Thursday, September 30, 2010

Links Sep 30: yuan pressure

China currency legislation passes US House. Bloomberg
Beggar-thy-neighbour. Martin Wolf, Gavyn Davies
Falling $US can save US economy and Obama. Simon Johnson
Trouble for the US ISM? Truck tonnage collapses. Calculated Risk
IMF beat-ups. David Uren, Tim Colebatch
Actual IMF reports. Australia and Liquidity risk.
China will boom on. Michael Stutchbury
Singapore clears 90% of iron ore swaps. Bloomberg
Copper rips again. Reuters
Slow death of equities continues. Zero Hedge
Headwinds building for rally. Zero Hedge
Efficient market hypothesis my butt. Bloomberg

Wednesday, September 29, 2010

Fitch prepares the rubber stamp (Updated)

The market is apparently abuzz with heavens knows what pertaining to the banks and the Fitch Ratings announcement that they are
...probing the potential impact of a spike in mortgage defaults or drop in house prices on the portfolio of Australian residential mortgage-backed securities and banks it rates.

Over the last few months, Fitch has received numerous enquiries as to the sustainability of Australian residential property prices and the possible impacts of a correction,” said Ben McCarthy, managing director for Australia.

While over the short-to-medium term, a downturn is not Fitch's central expectation, the agency is performing its stress test exercise on ratings impact under the hypothesis of an imminent housing market correction.

This blogger could not welcome this announcement more. However, the excersise is doomed before it begins. The danger for Australian banks is not an "imminent housing correction". We are in the midst of a raging commodities boom. APRA has already stress tested a scenario worse than this in June this year with:

- A 3 per cent contraction in real GDP in the first year followed by a V-shaped recovery;
- A rise in the unemployment rate to 11 per cent;
- Chinese growth dropping as much other countries;
- Commodities getting pounded;
- A peak-to-trough fall in housing prices of 25 per cent; and
- A peak-to-trough fall in commercial property prices of 45 per cent.

As a few commentators noted at the time of the APRA tests, they looked pretty much like the 1990s recession, perhaps slightly worse. The banks passed with flying colours. None breached 4% tier one capital requirements.

So, what might Fitch do differently? It might apply the tighter Basel III capital requirements to stress bank capital more severely. The results would be interesting but it seems a long bow. Although APRA is working behind the scenes to push Australian banks toward the new requirements, the rules aren't yet official.

Nor is it the real problem. As the recent Goldman report makes clear, the danger is a crisis that signals the end of high commodity prices and the impact that has upon Australian bank liquidity. In that event, wholesale markets dry up and/or become chronically expensive and, as argued here several days ago, there is no effective government guarantee to bail them out. That is the real danger and it comes without a v-shaped recovery.

So, will Fitch stress test the Budget too? And given its dependence on Chinese demand for commodities, will it also stress test that market? No and no. It is testing for an "imminent" correction.

Perhaps it is an inflation/interest rate driven housing rout - which seems the more likely trigger this month - that Fitch wants to test.

Either way, it begs the question, if "....over the short-to-medium term, a downturn is not Fitch's central expectation" and that is factored into its current ratings then exactly how stringent can the test be? A bad result is going to undermine its own credibility.

If Fitch goes through the stress test, only to produce a report based upon limited scenarios for falling prices, it will likely reinforce the myth of Australian bank invulnerability. A result that can only serve to set us up for a greater fall when commodities ultimately flatline.

Links Sep 29: you versus the corporation

Pick of the day. Forget left versus right. It's you versus corporations. Barry Ritholz Whilst this is undoubtedly worse in America, before you guffaw, think big bank bailout, ETS, RSPT, policy convergence and oligopolies in every sector...
Markets won't like a smaller QE2. CalculatedRisk and Karen Maley
Though perhaps it'll be BIGQE2 if this rank US data is any guide. Zero Hedge Goldman still sees US 2011 US double dip. Zero Hedge And Case Shiller Housing Index agrees. Calculated Risk
2007 Again. Blogosphere warning on Europe. Felix Salmon, Naked Capitalism, WSJ The Source
China ramps iron ore rhetoric. Reuters, Mining Weekly
More bubble top Chinese bullishness. SMH
Does anyone else find Ross Gittins' smug baby-boomer prattle intensely annoying? The Age
Chris Joye eats his words. Christopher Joye

Tuesday, September 28, 2010

Goldman warns of an Australian depression

This blog has been meaning to post on the relatively recent Goldman Sachs report on Australian housing by economists Tim Toohey, David Colosimo and Andrew Boak.

