by Peter Brain
Unfortunately, by 2019 these offsetting factors will weaken at the time when an expected rise in United States interest rates will increase the debt-service costs of Australia’s gross foreign debt and intensify the unfavourable trends affecting both the crisis-risk indicator and the year-ahead foreign-exchange-cover ratio.
The ratio of short-term debt to total foreign debt is projected to rise from 34 per cent at the end of 2015 back to the pre-GFC level of 45 per cent by 2021. Similarly, the share of foreign debt denominated in domestic currency is projected to fall from 43 per cent at the end of 2015 to 30 per cent by 2021, or back to its 2001 level when the $A/$US exchange rate was 50 cents. These trends will have the combined effect, given the stated gross-foreign-debt trajectory, of increasing the total annual borrowing requirement from 46 per cent of GDP in 2016 to 60 per cent of GDP by 2019, and to just under 70 per cent by fiscal year 2021.
In this baseline projection, capital outflows also affect Australia’s crisis vulnerability. An important reason for the reduction in vulnerability since 2011 has been a decline in capital outflows to between 1 and 2 per cent of GDP. However, the historical record shows that the rate of capital outflow increases into the 3.5–4.5 per cent range during times of heightened vulnerability of the Australian economy to crisis, such times being characterised by low growth, high current-account deficits, and relatively low exchange rates. In our baseline scenario, the outflow of both debt and equity is expected to return to these historical precedents.
As an example of the vicious feedbacks that are so common in economic affairs, the Australian economy is expected to suffer not only from a return of high current-account deficits, but also the return of capital flight. As regards the build-up of the net international borrowing requirement, it makes no difference whether the additional foreign debt has to be incurred to cover a dollar of the current-account deficit or to cover a dollar of capital flight.
In the baseline projection, the annual net international borrowing requirement increases to 40 per cent of GDP by 2017, and to 52 per cent by 2019. It continues to increase to 64 per cent by the end of the projection period. As a result, the year-ahead foreign-exchange-cover ratio falls from 0.32 in 2016 to 0.20 by 2019, and to 0.16 by 2021, by which time the ratio rates the probability of Australia experiencing economic catastrophe as between severe and extreme.
Although it rises rapidly between 2015 and 2017 from 0.33 to 0.52, the crisis-risk indicator stabilises at around 0.60 for the remainder of the projection period, as a result of the stability of the currency. This places it below the historical peaks of 1987 and 2008, and somewhat short of Code Red status. In turn, the currency is stable largely because the VIX Index of world financial-market volatility is assumed to be stable, with zero deviation from the mean, and also because the impact of exchange-rate changes on Australian foreign lending partially offsets the rise in gross debt. As a result, in the baseline projection the crisis-risk indicator rates the probability of Australia experiencing economic catastrophe as very high but not yet severe.
Our conclusion thus far is that, while our indicators concur that Australia’s risk of economic catastrophe is currently moderate, in the baseline projection (and hence in the Commonwealth budget projection) that risk will increase over the next five years. In particular, the foreign-exchange-cover ratios reached by 2021 make one wonder how an economic catastrophe can possibly be avoided without a severe recession.
However, this is getting ahead of the argument. What of the baseline projection itself? Is it pessimistic or optimistic? A case can be made that the baseline projection is pessimistic, in which case the probability of economic catastrophe recedes. A case can likewise be made that the baseline projection omits various risks that could hasten economic catastrophe. In the best tradition of economics — hoping for the best while preparing for the worst — it is wise to evaluate risks not included in the baseline projection that, on the balance of probabilities, should have been included so that the projection has a roughly 50 per cent probability of fulfilment. These risks are designated as strategic, in the sense that the effects will be large enough to alter the Australian risk rating if they eventuate.
Seven strategic risks for the Australian economy over the next five years
As of mid-2016, seven strategic risks may be identified for the Australian economy, of which we formally include two in this iteration of the risk-alert framework.
# 1: The quality of world political leadership
Measured by GDP at current exchange rates, the United States has been the largest world economy for a century or so. Over the last three decades it has been guided by neo-liberal policies. These policies came under a cloud with the GFC in 2008, and there is now considerable uncertainty as to which parts of the Washington Consensus the United States will jettison under President Trump. The uncertainty concerning these risks is so great that we reserve discussion of it for Chapter 7.
# 2: A second Global Financial Crisis
In the baseline scenario, the VIX index is assumed to maintain its mean value for the next five years. This is most unlikely. There will be instability, and this instability is highly likely to reduce world economic growth. Even if political stability is maintained, the process of weaning the various major countries away from the quantitative easing policies that they have implemented over the last five years will be inherently unstable.
