Factoring in the China slump

Election season in Australia kicked off with announcements that the mining boom was over - perhaps a good opportunity to align voter's expectations prior to starting on the campaign trail.  But there does seem genuine concern of the risks to Australia from a China meltdown, not only from the RBA but also from ratings agency Standard and Poor's:

Australian banks' credit ratings would be cut by up to two notches and house prices would fall by as much as a quarter if China's economy were to slow sharply, Standard & Poor's says.

In a report assessing how Australia's financial system would respond to a ''hard landing'' in China, the credit rating agency says a dramatic slowing in Asia's growth engine would have severe ripple effects on the domestic economy.

S&P sees a hard landing in China - where growth slows from about 7.5 per cent now to 5 per cent - as unlikely, attaching only slight probability to this scenario.

But if growth did slow this sharply, it says Australian banks would face credit rating cutsbecause of their heavy exposure to the domestic economy and the $1.2 trillion mortgage market. (here)

Australia is a basket case!

Well not quite...but a toy kangaroo is certainly in the frame - for the royal baby soon to be born to Duchess of Cambridge Kate Middleton (and Prince William of England)!

For those unaware of Australia's odd constitutional arrangements, the head of state currently is English Queen Elizabeth II and through their shared history Australians maintain a strong connection to events in old Blighty.

That doesn't explain the whole stunt though.  Due to massive party infighting ahead of the September general election, Julia Gillard is trying all manner of things to regain the initiative and garner lost popularity, amidst infighting with former also-ran Kevin Rudd.  One such step was to announce a return to her traditional side by commencing a knitting of a soft toy for the English royal baby (while having only engaged in a sexist tirade at fellow male parliamentarians the week before).  Quite daft really.

But there is a serious point here - the political sideshow is distracting from serious economic headwinds.  As Warwick McKibben notes at MacroBusiness, problems lie ahead:

The biggest risk Australia faces is the political uncertainty which is undermining consumer and business confidence.
It won’t be until the end of 2013 that there is a clear indication of the direction of government policy. The good news is that the portfolio shift into Australian assets has probably passed, partly due to this political uncertainty. A weaker exchange rate is to be expected. This will be a two-edged sword. It will help with the profitability of trade-exposed companies but it will also add to imported goods inflation which will likely push inflation outside the RBA comfort zone.

Jim Rickards on the RBA - "foolish"

And its policy will lead to inflation not growth.

Fresh from releasing his bestseller introducing the world to the ongoing Currency Wars, Jim Rickards interviewed on ABC's Business program (see link here) and was really on point on the current dynamics driving monetary policy in China and the US and impacts for Australia.

While not the first to identify infrastructure overkill in China, Rickards was emphatic and went into detail about what is wrong with Australia's policy settings and likely outcomes.

Oh and in case you missed it the RBA has joined the Currency Wars!  This Blog has advocated this as somewhat inevitable (although there are ways to implement and Rickards is correct that the Brazil example is not a good one to follow - hence the criticism to the extent which Australia has followed although not sure if this is accurate).

Rickards' proposed solutions of 12 months ago are unorthodox although it is now an academic question as to whether they would have been successful.

Watch out Australia!

The trade imperative

Similar to the decision to open swap lines between the Australian and Chinese central banks in CNY, the recent announcement that the Reserve Bank of Australia will diversify 5% of its holdings into Chinese government bonds makes good political and (in terms of encouraging trade) business sense.  

But are they a valuable instrument? In terms of currency value, the Chinese currency RMB would appear to most likely to appreciate (taking stated information about fundamentals as given).  But the likelihood that there will be a decent return from the Chinese government?

Don't bank on it.  It is a reflection of the broader alignment of the Australian economy too - and looking at the recent headlines doesn't make good reading:

The economic weakness in China clearly appears to be taking a toll on the Aussie economy.... (here)

Will Australia rebalance? Has any economy rebalanced?

