The electricians are working furiously to restore power to our headquarters here in St. Kilda. But in the meantime, your editor sat down at 6:30 this morning and did things the old fashioned way. We bought a cup of coffee from the Grocery Bar, bought a few newspapers, and began chortling and taking notes.
In today’s analog-inspired edition of the Markets and Money, we take a big step back and question some of our key arguments over the last three months. Is Australia’s banking sector at risk from foreign borrowing? Will Japanese sovereign debt be the first to run into higher rates, triggering a rise in the cost of global capital? And are we wrong about China’s fixed asset investment boom? Is it a bubble…or is it paving the way to decades of prosperity?
It’s a lot of heavy lifting today. And we did have a quick glance at the markets at home before heading into the office. It doesn’t look like anything important happened. So we’re going to get tucked into some of these weightier issues and see how they taste.
First, for the last few weeks we’ve been making the point that Australia’s banking sector is vulnerable because it’s a large importer of capital. All the booms in the local market – in shares, housing, or commercial real estate – are, to some extent, financed by foreign lenders. Like most foreigners, overseas bankers like what they see from Australia.
Capital flows are good now. The sun is shining and the country is lucky. But if we’re right and the strong Aussie dollar is mostly a function of the U.S. dollar carry trade, capital flows can reverse just as quickly. Currency traders probably love this because of the volatility. But the question is: how risky is it for Australia’s economy to source so much of its borrowing needs overseas?
Well, until today we’ve neglected one aspect of that question. When you borrow, you can theoretically borrow in your own currency – a loan denominated in Aussie dollars – or in another currency, say, American dollars. There are risks and advantages to both. America has been able to issue debt in its own currency for years, always paying it back in the same currency. It’s been a huge economic advantage (that’s probably going away slowly).
The big risk to borrowing in a foreign currency is that you must pay the loan back in the foreign currency too. That’s all well and good when exchange rates are stable. Let’s say you’re an Australian business and you borrow $100,000 in US dollars while the exchange rate is at .94 cents. If the rate stays there, you’ll pay back US$100,000 plus interest, but neither nor more nor less in principal.
In fact, if the Aussie dollar appreciates even more against the U.S. dollar (say it goes to parity, or one Aussie dollar buys you one U.S. dollar) then the loan gets cheaper for you pay off. The nominal amount (US$100k) is the same. But because of the exchange rate move, you can buy more U.S. dollars with your stronger Aussie. A move to parity from here, for example, could make your $100k loan about six percent cheaper than you first planned.
But if you borrow in a foreign currency and your own currency weakens against the currency in which you have borrowed, look out! This is what happened in many Eastern European countries over the last five years. The local banks borrowed from larger bank lenders in Western Europe (Austria especially) in order to finance local housing booms (yes, this DOES sound familiar).
When the local currency depreciates against the one in which you’ve borrowed, paying back the borrowed money gets a lot more expensive. You must somehow raise money in the borrowed currency to pay it back. You can sell things, give up equity, or default altogether in which case the collateral posted for the loan is transferred to the lender. And there’s always the possibility that you just throw your hands up in the air, shrug, and say, “Sorry. We’re all out of money! Go screw yourself.”
That’s why having a large percentage of your borrowing denominated in foreign currencies is dangerous. But the larger your demands for capital are (and Australia’s are large) and the less you can source new lending from existing deposits (for regulatory and other reasons), then the further abroad you must look to borrow, even if it IS in someone else’s currency.
A recent study by the Australian Bureau of Statistics concluded that Australia’s total foreign currency debts grew by 130% between 2005 and now. The ABS says the banks have $548 billion in foreign currency debts while “other financial institutions” have $117 billion.
If these borrowings weren’t properly hedged, a fall in the Australian dollar would make repaying them more expensive. But, according to the ABS, 95% of the foreign currency borrowings ARE hedged. According to Geoff Winestock in today’s Australian Financial Review, “The share of unhedged foreign currency debt is roughly the same as four years ago, even though the total volume of debt has increased.”
“In many cases,” Winestock reports, “the debts are naturally hedged because they have been used to buy income producing assets of shore. Taking this into account, Australia had a large net-positive foreign currency exposure.”
How about that? Not only is the rise in foreign currency debt not a problem, it’s a good thing! Aussie borrowers have taken that money, the ABS reports, and bought foreign assets that produce income. It’s a win-win! What could possibly go wrong?
