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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Unconventional Economist


  1. By 2015 the government will be re-negotiating with the car industry to aviod the further concentration around resources and to maintain employment/fight growing unemlpoyment and so that a fall in the currency can actually divert production from Japan, Thailand, Korea, China and Europe to Australia.

    Otherwise we will really know about Dutch disease!

  2. Leith this is the message so few understand. Every time I see another pundit say ‘Australian government debt is low in global terms’ I shudder.

    IMF recently noted that our government debt whilst comparatively low as measured against some other nations, was accelerating third fastest among rich nations – and this upswing commenced 2007/8 – Labor years !

    The budget emergency is real – not today nor tomorrow – but for our children and theirs.

    • @3d

      IMF recently noted that our government debt whilst comparatively low as measured against some other nations, was accelerating third fastest among rich nations – and this upswing commenced 2007/8 – Labor years !

      Can you stop singing the same song when your facts are wrong? The debt accelerated when the revenues started falling and also due to the response to the GFC. Every government put out a stimulus package in response, the Liberal would have done the same.

      That does not excuse Labor, they made some very poor policy decisions and even worse execution. However, the handouts and hence the expenditure side started way before the last Labor government.

      Unfortunately neither side of politics will solve the problem, they and their lackies will just throw dirt at each other. All you will have in the end is a big mess…

      • “That does not excuse Labor, they made some very poor policy decisions and even worse execution. However, the handouts and hence the expenditure side started way before the last Labor government.”

        Well put!

    • casewithscience


      That is misleading – The keynesian stimulus package in 2007/8 did do some damage. Then again, it saved the economy from the fate of Europe and America. I note China took the same approach (but on a far vaster scale).

      The largest increase in deficit was due to drop in revenues (which would have been far worse if the stimulus package was not in place).

      Also, the quote is misleading because the increase was due to stimulus and that is not a recurrent spend.

      • The Australian economy was never at risk of ending up like the European’s PIIGS. Labor shot their load unnecessarily.

    • “The budget emergency is real – not today nor tomorrow – but for our children and theirs.”

      emer·gen·cy, noun, often attributive i-ˈmər-jənt-sē

      An unexpected and usually dangerous situation that calls for immediate action.

      Leaving aside the fact that an emergency by definition can not not be a problem today or tomorrow but only at some unspecified time in the future…and the pathetic “won’t someone think of the children” garbage which strangely doesn’t apparently apply to climate change…

      If you believed there was a true emergency requiring immediate action, why would you be happy to wait (at least) a year or two for a tax review?

      After all, it’s clear to most sensible observers that our rising debt is at least partially because of a reduction in our tax revenue and our world-class tax expenditure rorts.

    • Ronin8317MEMBER

      The budget emergency is actually now, when there is still a chance to address the problem. Another few years, the hole will be so big that and it won’t matter. The government will confiscate everyone’s superannuation and turn them into ‘deficit bonds’.

    • The budget emergency is real: In that case we better hold off on purchasing the JSF aircraft or developing our own submarines and use that money to pay down debt.

      The Abbott govt has its priorities wrong. $245m for school chaplains? Abbott was always the wrong guy for the job, there is no way he will lead the libs to the next election.

      • “The Abbott govt has its priorities wrong.”

        I agree, the budget is full of contradictions and sends a very confused message. On the JSF, I genuinely hope they’re not lemons, but given the problems they’ve had why not hold off on buying more? I really hope the government knows something about the progress of these planes that we don’t..

  3. Who could give a damn about little bit of government debt when the private debt is so huge? When was the last time Australia posed a sovereign risk? Jack Lang?

  4. I don’t think Australia’s balance sheet meets Pettis’s definition of inverted. Australia’s debt is essentially AUD denominated, and there are large holdings of foreign denominated assets (e.g. in super accounts). So in a slowdown, the AUD will fall. This won’t blow out Australia’s liabilities (unlike, say, Thailand or Indonesia’s in 1998), and the AUD value of the offshore assets will rise. Australian spending power will decline but the risk of ‘sudden stop’ is mitigated by the free float.

    • Not purely, no. But it does if the Budget deteriorates enough for rating action because bank funding costs will jump not on currency but credit quality.

    • Ronin8317MEMBER

      Doesn’t matter if the debt is AUD denominated, as the debt is rolled-over rather than repaid. If the foreign lenders demands a higher interest rate, then Australia is screwed.

      The biggest issue is this : why are we borrowing so much money from overseas just to sell houses to each another at inflated prices?

      • Ronin
        “why are we borrowing so much money from overseas just to sell houses to each another at inflated prices?”

        Because the other part of that loop is that we spend all that inflow on imported goods…cars TV’s Computers Oil Trucks planes etc etc

        It is arguable, in my opinion, whether we think we are borrowing from overseas to pay for houses or borrowing to pay for our imports. The RBA prints up enough dollars to build the houses the banks lend them and they eventually get spent on imports.

  5. The budget emergency of the Liar in Chief is right up there with the the weapons of mass destruction farce.

    Abbott’s “Lie and Ambush” policy is plain for all to see.

    He has betrayed middle Australia. They will pay the most in dollar terms under the Budget of Betrayal. The lower quintiles pay the most in proortional terms.

    The permanent cuts in income for the bottom two and middle quintiles are shown by the NATSEM analysis.

    The well off pay a bit more for a couple of years and are then home free.

    Abbott is waging class warfare on the most vulnerable in society, and screwing the middle class at the same time.

    The middle class have been betrayed by the liar Abbott.

    Backbenchers now have to make the choice of whether to make his lies their lies or cut Abbott loose and bring in a budget for which they have a mandate.

    The mandate the Liberals got was for:
    “No cuts to education, no cuts to health, no change to pensions, no change to the GST and no cuts to the ABC or SBS.”