Australia – the lucky but unbalanced country

I get many emails asking for my opinion as to the Australian economy and the Australian banks in particular. That is not surprising because I am probably the best known Australian writing a global investment blog. Certainly I write the best known blog by any Australian fund manager.

Answering the question in one post makes about as much sense as answering the same question regarding say Canada or France. The country is too big for an easy answer. Moreover some of my correspondents are German or American and others are Australian and I can safely assume different levels of knowledge for each party. This is a post aimed at non-Australians. Nuance for locals is harder.

Australia’s macroeconomic miracle

You can’t understand why Australia works so well without a decent statement of the Australian macroeconomic miracle. Australia is one of the smallest and most indebted nations to be given the privilege of borrowing in their own currency and floating that currency. New Zealand (across the ditch) is the smallest country with the unlikely trifecta (has run large current account deficits for a very long time, borrows in its own currency, floats that currency).

This is incredibly useful. If you are highly indebted bad things can happen to you but they are far less severe if you are lucky enough to be able to borrow in your own currency and to float that currency.

Consider the situation when the macroeconomic environment moves sharply against a country – as might happen with a rapid terms of trade change – or also might happen with if people (say due to a global fear epidemic) think its possibly you can’t repay them.

• If your currency is fixed you will get a classic monetary recession. People will speculate against the currency (or withdraw their lending to you) and (due the central bank being forced to defend the currency) the local monetary supply will crash. The extreme version is what is happening to Latvia. It’s why Latvia should float their currency.
  
  
• If however your currency is floating and you are highly indebted in foreign currency then your currency collapse will bring into sharp relief and immediately the difficulty of repaying your debt. The lower currency increases the principal and interest repayment in domestic terms of your debt. In extrema it causes almost immediate default. This is what is stopping Latvia floating their currency.
  
  
• The Argentine solution is float the Peso in a crisis – but to rejig all old debts to new pesos at some new exchange rate and formalise the default. If you do that nobody trusts you again. If you are South American you do it a few times and you wind up looking like South America rather than Australia or the United States. In 1900 the three richest countries in the world per capita were Argentina, New Zealand and Australia (in order). Look how that worked out.

Now the Australian miracle (the trifecta) means that an external crisis can hit Australia and all that happens is that the Australian currency drops until our terms of trade improve again. The classic example was the 1997-99 Asian Economic Crisis: as we export mainly to Asia this was potentially devastating to our economy. But instead it was just devastating to the currency – which fell by about 50%. I remember travelling to the New York (for work) when the AUD was trading at 48c US. It was so expensive in New York as to be completely comical. The business hotel in New York cost more than a week’s average wages per night (it was a business hotel in the height of the dot.com bubble). But the fallen currency worked. It meant local export industries ticked up – the tourist industry did not collapse despite the lesser numbers of Asian visitors. The lower currency bailed out plenty of other industries as well.

When the crisis disappeared the currency went up again - more than doubling. Then China slowed a little and the currency fell.

If we did not have a floating currency and the ability to borrow in our own currency this would not have happened. We would have been just another case of macroeconomic road-kill.

This is a deal afforded Australia only because of 100 years of fairly good management. If you stuff up you lose our trifecta ... it is worth preserving. Fiscal rectitude – especially in good times – is worthwhile because it protects this privilege. And the reason why you want to run tight budgets in good times is precisely so the world does not force you to run fiscally contractionary policy during bad times.

General observation: whilst these conditions persist (which could be a long time), Australia will have the least trouble of any major OECD economy in adjusting to external economic shocks. The United States is pegged to China (although not by their own volition). Most of Europe is pegged to each other. [It will not help so much with domestic economic shocks. But governments of both persuasions are pretty good by global standards and they don’t look like stuffing it up. I am not so cheery about New Zealand – a country I think is very badly run by comparison with Australia.]

Anyway with the recent shock (China slowing commodity demand due to global economic conditions) we had the usual currency correction (currently reversed). Again and it looks like we have avoided the shock. The Australian economy seems indecently strong.