No and no.  Not in the short term anyway.  Whenever you read about politicians and/or bureaucrats having to engineer a rebalancing or engineer a soft landing, you know they will not succeed.  An excellent FT article paints the picture: 


...many forecasters are still worried. They do not believe business investment will be a major driver of growth and argue the Australian economy will have to rely even more heavily on housing construction to meet the RBA’s 2013 GDP growth forecast of 2.5 per cent....As such, they reckon the central bank, which has lowered its benchmark cash rate by 175 basis points since November 2011, will be forced to cut again to stimulate demand....

....“I think we are more of a quarry than what we were 50 years ago and that worries me. The strong mining cycle can’t last forever, that’s inevitable,” Bob Every, the chairman of retail and resources conglomerate Wesfarmers, told a gathering of business leaders in Sydney earlier this month. (here)

A petition to Glenn Stevens

Rumoured at one point to be the highest paid central banker in the world, Glenn Stevens, has been reappointed as governor of the RBA.  As his second three year term commences, we would like to petition Governor Stevens in respect of the following items which we believe must be addressed urgently:

1. The mining boom is over.  Stop twisting monetary policy to suit this bloated sector and start to focus on the ailing real economy.

2.  Admit the obvious and stop ignoring the currency war.  It is foolish to maintain one's head above the parapet.  All central banks are engaged in debasing their currencies.  The textbook has been ripped up and it is now beggar-thy-neighbour policies.  Ignore this at your peril - the high AUD is hollowing out the economy.

3. Accept that Australia is flooded in hot money which will withdraw in a hurry when yields return to normal.  Reread point 2 in respect of the high AUD.

4. Prepare for vaporisation of the banking system.  The safety in conservatism of the banking system is a myth (and that means the liquidity facility will be used for solvency).

5. Taking account of conditions in Australia and observing overseas, true inflation is much higher than official figures and should be dealt with accordingly.  Australian's purchasing power is soon to erode and quickly.

That's five big points to tackle Glenn.  If you have others, please comment or send an email to feedbackformhere@googlemail.com

Liquidity v Solvency again

One man's assistance is another man's bailout...

In the world of bank recapitalisations little is clear and labels are important as substance.  Of the many banks which imploded or suffered from the ongoing implosion in Europe, a vast number had been given a clean bill of health by the European Banking Agency during post-2007 stress tests.  In fairness the tests were focussed on liquidity management (liquidity strain being identified as the immediate cause of failures of banks like Bear Stearns and Lehman which kicked off the crisis), while as many now know (except it seems the heads of the EU and the ECB, the crisis has morphed into one of solvency - banks just don't have enough capital in general (as opposed to immediate funds to hand and agreed credit lines to see off a sharp rise in demand for return of funds).

And so it is that the same debate is playing out in Australia in respect of its new bank liquidity facility.  As noted several times in this blog, this has been characterised as a backstop, a safety measure which should not have to be used, or if used, only to cover temporary liquidity demands.  Taking this at face value there are fair questions to answer, but interestingly Michael West had an article out where he disputes the purpose - that the facility is in fact, simply a bailout fund from the RBA - with the suggestion being that Australia's banks are much weaker than they represent.

Over to Michael:

...Glenn Stevens doesn't think it's a bailout fund. It's a Committed Liquidity Facility - the $380 billion in Reserve Bank rescue money, sorry ''liquidity'' that is, which the banks can access should they find themselves in strife....Under this thingamajig, one must select one's words with care, if you are a bank and you are about to bite the dust then you can forget about a bailout. If you are even tempted to whisper the word bailout, snap out of it!...

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...If, however, you encounter ''an acute stress scenario'', why not shimmy on down to Martin Place - but only if you need a little something to facilitate your liquidity in a committed kind of way - flop out the old paw for a spot of lazy taxpayer liquidity, say $20 billion, and Bob's your uncle. Or rather Glenn's your lender. This is no freebie. You will pay dearly - a heinous 40 basis points over the official cash rate....

