Credit Code Red

by Peter Brain

  The banks’ success in pinning the blame for the 1990 recession onto the government was greatly, if unintentionally, aided by neo-liberal academics led by John Pitchford, one of a number of Australians who returned as professors of economics after exposure to neo-liberal theories while undertaking post-graduate study in the United States. Writing nearly two decades after the ‘Pitchford thesis’ was adumbrated in 1989, three Reserve Bank economists characterised its essence thus: ‘Rather than imposing a constraint on growth, a current account deficit is a means by which advantage can be taken of private investment opportunities, thereby raising potential growth.’7 Thus formulated, the Pitchford thesis was an almost comic example of the misapplication to policy of the highly abstract propositions of neo-liberal economics.

  As we have pointed out, overseas borrowing wisely invested can benefit both borrower and lender; the error in the Pitchford thesis was to assume, in line with neo-liberal economics, that this is always the case, provided the borrower is in the private sector. Historically, some of Australia’s most successful overseas-financed investments have been in the public sector — for example, investments in infrastructure that underpinned export industries. Similarly, some of Australia’s most regretted overseas borrowings have been by private-sector businesses — for example, the borrowing that underpinned the land boom of the 1880s.

  A second string to the Pitchford thesis was that, in the event of failure, private-sector businesses that have borrowed overseas can default without cost to the national economy. When non-financial businesses have borrowed overseas directly, either through equity or bonds and debentures, this is at least an arguable proposition. Though a run of business bankruptcies is likely to be associated with a faltering national economy, overseas ownership insulates the domestic economy from wealth effects, and therefore reduces the damage to the national economy. However, the proposition is definitely not arguable for overseas loans to private-sector banks. If a bank defaults on loans and deposits sourced overseas, there is strong pressure for it also to default on its domestic deposits and thereby impose serious costs on the national economy. Such defaults precipitated the 1890s Depression. The Pitchford thesis that over-borrowing overseas can, like domestic over-borrowing, be corrected through the bankruptcy of failed borrowers might be valid if overseas borrowing were confined to direct equity investment, but it becomes hopelessly naïve once financial intermediaries become involved.

  Though Pitchford and his followers encouraged complacency about private overseas borrowing, they held that their thesis did not apply to government borrowing, not only because (in the true spirit of neo-liberalism and in spite of a century’s experience to the contrary) they believed that governments never invest productively, but also because there is no available procedure for a government to declare bankruptcy. They accordingly argued that there was no need to worry about balance-of-payments deficits, provided that they were financed by private and not by government borrowing. The popularity of this particular misapplication of neo-liberal economics explains why the Australian authorities and media were so unconcerned when the current-account deficit ballooned during the 2000s; indeed, the banks themselves were probably numbered among the true believers. It was not in their interests to engage in a simple macroeconomic investigation and discover that the mortgage loans that were contributing so much to their profits had, in fact, financed consumption and were not generating foreign exchange with which to service the loans.

  Belief in the Pitchford thesis, accompanied by the diversion of blame for the 1990 recession from financial deregulation to the government, helps to explain why the Commonwealth government ignored the danger signals that warned of financial collapse during the urban land boom of 2002–07. The danger signals flashed, but there was no crisis, not even after the American and European economies collapsed in 2008. Does this vindicate Pitchford and his colleagues? Can Australia safely ignore indicators that elsewhere have presaged economic breakdown?

  How Australia escaped a crisis in 2009

  It has never been claimed that indicators of economic vulnerability are ineluctably followed by catastrophe. Reinhart and Rogoff remark that countries have been known to survive many years of dangerous indicator values. This does not invalidate the indicators, for economics depends on human behaviour, and what frightens lenders to one country will not necessarily frighten lenders to another country. However, survival despite poor indicator values can easily breed complacency, so that small changes of circumstance precipitate collapse, as in the straw that broke the camel’s back.

  On a more personal note, in the late 1990s one of us (Peter Brain) warned that countries pursuing neo-liberal economic policies were heading for a severe recession towards the end of the first decade of the new century. This would be followed by years of low growth rates. The warning applied particularly to the leading proponents of neo-liberal economics — the United States, the United Kingdom, and Australia. He predicted that three key factors would drive this outcome: an excessive increase in the burden of household debts to financial institutions; rapid increases in income inequality; and insouciance in the face of rapidly rising foreign debt and the high balance-of-payments deficits that generate foreign debt.8 Keeping watch on these key factors had allowed him to predict the 1997 Asian crisis five years in advance. Similarly, his prediction of trouble in the mid-2000s was correct for the United States and the United Kingdom. With hindsight, these three factors are now accepted by mainstream economists as the underlying causes of the 2008 Global Financial Crisis (GFC) — an event that turned out to be much worse than a mere ‘severe recession’. Much of the developed world is still trying to escape the negative economic consequences of the GFC and the policies adopted to combat it. However, the prediction was not fulfilled for Australia, which suffered no worse than a year without any growth in GDP.