The unbalanced Australia

Unfortunately it is not quite as simple as all that. The Australian economy is very unbalanced. It has Sydney – a huge financial city in three big rings. Inner Sydney is a financial city of very high wealth. By repute owners of almost half of the wealth of Australia reside East of the Sydney Harbour Bridge. And it is only 4 km (3 miles) to the ocean! [The entire city of Brisbane is east of the bridge too, but the wealth is in Sydney.]

The financial sector is hurt but not badly as credit markets never closed here for longer than a few hours.

Beyond this Sydney has a service ring – mostly people who service the financial city (cleaners, plumbers, school teachers).

Outer Sydney (fully an hour drive from my home) is a manufacturing centre and it is hurting – but not as badly as I thought. Indeed a falling currency seemed to keep it quite well adjusted.

Almost all of Sydney is NOT resource dependent. It is the least resource dependent city in Australia. (In order Perth, Darwin, Brisbane, Adelaide, Melbourne, Hobart, Sydney.) Hence the recession is nastiest in New South Wales – and even then it is not bad. [Sydney is the capital of the state New South Wales.]

China has taken off again – or at least Chinese commodity demand has resumed. Australia is going to have to have a big internal adjustment – which will downplay the role of Sydney. However as there has not been a financial system crash here that will be an adjustment which for the moment looks manageable. As long as the adjustment happens at less than say 80 thousand jobs per year it will happen without great financial stress. For that we need China to keep on demanding our commodities.

The insane Sydney Housing Market

I am long Sydney Housing. I own a nice house. I would prefer bet against the price of my house (a nice but not large house without beach views in the fashionable suburb of Bronte worth about AUD3 million). I assure you it is not quite as glamorous as Sheila Bair’s recently advertised palace. Really it is solid upper middle class suburbia but with a silly price tag.

Indeed I would generally prefer bet against Sydney generally as it makes no sense. Both of us at Bronte Capital live East of the Harbour Bridge. Both of us are owners of insane real estate. Australian housing is amongst the most expensive in the world relative to the incomes of the people who live in them (see this report from Demographia).

It is that insane real estate which is the risk to Australian banks – which are loaded with mortgages on overpriced housing and overpriced commercial property. Unlike in America though these mortgages are largely recourse to the other assets of individuals (there is no jingle mail in Australia).

And they are insane loans within a country that makes a lot of sense and which has a government which has been so fiscally responsible as to allow us to run deficits of 6-8% of GDP during a financial crisis without any real risk to long term solvency. [Contrast this to America which was running insane deficits in good times – and which thus runs some risk of impinging the ability to run necessary deficits in bad times…]

An adjustment path from here is easier for Australia (because of our macroeconomic miracle). But it would help a lot if Chinese commodity demand does not wane - and hence allows us time to adjust.

Anyway in summary:

I don’t like unbalanced economies. The global problems we are now having is because the economy globally had been so unbalanced for a decade before that. However we are and remain unbalanced within Australia. However a relatively mobile labour market (compared to Europe but not to the US), increasing internal migration and a common currency and language should fix that over time.

Australia – I like it. I do not like the price. As an investment we are far more likely to be short Sydney consumption – and short Australian stocks – but it is not a bet against Australia – it’s a bet against the unbalanced bits of Sydney. And none of that should be unmanageable.

As for Australian banks other than our insane housing market the biggest problems are on the other side of the ditch. New Zealand is Australia's Eastern Europe - the over-indebted place without the historical advantages and with which we are not quite politically and economically integrated. When it comes to the crunch Australia will not guarantee New Zealand's debts - but the Australian banks will - which as Europeans are discovering comes down to the same thing.

John

Disclosure: I have worked for both Australian and New Zealand Treasuries. I have very strong views – perhaps little jaundiced by personal experience – about which is run better. The voting system in New Zealand is insane – whereas Australia’s parliamentary democracy is amongst the finest in the world. The Treasury has an easier time in Australia and is far more talented. For macroeconomic management this matters. But not as much as the resources that Australia has and New Zealand does not.

PS. I should link to this - which makes a fair point about just how far Australian and New Zealand housing prices have run - but without the necessary observations about recourse.