Political and ideological factors meant that the fiscal stimulus that was adopted in most countries in response to the Global Financial Crisis (GFC) of 2008 could not be sustained. Like the generals who are caught fighting the last war, economists and politicians often prefer to address the last crisis, not the current one. Those who experienced the inflation of the 1970s — the monetarists — tended to be over-conscious of inflationary threats and to be particularly concerned about growth in the money supply, while more recent proponents of neo-liberal economics tend to be particularly concerned about government budget deficits and less worried about money supply. The initial response to the GFC was an uncoordinated series of budget deficits — fiscal stimulus — in the various North Atlantic countries and (thankfully from Australia’s point of view) in China. These immediately raised the ire of those for whom government deficits are anathema, causing a strong reaction into ‘austerity’ policies. As we discuss more fully in the next chapter, the political surprises of 2016 may make it easier to co-ordinate a world return to fiscal stimulus, but this is not to be relied on.
As the austerity policies bit, and recovery from the GFC faltered, governments desperately sought a replacement for the lost fiscal stimulus, and chose to over-rule the monetarist generation with its concerns for tight control of the money supply. Central banks in the United States, Europe, and Japan resorted to monetary stimulus or quantitative easing. They increased the money supply by buying government and private-sector securities on the open market, so forcing down both short-term and medium-term interest rates. In search of higher returns, investors transferred their capital to faster-growing emerging economies, and especially into the corporate bond markets in these countries. This had the additional effect of lowering the major developed economies’ exchange rates.
These ‘quantitative easing’ policies are currently being maintained in the Eurozone and in Japan, but have ceased in the United States. Though the Federal Reserve has stopped buying bonds, American interest rates have not yet increased very much, but we expect that the monetarists will have their revenge as soon as business confidence recovers a little. The quantitative-easing policies have left the United States banking system with US$2.4 trillion of excess reserves that, given a 10 per cent required reserve ratio, could potentially translate into US$24 trillion of additional money supply — an increase guaranteed to cause inflation. When the United States reaches the point where additional borrowing by the private sector, based on these excess reserves, starts to expand the money supply, the Federal Reserve will be forced to i
mpound the reserves by selling securities. This will increase interest rates on United States government bonds substantially and, in turn, have a disproportionate impact on American corporate-bond interest rates and hence on equity prices. When it starts from low rates, an increase in interest rates generates large capital losses on bonds. The resulting herd exit from bond markets will accentuate the increase in interest rates. In addition, the liquidity of United States bond markets has declined since the GFC, with the banks now prevented from trading in corporate bonds on their own account. This has removed a significant stabilising force and will further amplify the interest-rate overshoot.
This instability will be transferred to the world economy because it is likely to trigger a major reverse flow of funds from emerging economies back to developed economies. Countries that secured major inflows of foreign funds between 2011 and 2014 include Brazil, Argentina, India, Turkey, and South Africa. The process of fund repatriation from Brazil and South Africa has already begun. The risk for Australia arises from contagion. Though Australia was a relatively moderate borrower between 2011 and 2014, the volume of outflows from countries that borrowed heavily during those years could generate severe balance-of-payments deficits in one or more of them, creating flow-on effects that would impact negatively on Australia as a country with a high foreign debt.
These factors mean that the VIX volatility index is very likely to rise above its current mean value. To take this into account, we have modified the baseline projection by assuming that there is a 20 per cent chance that instability will be avoided; a 10 per cent chance that there will be a moderate increase in instability comparable with the 1997 Asian financial crisis; a 40 per cent chance of a somewhat more serious increase; a 20 per cent chance of an increase comparable with the 2008 GFC; and a 10 per cent chance of turmoil worse than the GFC. Two additional assumptions affecting the next five years are that a substantial positive deviation of the VIX from its mean will occur only once and will, as in the past, last a maximum of four quarters. The deviation could occur any time within the next three years.
The one positive long-run aspect of quantitative easing is that, increasingly, government debt will be held by central banks, especially in the Eurozone and Japan. This will drive down the net-government-interest burden, and eventually will enable the Eurozone and Japan to simply cancel the public debt. This will be useful when political pressure forces governments to be more active in driving growth, since it will give them the scope to increase public debt by between 30 per cent and 50 per cent of GDP. This will add to the one positive out of the Brexit vote (discussed below), which is that it may encourage the EU to undertake more aggressive fiscal-policy expansion.
#3: China
Australia depends on China for just under one-third of its merchandise export trade. The risks to this trade have three different elements, involving economics, security, and politics.
Taking the economic element first, in our baseline scenario the Chinese GDP growth rate is expected to decline to the 5–6 per cent range, reflecting recent success in increasing China’s living standards and hence a movement towards developed-country growth rates. Should the decline in the growth rate be greater, China’s demand for Australian exports is likely to fall below expectations.
Western analysts commonly express the fear (or perhaps a perverse hope) that China’s growth rate will decline even further to relatively low levels (2 to 3 per cent) because of high domestic-debt levels. This fear would be justified if the Chinese economy was similar to a North Atlantic developed economy, but it is not. It is a highly efficient planned economy in which the planners keep a firm focus on the 15 to 20 per cent of economic activity that drives growth. The enterprises that matter are those that are important to the export effort, the import-replacement effort, the provision of quality infrastructure services, knowledge creation, innovation, and new product development. Many of these enterprises are government owned or controlled. If a quality private enterprise becomes insolvent because of excessive debt, it can readily be absorbed into the public sector.
