I believe that the Australian economy will face a very rough landing and I am short iShares MSCI Australia Index Fund (NYSEARCA:EWA).
About a year ago, I met an Australian pharmacist in Hawaii on board a whale-watching ship. He introduced me to his family -- a strong Australian currency made it possible for them to come on this distant trip. We struck up a conversation about his business, life in Australia in general, and the booming Australian real estate.
This gentleman, in his early 50s, was thinking of retiring soon because he had re-invested most of the proceeds from his business in several Sydney condos that had almost doubled in price. He said he needed to work for a few more years as the cash flow from tenants was too short to cover his mortgage. But, not to worry, the great real estate capital appreciation will more than make up for some lost cash flow. He sneered when I told him that it sounded all too familiar. "But it's different from the US. The Australians have a very strong economy . China is buying our coal and iron ore like crazy! That's not going to stop any time soon."
The Australian economy today
What the bulls will tell you:
The Australian economy is a true success story compared to those of other developed countries. It almost completely escaped the "Great Recession" and with its GDP slightly dipping for only one quarter in late 2008, its unemployment stands today at an enviable 5.1%. Real estate is booming. Until recently, the Reserve Bank of Australia was raising rates to fight inflation and "economic overheating."
The reality is starkly different: Australia has a very vulnerable economy where upcoming bad news has not been "priced in" at all. The country suffers from an epic real estate bubble that greatly exceeds those of US, Ireland, and Spain. The average Australian consumer is completely tapped out. Take out a "consumer credit" punchbowl and reduce the Chinese voracious appetite for iron ore and coal, and the Australian economy will collapse like a house of cards.
Dependence on exports to China
Australia today suffers from a classic case of "Dutch Disease." Its reliance on natural resource exports for its GDP growth stunts the rest of the economic development, especially manufacturing. Australian manufacturing has been declining in relative and absolute terms at a faster rate than it is in the USA and Europe. Today, it imports most of its manufactured goods.
At first glance, exports are only a modest 21% of GDP compared to over 30% for other G20 countries such as Germany, China, and Canada. About 57% of all exports are minerals and agriculture, a highly sensitive sector prone to wild supply/demand and price fluctuations (2010):
Source: Department of Foreign Affairs and Trade, Australia
In 2011, China was the largest trade partner of Australia with total trade growing at 23.6%, close to $100 billion (about 7% of Australia GDP):
Source: Department of Foreign Affairs and Trade, Australia
The only export growing sector is energy and mineral resources. All other sectors are either flat or falling:
Until several years ago, Australia had thriving tourist and wine industries. The appreciated Australian dollar put a severe dent in their growth. Even Australians themselves ditched their domestic wine favorites for cheaper European and South American brands, according to Business Week.
Australia has traditionally run a trade balance deficit until a couple of years ago.
The commodity demand from China has pushed the trade in a surplus forcing Australian dollar appreciation and the rise in interest rates:
Australian bulls like to talk about their low debt of 22.3% of GDP and a manageable budget deficit of 3.6% (2011). They, however, completely ignore overall indebtedness, which is on par with other "indebted" developed economies (USA and Italy).
Australia has an unusually high household debt of 105% of GDP, the highest in the developed world (much due to the astronomical real estate prices). The consumer will need to deleverage sooner or later. It's almost certain that, in a crisis, the government will transfer much of the consumer debt to its balance sheet via various "stimulus" programs.
Source: McKinsey, Q2 2011
Why the economy is bound to slow down
Looking at the data above, one can see that the Australian GDP is very dependent on two commodities, coal and metal ore, for its economic growth, with most of it going to China.
Should the Chinese economy slow down, there will be few palatable options left. Devaluing the currency may not work because Australia has little manufacturing left to pick up the slack. Lowering rates may not be enough to encourage Australian consumers to spend as the falling real estate prices will force deleveraging. Also, the falling exports would create an immediate current account deficit leading to capital flight, currency collapse, and likely inflation. The Reserve Bank of Australia will not have an option of monetary easing at all.
