Worst case scenario

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Let me begin by saying that I am good fun at a party. Get a few beers into me and I’m even capable of taking over. In a good way that is, having fun with all and sundry, from atop a table. Usually it’s mocking myself because I’ve spent the prior couple of hours advising folks to reduce their exposure to real estate and have been branded a “pessimist” (or “Hanrahan” by the more cultured).

Well, today, I’m going to carry that tag into this post. I’m going to be pessimistic. Not because I want to be but because everywhere I look this morning my previous dour musings are coming true. As such I think it only fair I explore my darkest fear for Australia, which remains a slim but rising risk.

As regular readers will know, I see the Australian economy in very simple terms. We dig up dirt and sell it to Asia then leverage that income by borrowing offshore and use the money to trade houses with each other. Call it houses and holes, the ASX 8, whatever you like.

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In the pre-GFC world, this model made a certain short-term kind of sense. So long as you assumed that both the unprecedented export revenue derived iron ore/coal and the flow of credit coming from offshore via our banks were permanent. So long as these two happy assumptions held, we could probably have continued running enormous current account deficits for decades.

Of course they didn’t. Both assumptions crashed in the GFC. But they did not die.

Instead, what happened was that when the assumptions came under pressure they exposed Australia’s political economy to undreamt of pressures and change. By that I mean that the banks were for all intents and purposes nationalised in October 2008 with government guarantees to their offshore borrowings.

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Of course, ever since, every man and his dog in power has told us the opposite. But it’s a lie. You can’t have a private bank that doesn’t give two hoots about one half of its balance sheet: liabilities.

And today, that lie is becoming increasingly evident once more. There is a softening going on as bankers are on the hustings making utterances of dark outcomes from Europe. At The Australian its Gail Kelly:

Europe’s rolling debt crisis is increasing the nation’s economic vulnerability, says Westpac chief executive Gail Kelly amid increasing signs that the waves of contagion are starting to hit Australia.

Speaking to The Australian as news broke yesterday that the Commonwealth Bank was forced to postpone a euro-denominated fundraising program because of the crisis, Mrs Kelly said: “We’re all watching Europe and it’s a concern.

“It’s the contagion effect — there’s a lot of rumours, and because of the volatility and the unknowns, the market responds in quite a skittish fashion.”

As the local market sagged 1.4 per cent at opening before staging a recovery, Mrs Kelly echoed the thoughts of former ANZ Bank chief John McFarlane, who was quoted exclusively in The Australian this week saying that the eurozone crisis was “very serious” and that many European “banks will not survive or be a shadow of their former selves”.

CBA’s delayed euro issue is another indication of the ramifications of the eurozone crisis.

A spokeswoman for CBA said the bank was monitoring the markets and would seek an appropriate window to undertake its first covered bond issue — a new type of fundraising that banks have been eager to exploit. Westpac and ANZ had already successfully launched covered bond programs in the past week.

…While confidence in Australia had been dampened by the ripple effects of the crisis, Mrs Kelly said she had detected a slight uptick in confidence since the Reserve Bank’s 25 basis-point rate cut on Melbourne Cup day.

“It doesn’t mean people are going to buy their next home,” she said. “Customers are still preferring to save and repay debt, which is rational and appropriate, but the decline in confidence has been ameliorated.”

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Kelly has three targets in mind. The first is clearly the RBA. She wants a December rate cut to pad out bank margins. Her second target is the government, which, if things don’t improve and covered bonds remain paralysed, will soon be called upon to re-guarantee offshore bond issuance. The third is the public, who need to be softened up for the action.

It’s the second two that we need to focus on in our journey into the dark. As both S&P and Moody’s have made clear, government liability guarantees provide an explicit upgrade to the major banks of at least two notches. The outstanding amount from the last guarantee period is $114.5 billion. That basically means that the government’s credit rating is now inseparable from that of the banks, in much the same way that the US government credit rating supports Fannie Mae and Freddie Mac. So, if you’re going to assess the prospects for bank funding costs, you must also assess the health of the national budget.

