My newfound pessimism.
Until recently, I’d been quietly optimistic about Australia’s
future as we continue our transition away from the mining and resources boom. That’s
not to say there weren’t issues. The real economy had been sluggish for a while.
Housing markets got dangerously hot, especially Melbourne and Sydney. Australian
households are among the most indebted in the world. And wage growth still remains low despite economic
growth strengthening and unemployment falling towards 5%.
But I still had confidence. The RBA, APRA and ASIC had
effectively reigned in the property markets. And they did this with their
macro-prudential regulation and oversight. This meant the RBA didn’t have to raise
their own interest rates (which would have hurt the already sluggish real economy). Other sectors were
rising to take the place of the mining and resources sector, including education (Australia’s
third largest export). And the government had enacted its own fiscal stimulus
in the form of public infrastructure works, especially public transport.
All that was required was for wage growth to pick up again.
This would allow households to gradually pay down their debt levels without necessitating
a major correction. But time seems to be running out.
First, wage growth is still stubbornly low. And if
the US is any indication (4% unemployment and similarly slow wage growth), Australia
may still have a few years
before real wage growth emerges. And new information has revealed the Australian households’ savings
rate is now at a 6-year low. When that source of spending dries up, we’ll need
another.
Second, household debt may have reached a tipping
point. Not just because it is already so high. But because for many households,
it’s about to become a whole lot more expensive. One of the concerns of the
RBA, APRA and ASIC over the past few years has been the proliferation of
interest-only loans. Commercial banks gave a lot of mortgages that, for the first 5 or so years, didn’t require any of the principle to be paid. As the name suggests, only interest
needed to be paid. For financially savvy and ideally already-wealthy
individuals, this was a useful new source of financial flexibility.
Unfortunately, for many borrowers, it just delayed the inevitable realisation
that it was more than they could afford. And in 2019, 900,000 of these interest-only loans are due to expire. This will force the average interest-only
borrower to suddenly pay an extra $400 a month in principle. This potential
wave of defaults may not undermine the financial sector itself[1].
But the shock to household consumption and by extension, business investment,
could be significant.
Third, interest rates are rising around the world, driven
by the US. The Federal Reserve was already on a path towards normalising
interest rates. And the US government’s current spending spree – to the extent
it drives short term economic activity – is likely to accelerate this. The
additional debt the US government will have to issue will have the same impact
(more government bonds depresses their price and raises their yield – a key global
interest rate). And on top of the Fed’s cash rate, the Fed will also want to start
reducing the balance sheet they drastically expanded following the GFC. Again,
a sudden influx of these assets onto the market will depress their prices and
raise their yields. The RBA does have 1.5% worth of scope to drop our domestic
interest rates further (technically even more if they’re willing to consider
negative interest rates). But that is a lot of upward potential global pressure
to offset.
Fourth, any major economic downturn in Australia will
automatically worsen the federal budget. Income growth will slow or reverse,
causing government revenue to do the same. And outlays will expand as more
people require income and unemployment support. This is an ‘automatic stabiliser’
designed to stimulate the economy during a downturn and cool it during a boom.
Unfortunately, I’m concerned our conservative government may use that as an
excuse to tighten the budget further. This is the opposite of what is
needed during an economic downturn. And it’s especially unjustified given Australian
government debt is low by international standards and low relative to Australian
households. Their borrowing costs are also still low.
Slow wages, high debt, a sudden spike in local mortgage
costs, increasing pressure on international borrowing costs, and doubts
surrounding our government’s fiscal response – seems like the perfect recipe
for a downward spiral. And I haven’t even mentioned the potential for Australia
to get caught up in the US’s global trade war.
But this is not a “recession we have to have”. As I’ve written before, financial
crises – even Depression- or GFC-scale ones – can be managed without widespread
disaster and hardship. The Reserve Bank can provide the emergency liquidity and
(if necessary) the targeted bailouts to support the financial sector through
the initial panic[2].
Interest rates – both short term and long term – can be lowered, even into
negative territory. The Federal Government can take the opportunity (and
necessity) to borrow at these very low rates and enact even more significant
infrastructure investments. Targeted tax cuts are also an option. And once the
economy is back on solid footing (i.e. business, industry and households have
resumed as the main driving force) – but not before – debts can be paid down
and financial market regulation and oversight improved to avoid a future repeat
of such a crisis.
But this requires a lot of pieces in the right place at the
right time – and no small amount of luck. Hence my increasing pessimism.
[1]
Australian banks are quite well capitalised, thanks in part to additional
requirements placed on them by APRA in the last few years to hedge against
potential liquidity problems in the future.
[2]
Though as mentioned earlier, I don’t think the financial sector itself is in
significant systemic danger.
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