...Yes, you can only access this exciting opportunity if you are a bank and you are ''illiquid'', but not ''insolvent''. It is beyond this mere chronicler to explore the fathomless schism between a bank that finds itself illiquid and one that finds itself insolvent....(here)

This is not too different from some schemes tried elsewhere and the main message from the crisis in other jurisdictions is that early recognition and writedown of bad banks is necessary (this is the difference between the US and EU response).  Given that thanks to the EU, we are now in a world of depositor bail-ins (with New Zealand and Canada indicating they are considering such contributions so that bondholders, depositors and all sorts of creditors likely to be hit if a bank fails), the strong suspicion is that, notwithstanding the arrangements discussed beforehand, any stress at a major Australian bank will be messy.

More on RBA reticence

It has been noted on this blog that the RBA is clinging to its mining first policy and failing to engage with the rest of the world's central banks as they battle the nascent currency war.  Following its comments seeking to reassure earlier in the week, there has been some decent commentary on Macrobusiness.com.au about comments of the RBA and APRA on the difficult policy reform environment and how out of step the two bodies are with the rest of planet earth.

As noted RBA Governor Stevens decried reform fatigue:

....a point in the financial regulatory sphere where the G20 should be looking for careful and sustained efforts at implementation of the regulatory reforms that have already been broadly agreed, but being wary of adding further reforms to the work program....(here)

Macrobusiness notes the underlying concern could stem from a number of concerns - the amount of reform already, concerns about a change of government with new policies and the capacity of banks to comply more or even "that the RBA is more worried about the approaching mining investment cliff than they are letting on".

All true but this blog has a slightly different view.  Macrobusiness also talk about recent speeches at a meeting of central bankers in London this week, in particular from Fed Chairman Bernanke which it seems he is basically justifying the total debasement of the US Dollar via money printing programs:

....Regarding the effects of monetary easing on exchange rates and exports, I would note that trade-weighted real exchange rates of emerging market economies, with some exceptions, have not changed much from their values shortly before the intensification of the financial crisis in late 2008. Moreover, even if the expansionary policies of the advanced economies were to lead to significant currency appreciation in emerging markets, the resulting drag on their competitiveness would have to be balanced against the positive effects of stronger advanced-economy demand..... (here)

At a time of recurrent flagging demand! It goes on...

...It is true that interest rate differentials associated with differences in national monetary policies can promote cross-border capital flows as investors seek higher returns. But my reading of recent research makes me skeptical that these policy differences are the dominant force behind capital flows to emerging market economies; differences in growth prospects across countries and swings in investor risk sentiment seem to have played a larger role...

If this were true then the record high run of the Australian dollar would be simply down to the country's economic opportunities and not because Australian government bonds pay rates far higher than nearly most of the world!

So there you have it - Macrobusiness interprets this positively and mildly - positively in the sense that the Fed's actions are innovative policies and the actions by the RBA are failure to get with the program. This blog broadly agrees but comes to a different conclusion.  There is a currency war going on the the Fed's policies are especially provocative.  It is not that the RBA is not following - so far the RBA seems to be ignoring the situation completely and hoping it will go away..!  It will not and Australia is vulnerable...

What's wrong with the RBA

A well written piece looking at the short-sightedness of the RBA revealed by Philip Lowe in his speech this week.  While there was a logic to Lowe's statements, it is argued that they were unbalanced, skewed by bias and importantly not based on sound assumptions.  Couldn't agree more!

..., had macroprudential tools been used then the RBA would never have had to fear a blowoff in credit associated with the boom, rates wold have been much lower and the dollar too. We would not have had to embrace Dutch disease as a way of managing surging mining investment...

...Lowe’s internal balance (note it is not “external” balance leaving him an out later on) of course did have its casualties. The major ones being Australia’s non-mining tradable goods sectors: tourism, education, services generally and manufacturing especially. As we know, the last ABS private capex report showed manufacturing investment in outright collapse, running at 1989 levels before inflation adjustment: 

..The truth is it’s a punt and in this context it is hardly fair to describe Australia’s growth as  enjoying “internal balance”. If China does revert to mean, we’ll have nothing but under priced dirt to sell overseas...(here)

and that's not to mention the currency war!!

