A credit rating agency spinning its usual nonsense

There is a lot of talk among the economics journalists about the impending collapse of China, apparently drowning in mountains of unsustainable debt. Don’t hold your breath. The Chinese government fully understands its capacity as the monopoly issuer of its currency and demonstrated during the GFC how to effectively deploy that capacity. That doesn’t mean that the Chinese economy might record slower growth in the period ahead – but as Japan demonstrated in the 1990s after it experienced a massive property bubble burst – slower growth is not collapse. Appropriate use of fiscal policy can always prevent collapse if there is a will to do so. Further, Australia’s net foreign debt has risen significantly over the last few decades and now exceeds $A1 trillion. Most of it is non-government and the private banks have been at the forefront of the increase as they have been racking up loans from foreign wholesale funding markets. With China slowing, there is a possibility that the conditions for servicing these private loans may deteriorate. A chief of a credit rating agency (S&P) has been getting airplay in Australia the last few days claiming that this increased vulnerability arising from the foreign debt exposure requires the federal government to get into surplus as quickly as possible to provide it with the capacity to “absorb shocks” arising from a correction in the banking sector. His insights are nonsensical. Exactly the opposite is the case.

The ABC report yesterday (May 31, 2017) – Big banks putting Australia’s AAA credit rating at risk, S&P ratings boss says – claimed that because Australia had a “massive level of external debt” that the ratings agency would be forced to downgrade our credit rating.

That is, S&P are claiming that the higher external debt, the higher would be the risk of default. There is truth in that statement when applied to the non-government exposure.

But there is no truth in that conjecture when applied to government debt, unless that debt is denominated in a foreign currency.

So the first question being raised is whether we should worry about that scale of foreign exposure.

The ABS provides data for – Australia’s Foreign Debt position.

The following graph shows the stock of Australia’s net foreign debt (foreign assets less foreign liabilities) from the September-quarter 1988 (when the data series began) to the December-quarter 2016 by total and private sector.

The difference between the two lines shown is obviously public sector debt (which is made up of general government and public sector financial corporations).

You can see that Australia’s Net Foreign Debt is now above $A trillion and at the end of June 2016 ($A1,023.6 billion by December 2016) – this was 61.9 per cent of Australia’s 2015-2016 nominal GDP.

We would now be in breach of Eurozone fiscal rules!

The following graph shows the annual movements in Australia’s total net debt to GDP ratio since 1989 (annual data evaluated as at the end of June in each year).

The federal government’s overall net debt position is around $A320 billion and although about 60 per cent of it is owed to foreigners, none of it is denominated in foreign currencies. The other 40 per cent by the way is largely owned by Australian banks and other investors (superannuation funds etc).

The foreign debt accumulation arises in a number of ways.

First, we run persistent current account deficits (we import goods and services and net transfer income more than we export goods and services).

The capital flows that accompany these trade patterns result in borrowing from abroad or in direct investments in our assets.

The net transfer of income (the ‘net income deficit’) is the interest and dividends we pay on those foreign funding sources. In Australia’s case, even if the trade account is in surplus (rarely), the overall current account is in deficit because of these net income flows abroad.

This is why our foreign debt has been rising.

Those who watch these things know that:

1. The debt to GDP ratio has been rising lately which means the interest component of total income is rising. When does the private sector, which is holding most of the debt find the rising interest burden to be a problem?

The answer is when the economy enters a recession or a significant slowdown and the capacity of the private sector to repay the debt becomes impaired.

If the non-government, foreign debt is denominated in a foreign currency, then the problem is extended and requires export growth to continue.

Argentina encountered its debt crisis in late 2001 because a significant portion of its debt was denominated in foreign currencies (particularly US dollars) and repayment was reliant on export revenue to generate stockpiles of these foreign currencies.

The peg against the dollar exacerbated matters and further drained foreign currency reserves.

2. A proportion of the foreign debt is clearly borrowed to fund non-government capital formation, which increases productive capacity and future income potential. In that sense, even if the debt levels are rising, there should be no issue if the productive capacity expands and the capacity to repay also expands.

In terms of sectoral balanecs, if the non-government sector is still saving out of disposal income in a growth environment and the current account deficit reflects capital imports (machines, equipment, intellectual capital, etc) then the alarm bells will be silent, no matter what S&P and its like says.

So it is the composition of the private domestic balance that should be considered when thinking about the non-government, foreign debt exposure.

At present, Australia’s private investment ratio is at depressed levels as the economy grinds along and investment opportunities are considered to be weak.

