Protecting Australia’s inverted balance sheet

ScreenHunter_01 Feb. 17 18.55

By Leith van Onselen

The Former head of the World Trade Organisation, Pascal Lamy, warns that Australia’s low level of government debt – around 32% of GDP – could easily escalate and cannot afford to reach European levels because of Australia’s over-reliance on commodities. From The AFR:

“It’s true that if you’re Japanese or French, and you look at the public debt of this country, you say ‘why are these guys bothering’. But you know the dependency of the growth of this ­country on resources is there.

“That’s not a problem Japan or France would have in the composition of its growth pattern”…

Lamy is right to be concerned. One of the key factors behind Australia’s low level of government debt was the massive surge in commodity prices and the terms-of-trade between 2003 and 2011, which dramatically boosted national income and flooded the Federal Budget with revenue via increased company and personal taxes, as well as higher overall economic growth.


However, in the process, the Australian economy has become increasingly undiversified, as the high dollar has caused many non-mining industries to close (e.g. manufacturing), leaving the nation and Budget highly exposed to a commodity-led downturn.

The situation has been made worse by the Australian banks’ over-reliance on offshore borrowings to fund their mortgage books. This has opened the banks up to a potential liquidity crunch / funding squeeze in the event that China’s economy hits turbulence and there is dislocation in foreign capital markets. Further, because Australia’s banking system is tied to the sovereign rating, if Australia’s credit rating is downgraded, then so to are the banks, removing a key pillar of support to Australia’s housing market.

Indeed, in 2010, Professor Michael Pettis provided an excellent explanation on the relationship between high external debt, commodity prices and asset prices, which is particularly relevant to Australia and supports Lamy’s warning:


With inverted debt [structures], the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times (when asset prices and earnings rise) and rise in bad times…

Foreign currency and short-term borrowings are examples of inverted debt, because the servicing costs decline when confidence and asset prices rise, and rise when confidence and asset prices decline. This makes the good times better, and the bad times worse…

Inverted debt structures leave a country extremely vulnerable to debt crises… Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.

This is especially a problem for countries whose economies are highly dependent on commodities. Not only are commodity prices volatile, there is a long history suggesting that global liquidity dries up at the same time that commodity prices collapse. This is a deadly combination for highly indebted economies with big commodity sectors…

Countries with a lot of short-term debt, external debt, and asset-lending-based banks, especially large amounts of real estate lending, are far more vulnerable than they might at first seem because the debt burden is likely to soar at the worst time possible – just when everything else is going wrong…

In fact some of the recent “star” sovereign performers may very well be the biggest risks, since their great performance may have been caused in part by highly inverted balance sheets [Australia?]. These kinds of debt structures ensure that good times are magnified, but they also ensure that bad times are exacerbated…

When the economy is doing well, rising asset prices make existing loans seem less risky and encourage riskier debt structures (i.e. loans whose servicing cannot be covered out of minimum expected cash flows) because creditworthiness seems constantly to rise. But once the crunch comes, asset values and creditworthiness chase each other in a downward spiral.

While Australia’s current level of federal government debt looks fairly benign, the fact is the Budget is facing extreme medium-to-long term pressures from both falling commodity prices and population ageing, which without action on the revenue and expenditure sides will see Australia’s federal debt-to-GDP ratio escalate. The situation is made worse by Australia’s inflated housing values, caused in part by our high household debt and heavy offshore borrowings by the banks, which could come under intense pressure if access to foreign capital is turned-off (or funding costs rise), owing to a downgrading of the sovereign credit rating and/or dislocation in international capital markets.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.