Australian Real Estate Bubble
What the bulls will tell you:
We hear bubble warnings all the time today as many people see bubbles everywhere where a price has appreciated. You can hear about "commodity bubbles", "treasury bonds bubbles", "new dot.com bubbles", etc.
Australian housing is built on solid fundamentals due to economic and population growth. There is not enough land in large cities to build houses to meet ever-increasing demand.
It's always instructive to take a look at historical trends and plot a "mean-reversion" graph before concluding that something is significantly overpriced.
Optimist's claims are not supported by any other data such as high GDP growth rate, rising rates, or increasing construction costs.
House prices are grossly overvalued
What's truly remarkable is that the Australian economy had sub-par GDP growth rate (under 2% vs. USA over 3%) for the last 30 years, while real estate prices significantly outpaced those in the USA. The fact that the Australian real estate bubble is probably 30 years old is missed by many observers who plot data from the year 2000.
To get a proper scale of the problem, one would have to go back all the way to Japan in late 80s when the land surrounding the Emperor's palace was valued higher than the land in the state of California.
It's interesting to see how the Australian prices may proceed for the next 20 years by looking at a Japanese real estate price chart since then:
Australian prices matched some of the other country's bubbles until 2008. But while the real estate process elsewhere has been deflating, the Australian prices marched higher after a brief respite:
Source: Prosper Australia, www.prosper.org.au
There are several other metrics clearly showing every sign of a bubble:
The sharp deviation of rents from rapidly growing house prices completely refutes the bullish case that Australia is experiencing a housing/land shortage. The rising income and rising construction costs were (at best) only minor contributing factors to the price rise.
Source: IMF, 2009 data
While Australia is still behind the Netherlands, Denmark, and Ireland in 2009, it's catching up fast. A large portion of the Irish debt has been defaulted by 2012.
This is just the beginning of the problem though. Australia's 4.25% short-term rate vs. the near 0% in the US and 1% in Europe drastically increases debt-servicing costs (in Australia and Europe most of the mortgages are adjustable rate). The trajectory of Australian mortgage debt has been sharply accelerating and by now (the chart is from 2009), it's probably the chart leader.
Finally, the bulls state that Australians took rock-solid prime full-recourse mortgages with loan-to-value ratio (LVR) rarely exceeding 80%. Plenty of evidence to the contrary is given in an excellent paper by Philip Soos ("Bubbling Over"):
"Mortgage House a non-bank lender, is offering loans topping out at a LVR of 105%, and the major banks are also offering similar LVRs (Anonymous 2010c):
…Westpac raised its LVR for new customers from 87 per cent to 92 per cent, reversing the cut it made back in January; while ANZ also last week raised the maximum LVRs from 95 per cent to 97 per cent for existing customers, and from 90 per cent to 92 per cent for new borrowers. Commonwealth Bank has left its LVRs unchanged, at 97 per cent…
Incredibly, Westpac announced it would accept imputed rental payments as a form of saving and Australia's fifth largest lender, ING, now provides a never-ending mortgage that has no fixed term and no requirement to pay any principle along the way (van Onselen 2011c)."
It looks like sub-prime, Alt-A, NegAm has gone down-under. I will talk more in the last part of this article why Australian banks got into risky lending.
What may "pop" the bubble
The Australian real estate bubble has run longer and deeper than recent property bubbles in the USA, Ireland, and Spain. Heavily indebted Australian consumers, just like those in America, have a large portion of personal wealth tied-up in real estate. The price correction has not yet run its course (the mortgage defaults hover around 2%). When it does, it will certainly plunge the Australian economy into a severe recession.
Australian Banking System
Australia has four major banks: The Commonwealth Bank of Australia (NYSE:CBA), The Australian New Zealand Banking Corporation (ANZ), The National Australia Bank (NAB) and Westpac (WBC in Australia, WBK ADR in USA). While all of these banks are international, the vast majority of their lending and assets are in Australia, with 86% share of all domestic lending in 2012.