But then the current account deficit has also shrunk from an average of around 4.8 per cent of GDP up to the GFC to something around 2.5 per cent now. In part, this has been accomplished by a reduction in interest rates that hhave reduced the net income deficit and the cross-border payments that flow from that (net outflows).

The S&P argument is somewhat different to the usual fear of foreign debt as a matter of course.

Among other things he said they were focusing on the “fiscal trajectory … path back to balanced budgets and even surpluses down the road” as well as the non-government credit conditions relating to the housing market.

You can see the – Extended interview with Moritz Kraemer – Global Chief Ratings officer for S&P.

But the summary claim from that Interview is:

Through the banking system, Australia has accumulated a lot of external debt and that’s the result of many years of large external current account deficits which need to be funded by borrowing …

Among the AAA rated – the top notch rated sovereigns, of which there are only 12 left in the world … the only country with a large external debt is actually Australia …

Actually it goes further it’s the only AAA sovereign that has any net external debt. This is a clear outlier. This is a weakness of the credit profile as you call it …

Now in order to offset that, Australia needs very strong public finances so if you have pressure on the current acount that the government can actually take counterveiling action, absorb the shock, through the fiscal accounts and that is why we focus on fiscal.

If we just compare Australia with Germany, or France, or the US or the UK its very strong, the debt ratio is very low. But it be low because the external vulnerabilities are so high. So we have to weigh against each other these various factors.

That is why we express concern about the repeated delay of returning to a balanced budget because Australia needs this fiscal strength in order to compensate the vulnerability on the external side.

If a first-year undergraduate student in macroeconomics had have put that series of statements together I would have failed them badly and advised them to explore another career option.

As noted above, external debt arising as liabilities of a currency-issuing government, denominated in the local currency is no issue.

But the debt of the non-government sector may become an issue under certain circumstances, whether it is denominated in local currency or not. Remember, the non-government sector is a user of the currency of issue.

In that sense, its access to it is not much different to its access to foreign currency. It has to earn income, use prior savings, sell assets or borrow in order to spend.

Accessing foreign currency to service foreign-currency denominated debt requires them to do the same.

The S&P chief focused particularly on the role the private banks in Australia have played in the rising debt.

He argued that much of the increase in non-government foreign debt exposure in Australia was due to the borrowing by Australian banks on the wholesale credit markets to “partly fund the real estate spending spree that has sent property prices surging in Sydney, Melbourne and Brisbane.”

How much of that net foreign debt position is due to Australian-owned banks? The next graph shows the net international position (assets less liabilities) of the Australian banks ($A millions) (from RBA statistics).

Clearly, the banks have reduced their initial exposure that peaked in 2010.

Remember, that as the GFC was unfolding, the big four banks in Australia, that dominate the sector as a tight-knit oligopoly, were within days of insolvency in late 2008 when their massive exposure to the frozen global wholesale funding markets meant they were unable to repay their maturing loans.

At that point, like all those institutions that survive on ‘corporate welfare’ they went cap in hand to the Federal government and requested that it provide a guarantee on all new foreign currency borrowing.

The government duly agreed and the big four were immediately able to access funds and roll over their debt exposures.

I have noted before that it is not widely known or discussed (and actively denied by the banks), the entreaty that the banks made to the Federal government at the time was reported in the book “The Great Crash of 2008” (by Garnaut and Llewellyn-Smith) to be along these lines:

In the early days of October 2008, money poured into the big four Australian banks from other financial institutions. But life was becoming increasingly anxious for them as well.

One by one they advised the Australian government they were having difficulty rolling over their foreign debts. Several sought and received meetings with Prime Minister Rudd. The banks told him that, if the Government did not guarantee their foreign debts, they would not be able to roll over the debt as it became due. Some was due immediately, so they would have to begin withdrawing credit from Australian borrowers. They would be insolvent sooner rather than later …

The government quickly formed the view that the avoidance of a sudden adjustment through the automatic market process was a worthy object of policy. On 12 October it announced that, for a small fee, it would guarantee the banks’ new wholesale liabilities. This would include the huge rollovers of old foreign debt as it matured. The government also announced a guarantee on all deposits up to A$1 million. All four banks expressed their thanks and relief in a joint meeting with the Prime Minister on 23 October …

In Australia, however, the difficulties were on the liability side of bank balance sheets. Banks had become heavily reliant on foreign borrowing and suddenly they were unable to borrow abroad. The non-banks had had no buyers for their securities for almost a year.

There are no degrees of insolvency. A firm is just as insolvent if it is not able to meet its financial obligations as they fall due because it cannot roll over debt, as it is if the value of the assets in its balance sheet is deeply impaired.

