Australia, You’re Running out of Options. --Who would’ve thought the end of the Federal Reserve’s QE experiment would’ve caused such carnage at the outer rim of the financial system? Commodity producers (especially emerging markets) are feeling the pinch. As capital flows back into the core of the financial system (US capital markets), it’s leaving these periphery nations in tatters. --As a result, you’re seeing falling currencies and upward pressure on interest rates. It’s an important point for Australia to take into account, or at least it will be in 2015 and beyond. --The biggest concern right now is the oil price collapse. This should be good for markets — or at least it should be good for Western consumer markets — but that’s not the way it’s playing out. --The long oil boom led to a lot of borrowing, both in the corporate debt market and through the banking system. This borrowing looked safe and secure at US$100 per barrel prices. At sub-$60, some of it now looks very risky. If prices stay down at these levels, you’ll start to see defaults and restructuring. --This won’t be big enough to cause any systemic problems, but it could hit investor (or speculator) confidence, which in turn affects market liquidity more broadly, which is probably what is happening now. --The other issue is Europe. Greece is again freaking markets out. The concern this time is that a potential general election might result in a win for the populist Syriza party, threatening Greece’s austerity drive and their position in the Eurozone. --The concerns are probably overblown, but it’s adding some nervousness to the markets. On top of this, you’ve got an uncertain political environment in Italy too. 2015 looks like another tough year for the Eurozone. --Not making it any easier for the region is the ongoing slowdown in China. Granted, the slowdown is so far an orderly one. But it will continue to have an impact on the Eurozone, as trade between the two regions is huge. --Obviously, you’ll see a greater impact of the China slowdown here at home. It’s already blown up the iron ore price. The government now expects China to grow at a slower than expected 7% per annum and for long term iron ore prices to stabilise around US$60 per tonne. That’s far more realistic than earlier projections, although they’ll be surprised to see China’s growth grind lower in the years ahead. --And while US$60/tonne for iron ore might seem conservative, prices always go further than you expect on the downside (as they do on the upside) and so you’ll probably see a brief period where iron ore gets close to $50/tonne. --In many emerging markets, you’re seeing foreign capital flee on weaker commodity prices. That means falling export revenues, which in turn put pressure on these governments’ fiscal policy. If foreign lenders don’t view these governments as credible (that is, give them credit), they’ll sell out, pushing the currency lower. --The fall in the currency, if extreme enough, threatens to bring about inflation, so in many cases, interest rates need to rise to protect the currency and entice foreign capital back in. Such a response obviously constrains the flow of credit and leads to a sharp economic slowdown…if not outright contraction. --With the Aussie dollar down sharply over the past few months, is this something we need to worry about? --Not yet. Foreigners still see the government as a credible borrower. Total debt is low and we retain one of the world’s few AAA credit ratings. It’s this credit rating that implicitly backs the banks (who collectively borrow much more from foreign creditors than the government does) and makes it easy for them to borrow at low rates. --But if the government doesn’t have some sort of sustainable medium term plan to get the budget in order, then we’re at risk of losing that AAA rating. David Murray said as much last week when releasing the ‘Financial System Inquiry’. If that happens, the resulting adjustment in the cost of credit would put Australia into recession. (A ratings downgrade pushes up the cost of credit, regardless of what the RBA does to interest rates). --This isn’t a risk for tomorrow or even next year. But it’s a looming risk at a time where Australia must deal with a structural change to the budget. That is, the revenues we’ve grown accustomed to through years of booming commodity prices are no longer. Yet the spending promises remain. --That means the government will have to make some tough choices to structurally change the budget, like modifying negative gearing and reducing other tax and super perks for the relatively well-off. --But will it happen quick enough? Probably not. The government wants to raise these issues in an upcoming tax ‘white paper’. But that is not due until the end of 2015. After debate and discussion, and an election that must take place before January 2017, you’re not likely to see structural reform implemented (if at all) until well into 2017. --If in the meantime another global crisis hits our shores (and, there’s a good chance of that happening) and Australia doesn’t have a plan to deal with it, our credibility in the eyes of foreign creditors will come into question. Last time the plan was China. We got lucky. **Greg Canavan, For The Daily Reckoning Australia
Posted on: Wed, 17 Dec 2014 06:25:24 +0000
Trending Topics
Recently Viewed Topics
© 2015