It is a very long report and there is little point in going through it blow-by-blow. But, contrary to the way it has been reported, the research is frighteningly bearish.

The most significant part of the report begins:
On whether Australian house prices constitute a speculative bubble: No
• We think that the behaviour of house prices over the past year, and indeed the past decade does not resemble a speculative bubble. Our rationale is that: i) Refinancing of established homes is at a 9-year low. ii) The turnover of home sales that needed some form of financing as a share of the existing housing stock is low compared to the past 20 years. iii) The loan to valuation ratio of established dwellings remains well below the level seen at the start of the decade. iv) The loan to valuation ratio of new dwellings has remained broadly unchanged over the past decade. Indeed, even with the large lift in first home buyer incentives, LVRs remained largely unchanged.
• There is a very big difference between a speculative bubble and a period of overvaluation. BIS analysis suggests that there is less than a 40% probability of a house price boom ending in a bust based on a study of 16 house price boom and busts since 1970. Periods of overvaluation can extend for long periods of time and if they are supported by fundamentals, need not enter a period of dramatic price reversal.

Obviously, this blog disagrees with this analysis. Ten years ago there was no commodities boom and there was still tear away growth in house prices. That a commodities boom came along and bailed out a housing bubble is an important historic and conceptual point. It also finds the quote from BIS ridiculous. A 40% chance of a bust is fantastically high coming from the permabulls at BIS.

But that is a by-the-by for this post. What matters is that despite different terminology, Goldman has identified a major overvaluation of Australian housing and they go on to estimate in the 24-35% range. Next comes the kicker.
On a template house prices deflation: The terms of trade and China excess returns
• The 1880-1900 period serves as an interesting historical parallel. i) House prices to income per head are currently as high as at any other time other than 1890. ii) Business investment as a share of GDP in 2011 will likely reach levels not seen for over 120 years. iii) Residential investment as a share of GDP finished 2009 well below the 2004 peak, yet it remains surprisingly historically high. If we are right in our forecast that residential investment will cycle up strongly in 2013, Australia's residential investment as a share of GDP will approach levels seen in 3 historically high investment periods: the mid-2000s,
the mid-1970s and the mid-1880s. iv) Australia's export mix has again returned to a dominance in primary commodities with its economic fortunes increasingly tied to its largest export market. In 1890 it was Britain. In 2010 it is China. v) The withdrawal of foreign capital was a primary catalyst of the 1890s recession. The main risk in the modern era remains Australia's reliance on foreigners to fund Australia's investment savings gap which requires ongoing foreign appetite for Australian bank bonds.
• In many ways the 1880's provides a rudimentary template for the economic conditions that could prompt the deflation of the Australian housing market. The prospect of an abrupt and sustained decline in Australia's terms of trade, most likely associated with the combination of deteriorating excess returns in China and substantially stronger resource supply, would be the key catalyst for a shift in Australia's house price dynamics. Absent a severe recession in China in the interim, the most likely period when such an event could occur is when bulk commodities enter a period of global excess supply. Our best guess is that iron ore and coal markets could well face this prospect in 2013-14.

In other words, whilst Goldman refuses to use the word ‘bubble’, it is nonetheless predicting a convergence of inflated prices, increased housing supply and falling national income in 2013. And it isn’t done. The final blow is below:
On the economic costs of a bust in housing: Could test Australia's policy capacity
• We study 6 house price booms and busts from the US, UK, the Nordic countries and the Netherlands. We conclude that: i) The experience of Australia during the boom phase is remarkably consistent with the other boom economies in terms of house price growth, credit growth, GDP growth, consumption growth, the decline in the unemployment rate and even the extent of interest rate rises. ii) The only real difference is that Australia
thought it fiscally wise to spend over 4% of GDP during the boom phase! iii) 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. iv) 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. v) In the event of a combined terms of trade and house price decline, the magnitude of interest rate reductions in Australia would quickly breach historical lows.

