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Overview

This article is the second of a two part series that seeks to present a balanced overview on the state of play for financials in Australia and reinforce the underlying value of the Australian economy within the global marketplace. Part 1 covered the resources sector, iron ore pricing, and the housing market. Part 2 will focus on funding pressures facing Australian banks, the impact and effect the Reserve Bank's monetary policy has on the economy, and will conclude with a comparison on where the Australian economy sits in the global environment. Investors long and short can refine their own positions as appropriate - the comments section on many of the above articles is where the real interest and debate has and continues to occur.

Funding by Banks

We have been hearing ad nauseam about the funding pressures on Australian banks since the GFC, usually once a month after the Reserve Bank of Australia [RBA] makes its monthly announcement on the current cash rate (you can access these here). Strange though that with all these funding pressures, the "Big 4" [Commonwealth Bank (OTC:CBAUF), Westpac Bank (WBK), National Australia Bank (OTCPK:NAUBF) and ANZ Bank (OTCPK:ANZBY)] have continued to generate inordinate profit margins on successive reporting periods during one of the most challenging economic periods for the banks. Recently some have begun to try and separate themselves from the "perceived requirement to mirror the RBA's stance on interest rates," such as ANZ Bank choosing when they will announce interest rate changes following the RBA's announcement, and by how much they will change (i.e. passing on a rate cut in full, or only a percentage of the cut). This "independent" stance can be seen as a strategic decision by the banks to allow them more tactical discretion in underwriting their own bottom line, much to the distress of the Australian Treasurer.

The funding pressures on Australian banks are real (see Australian Financial Review article here), but they are not driven by the exact same pressures being faced by a broken banking system in the USA, or within a complex and intertwined banking system as is the case in the European Union. The regulators of the Australian Banks (APRA) and the Treasury have both expressed confidence that the banks are prepared to weather short notice funding pressures or a credit squeeze as a result of money markets tightening.

While the saying "buy when there is blood on the streets" offers opportunity for both long and short traders, would investors feel more comfortable sleeping at night with large sums of capital tied up in the banks of PIIGS, the "too big to bail" banks in the USA, or the big four banks of Australia? That's not to say there aren't opportunities in the PIIGS or the U.S. financial system, but in relative comparative terms the example is offered for contemplation.

Reserve Bank Policy

The RBA is responsible for setting monetary policy within Australia, in doing so "the RBA has an 'inflation target' and seeks to keep consumer price inflation in the economy to 2-3 percent, on average, over the medium term." Fiscal policy in Australia is set by the government and implemented by the Treasury. The separation of the two functions ensures a balanced and unbiased approach to managing the Australian economy. Nowhere is this more keenly observed than the monthly announcement of the RBA's independent decision with respect to the official cash rate. When interest rates began their upward trend post GFC, the public frustration of the Treasurer was obvious as it became plainly clear that the government of the day is unable to pressure the hand of the governor of the RBA, and the RBA continued to lift interest rates in accordance with monetary policy. This separation of powers is actually a strength of Australia's economy and fiscal policy rather than a weakness (note: such is the folly of fighting an election along the lines of a promise of keeping interest rates low for homeowners).

Bottom line observation is that extreme views presented in the media and in finance blogs about the RBA actions, and what it may do or not do to control the official cash rate, are just that - extreme views. The historical performance of the RBA's charter to control inflation through monetary policy is shown in the following graph since the target was introduced in mid 1993 (following the infamous recession that Paul Keating said "we had to have" in 1991):

Likewise, many comments regarding the AUD/USD relationship are extreme and without basis. Claims that the AUD will drop by as much as 50% in coming weeks are usually backed up with no evidence or rationale argument. The strong performance of the AUD is significantly affected by the poor performance of the USD and U.S. monetary policy. A strong AUD directly affects Australia's competitiveness as an exporter of natural resources. The current parity (or higher) of the AUD to the USD over recent years is not normal, and it is expected that the USD will eventually return to being the stronger currency of the two. Two key issues need to be addressed for this to occur; first is the successful resolution of the fiscal crisis within the EU, and second is the looming U.S. fiscal cliff and the government's appetite for foreign debt. The upcoming U.S. presidential election is likely to be the first event influencing the two, the outcome of which will affect both.

Comparison to Global Markets

Where then does Australia sit within the current global economy by economic performance? It is presently ranked 3rd in the World , ahead of Ireland (9th), USA (10th), U.K. (14th), Spain (36th), Portugal (68th), Italy (92nd) and Greece (119th). It therefore pauses me to ponder; why the overly negative fixation on the 3rd strongest economy in the world, when the red flags being raised don't necessarily appear to be substantive issues for the long term prosperity of the country? For much of the doom and gloom predicted within some of the negatively focused articles in the media, for their premise to come reality, would in actual fact require either:

a) A quite remarkable turn of fortune for the USA (SPY) and the PIIGS (IEV), or

b) A subsequent global financial crisis directly affecting Australia (EWA), or indirectly via the effects of contagion.

More desired though is the resolution of the looming economic issues for the USA, as it is the catalyst from which the world markets (and other economies) pivot.

Security as an Asset to Value

The last point I wish to raise is that Australia is a land rich in natural resources, supporting cyclical markets, and some of these resources are not exploited to their full potential:

  • Coal
  • Liquid Natural Gas
  • Diverse Mineral Resources
  • Cotton
  • Wheat & other cereal crops
  • Live Cattle & Sheep Export
  • Vast Tracts of Agricultural Land
  • Gold

In valuing these assets, the higher costs of production (compared to countries with lower labor cost) need to be offset against the security of the assets and resources at stake, and therefore security as an asset should be valued by the market (or investor). As an example, in the short to medium term lower iron ore prices might make sources in South America appear more attractive, whereas the security of operating in some countries, and the political stability (of the country, government and government policy) might make those advantages less competitive (or marginal at best). Chevron Corporation (CVX) can see this with respect to its production assets in Brazil, and the litigation issues from Ecuador arising from its acquisition of Texaco and its legacy issues (this in no way detracts from the attractiveness of Chevron as a potential investment, but it is a risk that needs to be managed none-the-less).

Summary

In penning both articles I have tried to present a balanced overview of some of the key areas that commentators are bearish on with respect to Australia. I have a natural bias (being Australian), but I have hopefully provided additional context for investors when assessing the merits of articles presenting worst case scenarios for Australia. The near term effects on Australia's economy are real, yet are no surprise. Government and private sectors have been planning for these eventualities, for a return to a more normalized relationship in the markets (the cooling of the two speed economy), and individual investors have been cautious about the long term outlook since the GFC and adjusted their spending accordingly (with the market slump in second half 2011 a cautious reminder). From a long term perspective though Australia has been, and still remains the lucky country, in comparison to the challenges facing other problem economies within the world.

Source: Is Australia Still The Lucky Country? (Part 2)