  The failure of the 1999 prediction that Australia would join the other neo-liberal countries in the GFC can be traced to a failure to anticipate the boom in China’s mineral imports. At the end of 2008, it did indeed appear that Australia was heading for a severe recession in line with the other neo-liberal countries. Short-term foreign debt was increasing rapidly, and the exchange rate and commodity prices were declining. What saved Australia was the very large fiscal and monetary expansion implemented in China during 2009. This expansion was steel-intensive, and quickly generated a recovery in coal and iron ore prices and thereby in the health of the Australian international accounts. The Australian exchange rate shot upwards, and the mining industry boomed. To the great benefit of Australian consumers, the Australian dollar price of imports plunged. Unfortunately, this inflicted lasting damage on Australia’s non-resource export and import-competing sectors.

  Now that the mineral-export boom is winding down and Australia’s terms of trade are declining, it is likely that mining-boom damage to its import-competing and non-resource export sectors will outweigh the benefits from the expansion of mining capacity. This will result, by 2021, in Australia being worse off than it would have been had there been no mining boom, at least in the sense that net national disposable income per capita will be lower.

  Though the mining boom was not a long-run blessing, it allowed Australia to escape the GFC and, by current global standards, to retain a high level of business confidence. However, one narrow escape does not create permanent immunity — hence the continuing need to monitor the likelihood of crisis. The 1999 prediction of an economic crisis for Australia still threatens to come true, but after a delay of a decade. Neo-liberal policies might have seemed beneficial during the mining boom, but they now underlie Australia’s increasing vulnerability to an economic crisis. Two questions arise. How close is Australia to the brink of crisis? Is evasive action possible?

  5

  Australia under credit watch

  International lenders continue to monitor Australia’s overseas borrowing position. In normal times, they calculate that the hi
gher interest they can earn in Australia compensates them for the risk that Australian borrowers will fail to repay in full and on time. Should this confidence be disrupted, they will refuse to roll over their loans and demand repayment. If their loans are not repaid in foreign exchange and on time, a banking crisis will ensue. To assess the likelihood that confidence will be disrupted, one needs to look at the indicators that are monitored by the lenders. Though the macroeconomic indicators of vulnerability to crisis that are watched by the markets are closely related to the indicators we have already discussed, there is another group that we have not yet described — indicators of the adequacy of Australia’s foreign-exchange reserves.

  The Australian government’s first line of defence in the event of a loss of confidence in the Australian economy by overseas lenders is its foreign-exchange reserves. An indicator of the adequacy of these reserves (akin in some ways to the capital adequacy of a bank) is the year-ahead foreign-exchange-cover ratio. The higher this ratio, the less likely is an over-borrowing crisis.

  Australia’s annual gross international borrowing requirement

  High short-term foreign debt — that part of foreign debt which matures within twelve months of any given date — played a key role in the 1997 Asian crisis. Short-term international debt is of critical importance. As it falls due, it has to be repaid, rolled over, or replaced by loans from other investors. Total foreign debt is also important, because lenders know when its components are going to mature, and so require repayment or refinancing. If such medium-term debt is judged too high, they may not be willing to roll over or replace short-term debt, even when it would otherwise be manageable.

  When short-term debt and potential short-term debt are high, and especially when they are high relative to foreign-exchange reserves, there comes a point where foreign lenders lose confidence and are unwilling to roll over the debt. The lenders demand repayment, triggering an economic crisis. The rule of thumb for developing and emerging economies that wish to avoid a debt-rollover crisis is that they should match their short-term foreign debt with the same level of foreign-exchange reserves.

  Since the Second World War, Australia has not found it necessary to observe this rule of thumb, having consistently incurred greater short-term debt than its foreign-exchange reserves, and (so far) has done so without disaster. However, this does not mean that there is no upside limit to Australia’s capacity for short-term overseas borrowing. To assess Australia’s position, we have offset its foreign-exchange reserves against its short-term debt. Its annual international borrowing requirement at the end of each quarter is accordingly defined as its short-term foreign debt (being that part of its foreign debt issued by both the public and private sectors that matures over the next four quarters), plus its expected current-account deficit over the next twelve months (for the sake of simplicity, taken to be equal to the quarter’s current-account deficit multiplied by four), less its (public-sector) holdings of foreign-exchange reserves.

  This annual borrowing requirement can be assessed in relation to various other economic magnitudes — for example, the level of export earnings — but in the first instance we compare it to GDP.

  Figure 2 profiles the annual gross Australian international borrowing requirement since the mid-1990s. Over the second half of the 1990s, the ratio ranged from 25 to 30 per cent of GDP; over the first half of the 2000s, the ratio was reasonably stable in the vicinity of 35 per cent. In the run-up to the Global Financial Crisis, the ratio rose rapidly to hit 51 per cent in the September quarter 2008. During 2009, in response to the GFC of the previous year, Australia undertook large-scale fiscal expansion, which resulted in further increases in imports and borrowing. This raises the question, why didn’t Australia experience an economic crisis in 2009? We have already provided the answer: China undertook a large-scale monetary and fiscal expansion that raised the price of Australian mineral exports. This put a floor under the currency, such that the Australian dollar rose from 66 cents per US dollar in December 2008 to 91 cents by December 2009. This rising exchange rate pushed the annual gross international borrowing requirement down to 40 per cent of GDP by the December quarter of 2009. Had China not expanded, and had Australia not been a major supplier of Chinese imports, it is strongly arguable that the expansion of 2009 would have raised the balance-of-payments deficit (through increased imports unmatched by exports) and so brought the GFC to Australia.

