Nation needs to take stock
Few countries should be as worried about the prospect of sharply higher global interest rates as Australia.
When interest rates are the rising tide, boats sink, especially those heavily laden with debt.
Indeed, few countries should be as worried about the prospect of sharply higher global interest rates as Australia, whose households and government have binged on debt since the financial crisis a decade ago. Not many nations have accumulated $990 billion in net foreign debt like we have, equivalent to about 56 per cent of GDP, up from 8 per cent in 1995.
While many other countries’ national debt levels are far higher, few have sourced so much of theirs from foreigners. The Japanese government, the world’s most indebted, is the classic case, having borrowed almost entirely from its own citizens. Unlike Japan, Australia’s governments can’t tax foreigners more if they refuse to roll over the loans.
Policymakers aren’t alarmed yet — and it’s in their interest to always appear calm in public — but a sustained rise in interest rates could be the sledgehammer that derails Australia’s Goldilocks economy. Household spending — the biggest part of economic activity, already labouring under sluggish wage growth — would suffer if mortgage repayments began to climb.
In the past few months we’ve enjoyed a drip feed of refreshingly positive data. Who could forget the jobs boom, more than 400,000 strong last year, and the relentless rise in stockmarkets from Sydney to New York?
But it was a pitter-patter of bad news yesterday that reminded the optimists how things could turn south fast. The trade balance flipped back into the red, posting a $1.3bn deficit for December despite widespread expectation of another surplus. (It was the high iron ore and coal prices last year that have saved the Australian dollar from tanking.)
Then it emerged retail spending shrank in December, after a bumper rise in November. In the Christmas month it declined 0.5 per cent, the second biggest fall in monthly spending in almost five years.
“We had thought that lower fuel prices in December, firmer consumer confidence, ongoing job creation and reasonable anecdotes from the major retailers into Christmas would temper the likely correction in retail sales in December, but retail sales were disappointing in our view and suggest a more persistent softness,” says Royal Bank of Canada strategist Su-Ling Ong.
But it was the US mini stockmarket crash, reflected in $60bn wiped off our own blue-chip equities, that drew attention to Australia’s vulnerability yesterday. With the Dow Jones Industrial Average falling more than 5 per cent over two days, it’s been enough even to silence US President Donald Trump’s routine boasting about the stockmarket. “Dow goes from 18,589 on November 9, 2016, to 25,075 today, for a new all-time Record. Jumped 1000 points in last 5 weeks, Record fastest 1000 point move in history. This is all about the Make America Great Again agenda!,” Trump tweeted on January 5.
The Dow fell more than 1100 points this week, and US futures point to a further fall overnight. The famous fear index, VIX, had its biggest one-day rise ever. The VIX index reflects the cost of buying insurance against moves into financial market prices.
Australia’s total foreign debt, totting up those of government, households and business, totalled just under $1 trillion last year. That’s a higher ratio than Argentina or Mexico, reflecting foreigners’ confidence in the Australian economy and our ability to repay our debts.
The current level of foreign debt is roughly twice the proportion of GDP it was in the late 1980s, when serious people, including then treasurer Paul Keating, worried it was too high.
Keating oversaw politically painful budget surpluses for three years to try to curb our debt dependence. We haven’t had any of those for a while.
Too much foreign debt, the argument went, risked a financial and economic crisis if foreigners, for whatever reason — spooked, say, by a collapse in the price of Australia’s commodity exports — decided Australia hadn’t the economic capacity to repay.
“If it weren’t for the level of foreign debt, interest rates in this country would be much lower,” John Howard said in the 1996 election campaign he would go on to win.
According to calculations by respected economist Saul Eslake, the implied net interest rate on Australia’s current foreign debt mountain was just under 2.3 per cent last year.
About a decade ago, when foreign debt was $535bn, it was closer to 5 per cent.
Back-of-the-envelope calculations suggest a return to 5 per cent would cost more than $20bn a year in extra interest payments, money that could have gone on new cars, smartphones or kitchen renovations. Australian households are the main culprit in the foreign debt bubble, having a total credit-to-GDP ratio of 122 per cent, putting us at the top of the world rankings with the Swiss.
But governments now contribute about $250bn too, up from zero at the end of the Howard government’s tenure.
Eslake is sanguine, suggesting the US mini-crash this week is not “particularly concerning” and local mortgage rates shouldn’t be affected in the short to medium term. “Obviously we need to watch what’s happened but at the moment it’s really just a belated thump on the head by the US bond market,” he says.
“The Fed has been saying for some time it would lift rates and now the market suddenly believes them.”
For a few years up until late 2016 the winning trade had been to assume rates would keep falling — whatever the Fed said. Since then it’s been a poor bet. Now it appears the US isn’t hurtling towards a Japan-style financial funk after all.
The Reserve Bank controls Australia’s short-term interest rate by dictating the money it pays banks on the compulsory deposits they must hold with the central bank. But longer-term interest rates tend to move in tandem with the rest of the world.