The Financial Times has a more sober analysis, focussing on the yield curve returning to normal (with its suggestion of a return to normal interest rate expectations).  As above, expectations of lower short term yields probably rests on assumptions which may simply not be true...wait and see.

Receivership - coming to a company near you

Recent reports of failed businesses include high-tech Adelaide engineering company Priority Services, Potato company Mondello Farms and Victorian manufacturer the Starmaid Group.

....Priority Engineering Services had been operating in Elizabeth South since 1984 but a downturn in contracts has led to receivers moving in and staff yesterday being made redundant....Receiver Ferrier Hodgson was already talking to parties interested in leasing or buying the company's 10,000sqm site.

What links all of these together apart from general slowdown and industry specific factors?

...It is no secret that ...manufacturers are facing extremely challenging times...Companies are struggling under a high cost, high wage, high currency environment."

If you are confused about how the high currency and other policies could be causing damage to the economy while being proclaimed as good by the Reserve Bank of Australia, then you are not alone - so are we!  In fact we think the RBA is suffering from short sightedness or only looking through one eye

The one eyed central banker

Interesting statements from Deputy RBA governor Phillip Lowe that high AUD has been a boon for Australia.  In classical theory a high currency slows imports and curbs inflation.  But this analysis ignores hot money flows and asset bubbles....

..."Had we not experienced the sizeable appreciation (in the value of the Australian dollar) over recent years, it is highly likely that the economy would have overheated and that we would have had substantially higher inflation and substantially higher interest rates," he told an economics forum in Sydney on Tuesday...

Well possibly, but globally inflation is low and interest rates are at rock bottom and the rest of the world...

...."At the moment though, the available evidence does suggest that lower interest rates are doing their work broadly as expected." (here)

This is a very narrow analysis.  Will Dr Lowe agree with this analysis when the hot money recedes, the currency drops and low interest rates fail to stimulate as is occurring elsewhere?

RBA hacked...

...The Reserve Bank of Australia (RBA) said it had "on occasion been the target of cyber attacks", following a report in an Australian newspaper. (here)

More on the RBA backstop

Excellent piece from Chris Joyce on the RBA Backstop.  Question is does it show the full extent of the weakness of the Australian banks in their descent into crisis or is this the pre-emptive strike to hit out at the markets?  Yes Aussie banks are vulnerable coming off good times due to their reliance on wholesale funding, but will the RBA's actions be enough?

...In a globally unique policy, the Reserve Bank of Australia will supply banks with a permanent bailout facility worth up to $380 billion by 2015....The policy has been designed by the RBA to help banks satisfy stringent new liquidity tests which simulate “acute stress scenarios” that deny banks funding for 30 days under the post-GFC rules, Basel III....Local regulators argue that insufficient liquid assets such as government bonds meant they had no choice but to give the banks a new taxpayer-backed “line of credit” that could be tapped at a cost just above the RBA’s cash rate. Smaller building societies and credit unions are not subject to the liquidity tests and will not, therefore, have access to the bail-out fund....

...The Australian Financial Review has been told that the Swiss-based Basel Committee, which is the supra-national regulator of bank regulators, was initially opposed to what is known as the “Australian solution”. Only one other country, South Africa, has emulated it, although Singa­pore is evaluating it....

...With actual leverage of roughly 26.5 times, a 4 per cent fall in asset values would, on average, wipe out the major banks’ capital. While the banks are regarded as being durable institutions, it does not take much duress to invoke solvency threats. The Basel Committee’s second finding was that banks should hold more liquidity in the form of high-quality liquid assets to pay out depositors and wholesale bond holders during times of stress....(here)

A splintered backstop for Oz banks

Great piece in AFR analysing the nature of the RBA's commitment to backstop Australia's large banks in case of emergency.  As has been so problematic in Europe, it seems the central bank is on the hook, and early.

...The Reserve Bank of Australia’s unique Committed Liquidity Facility – a little-known, taxpayer-backed “line of credit” to help banks overcome solvency crises – creates as many problems as it is intended to address. And it is not clear officials have thought these through....

