One area where Australia clearly is more vulnerable is in foreign debt. Thanks to a chronic current account deficit ranging between 2 and 6% of GDP – even through the mining boom – Australia has remained reliant on foreign capital. As a result, net foreign liabilities – which includes debt and equity and is labelled net international investment position in the next chart – is relatively high at 60% of GDP.
Source: IMF, ABS, AMP Capital
Quite clearly Australia would be vulnerable should foreign investors change their view of investing in Australia. Mind you this has been a risk since the 1980s!
While Australia’s debt levels are not causing problems now this is not to say they are not without risk. For example, just before the GFC Ireland’s public debt to GDP ratio was the same as Australia’s is now but this changed when house prices collapsed and banks had to be recapitalised.
The main risk is that something happens that severely affects the ability of households to service their mortgages and results in foreign investors changing their attitudes towards investing in Australia. Obviously, the RBA is unlikely to trigger the former by raising interest rates too far as it seems very sensitive to household fragility.
The prime risk is that China has a hard landing causing a slump in Australia’s export earnings, a sharp rise in unemployment, defaults, bank problems necessitating recapitalisation by the Government and a loss of confidence on the part of foreign investors.
However, while this is clearly a risk, several factors are worth noting: Firstly, the tolerance for a hard landing in China is very low in view of the social unrest it would trigger and in any case recent Chinese economic indicators suggest that growth there may be bottoming around 7.5%.
Secondly, while house prices remain overvalued the risk of a house price collapse remains low given undersupply, low loan to valuation ratios and full recourse loans in Australia.
Thirdly, if the economic environment for Australia sours significantly there is still plenty of scope for the RBA to cut interest rates. In fact 325 basis points worth, which would translate roughly into a fall in the standard variable mortgage rate to 4% if the banks continue to pass though 80% of RBA cuts. This would translate to an annual interest bill saving of around $6,500 for someone with a $300,000 mortgage.
Fourthly, unlike the situation in countries like Japan or peripheral countries in Europe, Australia’s currency acts as a countercyclical buffer and would likely collapse if there were a big collapse in Australia’s export prices (they haven’t really fallen so much so far, so the fact that the $A is around $US1.04 is not surprising). This could see the $A easily fall back towards $US0.60 delivering a massive boost to industries such as manufacturing, tourism and higher education that have struggled through the mining boom.
Finally, pent up demand exists in big parts of the Australian economy, in part due to measures to make way for the mining boom. Housing construction and retailing have been running well below capacity. This can be unleashed as mining slows and lower interest rates and possibly a lower $A would be part of the mechanism to achieve this.
Australia is not without its risks on the debt front and to be safe needs to continue to head back towards a budget surplus (to cap public debt) and for households to continue to run relatively high savings in order to boost their net wealth and cap household debt. However, the probability of a major debt crisis occurring is likely low as China is unlikely to have a hard landing, there is still plenty of scope to cut interest rates and the Australian dollar is likely to fulfil its role as a shock absorber in the event of a big loss to national income.
Dr Shane Oliver is the head of investment strategy and chief economist at AMP Capital. Please note that this article is intended as general information and not as investment advice.