Economists seem divided on the extent to which the RBA can insulate Australia from changes in global interest rates.
“A lot of people don’t fully appreciate but the RBA only cares about the rates that people actually borrow at, such as mortgage rates. It can adjust its official rate, currently 1.5 per cent, to accommodate what happens overseas,” Eslake explains.
Warwick McKibbin, one of the country’s top macro-economists, believes rising global rates would filter through to suburban mortgage payments.
“Everything else taken as given, a change in the US long-term bond rate will eventually feed into borrowing rates here,” he told The Australian yesterday.
“I’ve been saying this reversal in the US will happen for about a year because the valuation in asset markets is inconsistent with what’s happening in the real economy. Markets have been overpricing because of the enormous liquidity being pushed into markets by central banks.
“Our modelling of Trump’s policies gives us an extra 1 percentage point on bond rates above from where they are now. That’s quite a lot. And we see a spill over to Australia of about 70 bps here.” Home mortgage rates of 3.59 per cent might be a thing of the past. “The change can happen reasonably quickly,” he adds.
It’s not only the foreign debt that would increase if global rates rose. Combined owner-occupier and investor home loans have risen from $1.2 trillion to $1.7 trillion in the past six years (some of this ultimately is borrowed from foreigners via the banks). A big chunk of investor loans (about a third of the total) are “interest only”, and highly sensitive to changes in variables rates.
Andrew Boak, Goldman Sachs chief economist, is more comfortable with Australia’s debt burden. “If mortgage rates rise by 1 percentage point by the end of 2019 as we expect, we estimate a net impact of households cash flows of only around $900m to $2bn,” he says. “This is only a very small headwind in the context of our annual level of household income of around $1.1 trillion.”
Perhaps the bigger concern for policymakers is what changes in the US do to house prices in Australia, which are already showing signs of falling. Just as a US Treasury bond pays a regular coupon to the owner, so does a house in Melbourne or apartment in Sydney: it’s called rent. To an investor they are similar assets (abstracting from the ongoing costs of owning property). US bond yields have increased to about 2.75 per cent, which is still low, but if they return to more normal levels around 4 per cent then why would a global investor want to own Australian property?
Net rental yields in inner-city Australia, after taking out all the council rates, upkeep and insurance, can be as low as 1 per cent. Foreigners would be inclined to sell and shift money back home.
The Reserve Bank took a cautious stance yesterday, sitting on its policy hands for the 18th month in a row. After its first board meeting of the year, Philip Lowe, the RBA governor, indicated official rates were unlikely to rise soon.
“Long-term bond yields have risen but are still low. As conditions have improved in the global economy, a number of central banks have withdrawn some monetary stimulus,” Lowe said.
“Further progress in reducing unemployment and having inflation return to target is expected, although this progress is likely to be gradual.”
McKibbin explains how rising expectations of future rates affect activity. “They just sit pat for a few board meetings if they want to see rates rise.”
There was about an 85 per cent chance yesterday of official interest rates increasing to 1.75 per cent before the end of the year.
“The RBA doesn’t want to go on record saying that lower equity prices are justified or not, but the health of the global and local economies should provide some support to equities,” says Capital Economics chief economist Paul Dales.
“Raising interest rates at this point would just make things more difficult for the bank by strengthening the dollar, crimping business investment just as it got going, hurting households when income growth is still low, and it would be tantamount to taking an axe to the housing market rather than the scalpel used by the banking regulator,” he adds.
If the Reserve Bank does try to insulate rates from the expected rise in the US, the Australian dollar is likely to fall further. Historically, Australian interest rates have been higher than in the US.
“It is striking the last time the rate difference was this narrow the Australian dollar was struggling to hold above US50c,” says Eslake. Conventional economics hasn’t been much help in predicting exchange rate movements for some years. “You would tend to expect that with further widening of the spread the Australian dollar would start to fall,” noting the gap between the 10-year Australian and US government bond yield had shrunk dramatically. Yesterday the Australian 10-year bond rate was 2.81 per cent, just a 0.04 percentage point higher than the US.
But if the price of iron ore eases our defensive shields might disintegrate. Policymakers like a weaker exchange rate, but it is hard to see anything below US65c being very popular.
Whatever happens globally is beyond our control. For all its impressive growth Australia’s economy is still less than 2 per cent of the world’s GDP. As The Australian’s editorial argues today, the two men with the most powerful effect on Australia’s economy are probably China’s President Xi Jinping and Donald Trump.
So far both economies are performing better than most would have expected a year ago. But it would be prudent for governments here to do what they can to increase Australia’s resilience to whatever might be around the corner, such as accelerating reform of the tax system, including cutting and simplifying income tax. The most important goal must be for Australia to maintain its reputation as a desirable and prosperous place to invest and work. The next federal election offers political parties the opportunity to outline how they would do this.
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