...The Australian Prudential Regulation Authority appears to understand this nuance [of solvency]. Officials acknowledge that if a bank needed to draw on the CLF, it would be trading insolvent under the Banking Act in the absence of the taxpayer support, irrespective of whether it had “positive net worth”....The Committed Liquidity Facility opens a Pandora’s box of problems. The most obvious concern is that it inverts the logic of the Basel Committee’s post-GFC policy remedies by entrenching taxpayer loans as a first, rather than last, line of defence against bank collapses. (here)

RBA in numbers

Interesting data out via a Bloomberg FOI request (via FT Alphaville).  Some detail of foreign holdings of AUD (in particular central banks) and the way RBA goes about determining the extent of overvaluation.

....The staff's preferred model is based on the long-run relationship between the real exchange rate and the terms of trade and the real policy rate differential with the G3 (US, euro area and Japan) over the post-float period. It suggests the exchange rate is around 5 per cent overvalued.......While the bank has signalled that the dollar has been a factor in deciding recent rate cuts, and there's been a bit of 'passive intervention' with a chunk of foreign currency, so far it does not seem to have done much....

...We have to wonder how much of the central bank's low-key response to the AUD's overvaluation is because officials genuinely think the Australian economy can cope, and how much of it is because doing anything about it is too damn difficult. The RBA is already in a cutting cycle but slashing rates very low would risk inflation. Going Swiss is not an attractive option for small economies that have inflationary pressures; as the New Zealand central bank governor outlined last week....(here)

Fair enough but what is likely disturbing is that there are well a couple of assumptions in play, particularly that i) the high AUD hasn't had an impact yet (arguably it has) and ii) the RBA still has control of its currency

...In that scenario, how long might it take before even a 'moderately' overvalued currency takes its toll? We also can't help noting that the central bank of New Zealand, a much smaller economy in a very similar predicament, has decided that despite the risks it is time to go a little harder by explicitly threatening intervention .... RBA governor Glenn Stevens says that if things get really bad, a strong Australian dollar probably would cease being a problem....

What if the AUD doesn't fall or falls very abruptly?  There is a currency war after all. And in case you are wondering whether imports (including outward tourism) are on expanding too rapidly, symptomatic of an overvalued currency, then read this.

AUD is not a reserve currency...

An interesting side issue from the currency war debate.  In talking up the likely devaluation of the Aussie dollar, Debelle mentioned its widespread holdings among central banks.  It is true that hot money, including from central banks has been attracted to Australian bonds, with Australia seen as a relative safe haven, having high interest rates and good metrics.  

First thing to note is that metrics are degrading.  Swan's budget is sinking into deficit like a dead dodo (estimates are sinking to $15 billion here).  This means less incentive to hold Aussie dollar bonds.

But more significantly, Australia is a very small economy.  The argument made previously for not intervening is that Australia's debt markets and central bank are too small to counteract global flows.  Overall, thanks to mining plays, Australia's dollar has the character of an emerging market currency, once hot and decoupled from atlantic turmoil, now facing outflows.

Unlike China, which cannot sell parts of its massive holding of treasuries for fear of wiping out its remaining holdings, there is no reason why all those central banks Debelle is talking about will feel inclined to keep their Aussie bonds.  Debelle said:

....There's no limit on our ability to supply Australian dollars...we have more Australian dollars than anyone else in the world because we print them," he added, pointing out that Switzerland had successfully capped the value of the Swiss franc against the euro since 2011....(here)

Firstly there is no comparison between Switerland and Australia in terms of the size of their fx markets or Switzerland's proximity to the Eurozone.  Secondly and more importantly, who will even want Aussie dollars in months and year's time? 

RBA fighting a phoney war

Well certainly not a currency war.  As twitter posts have been appearing with news that Malaysia has joined the currency war, RBA board members are now talking about the possibility of joining - following other nations to lower their interest rates....Roger Corbett got a mention (here) as did Guy Debelle...

