Monday, November 29, 2010


Late last week, the blog Data Diary posted on the dynamics of how a Chinese slowdown would trigger an Australian bust. According to the capital market community that is 'short' the banks and commodity giants:
1) Australia has had a massive terms of trade boost as a result of the Chinese property building boom. This has principally flowed through to the domestic economy through taxes on these commodity exports.
2) The domestic economy has taken these tax receipts (distributed via tax cuts or government handouts) and leveraged them, via low interest rates, into the housing sector.
3) Australian household leverage has pushed to very high levels by most sensible measures. This leaves the economy vulnerable to a terms of trade shock – principally a downturn in Chinese property construction.
4) The transmission mechanisms?
A wealth effect from lower share market prices – whatever the failings in logic, commodity companies trade in line with movements in spot prices.

An income effect from declining GDP – if you accept that debt accumulation has peaked, then following the logic that our housing construction sector is built around continued debt driven demand, it is very exposed to stagnation in debt or worse still deleveraging. While housing construction only directly employs 10% of the workforce and comprises 7% of GDP, the multiplier effects through the economy would be significant. This is why governments of all persuasions are so willing to throw taxpayer subsidies towards keeping the sector growing.

And the most scary – and by no means certain – is that we then enter a house price correction – with the attendant wealth effects that are currently haunting the US.

Regular readers will recognise this blog's most feared risk scenario. It is the reason why it is named Houses and Holes.

These are not the rantings of a lunatic pessimist. A 2005 RBA report showed how the income from high terms of trade is channeled into the real economy via two roughly equal courses:
A substantial part of the increase in profits accrues to state and federal governments. Royalties, which are a pre-tax item, are payable to state governments on mineral and onshore petroleum production.4 These are mostly at ad-valorem rates, and although there is substantial variation in rates and defi nitions, they probably imply that around 5 per cent of additional revenues from higher commodity prices typically accrue to state governments. More signifi cantly, based on the statutory corporate tax rate, up to 30 per cent of the increase in profi ts would be payable in corporate income tax to the Australian government. The higher level of profi ts would also result in some additional tax revenue from personal income taxes paid by shareholders on dividends or – in the longer run – on capital gains. Although the payment of these royalties and taxes may initially reduce the stimulus from higher commodity prices, there will still be an expansionary impact to the extent that higher government revenues allow higher government spending or a reduction in tax rates. Over a period of time, assuming government net fi scal positions are held roughly constant, the increase in revenues fl owing from higher export revenues to domestic governments would thus represent a corresponding stimulus to the economy.

The remainder of the initial boost to revenues (roughly two-thirds of the total) accrues to shareholders of the companies. This occurs either in the form of higher dividends, or if earnings are retained, in the form of capital gains. Domestic shareholders include both households and institutional investors such as superannuation funds. However, to the extent that there is foreign ownership of the Australian resources sector, part of the addition to incomes will accrue to foreigners. Although there are no precise figures on aggregate foreign ownership, some ABS data for 2000/01 suggest that foreign ownership in the resources sector is around 50 per cent.

In short, two thirds of the income gain remains in Australia, split evenly between government and shareholders. Data Diary is simply hypothesising a reversal of these two income effects in the event of a China accident. A far from crazy supposition.

However (and at this point you'd better sit down), in this blogger's view, the Data Diary story of commodity bust > sharemarket bust > housing bust > bank bust leaves out one crucial dimension. That is, that our banks already owe $500 billion to offshore creditors.

In the event of a China bust and the attendant likelihood of a structural slowdown, the interest rates on this money is going to rise, perhaps quickly. Just how far will depend upon how well we rebalance our spending against the lower income.

This rising cost of funds will hit the banks just as the negative income effects outlined by Data Diary are crunching their assets. And because the Budget is facing a simultaneous structural deficit on falling commodity-related tax receipts, and declining real economic activity, plus the need for stimulus and the rising costs of automatic stabilisers like unemployment benefits, its effectiveness as a backstop guarantor will be impaired.

The result is a negative feedback loop of credit rationing as the banks' falling assets prices and rising liability costs feed on one another.

The RBA would shred interest rates. But in large part, the banks would be unable to pass on the cuts as they attempt to absorb the pincer squeeze on their balance sheets by expanding interest margins.

As the recent Goldman Sachs report into Australian housing put it:
House price bubbles that are augmented by reversals in the terms of trade can be far more painful events than an independent house price bust pricked via monetary policy. A house price bust consuming somewhere between 5% and 10% of GDP in fiscal resources of other countries would quickly exhaust Australia's fiscal capacity and the patience of foreign and domestic investors if replicated in Australia.

In the terms of Data Diary, the bust mechanisms shift to commodity & sharemarket bust > financial crisis & housing bust > bank bust. This blogger is unable to say what the next step is. Perhaps the superannuation pool is big enough to buy the banks. Perhaps China buys them. Perhaps the Abbott government does (with the ultimate help of the IMF).

A collapsed dollar would help stabilise us eventually but this is still a nasty fate and goes a long way towards explaining why this blogger keeps bleating about wholesale funding, as well as trying to push the bank debate towards finding a way out while the high income is still flowing.

The scenario may be a Black Swan but it's plausible enough to take very seriously.


Bear Feller said...

China ain't going to buy the assets if it's the reason for the bust in the first place. My money is with Uncle Sam, his massive food exports, his high-growth technology industries and his eleven nuclear-powered aircraft carriers.

Parag said...

The chinese have been Rising interest rates, they know they have an inflation problem, they know they have a real estate bubble in urban coastal areas, and they are trying to deal with them both. That sort of thing I watch, it is good what they are doing, I think they can do other things as well.

The Lorax said...

Why is it a black swan? If China busts big time, a housing bust and financial crisis in Australia are almost inevitable.

And every day the mining boom continues Australia becomes more leveraged to China. The sooner it busts the better.

Rohan Clarke said...


Yep - the bank's reliance on offshore funding has all the shiny-edged attraction as the sword of Damocles. Even given the structural deficit problems that will swamp all levels of govt under that scenario, the bank's will be back in Canberra asking for a re-instatement of the guarantee. As you suggest - the question is what will it be worth?