What the bulls will tell you:
Australian banks are among the safest and best capitalized in the world (Tier 1 ratios between 9.7 for WBC and 11.0 for NAB). IMF gave Australian banks a clean bill of health after running a stress-test calibrated on the Irish rate of default ("Bank Capital Adequacy in Australia"). S&P and Moody's rate banks (AA and Aa2) higher than the vast majority of American and European banks (A and Aa3 at best). Non-performing assets are also low (just over 2%).
The banks look well-capitalized today but they heavily rely on a wholesale market (i.e. they issue bonds sold to foreign investors). There isn't enough deposit money from indebted Australians to cover all loans. While everything seems stable today, the foreigners may dump Australian bonds in a panic just like they did with Italian and Spanish bonds, pushing the yields up to prohibitive levels. The Australian banks will look healthy when the economy is good, but they are subject to a large "tail" risk if Australia stumbles, as the capital flow will dry up at the worst possible time.
Banks' Achilles' Heel
Today, almost one third of the Australian banks' liabilities (or about a quarter of total assets) are funded by foreigners:
The best metric to see how loans are funded is to look at the loans/deposit ratio. When this ratio is larger than 100%, it usually means that loans are funded by selling debt securities (bonds and preferred stock), or borrowing money from the central bank.
Table 1: Bank comparison:
Tier 1 ratio
Source: Greg Hoffman, Bank Reg Data, IMF
To its credit, Moody's sounded a warning last February when it put the "big four" on a downgrade watch because of their reliance on wholesale funding.
The profitability of Australian banks is also eroding due to an inverted yield curve. The banks are forced to pay a high yield on short-term deposits but unable to lend long-term at a much higher rate.
Source: Bloomberg, 02/19/2012
It must be disconcerting to see that the shape of the curve is somewhat similar to the US curve in 2006, just at the start of the housing bust:
Source: US Treasury
This problem clearly shows up in poor Net Interest Margins (NIM) (see Table 1) which is a difference between the cost of funding and yield on assets. Australian banks have a difficult time making money from prime mortgages, which should push them into riskier loans, just like US banks did in 2006.
The Australian government (Australian Office of Financial Management) is trying to extend the party by urging RBA to mimic Bernanke and introduce its own QE, which is only open to smaller banks (not the "big four"). It already spent A$20 billion buying their Residential Mortgage Backed Securities (RMBS). However, these purchases are much riskier than American QE where the majority of bad loans have already defaulted and MBS issues are guaranteed by Fannie and Freddie (i.e. taxpayers). Australian MBSs are usually "covered bonds", where the default risk stays with the issuer (a bank). Should the mortgage holders default en masse, the issuing lenders will quickly become insolvent.
Interest rates/currency conundrum
Australian currency is strongly correlated with the commodity prices and the health of the emerging markets (the exact opposite of the USA and Japan). Should emerging markets slow down (especially China), the Australian dollar will quickly depreciate.
Australia, which heavily relies on imports of most manufactured goods, will find itself with a sudden inflation problem. It may be unable to introduce a zero interest rate policy (ZIRP) to re-flate local asset prices and save its banks.
How the banks may fail
Australian banks seem safe today sporting low default rates, high ratings from credit agencies, and strong capital adequacy ratios. They will remain safe as long as the Australian economy keeps expanding and real estate prices remain stable. However, once the music stops, I expect a "perfect storm": loan defaults will spike, funding will disappear, but interest rates will still stay high.
The Australian economy seems to be doing well today: the external debt is small, the unemployment is low, and the currency is strong. Yet, in many ways, it's very similar to the US economy in 2007 where much of the economic "wealth" was created by real estate boom and over-leveraged banks. Australia is likely to face its own "Great Recession" in the upcoming years, perhaps when commodity exports slow down. In many ways, this recession may be worse than the American one of 2008, as Australia neither enjoys the benefit of "reserve currency" that would allow it to easily "print" money nor a strong manufacturing base that would benefit from a currency devaluation.
Disclosure: I am short EWA.