The difference is that the problem on the liability side is much more easily (and in most cases cheaply) repaired by a guarantee than the problem on the asset side. The sudden risk of insolvency in Australian banking was simply a more tractable problem than those experienced by other Anglosphere nations …

The Australian banks’ dependence on government-guaranteed debt was exceptional: in July 2009, Australian banks accounted for 10 per cent of the world’s government guaranteed debt. Through foreign borrowing to support domestic lending, the big four Australian banks were active, enthusiastic participants in the global shadow banking system that was now unravelling.

At the time, in inimitable fashion, the Australian Bankers Association put out a press release (October 13, 2009) claiming that “the evidence is that the Australian banks were not insolvent and the wholesale funding guarantee was introduced as a means of ensuring banks could maintain lending growth, not to restore the solvency of banks.”

Which is hilarious – a denial that agrees with the obvious – if they had not gained the guarantee they would have defaulted on loans due. Then their capacity to lend would have disappeared because they would have been bankrupted.

Whichever way you want to look at it, it was the federal government’s currency-issuing capacity that saved the Australian major banks in the dark days of the GFC.

The major banks were not as robust as they make out. They were about to become insolvent and given their dominance in the sector that failure would have had dramatic negative consequences for the Australian economy and would have required a much larger fiscal intervention.

So a large foreign debt exposure by the banking sector associated with a housing market that is reaching the end of the long boom and will correct somewhat in the coming year or so is not a small problem.

This is where the exposure to China argument comes into play. China will not go bust. But it might slowdown and the sensitivity of the Australian economy to such a slowdown is probably quite high these days given the lack of non-mining investment and the austerity coming from government.

If China slows and the housing market corrects somewhat then Australia’ export side will weaken (perhaps compromising the capacity to service the massive non-government external debt) and the record levels of household debt will start to come into play.

That would reverberate back onto the banking sector which requires its non-competitive, high rates of return to keep paying exhorbitant management salaries, service the wholesale debt it has binged upon in foreign markets, and satisfy their overly greedy shareholders.

So as far as it goes, the external debt and the domestic household debt is not a small issue.

But then to claim, as the S&P Global Chief Ratings officer said in his interview (above), that this requires the Government to get back into surplus as quickly as possible so that it can “take counterveiling action” to “absorb the shock” arising from tension arising from a non-government slowdown is absurd.

You can always tell if a person really knows anything about macroeconomics – or is faking it. How? Well, if they start conflating monetary systems.

The S&P commentator claimed that it was legitimate to “compare Australia with Germany, or France …” in terms of debt positions.

It is never valid to compare a Eurozone Member State, which uses a foreign currency (the euro) to a currency-issuing nation such as Australia.

The two governments have very different fiscal capacities and financial constraints on spending. In Australia’s case, the federal government has no intrinsic financial constraints on its capacity to spend in Australian dollars.

In that sense, what meaning should we place on the federal government having “very strong public finances” and requiring those positions (which in this context means fiscal surpluses given the neo-liberal bias of the S&P commentator) to offset non-government spending weakness?

Answer: his claim is total nonsense.

The fact that the ABC interviewer didn’t pick him up on the rubbish he was talking shows that she didn’t have a clue either.

The Australian government has a near infinite financial capacity to buy anything that is for sale in Australian dollars at any time.

The only constraint it faces, other than the voluntary financial constraints that arise form its neo-liberal bias, are the availability of real resources for sale in Australian dollars.

That is the limit of Australian government spending. So it makes no sense to say that the government has to run surpluses to increase its capacity to spend in the currency it, and it alone, issues.

Further, the very pursuit of a balanced fiscal position or even a surplus is the last thing that is indicated in an environment where non-government activity is becoming increasingly precarious.

It is a sure bet that if the Australian government vigorously pursued a fiscal surplus, then the likely recession that such a strategy would cause would expose the banks very quickly to insolvency.

The non-bank holders of the foreign debt would also be compromised if Australia’s GDP growth slowed considerably on the back of the government austerity push.

The point is that a government intent on running surpluses at a time when the external balance is in deficit and private domestic spending is weak, will reduce the capacity of non-government sector to service their loans and assuredly precipitate defaults.

Conclusion

A ‘strong’ fiscal position is actually one that is consistent with full employment. In Australia, at present, we are a long way short of that desirable state and so the fiscal deficit is too small.

The fiscal dynamic should be to increase the deficit not cut it.

The S&P analysis is, as usual, ridiculous and should be disregarded. Better still, the government should outlaw the credit rating agencies.

Please read my blog – Time to outlaw the credit rating agencies – for more discussion on this point.

That is enough for today!

(c) Copyright 2017 William Mitchell. All Rights Reserved.