Well, one interesting fact from the ABS report is that while the debts appear to be properly hedged, the assets are not. For example, Australia has $456.7 billion in foreign equity assets, half of which are denominated in U.S. dollars. The ABS concludes that, “Overall, the reported net exposure of $388.1b appears largely due to equity assets and net foreign currency receipts that are largely unhedged.”
Hmm. The only thing we can think of that might go wrong is that assets can fall in value while debts generally do not. Take, for example, collateralised debt obligations and other securitised assets. They are bundles of debt whose value is based on the regular income and principal payments of borrowers. And they never fall in value at all, do they?
Oh wait. Yes. Sometimes assets DO fall in value. Like U.S. houses…and all the securities that derived their value from those houses.
So it comes down to the quality of the assets you get with your borrowed money and how regular the income is. And frankly, we haven’t given the assets that much scrutiny yet. It could be that a U.S. dollar rally raises the value of Australia’s dollar-denominated stocks, even as it makes paying debts more expensive. That would be the hedging.
But you can colour us a tad skeptical. We’ve heard plenty of people claim debt was not a problem. We’ve heard very few claim it was “net positive.” And we’re not hearing many people show that assets denominated in U.S. dollars and that are unhedged are risky assets.
But maybe we’re just being old-fashioned. Is debt really that big a deal? Isn’t a bit hysterical to claim, for example, that a sovereign debt crisis is unfolding in the Western Welfare states?
Well, maybe not. Yields on 10-year Japanese government bonds are up 12% since the start of the year. According to Brendon Lau in today’s AFR, “The fall in prices and the subsequent rise in yields may reflect worries about the country’s deteriorating fiscal position, as government spending is tipped to surpass tax revenue this financial year for the first time since World War II.”
Japan’s public sector debt-to-GDP ratio is approaching 200%. But the Japanese are no longer saving at the same rate they used to. Granted, the pool of national savings remains high. And the government is hoping the ageing Japanese population will transfer its pension assets to government bonds and continue financing large deficits.
But Lau reports that the Japanese saving rate has fallen from 15% in 1991 to just 2% today. That rainy day everyone was saving up for – or that retirement – is finally here. Japan’s own people may not be able to finance the government’s large Keynesian deficit. So the country will have to find the money from somewhere else.
Hmm. Britain and America are already shaking down the world’s saving nations for more money. Japan may find lenders. But you can be sure that it will cost more money to borrow. Rates will keep rising. Already the five-year credit default swap spread on Japanese bonds has risen 0.75 percentage points.
In other words, the cost of insuring Japanese sovereign debt against default is rising. Japan’s CDS spreads now put in the same neighbourhood as Chile and the Czech Republic. By all accounts, Chile and the Czech Republic are nice places to visit and live. Chile sounds like a great place to visit and the Czechs have great beer.
But Japan is the second-largest economy in the world. Its cost of capital is going up. This could be the first sign that the cost of capital is going up all over the world. Higher interest rates are on the way.
That would be a major change. As we showed earlier this week, the cost of capital (like the cost of energy) has been in a long-term downtrend. Cheap money and cheap energy have both fuelled a global boom – a boom in which 2 billion people have been lifted out of poverty and brought into the industrial economy. Nowhere has this been truer than China.
Which brings us to reconsider what we wrote about China yesterday. We wrote that its rates of fixed asset investment were largely driven by political and not economic considerations. China’s central planners value stability, and full employment brings stability. Even if factories are cranking out goods Americans can no longer afford (or want) to buy, it keeps people working.
Idle hands do the revolutionary’s work.
But Glenn Mumford tells us not to worry. He quotes from a report by Mingchun Sun, the China economist for Nomura International. Sun says that China’s current investment boom will prove, “a major milestone in China’s economic development.” The main claim, though, is China is paving the way for decades of new growth, greater consumption, and more developed domestic economy with rising per capita incomes.
In fact, China might actually be UNDER-investing in fixed assets. “Sun warns that investment demand for capital goods, raw materials and energy could be so strong that some upstream sectors now facing overcapacity may soon experience shortages…[Sun] is forecasting fixed-asset investment in the first-half of 2010 to rise 40%, year-on-year. This would be great news for Australian exporters.”
Anything is possible. It certainly IS possible that the China boom is sustainable and getting larger. But it’s also possible that the Super Cycle in fiat money is reaching a thunderous climax. And after the boom?
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