Explaining Australia’s World-class Debt Performance

Autralian dollar banknotes in the suit pocket

Yesterday, I discussed the pivotal role that debt plays in the global economy. By necessity, I had to leave a lot of detail out. If I didn’t, you would’ve dozed off.

But the main point was that US dollar denominated debt is actually an asset in the hands of foreign central banks. And this asset forms the reserve base for the local banking system to create even more credit (debt).

In the modern world, debt begets debt.

If you understand this, you understand how debt has now grown to ginormous proportions. And it will keep on growing. That this monetary charade will blow up one day is not in doubt. The only question is: When?

In my view, the ‘when’ happens in a deflationary bust or an inflationary blow-off top, which will precede the death of currencies as we know them.

As I said yesterday, if you’re interested in this stuff, you simply must read and follow Jim Rickards. The man knows more about international finance that just about anyone else I know. You can get a great deal on his new book, The Road to Ruin, here.

While I wholeheartedly agree that the system we all operate in — one where debt builds on debt, which builds on more debt — is screwed up and bound to fail, I simply don’t know how it fails, or in what timeframe.

For that reason, I don’t engage in much discussion about ‘when’. It’s just an opinion, and you know the old saying about opinions, don’t you?

Perhaps instead of opinions, you should look for signs. For example, if Zero Hedge shuts down or turns bullish, you’ll know something is brewing!

But that’s not what I wanted to discuss today. Given yesterday’s topic, I thought it might be interesting to see how Australia sits in the international debt race.

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Australia’s Debt is World-Class

Unlike China, we don’t run a trade surplus with the US. Therefore, we don’t sit on a large pile of foreign exchange reserves, which our banks can create a mountain of new credit on. So how do we manage to perform at a world-class level on the debt rankings?

Relative to the size of the economy, Australia’s household sector is one of the most indebted in the world. There’s a lot of moaning about government debt, but that’s not the problem. Our government is reasonably frugal when compared to other developed economies. But because household debt is so high, and much of this debt is held in the banking system, the government is on the hook if anything goes wrong.

This is why the credit ratings agencies threaten to strip Australia of its AAA credit rating if they can’t get their deficits under control. High household debt is manageable, but high household debt AND continually growing government debt isn’t so good.

Anyway, let’s look at just how the household sector has taken on so much debt, and how the banks have been able to do it.

Because Australia doesn’t run a trade surplus (meaning we consume more than we produce), we don’t have enough savings to satisfy our demand for debt.

Therefore, we need to borrow from overseas. Our ‘net debt’ position is currently around $1 trillion. That’s the net amount we have borrowed from foreigners to fund our lifestyle and our love affair with property.

‘Why do foreigners keep lending to us?’ you may ask

Well, when you have savings, you have to ‘invest’ it somewhere. And whether you agree with it or not, debt secured by Australian residential property, or backed by the AA-rated banks who are in turn backed by the AAA-rated Aussie government, isn’t such a bad deal.

Australia is a relatively peaceful and clean place to live. It’s not under threat of invasion, and our education and health systems, rule of law and respect for private property are all positives in the world of international lending.

As discussed yesterday, when you get a home loan, the bank creates the money and puts it in your account. The loan sits on the asset side of the balance sheet, as it is secured by the property. But the bank needs to balance this on the liability side. If it doesn’t have enough local deposits to cover the loan (and it doesn’t), it needs to borrow in offshore ‘wholesale’ markets.

This is where the foreign borrowing comes in.

As long as our banks have adequate capital reserves, they can keep creating credit. Capital reserves come from retaining profits or via capital raisings. Our banks are pretty good at this. And if the economy slows, the RBA has been pretty good at increasing the amount of ‘money’ in the system (called exchange settlement funds), which then lowers interest rates.

This all goes swimmingly when the global economy is growing. But Australia will be in all sorts of problems during the next crisis. That’s because we rely on $1 trillion of foreign money to keep our house prices elevated and our baristas employed.

In a credit crunch, no one wants to lend. They just want their assets in the securest form possible. But because assets are debt, when debt goes bad, assets go bad as well, and everyone freaks out.

When this happens, Australia won’t be able to borrow on such favourable terms. Our dollar will collapse first, and then interest rates will rise to reflect the increased risk of lending to a debt-addled household sector.

So when will this happen? Well, it did happen in 2008. But the cavalry arrived in the form of central bank bailouts and China’s credit boom. This eased fears of a debt (asset) collapse and got funds flowing again.

In fact, Australia benefited immensely from China’s credit boom, and still is. That’s because much of the newly created debt in China is fleeing elsewhere. You’ve probably heard that China has a capital flight problem. A lot of it is coming to Australia to buy property and other assets.

Will a 2008-style credit freeze happen again? Maybe — I don’t know. But as the saying goes, lightning never strikes in the same place twice.

In my humble opinion, everyone is too busy looking at the past and waiting for a repeat. The template for the next crisis will be completely different. And it could be years away.

In the meantime, there is money to be made!

Regards,

Greg Canavan

Greg Canavan

Greg Canavan

Greg is the Managing Editor for Money Morning. He helps investors preserve their wealth over the long term using a method known as value investing. Lucky for Money Morning readers, he imparts some of this knowledge on them three times a week with editorial spots.

Greg Canavan is a feature Editor at the Money Morning and is the foremost authority for retail investors on value investing in Australia.

He is also the Editor of Crisis & Opportunity. An investment publication designed to help investors profit from companies and stocks that are undervalued on the market. Greg is the former head of Australasian Research for an Australian asset-management group and has appeared on CNBC, Sky Business’s ‘The Perrett Report’ and Lateline Business. He has written articles for The Sydney Morning HeraldThe Australian and www.ninemsn.com.au. Greg’s aim is to help you create a portfolio of stocks based on sound, proven, investing principles. His system for identifying stocks trading beneath their ‘intrinsic’ value combines a big picture understanding of the financial markets with a thorough valuation analysis of individual securities.

Greg’s method of investing is not about taking huge risks and rushing into big positions. He investigates highly profitable companies trading at a reduced premium to their net asset value, or ‘equity’ value as he puts it – and passes that research on to his subscribers to incorporate into their financial plan as they see fit.

With Greg’s help, you can implement a long-term wealth building strategy into your financial planning, be better prepared for the tough financial challenges ahead and stop making the basic, costly mistakes that most private investors make every time they buy a stock.

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