According to Goldman then, there's no housing bubble, but there is an Australia bubble; where overspending is based on the psychological extrapolation of past and current commodity prices and economic growth to the future. The unstated but inescapable conclusion is that when the terms of trade correction happens, we’ll face a balance-sheet recession (or depression) as assets deflate.

As the title of this blog suggests, unless we change direction, it agrees there is a significant risk of Goldman's scenario playing out.

Foreign bond deluge

This blogger tracks Australian bank's foreign liabilities using the ABS's National Accounts: Financial Accounts. It aggregates the bonds our banks sell to oversees investors. June quarter figures were just released and show that our banks now owe $323.9 billion on bonds with maturities above one year. And another $83.3 billion in bonds with maturities under one year. A total of $407.2 billion and up an unbelievable 4.5% in the quarter. Crikey! That is an annualised growth rate of 18%.

It appears there is some cycling of funding types going on, with bills of exchange falling $6 billion. However, that is not a terribly reassuring fact either. A great new post by The Unconventional Economist draws and quarters the Great Australian Housing Bubble and includes RBA statistics pulled from statistical table B3 on Australian bank's foreign liabilities - see the chart above. When we look at the RBA figures, the total of foreign liabilities rises again, to above $500 billion. Presumably the extra liabilities are made up by bills of exchange and foreign deposits, amongst other items. And one has to seriously wonder, when push comes to shove, just how sticky will these sources of funding be.

Links Sep 28: Pascoe smackdown

Must read: Pettis does Pascoe. China Financial Markets
Why the Plaza Accord was not responsible for Japan's bubble. Models and Agents
When will the USS QE2 sail? Calculated Risk
Ireland and Portugal spreads won't stop. FTAlphaville Greece looking a bit better. Bloomberg
Hope springs eternal. The Dow is going to 38,820 (LOL). Bloomberg
China trade war. Real Clear Markets
US dollar breaks neckline of head-and-shoulders top. Going lower. Bloomberg
Uh oh, there goes the "implied" banking guarantee. SMH
China to build steel mills in Australia. So long as they can use indentured slaves. The Australian
John Garnaut wrote something. Ipso facto, you should read it. SMH
Treasury embraces Dutch Disease. Tim Colebatch. So do Malcolm Maiden and Michael Stuthcbury.

Monday, September 27, 2010

Is Aussie Mac real?

Robert Gottliebsen today takes on government guarantees of Australian banks. It is more than welcome that this topic gets greater public scrutiny. It is nothing short of bizarre that the very foundation upon which Australian banks operate has shifted and yet we carry on as if nothing has changed. Nonetheless, there are a series of questions that this blog needs to raise about the Gottliebsen angle. The great story teller reckons that:
Australian banks did not make the lending mistakes of their overseas counterparts, but they are hooked on overseas borrowings which are so great that in times of strife the implicit government guarantee of the deposits must be converted to an actual guarantee.

Our government charged a small fee for that actual guarantee but the implicit guarantee that Australian depositors will rely on next year comes free of charge. Theoretically, if the government declared that it would not stand behind the banks but subsidised specific lending, then banks would have to raise vast amounts of additional capital to lower the risks to depositors and shareholder returns would be slashed.

Let's leave aside the question of whether Australian banks' wading into very high LVRs in the early 2000s and their enormous reliance on mortgage insurance are lending mistakes. Instead we'll focus on Gottliebsen's second point, which seems confused. Australian bank borrowing from overseas is in wholesale markets, not retail deposits. The government therefore had to make two guarantees during the GFC to prevent bank runs. One to local retail deposits. The second was to the bonds that the banks sell into global wholesale markets.

