The worst of the downturn will hit Australia this year. But there won’t be a quick rebound. While Australia won’t experience anything like the severity of the recessions in many developed overseas economies, there is a second phase of the downturn which will impede recovery for some years yet.
Australia is not suffering from the same problem that is causing world recession. But there are linkages that will affect Australia. And there are similarities in the behaviour of some of our investment and banking sectors that are causing problems.
Overseas, the global financial crisis (GFC) was caused by aggressive lending and the search for quarterly returns by investors, leading to a gearing up of investment markets with a short-term financial focus rather than business-building mentality. The injection of funds led to an oversupply in property markets. With property the collateral for many loans, falling property prices and failures amongst the more highly geared financial engineers crystallised bad debts in the banking system, the need for write-offs, falling bank equity and, in many cases, bank insolvency.
This was the sort of thing that happened in Australia after the 1980s investment boom busted. At that time, the fallout threatened the solvency of several Australian banks and caused a sharp recession followed by a decade of weak investment. Business went into cost-cutting mode keeping growth weak for more than a decade. The way through was to separate the “bad bank” operations, allowing them to trade out of bad debts, and hence freeing the “good bank” to fund ongoing healthy activities. And we needed to refinance the banking system – in Australia’s case, courtesy of the mortgage belt, by charging a 4 per cent margin for housing loans above the bank bill rate for four years before the entry of smaller operators competed the margin back down to 1.5 to 2 per cent.
Actually, the current situation overseas is worse. Bank failures are widespread through developed economies. It means severe recession in the US, the UK, Germany, and Japan amongst others, followed by a protracted period of weakness. It means a world recession with no quick rebound. And while there has been talk by authorities about solutions, action has been slow.
That’s not what’s happening in Australia. Only a few highly geared operations have failed. And there is no significant oversupply in property markets to destroy bank equity. With overseas banks retreating, Australian banks have the field to themselves and will come out stronger than ever.
Let’s give credit to the Reserve Bank for bursting the housing price bubble in 2003, curtailing excessive investment before it started. That didn’t happen overseas. Indeed, the resultant under building and current deficiency of residential stock has set the preconditions for the next upswing in residential. Triggered by the fall in interest rates, it’s starting now.
I’m not keen on regulation. Certainly there are market failures, but we need to see them before they happen. Regulation after-the-fact is shutting the door after the horse has bolted. It’s pointless. The markets themselves won’t make the same mistake again quickly. There will be different mistakes causing the next market failure. That’s not to say all regulation is bad. But we do need to be careful not to hamstring markets. Regulation must be forward, not backward looking.
Back to the economy.
Certainly, there are linkages to the GFC and recession that hurt the Australian economy:
1. The first effects came as troubled overseas corporates and financials cashed in Australian shares, taking money home to save the farm. The outflow of funds was what initially hurt the sharemarket and caused the fall in the Australian dollar.
2. Australia has an overseas borrowing requirement, resulting from the need to finance the Current Account Deficit and refinance external debt. I have always worried about the CAD, thinking that it would be problems in Australia and loss of confidence from investors that would cause a withdrawal of funding, a collapse of the currency, rising interest rates and domestic recession. Who would have thought that it would be problems overseas and repatriation of funding that would cause a credit squeeze? And that’s what we have in Australia – a credit squeeze, not a financial crisis!
3. Having been suckered into increasing gearing by pressure for short-term returns from aggressive investors and the analysts that serve them, corporate Australia is now being asked to gear down at a time when insufficient equity funding is available to replace debt.
The boom logic was all about maximising the share price by maximising dividends. The financial engineering logic prevailed, bullying companies into securing cash flows and gearing up to improve the return on equity, with little regard for the consequent risk. There was huge pressure from analysts on companies with “lazy balance sheets”.
Now, both investors and banks are running in the other direction, with analysts leading the lynching party for those who followed their advice. Most affected are the listed property trusts, the miners and other highly geared companies. The financial engineers have already gone.
Pressure to reduce gearing is leading to asset sales with few buyers. Markets aren’t clearing. And prices are overreacting.
The other side of the coin is that the banks feel they are “overexposed”. They are rationing credit, trying to claw back gearing. All are in an environment where falling prices are increasing loan-tovalue ratios (LVRs). But the banks are locked in. Were they to foreclose on companies breaching covenants, sales of those assets would lead prices to fall to levels which would cause substantial bad debt, destroying their own asset base. They would be crazy to panic. And they won’t. They can’t – if they know what’s good for them. All they have to do is ride through the current setback. Any market overreaction will be reasonably short-term. Australian markets are not significantly oversupplied.
Meanwhile, the super funds are nowhere to be seen. At the behest of their investors, they have retreated to the security of fixed interest.
The sector needs an equity injection. And we will need the super funds to come back in to provide it.
Until that happens, the shortage of funding will inhibit real investment. The next round of property and mining projects has been slaughtered. BIS Shrapnel’s forecast is for private non-residential building investment to fall by more than 30 per cent over the next two years and private engineering construction by more than 20 per cent.
4. The world recession and fall in world demand for manufactured goods is affecting demand for the materials that produce them. China is not sheltered. We now know that the end of the minerals boom will lead to a substantial fall in minerals investment, affecting Australian sectors and regions geared up to service that investment. So much for the “Super Cycle”. In BIS Shrapnel’s Engineering and Mining reports, we estimate that the value of work done on minerals investment will fall by half over the next two years. That could prove conservative.
So far, most of the impact on the real economy has been self-inflicted.
In phase one of the downturn, we have experienced a demand shock due primarily to precautionary saving by both households and business:
– For households, a collapse in confidence and fear of unemployment stalled consumer spending. Households are saving.
– Business is in cost cutting / cash preservation mode, (correctly) expecting weak demand and falling profits.
Fear is self-fulfilling. Demand has stalled.
The severity of the downturn will be determined by the extent of layoffs as business fights falling demand and profits. Employment will fall and unemployment will rise significantly. The wild card that will determine the severity of the downturn is confidence and household spending.
There won’t be a quick rebound. Recovery will be impeded by a second phase of weakness as falling business investment constrains growth. Until now, investment has remained strong as we finished the last round of projects. But we already know that much of the next round of projects has evaporated and that business investment will fall substantially over the next two years, we think by more than 20 per cent. Property and minerals investment will be worst affected, but the setback to investment will be general across the business sector.
Fortunately there are offsets.
Strong government investment helps, provided that governments hold firm in the face of pressure from escalating deficits and ratings agencies and that there are sufficient projects ready to proceed.
The driver of the next recovery will be residential investment. We think that recovery has already started at the lower value end of the market, driven initially by owner-occupiers, helped by the First Home Owner Grant, as low interest rates have improved affordability and high rents make investment attractive on a cashflow basis. Investors will be next, attracted by positive cashflows. High-value housing and holiday homes will be last to recover – they still have further to fall as the incomes financing them are affected by the downturn. The recovery will be slow at first, building momentum over the next three to four years.
Investment is a primary driver of growth. In particular, construction investment is domestically serviced and has a high multiplier into the rest of the economy. Fluctuations in investment are closely linked to fluctuations in domestic demand.
Taking a five-year view, recovery will be slow to start. This year, we’ll see the magnitude of the downturn. Growth in the subsequent two years will be slow as falling investment impedes growth. It’s only in years four and five, as the strength of residential investment builds momentum, that we’ll see the recovery pick up strength.