  By watching the annual borrowing requirement, we correctly predicted (to within a year or two) the Asian economic crisis of 1997 from the viewpoint of 1994, and the Australian recession of 1991 from the viewpoint of 1985. Alarmingly, the borrowing requirements that foreshadowed these events were lower than those that prevailed for Australia in 2008 and indeed those that prevailed at the end of 2015, when the ratio was 45 per cent of GDP. This raises the question as to whether Australia is already in highly dangerous territory. However, over the past couple of decades, capital outflows and the potential hedging of short-term foreign debt have changed the significance of the international-borrowing-requirement indicator.

  Figure 2: Australia: Year ahead gross and net borrowing requirements and foreign-exchange-cover ratio

  Private-sector short-term overseas assets

  If the current level of Australia’s international borrowing requirement as a percentage of GDP had the same significance as it had in the 1990s, the Australian economy would now be in extreme danger of crisis. However, allowance should be made for the increase in Australian short-term foreign lending. The question then is: how much allowance?

  In the post-war period, foreign borrowing and foreign lending could be offset against each other because most foreign debt and lending was held by governments or their Reserve Banks. In the build-up to a crisis, governments could sell their foreign assets to augment foreign-exchange reserves and so reduce the risk of default on foreign debt.

  This is not the case today. Holdings of foreign short-term financial assets are dominated by private-sector institutions, and may be divided into two classes. The first class comprises foreign short-term assets held by financial institutions (mostly banks) as partial offsets to their short-term foreign borrowings. These assets are held as part of the banks’ strategy for managing their overseas obligations. It can be assumed that in the event of a crisis these assets will be at least partially available for offset against overseas liabilities.

  The second class comprises foreign short-term assets held by institutions (mainly investment funds), and indeed by individuals, without any corresponding overseas borrowing. The motives for doing this vary from insurance against exchange-rate movements through to outright speculation against the devaluation of the Australian dollar. Expectations of devaluation will be particularly strong in the period immediately before a crisis when the exchange rate is already falling. In this situation, domestic holders of foreign assets that are not offsets to foreign liabilities will have every incentive to keep these assets offshore and therefore prevent their being offset against overseas liabilities.

  Given this distinction, Australia’s international-borrowing requirement should be adjusted to allow for bank holdings of short-term overseas financial assets, defined as those that will mature within a year. In this respect, financial deregulation has returned Australia to a situation akin to that before the 1930s Deptession, when Australia’s foreign-exchange reserves consisted largely of the ‘London balances’ of the commercial banks, with one important difference: the exchange rate is now market-determined. This means that, in addition to their function as reserves, bank holdings of overseas liquid assets have a ‘hedging’ function: they are held to compensate banks that have borrowed overseas for adverse changes in the exchange rate.

  We allow for the partial availability of bank overseas holdings of short-term assets to meet short-term demands for overseas funds by subtracting them from the borrowing requirement after allowing for their hedging function.1 On this defini
tion, the net annual borrowing requirement is equal to the gross annual borrowing requirement, less bank short-term foreign lending, other than that held for hedging purposes.

  The resulting net borrowing requirement series is profiled in Figure 1. The adjustment for bank holdings of foreign short-term assets reduces the annual gross international borrowing requirement from $737 billion to a net requirement of $505 billion in the December quarter of 2015 — a reduction from 45 per cent of GDP to 33 per cent. The gap between the unadjusted measure and the net measure has widened considerably over recent quarters, because the ratio of foreign lending to GDP increased from 51 per cent in June quarter 2014 to 70 per cent in December quarter 2015, with the share of short-term foreign lending increasing from 42 per cent to 47 per cent.

  Purchasing overseas short-term assets is not the only way in which the Australian banks protect themselves against exchange-rate risks. They also hedge by making what are effectively insurance payments over and above the value of foreign assets and liabilities. However, this provides only short-term protection, particularly into the future. As the risk profile of the Australian economy increases, especially in regard to exchange-rate risk, the insurance premiums will increase rapidly to the point of unaffordability, which will force institutions and enterprises to reduce their hedging defences. In a severe crisis, there is an additional risk that the costs to the counterparty to the hedging arrangement will be so large that the counterparty defaults — as happened during the GFC. Counterparty default is particularly likely if the exchange rate falls sharply, and especially if this occurs in the context of world-wide currency instability, as would be the case in a second version of the GFC where the counterparty could experience losses across many segments of its portfolio.