Mark

    • The Blissful Ignoramus March 10, 2012 at 8:36 pm #

      Yours was one of the best, most on-the-ball and insightful papers I’ve read in a long time, Mark. Thank you for authoring it, and for seeking to draw attention to these fundamental, yet invariably overlooked issues.

      You would be welcome to Guest Post or cross-post here on BiR, to help give your insights wider exposure, if that is of interest.

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