The fee that banks paid was for the guarantee on large deposit and wholesale debts and the latter was used with abandon in global markets, racking up $157 billion in contingent liabilities for the Budget before its withdrawal. Here is the website where you can track it.

Gottliebsen makes a good point that without the guarantees (assuming he means both), that the Australian banks would face significantly higher capital requirements, but it is the implied wholesale guarantee that is most destructive to market dynamics. Moral hazard here continues the practice of banks' borrowing offshore that keeps the Australian housing ponzi inflated.

This blogger has argued consistently for a year that the banks are now operating much like Fannie Mae and Freddie Mac used to, with an implied guarantee for bond investors. However, the Gottliebsen story, as confused as it is, has got it wondering if the implied guarantee thesis is legitimate.

To open this question, let's run a hypothetical. In the event of another freeze up in global funding, would the application of another guarantee save the banks and Australian housing?

The year is 2012. Australian pubic debt has peaked at $220 billion, 20 per cent of GDP. We don't know the maturity duration of the guaranteed debt but its likely to be as long as possible, so much of it remains intact, say $130 billion. Going into the shock, brought on by a sovereign default in Europe, commodities collapse 50%. A combination of falling revenues, automatic stabilisers and stimulus send us into a far from outlandish projected deficit of say 7% of GDP for the year ahead and 5% the year after on some rebound in commodities.

So, before we guarantee any more bank debt, we are facing a debt stock at roughly a third of GDP and contingent liabilities that push the total up the 40% of GDP, higher than it has been since WWII. And that assumes that the Budget is not in structural deficit on the back of lower commodity price revenues. We would also likely face pressure on the sovereign rating, making all debt servicing more expensive.

This is back of the envelope stuff, but one has to wonder how effective a guarantee would be in these circumstances. If the conclusion is it would not work, then Australian banks are not trading on the public purse. On the other hand, if the banks faced refinance disaster in this scenario, we'd have no choice, and they do have an implied guarantee.

Currency meltdown

David Uren has a useful piece this morning suggesting the bull market in gold is presaging a global currency crisis.
If money is a store of value, printing more of it represents a devaluation. These concerns were further fanned last week by the central banks of England and Japan. Minutes of the Bank of England's interest rate setting committee also discussed the need for further quantitative stimulus amid concerns that the recovery may falter. The committee was divided, but the idea is again on the table.

And in Japan, acting on the instructions of the Ministry of Finance, the central bank intervened in the currency market to stem the yen's rise in value, spending the equivalent of $US20 billion ($20.8bn) in a day buying US dollars. The intervention, which pushed the value of the US dollar up from 83 to 85 yen, is funded by the central bank by simply printing more yen.

The increasing intensity of competitive devaluation is a serious issue and Uren is right to highlight it (he doesn't mention that Brazil and Peru also joined the ranks of central banks buying dollars last week). However, when he turns to analysis, Uren loses his focus:
RBS foreign exchange analyst Greg Gibbs, who says the odds are building of a meltdown in major currencies, argues that the ECB will come under increasing pressure to restart its the quantitative easing as its economies suffer from their rising exchange rates.

But what exactly is this looming "meltdown"? Competitive devaluation by the major powers doesn't look likely to trigger any imminent "meltdown" so much as a melt-up in gold.

Devaluation, nonetheless, can signal two other possible crises in the future. First, it is a sign that countries are looking to push a shortfall in demand onto their neighbors. If everyone is doing it at once, and therefore be definition failing, the next steps on the road are toward more obvious and destructive policies that seek the same goal: protectionism.

Second, we must remember that the global economy is a series of concentric circles. The inner and smallest circle is normal commerce and trade. The next circle out is the regular channels of savings and lending, currency exchange and transactions that finance the inner circle. Well foreshadowed fiscal and monetary manipulations of the second circle are normal business, even if more exaggerated now.

The third circle, and by far the largest, is the esoteric and etherial universe of derivatives that help manage and bet upon movements in the second circle. It is here that we will find any trigger for a "currency meltdown".

