This article was published on AB&F Daily Online on Monday 14 May 2018.
Australia is locked into a growth by debt feedback loop that can only stop with the end of ever-increasing international debt and a system reset; in the meantime borrowing offshore against our housing is critical for growth.
Let’s look at the effect of the cumulative current account deficit (CAD) and the debt that’s funded most of it.
Australia’s GDP has increased by $1.2 trillion since 1980 and that is equal to the cumulative CAD of $1.2 trillion over the same period.
So the only growth in the Australian economy generated over the last 40 odd years is from either selling assets or borrowing funds from offshore to fund the CAD.
I’ve thought about our country’s CAD being equal to GDP for quite some time. My thesis is that an open economy that persistently generates a CAD and borrows to fund the CAD, distorts itself by the simple matching of the purchase of offshore manufactured goods with the need to sell or borrow to fund those purchases.
In these circumstances any GDP growth must equal the cumulative CAD over time.
This is not traditional economics rather it’s a form of behavioural economics where incentives, or decisions made by taking the easy way today, create a positive feedback loop that inevitably locks an economy into a total reliance on external debt.
Regardless of the correctness of my thesis, the facts are these. Australia has a $1.2 trillion cumulative CAD funded by $1 trillion of debt with the balance funded by selling assets.
The external debt is the real issue for us right now and for future generations. Around $750 billion of the debt is on bank balance sheets and $250 billion is mostly government debt.
As our banks hold mortgages as their major assets, any offshore debt issue is essentially secured against Australia’s housing.
Banks borrow offshore to fund the reduction in their deposits caused by paying for the CAD. All else being equal, if banks didn’t borrow offshore they would have a deficit of funds and the central bank would need to print or have a form of QE to maintain the funds in the system created by banks.
Now let’s look at the FX consequences of borrowing offshore to fund the CAD.
A CAD is caused by simply having an excess of payment obligations offshore over the payment receipts from offshore. So consequently Aussie dollars are taken out of banks and used to meet foreign currency obligations, ie selling A$s.
When a bank fills the deposit gap by borrowing offshore generally it borrows foreign currency and swaps that into Australian dollars ie buys $As. The buying and selling of $As balances and therefore the fall in the $A that would normally occur by using $As to fund the CAD is cancelled out.
Many point to the third leg of funding in a foreign currency, the currency hedge $As to pay back the foreign currency when the debt is due as countering the balance but that’s incorrect.
That’s because the hedge is priced off the interest differential based on today’s spot price so it has little effect on actually changing the spot price of $As when the borrowing is made.
At this point we should be able to understand that borrowing offshore to fund the CAD inflates the value of the $A compared to the situation where no borrowing occurred, and the CAD was funded by taking $As out of the system or the central bank printed by QE or a computer.
Of course, the problem with offshore debt is that it does not go away without repayment, and the terms of rolling over the debt are in the hands of the lender and if unacceptable may not be rolled over.
The federal and state governments issue $A bonds that are purchased by offshore borrowers, funds raised under this method to fund the CAD have the same effect.
Except the lender does the swap, not the borrower. The result is boosting the value of the $A and distorting the productive exporting and importing businesses of Australia.
Funding the CAD by debt with no prospect of generating a surplus to repay the debt is an easy alternative to either printing, QE or reducing the money supply.
The later alternatives would remove the capital transactions described above allowing the $A to reduce to its unboosted trading level, increasing the cost of offshore goods but stimulating innovative export businesses.
If you’ve ever wondered why it’s so important for government and regulators to profoundly and loudly push our banks as “unquestionably strong” and vitally important to the economy, then funding the CAD is the reason.
It follows then that the state of the housing market has a profound impact on funding the CAD as the major assets on the banks’ balance sheets are residential mortgages.
A serious issue is that burden of funding the CAD lies primarily with our major banks. This concentration of risk is a position that is not healthy for the country and issues being unfolded by the royal commission would seem to support that view.
So what should Australia do?
* Whilst Australia has active and established non bank lenders that fund home loans they are not at the size relative to market share where they need to be in the future and this must change.
* Quality lenders are needed to provide a diversity of low risk debt product to real money investors such as the institutional and super fund markets in Australia and offshore.
* Technology must be used that allows for transparent open origination and funding platforms that enable investors to invest like a bank without the need for complex and expensive infrastructure by investors to determine their risk.
* Specifically, distributed ledger technology must be harnessed so that reliable, trustworthy real time data can be provided directly to investors both onshore and offshore.
* Non-deposit taking institutions must promote the strength of the Australian mortgage market and the robustness of their technology driven origination and funding platforms, including that they will remain reliable and trustworthy even in times of market stress, to investors both domestically and offshore.
* Canberra should get behind any non-deposit taking institution that develops the technology and the business to diversify and mitigate Australia’s offshore debt risk through funding high quality mortgages to institutional investors both domestically and offshore.