And that’s where our journey to the centre of Australian vulnerability comes full circle, back to holes. It is the tax take from our sales of dirt that supports the Budget. David Uren today discusses how sensitive that dependence is:

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The new mining tax is so compromised by its bastard birth that it puts the commonwealth budget at risk and cannot be considered an economic reform.

A fall in commodity prices of no more than 20 per cent would entirely wipe out the government’s mining tax revenue but leave it paying out $4.5 billion and rising for the various concessions on superannuation, company tax and small business that were supposed to be paid for by the resources boom.

The idea of a resource rent tax is sound and was supported by the mining industry in submissions to the Henry tax review. A resource tax, levied on profit, after allowing for the cost of investment, is superior to royalties, which discourage start-up enterprises.

But there was never any question of replacing state royalties. Had they been offered generous compensation, there could have been a negotiation with the states, but the commonwealth never tried.

…Whereas the original super-profits tax would have raised many times the state royalties at the peak commodity prices factored into this year’s budget, that is not the case with the minerals resource rent tax.

The mining tax revenue is now the slender slice left after allowance for investment and royalties. Even with peak commodity prices, the deductions for state royalties will consume more than half the tax.

If prices fall, the revenue flowing to the commonwealth quickly drops away to nothing.

…”The tax take is very sensitive to relatively small movements in commodity prices. There is an accelerated impact,” says Deloitte Access Economics director Chris Richardson.

We can add to this material from Business Week on the current state of the iron ore market:

Iron ore, which has surged 24 percent this month, may resume a decline as steelmakers in China, the world’s biggest consumer, restrict output due to falling demand, according to Peter Arden, an analyst at Ord Minnett Ltd.

…“Iron-ore prices have risen dramatically since the belting they got last month but they may get another belting soon,” Arden said in a phone interview from Melbourne today. “Prices have peaked. There’s usually a rise in buying from Chinese steelmakers at this time of year, but I see more grey clouds.”

China usually begins restocking of bulk commodities in November before ramping up production in the New Year, UBS AG said in a report today. The nation’s credit-tightening policy has curbed demand and prompted local mills including Baoshan Iron & Steel Co. to cut prices, while the debt crisis in Europe has raised concerns that economic growth may slow in emerging countries, Tokyo Steel Manufacturing Co. said yesterday.

“Short-term seasonal factors have led to this month’s rise in ore prices, as the northern-hemisphere steel mills stock up ahead of winter,” said Peter Strachan, who heads Perth-based independent advisory firm StockAnalysis. “Some steel mills are starting to throttle back in response to lower demand and prices for steel generally. Prices will weaken from now into 2012.”

…“This month’s rebound seems a bit overdone, so the price will settle lower,” Arden said. “The world’s not in a great shape and I can’t see what’s going to drive higher prices. China is not immune to problems in Europe and the outside world, and it has some problems of its own emerging.”

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I agree. Iron ore is in for more weakness. Metallurgic coal rebounded a little too with iron ore but I think that will also roll over. Thermal coal is also falling consistently. Combined that is 50% of Australia’s terms of trade. Moreover, BHP, Rio, FMG and Xtrata are all extremely sensitive to these commodities and are going to take a big hit in my view. So is Budget revenue.

So, the worst case scenario is this: a simultaneous blow to government revenues and bank funding costs that leads to a sovereign downgrade and subsequent bank downgrades, bringing on an outright Australian current account crisis.

How close are we to it today? Not very. Perhaps even distant. It’s much more likely that the various pressures will simply prevent the economy from growing at anything above a crawl for as far as it matters. But the worst case is very much worth considering on a day like today when both halves of the potential crisis are moving in the wrong direction. Every time we re-guarantee the banks or even loosen monetary policy to the extent that credit demand rises enough to require more offshore borrowing we take this risk again. Every time we allow more commodity revenue to slip through our fingers we take it as well.

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I don’t know about you, but I’m not going gently into that good night.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.