David Murray on Australia’s growth straight jacket

By Leith van Onselen

David Murray, chair of the Financial System Inquiry, appeared on ABC’s The Business on Monday night and gave a frank assessment of the Australian Budget’s and economy’s vulnerabilities (watch above).

In the interview, Murray claimed that the Australian economy is in a vulnerable position due to it being highly dependent on commodities, which are inherently volatile:

“We’re are a more vulnerable economy than many other advanced economies… Because of these long commodity cycles and these vulnerabilities… we need to have a high quality setting…”

Murray also argued that Australia risks losing its AAA credit rating, which would automatically downgrade the banks and push-up the cost of borrowing:

“We have not had a debate about what our credit rating should be… I think we now have limited time – a reasonable amount of time – to convince foreign investors and bond holders that we can get a path that will stabilise debt…”

“If the commonwealth rating is lost then the banks are downgraded, the states are downgraded, and the cost of debt rises”…

He also warned that Australia’s combined state and federal debt cannot rise materially without risking the credit rating:

“The net debt number that is used by the ratings agencies is the aggregation of commonwealth and states”..

He also claimed that this straightjacket on debt is precluding the states from borrowing to build productive infrastructure, which is required given the fast growing population. As a result, the Commonwealth’s asset recycling project is necessary, since it allows the states to fund new infrastructure via privatisation (topped-up by the federal government) without raising borrowings and putting at risk the AAA rating:

“If it’s not possible for the states to borrow in the normal course to build infrastructure, which is actually what they should do… It’s the states that need to do the borrowing, but if they push it up too high and it hurts the Commonwealth position, they get hurt as well…”

That’s why at the present time, if we are to get the productivity improvement of new infrastructure, and we want governments to take the lead in doing it, then the only sensible path at present is for them to recycle it to afford the new infrastructure”…

Essentially, what Murray is saying is that because of Australia’s ginormous stock of private debt (mostly mortgages):

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Which has been largely funded by foreigners:

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Australia faces a potential liquidity shock in the event that a downgrading of the sovereign credit rating automatically increases the cost and reduces the availability of offshore funds, since foreign investors would be less inclined to continue extending credit, leaving Australia’s banks, house prices, and broader economy exposed.

In turn, concerns around the credit rating have created a straightjacket on growth, whereby Australia is unable to take advantage of record low borrowing costs to fund infrastructure (required to support the population ponzi), for risk of increasing government debt.

The arguments put forward by Murray also remind me of similar warnings by Professor Michael Pettis, who in mid-2010 made the following remarks about the risks inherent in highly-indebted commodity producing nations, like Australia:

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 [Australia?] may very well be the biggest risks, since their great performance may have been caused in part by highly inverted balance sheets. 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…

This is what happens when you base your economy on debt-funded houses and holes.

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