...‘To date in Australia, we have been able to counter the effects of the higher Australian dollar with lower interest rates,’’ he said in a speech to the University of Adelaide Business School. ‘‘We still, obviously, retain scope to lower interest rates further, should the need arise, including to counterbalance the pressures of an elevated exchange rate.’’....But Mr Debelle warned that cutting interest rates too far could also create problems for the economy - forcing up the price of assets and causing people to borrow more than they could afford....(here).

This is for an economy where there is already a bursting property bubble and asset price trend.

Meanwhile even the RBA is admitting the Aussie dollar is overvalued, but not by much they say!

....THE Australian dollar was overvalued by as much as 15 per cent late last year according to modelling released by the country's central bank....The local currency was between 4 per cent and 15 per cent over valued in September and about 7 per cent above fair value in December, papers released by the Reserve Bank of Australia under the Freedom of Information Act showed....Even so, the central bank papers said the currency wasn't having a "highly contractionary" affect on the economy...(here)

(the Economist calculated the overvaluation at 60% recently).

Cost of funding - cheap and risky?

More on Oz banks' low cost of funding - it's due to nice instruments called covered bonds, invented in the former European state of Prussia in the 18th Centure and rolled out globally in the 2007-8 financial crisis:

....Now the evidence is in. Covered bonds have brought down bank costs even further. In a confidential note to its institutional clients, Westpac describes the fall in wholesale funding costs over the past year as ''extraordinary''.....No longer can the banks rely on that hoary old chestnut of ''high funding costs'' to pass off their failure to match the successive cuts in the official cash rate....Margins are fatter than ever, veritably bulging, and there is scant proof that borrowers are getting their grimy fingers on a single cent of it. It's a good thing for shareholders though, some cautious at the listless growth in credit....(here).

But like all good things in banking, risks are appearing...

....BlackRock Inc. said using loans to small- and medium-sized companies, or SMEs, to back the securities rather than safer real estate or public-sector debt may devalue the asset class. Pacific Investment Management Co. said the first European deal, being marketed now by Commerzbank AG, may call into question SME issues as true covered bonds if it fails to qualify for indexes benchmarking performance....(here)

Rules of engagement

An RBA/Glenn Stevens defence piece by Michael Pascoe in the SMH.  A fair point but for how long will either Australia's policy makers blame the markets for inaction. New Zealand showed a much more assertive stance last week (here).  And while it is true that Australia is a small market that can get flattened by the FX monster, Australia will be in the unenviable position of being the only country not to engage in the currency war.  Brave?

....“You could argue we would be better off with some different configuration: a lower exchange rate and higher interest rates - or more normal level of interest rates - but, given the configuration of the global economy, I just do not think that is possible at the moment. The weakness in the North Atlantic and their money creation is leading to their currencies wanting to depreciate, and someone has to be high.”...(here).

Sounds like "the exchange rate we had to have"... (heard something similar before? here).

 Australia really is the lucky country...!

NZ performs the Haka

In the currency war being unleashed around the world, central bankers have some weapons at their disposal but not many.  Trading strategies - money printing, security creation and bond buying have taken off in the last few years but the role of policy, briefing and government led signals are important too.  The most notable stunts have included a parade of camera work at the Bank of England gold vaults (including a visit by Queen Elizabeth II), sound bites by Russian central bankers and outright lies issued by the G20.

New Zealand has chosen to go for the talking down option (sensible given New Zealand is a small country with little reserves) but has really performed a Haka dance - that made famous by the All Blacks rugby team, defined by Wikipedia as:

... a traditional ancestral war cry, dance or challenge from the Māori people of New Zealand. It is a posture dance performed by a group, with vigorous movements and stamping of the feet with rhythmically shouted accompaniment...

As detailed by FT Alphaville, NZ is entering the fray:

....We believe the exchange rate is significantly over-valued relative to what would be sustainable long term in the absence of sizeable increases in the terms of trade and productivity....The Bank will intervene when circumstances are right. We will use the OCR as circumstances require and we’re exploring the scope to use macro-prudential instruments that address increasing challenges to financial stability associated with ongoing increases in house prices, and that can also support monetary policy.... (here).

http://1heckofaguy.com/

Now, it is about to be Australia's turn, yet the RBA is silent...what gives?!