Like LTCM in 1998, we need to be cautious of an outsized bet, using an exotic instrument and vast leverage, that goes bad because of an unexpected and dramatic move in the underlying currency. The only candidates this blogger can see for this right now is in Europe. If one of the PIGS makes an unexpected move to dump the Euro and return to a dramatically devalued native currency. Such a move could catch a large currency player with his pants down and set off a chain of losses that are impossible to track, thus unhinging confidence and setting off a run on associated currency products. It is Europe that we need to watch.

Sunday, September 26, 2010

Deciphering Treasury's Red Book

Delusional Economics highlights an important Business Day scoop in which they have gotten their hands on parts of Treasury's Red Book for the incoming government.

It includes the following passages: "A key risk for the Australian economy is our reliance on short-term external debt, largely intermediated through the banking system ... Among Australian financial institutions there has been some shift away from short-term funding since the crisis, but exposure to financing risk remains significant."

Business Day goes on to state that, "The following paragraph was blacked out, but later on the Red Book also highlighted the dangers of the property-led surge in household debt."

This blogger is unsure but will hazard a guess that the Red Book is prepared under the aegis of David Gruen, Executive Director - Macroeconomic Group.

Assuming that's the case, from some of Dr Gruen's public comments after the GFC, we can speculate at what terrible secret has been blacked out in the Red Book.

At a 2009 ANU forum available in video at Slow TV, Dr Gruen admitted:

"If there is a global financial crisis in which the New York and London capital markets effectively close down and we are in a world where our banks borrow large amounts in wholesale markets, if that world exists, and the government has to come in and guarantee those debts in extraordinary circumstances, then that changes the debate about the consenting adults view of the current account."

In short, Gruen is abandoning the Pitchford Thesis, the theory that current account deficits don't matter if driven by the private sector in the time of a floating currency. At the same event he went on to acknowledge the importance of tracking asset bubbles in macro-economic management, though he did not endorse the use of interest rates to prevent them.

So, returning to the Red Book's missing paragraph, any one of the following would slot in nicely:

'If global markets freeze again, the Federal Budget may again be called upon to guarantee the bank's wholesale debts. Given the Budget is already carrying $157 billion in contingent liabilities from the 08/09 guarantee, we foresee difficulty in bailing out the banks a second time around.'


'Despite the 2008 Reserve Bank extension of the rules on the collateral it accepts from banks in return for cash (known as "repo" transactions), there is the possibility that the bank's short-term funding needs will again call upon a Budget guarantee. We suggest that the Budget return to surplus sooner rather than later.'


'If global markets freeze again in the next five years, bend over and place your head firmly between your legs then kiss your butt goodbye.'

Friday, September 24, 2010

A plea for a G2

As China and the US shunt their way towards a trade war, I offer this excerpt from The Great Crash of 2008 as a roadmap for economic co-operation between the powers. I co-authored the book with Ross Garnaut but this section was written by the good professor. Sadly, I see little chance of this happening...

Bipolar cooperation for economic stability
The maintenance of global economic stability and growth is among the issues that can no longer be solved without cooperation between China and the United States. It is clear that there were risks in early twenty-first century imbalances for surplus and deficit countries. China could have set out to reduce its surplus by increasing domestic expenditure. To avoid unwelcome inflationary pressures (and inflation had emerged as an issue immediately before the Crash), it would have had to raise the foreign exchange value of the yuan earlier and more than it did. Alternatively, it could have ignored the inflation risk and held the yuan steady while increasing expenditure. This would have led to higher inflation within China which, in turn, would have raised the real (inflation-adjusted) exchange rate, slowed export growth and raised imports. Regardless of how the increase in the real exchange rate were achieved, exports would have grown more slowly and imports more rapidly.

An increase in expenditure is easier said than done, at least if it is to be useful in raising current and future standards of living. There is a limited capacity to plan and implement efficient government programs. The household consumer is not so easily persuaded over a short period that her interests are served more by increased consumption than increased savings. That said, the early success of the Chinese Government in quickly increasing domestic expenditure after the Great Crash of 2008 suggests that more could have been done earlier. It is notable that the rapid expenditure increases since October 2008 have been dominated by investment. If it had been possible to substantially increase expenditure in China before the Great Crash, we cannot be entirely sure whether this would have led to lower, similar or higher growth rates than were actually achieved. The increase would probably have been focused mainly on investment, broadly defined to include education and other avenues to the improvement of the productive capacity of the labour force. It’s a shocking thought that this would have generated an even higher rate of growth.

