Early Warnings Flashing Amber for Aussie Economy

The last time Australia suffered a recession was back in 1991.

It was the year the USSR stopped existing…operation Desert Storm was in full swing…and the movie Home Alone had just hit the cinemas…

In short, it was a long time ago.

Australia avoided the worst of the Global Financial Crisis’ (GFC) fallout in 2008.

Australia´s economy is still growing…but very slowly. In fact, it’s growing at the slowest rate since the GFC.

Consumer spending is sluggish, household debt is at almost 200% of disposable income. Australians are saving less, but they’re not spending. Their money is covering higher bills as prices go up and incomes stay put.

Yet it’s not just Australia.

Most of the economies affected by the GFC haven´t really bounced back. The ‘recovery’ has been frail.

The world has accumulated a record high debt of US$233 trillion. That’s over 325% of the world´s gross domestic product (GDP).

Now it looks like interest rates are on the way up. With all that massive debt looming over us, how do we know if we’re heading for a banking crisis?

Are there any early warning signs for the Aussie economy?

Well, that’s something the Bank of International Settlements (BIS) explored recently. If you’re not familiar with the BIS, it is the bank for central banks.

The BIS identifies two potential weaknesses that could lead to a banking crisis. One is household debt.

The BIS places great importance on the household sector. As they said:

While higher household debt boosts consumption and output growth in the short run, too much of it can lower output growth in the medium to long term. Excessive household debt has also been found to herald banking crises.

They also focus on international debt. In particular, foreign currency and cross border debt. As the study noted, ‘The growth rate of the foreign currency debt-to-GDP ratio increases strongly pre-crisis, though it exhibits relatively high variation across countries.

For this, the study looked at historical data and identified four Early Warning Indicators (EWIs) that should start flashing before a banking crisis.

The first indicator is (households) credit to GDP gap, which shows how fast credit is growing.

The second is Debt Service Ratio (DSR). That is, how fast we are paying down that debt.

The third is the property gap, which shows the speed at which dwelling prices are rising. They measure interest payments and amortisations in relation to income.

Both the second and third indicator were high before past crises.

The last indicator is cross border claims to GDP. For this they looked at current account deficit or exchange rate developments.

That refers to the difference between exports and imports. A country with a strong currency will have fewer exports, as they are more expensive.

This could create a negative balance, which means that the country is spending more than what it is bringing in. To counter this, the country will use its reserves — their savings — or take on debt. 

EWIs provide an early indicator for the potential risk of a financial crisis. A colour change means that the indicator is in alert zone and has crossed a BIS critical threshold.

According to the bank, there are some risks in Australia’s credit market. Three out of the four indicators were flashing amber, as you can see in the table below.

Early Warning Indicators for financial crisis 15-03-2018

Source: BIS
[Click to enlarge]

That is, debt service ratio, household debt service ratio, and cross-border claims.

Canada is also flashing red in two indicators and amber in another two. China, Hong Kong and Russia have two red alerts.

As the bank warns, EWIs are not perfect, but they provide a starting point to check for areas of weakness.

The indicators we should all look at

There are several other indicators I like to keep an eye on to see how the economy is faring.

For one, the unemployment rate is another useful indicator to look at the state of the economy.

In an economy with a high employment rate, another area to look at is underemployment. Namely, the people that would like to work more hours but can’t, or are in a job they are overqualified for.

Another one is debt to GDP. This refers to government, household and/or financial debt. The length of the debt is also worth noting, whether the debt is payable in five years or 50 years. This will make a difference on the liquidity of the country.

A country can crumble if it runs out of reserves and cannot take on any more debt to sustain the system.

Wage growth is another good one. A slowdown in wage growth, combined with higher bills — as is happening in many parts of the world — means households have less disposable income. This makes it difficult to save or pay bills, which decreases consumption.

Building approvals is another important indicator — especially for the Australian economy.

There is an easy way to check how this indicator is faring. Look out the window and count how many cranes you see in the sky. During the property boom in Spain, you would see hundreds of cranes. You can check out the actual number of cranes in Australia per city with the RLB Crane Index.

Then ask yourself: Do we have enough demand to absorb all this construction? Do people have enough money — or access to debt — to buy these new residences?

None of these indicators on their own predict a crisis, but they can give you a general idea of how the economy is doing.

The truth is that no matter what you hear, no one can predict when or where the next crisis will hit.

Let me give you one more indicator, one that is hard to measure: Greed.

In long periods of prosperity, investors get greedy. They underestimate risks, assuming things will always stay the same.

Be careful in these periods of general euphoria. It is when everything collapses that this greed turns into fear.

Port Phillip’s Editor Vern Gowdie has been warning about investor optimism and the dangers of high debt level. In fact, he is convinced the next ‘Great Crash’ is coming. That’s why he has outlined a step-by-step plan to survive it.

If you want to find out more, you can click here.

Kind regards,

Selva Freigedo,
Editor, Markets & Money

Selva Freigedo is an analyst with a background in financial economics. Born and raised in Argentina, she has also lived in Brazil, the US and Spain. She has seen economic troubles firsthand, from economic booms to collapses and the ravaging effects of hyperinflation, high unemployment, deposit freezes and debt default. Selva now writes from her vantage point here in Australia. She is lead Editor at the daily e-letter Markets & Money. And every week, she goes through each report and research note produced by our global network of trusted advisors to find the best investment opportunities for you in Australia and overseas. She packages these opportunities for you in Global Investor.

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