More generally, the government owns the banks that lend to public or quasi-public enterprises and to the other tiers of government. The net financial assets of the public sector as a consolidated whole, including the assets of the central bank, are larger than in Western economies. With high foreign net assets, the central bank can readily recapitalise banks and enterprises without negative consequences other than on the wealth of the business owners directly impacted. Any necessary financial restructuring is therefore likely to have a relatively small impact on growth, and will be regarded by the Chinese government as a cost of maturing the role of the finance sector. Domestic debt is therefore not of concern to them.
There is, however, one major downside risk for countries that export to China. The cause is not China’s growth rate, but the import content of that growth rate. Since the GFC, the growth of world trade has fallen from well over the growth rate of world GDP (between 1.5 times to 2.0) to equality with world growth. China has made a major contribution to this by switching to import replacement as a source of growth, which it has done by increasing the vertical and horizontal integration of its domestic industry clusters. This is to be expected — the United States went through the same process between 1900 and 1950, moderating its imports and contributing to the factors that caused European economies to embark on warfare to secure alternative global markets. Even if warfare is avoided, slow growth in world export markets (particularly commodities markets) will weaken the prospects for Australian exports, and indeed will provide opportunities for China to discriminate against Australian exports, should it so wish. Australia is exposed to such discrimination because China’s share of Australia’s merchandise exports has risen to 32 per cent. In 2003–04, before the China-driven mining boom, China’s share of Australia’s merchandise exports was 9 per cent.1
From the security perspective, this dependence could not have come at a worse time. China and the United States are both large countries comprising disparate regions and social groups that, at times, have been difficult to hold together. Both have experienced civil war; the leaders of both are subject to the temptation to seek domestic unity by emphasising opposition to a foreign enemy.
China has a clear objective over the next two to three decades of becoming the hegemon of the Western Pacific in succession to Japan (in the 1930s and up to 1945) and the United States (since 1945). Via its state-controlled media, it has repeatedly warned that Australia cannot have it both ways: Australia cannot, in the long run, expect to be firmly attached to the Chinese growth locomotive as well as firmly embedded under the United States security umbrella. Until now, Australia has ignored these warnings.
Economic warfare, otherwise known as sanctions, arises when countries refuse to buy and sell when markets indicate that it would be advantageous to do so. Over the past four years, the United States and others, including Australia, have implemented economic warfare against various countries, including Russia. China has likewise implemented economic warfare against countries with which it has territorial disputes — Japan and the Philippines — and countries that have disregarded its warnings not to undertake specific actions, of which Norway is perhaps the best example. These tactics include a refusal to buy imports from these countries, as well as the erection of obstacles to travel between these countries and China.
The risk that China will engage in economic warfare against Australia will build up over the next ten to twenty years, in tandem with its rising military strength. Over the next five years, it is possible that China will implement a strategy to reduce its dependency on imports from Australia, thereby reducing Australia’s economic growth opportunities and increasing Australia’s economic vulnerability. Even if this is not done deliberately, the greater the success of the ‘one belt, one road’ strategy, which is aimed at better integrating peripheral countries into the Chinese economy, the greater will be the �
�market forces’ decline in China’s imports from Australia. In any case, steadily increasing worldwide excess capacity in the production of iron ore, liquefied natural gas, and coal, much of which has resulted from Chinese investment, will give China ample scope to switch to alternative suppliers and also to ensure that prices remain low. Beyond 2021, the risks to these commodity trades can only increase.
By allowing such a high dependence on Chinese imports of a narrow range of its commodities, Australia has put itself in a position where even the merest hint by the Chinese government that it will discriminate against imports from Australia may be enough to trigger a crisis in the Australian economy, forcing a sudden loss of foreign-investor confidence. Recent rhetoric about the South China Sea could quite easily — and possibly unintentionally — spill over into such hints.
A third reason why China’s imports from Australia may fall below expectations, which has been much discussed by Western commentators, centres on the risk that social-political instability will increase as citizens tire of the regime, especially if it becomes increasingly authoritarian. Whether it takes the form of class conflict in the Chinese heartlands or ethnic conflict on the fringes, internal dissension would significantly damage China’s economy. However, the Chinese government is very sensitive to these issues, and we consider it unlikely that they will seriously affect economic activity over the next five years.
Whatever the reason — be it economic, strategic, or political — there is a significant risk that China’s demand for Australian exports will fall below the level assumed in the baseline projections. A 2 per cent per year decline in total Australian exports from the baseline projection translates at best into either no increase in annual exports to China and more probably into a modest decline. The revised projection assumes that there is a 30 per cent chance that baseline exports to China will be achieved, a 30 per cent chance that they will fall by 2 per cent for one year, a 20 per cent chance of a 2 per cent shortfall for two years, a 10 per cent chance that the shortfall will last for three years, and a 10 per cent chance that it will last for four years.