The rising real exchange rate would have forced the accelerated restructuring of the export and import-competing sectors of the economy. Labour-intensive production would have declined more rapidly, and the emergence of newly competitive and more technologically sophisticated, capital-intensive production would have been more rapid. The maintenance of high employment and a socially acceptable distribution of income would depend heavily on the composition of the expansion of government expenditure.

If China had adopted such an alternative strategy before the Crash, the crisis would have been less costly for it and its international partners.

The United States would have faced unpalatable choices. There would have been a more challenging inflation environment, one in which the funding of private and public deficits was more difficult and costly. Interest rates and taxation would have had to be higher and government expenditure lower. President George W Bush’s wars would have been contested more strongly on economic grounds. Economic growth, incomes and employment would have been lower than they were. But through these means, the US deficit would have fallen more or less commensurately with the Chinese surplus. The United States would have been less vulnerable to the Great Crash.

What if the United States had not been prepared to do these hard things in response to Chinese adjustment? The result would have been higher global inflation and interest rates, and probably greater vulnerability to financial instability. This would have been a bad outcome for China, the United States and the world as a whole. On the other hand, what if the United States had heeded the warning signs in external deficits before the Great Crash, and alone had tried to take preventive action? Could it have unilaterally taken steps to reduce its deficits, thereby forcing China to accept lower surpluses? If the US Government had been less profligate with expenditure or tax cuts, and had run much lower budget deficits in the George W Bush era, this would have lowered the exchange rate (and also long-term interest rates). Export growth would have been stronger and import growth weaker. This would have fed back into smaller Chinese exports and larger imports. China’s external surplus would have been lower. In the absence of countervailing increases in Chinese expenditure, growth would have been lower in both China and the United States. Unilateral and unreciprocated action along these lines would not have been an attractive option.

The best result would have been active coordination of macro-economic policy, within which increased expenditure in China coincided with expenditure restraint in the United States. Cooperation would have created less risky and more rewarding policy options for both countries.

Links Sep 24: Wen flips the bird

Wen: No way, Jose to 20% yuan lift. Bloomberg
Why the US should have gone Swedish (with the bailout). Barry Ritholz
US leading indicators: all about cheap dough. Econompic
Mr copper still ripping. Bloomberg
Is the US in 1931 or 1921? Baseline Scenario

Thursday, September 23, 2010

Bubbles Macfarlane

This post began as a critique of yesterday's RBA release of its discussion paper: Asset Prices, Credit Growth, Monetary and Other Policies: An Australian Case Study. The study is in large part an examination of the Macfarlane RBA's attempts to "lean against the wind" in 2002 and 2003 as an Australian asset bubble emerged. The paper draws the diffident conclusion that Macfarlane's efforts probably burst the bubble. Macfarlane has basked in the glory of the same apocryphal truth for the past decade, enjoying a reputation as the first and only central banker to address asset prices.

But what happened when this blogger delved into the data was a jolt to the memory stick. In looking at the above table, it is obvious that once past the early nineties post-recession rebound, the main credit and asset growth story can be dated virtually from the month of Macfarlane's appointment to the RBA in September 1996. Tellingly, the official interest rate was 7% in August of that year. By December it was 6%. By July the next year, it was 5%. In addition, the spread between the official rate and bank rates had also diminished another 50 basis points as competition from multinational and non-banks crimped the big four's margins.

And look at what happened in the chart below. 1996 dates the sudden upwards shift in long-term income to price ratios from around 3x to above 4x. Rates spiked briefly through 2000 but were back to below 5% in 2002. This helped along the second leg up in income to price ratios to above 5x (which was also fired up by the First Home Buyers Grant).

Now, there was a new Conservative government from 1996 crimping fiscal outlays to pay down debt. And Australia was still enjoying its productivity surge from the reforms of the late eighties through the mid nineties. From mid 1997 we also faced the Asian financial crisis, which played a role in keeping interest rates low right through until the early 2000s.

And yes, inflation rates were subdued during the periods when Macfarlane cut rates hardest.

But by way of comparison, when, in 2000, Australia faced four consecutive quarters of GST-induced inflation above 6%, official rates peaked at 6.25%. Whereas, in 2008, under Glenn Stevens, when Australia faced three consecutive quarters of commodity-price induced inflation from 4.5% to 5%, rates peaked at 7.25% with another 50 basis points added for real rates as banks widened the spread.

If the RBA is going to credit Iain Macfarlane and itself with successfully "leaning against the wind" in 2003 then shouldn't it also acknowledge his and its role in the creation of that very same gale?

Links Sep 23: Bernanke's fires up the whirlybird

Gavin Davies notes that the US FED has overturned decades of hard yakka and has now committed itself to making inflation rise. He concludes " is not difficult to see why the dollar has been falling, and gold rising".

But Chris Whalen goes bananas on declining profitability in the US banking system and declares ahead lies "...the worst economic contraction since WWI". Perhaps that's why Larry Summers is abandoning ship.

Gregor Macdonald on China's crazy coal use.

Martin Wolf does Michael Pettis does China's fixed investment dependency. And for those who can remember, John Garnaut made the same argument six months ago.

And, courtesy of Michael Pettis, the following links on a trade war between China and...well, everyone else:
- U.S. may trigger trade war with China on currency issue: Experts
- EU should think twice before taking trade defense measures against China
- China still a renegade nation
- China's yuan on long gaining streak

Of course, according to Jim O'Neill and his breathless reporter Michael Stutchury, it's all good in China. Oh yeh! Stutch is making a habit of loving in with Goldman luminaries.

Even as iron ore prices trace out what looks suspiciously like a head-and-shoulders top on withering demand and world steel capacity utilisation fell again in August.

The counter argument being that the US dollar shows the same pattern, only clearer still.

Wednesday, September 22, 2010

Determined denial

Everyone has seen the ads. A sturdy and commonsense banker confronts a troupe of American advertising hot shots. The banker responds with steady incredulity to their fast and loose attempts to modernise his brand. He is the model of prudence, juxtaposed against faddish spin doctors.

In the real world, Commonwealth Bank executives are travelling internationally (including to, presumably, America) to do more than dispense with a fictitious advertising agency's foolish ideas. They have gone "overseas to meet with some of the group's offshore shareholders and other investors interested in Australia and the Australian banking sector".

Last week's press release heralding their departure came complete with a 19-page presentation that will be used on the trip to reassure international investors that there is no housing bubble in Australia. It included quotes from such notable housing bears as Morgan Stanley's Gerard Minack and GMO's Jeremy Grantham that it aims to refute. CBA management has set sail on a bubble-busting roadshow.

Given the stake we Australians have in this little exercise, we should assess how the fundamentals of our housing market are being presented around the world by our biggest bank. Is the presentation likely to reassure footloose global investors, now acutely aware of the damage a housing bust can do to their capital? Perhaps, but only if they are closely related to the dunderheaded Americans that CBA uses in its own ads.

The presentation begins with the argument that "taking into account geographic differences, the ratio of house prices to income in Australia is not that much different to most other comparable countries".

The document provides some nice graphs making the comparisons clear. And they look reasonable enough except the statistics aren't explained. We don't know what income measures are being used, nor what median prices. Worse still, the statistics are cherry-picked from different sources to ensure the most favourable comparisons.

The lack of detail in the presentation is quickly forgotten as CBA's arguments sink into a fallacious morass. According to the bank: "Australia is the fourth least densely settled country in the world - 83 per cent live within 50 kilometres of the coast. Coastal locations demand a premium - Australia's population concentration in capital/coastal cities distorts comparisons to other, more densely settled countries."

You will forgive this writer if he points out that if 83 per cent of Australians live in coastal cities then that surely constitutes 83 per cent of the housing market. There is, therefore, no greater market against which a premium for coastal property can be justified. As opposed to other nations, where an even spread of population means there is elevated demand for coastal living as a reward for success. Nor has there been a great Australian exodus to the coast from the bush in the past 15 years. We've always lived by the seashore.

The CBA argument would still make sense if it were positioning Australian cities in a context of global demand for coastal living, but it is clearly not doing so. CBA's logic is simply that because coastal property everywhere is expensive, and Australia has largely coastal property, then Australian property is justifiably expensive. Aristotle would turn in his grave.

CBA's second argument begins: "Population growth has been a key driver of Australian house price appreciation" and offers a series of graphs showing that growth above historic averages as well as falling housing starts since 2005.

This rationale does help account for the 50 per cent or so rise in median house prices from 2005, when the commodity boom prompted skills shortages and immigration rose strongly.What CBA doesn't mention nor explain is the prior eight-year burst in prices of 120 per cent, driven largely through rocketing demand for investment mortgages, up 308 per cent over the period.

To understand that, CBA turns to its third argument, that there are "other drivers of house price appreciation [that] are structural, rather than cyclical in nature". According to the bank, "Australia's low inflation/low interest rate environment has dramatically increased the demand for, and accessibility of credit". CBA then concludes: "On RBA estimates, the reduction in mortgage rates during the 1990s expanded the potential housing market by 600,000 households. Absent a dramatic response from the supply side, a large part of the lift in valuation ratios is a permanent structural shift."

Those who interpret Australian house prices as a bubble would hardly disagree that a period of historically easy credit is a major cause of asset-price growth. But for the purposes of CBA's presentation, that is not the important point. The main claim is that this is a "permanent structural shift" and it makes it without a jot of evidence. There is no analysis of inflationary dynamics in the Australian economy. No mention of the effect of commodity prices. No breakdown of labour market trends. Nothing about capacity utilisation. Nor is there any mention that the supposed same ''permanent structural shift'' was thought to have occurred in the US, where it was dubbed the Great Moderation and culminated in the mother of all cyclical busts.

The failure to address this point is a key failing in the report, given Jeremy Grantham has stated that the Waterloo for the bubble will come with higher interest rates.

The same failing is also unfortunate given that this presentation is likely to be aimed in part at the global bondholders who determine the interest rates at which CBA borrows its wholesale funds and, therefore, in part, Australian interest rates. For them, the bank isn't arguing an objective case for continuing low interest rates, it is assuming those rates will be forthcoming and arguing that that will sustain house prices. Needless to say, this is dangerously circular.

Undeterred, the CBA presentation ploughs on. Next it claims that "the household debt ratio in Australia is similar to many other developed countries". Again it offers a pretty graph, this time of Australia's ''household debt as a percent of household disposable income'' as compared with Britain, New Zealand, Canada, US, Japan and Germany.

The problem with this item is that Australia is second only to Britain, the other market identified by Grantham as having the last of the great housing bubbles. Moreover, it is clear in the graph that Australia is in a much worse situation than US households and almost twice as bad as Germany. If anything, the graph makes it startlingly clear just how enormous Australia's housing bubble has become.

At this point, if I'm an international investor, I'm thinking ''we gotta short these chumps''.

The point of this analysis is not to predict an imminent housing crash. In fact, conditions are not yet ripe for the reckoning of the great Australian housing bubble. It would have happened in 2008 when global markets closed to wholesale Australian bank debt, but was postponed by a strong federal budget that supported both the asset and liability side of the banks' balance sheets.

The willingness of the government to support the bubble means the reckoning can only come when the budget also finds itself under pressure from a more serious and long-term correction in commodity prices or, as Grantham has hypothesised, from a burst of serious inflation.

But in the meantime we might rightly ask: is CBA's reputation in global markets currently so at risk that it need resort to the spin pilloried in its own advertising?

This article was originally published at Henry Thornton and was reproduced by Debtwatch, and Business Day. It also got picked up in New York.