Monday, June 29, 2009

Australia – the lucky but unbalanced country

I get many emails asking for my opinion as to the Australian economy and the Australian banks in particular. That is not surprising because I am probably the best known Australian writing a global investment blog. Certainly I write the best known blog by any Australian fund manager.

Answering the question in one post makes about as much sense as answering the same question regarding say Canada or France. The country is too big for an easy answer. Moreover some of my correspondents are German or American and others are Australian and I can safely assume different levels of knowledge for each party. This is a post aimed at non-Australians. Nuance for locals is harder.

Australia’s macroeconomic miracle

You can’t understand why Australia works so well without a decent statement of the Australian macroeconomic miracle. Australia is one of the smallest and most indebted nations to be given the privilege of borrowing in their own currency and floating that currency. New Zealand (across the ditch) is the smallest country with the unlikely trifecta (has run large current account deficits for a very long time, borrows in its own currency, floats that currency).

This is incredibly useful. If you are highly indebted bad things can happen to you but they are far less severe if you are lucky enough to be able to borrow in your own currency and to float that currency.

Consider the situation when the macroeconomic environment moves sharply against a country – as might happen with a rapid terms of trade change – or also might happen with if people (say due to a global fear epidemic) think its possibly you can’t repay them.
  • If your currency is fixed you will get a classic monetary recession. People will speculate against the currency (or withdraw their lending to you) and (due the central bank being forced to defend the currency) the local monetary supply will crash. The extreme version is what is happening to Latvia. It’s why Latvia should float their currency.

  • If however your currency is floating and you are highly indebted in foreign currency then your currency collapse will bring into sharp relief and immediately the difficulty of repaying your debt. The lower currency increases the principal and interest repayment in domestic terms of your debt. In extrema it causes almost immediate default. This is what is stopping Latvia floating their currency.

  • The Argentine solution is float the Peso in a crisis – but to rejig all old debts to new pesos at some new exchange rate and formalise the default. If you do that nobody trusts you again. If you are South American you do it a few times and you wind up looking like South America rather than Australia or the United States. In 1900 the three richest countries in the world per capita were Argentina, New Zealand and Australia (in order). Look how that worked out.
Now the Australian miracle (the trifecta) means that an external crisis can hit Australia and all that happens is that the Australian currency drops until our terms of trade improve again. The classic example was the 1997-99 Asian Economic Crisis: as we export mainly to Asia this was potentially devastating to our economy. But instead it was just devastating to the currency – which fell by about 50%. I remember travelling to the New York (for work) when the AUD was trading at 48c US. It was so expensive in New York as to be completely comical. The business hotel in New York cost more than a week’s average wages per night (it was a business hotel in the height of the bubble). But the fallen currency worked. It meant local export industries ticked up – the tourist industry did not collapse despite the lesser numbers of Asian visitors. The lower currency bailed out plenty of other industries as well.

When the crisis disappeared the currency went up again - more than doubling. Then China slowed a little and the currency fell.

If we did not have a floating currency and the ability to borrow in our own currency this would not have happened. We would have been just another case of macroeconomic road-kill.

This is a deal afforded Australia only because of 100 years of fairly good management. If you stuff up you lose our trifecta ... it is worth preserving. Fiscal rectitude – especially in good times – is worthwhile because it protects this privilege. And the reason why you want to run tight budgets in good times is precisely so the world does not force you to run fiscally contractionary policy during bad times.

General observation: whilst these conditions persist (which could be a long time), Australia will have the least trouble of any major OECD economy in adjusting to external economic shocks. The United States is pegged to China (although not by their own volition). Most of Europe is pegged to each other. [It will not help so much with domestic economic shocks. But governments of both persuasions are pretty good by global standards and they don’t look like stuffing it up. I am not so cheery about New Zealand – a country I think is very badly run by comparison with Australia.]

Anyway with the recent shock (China slowing commodity demand due to global economic conditions) we had the usual currency correction (currently reversed). Again and it looks like we have avoided the shock. The Australian economy seems indecently strong.

The unbalanced Australia

Unfortunately it is not quite as simple as all that. The Australian economy is very unbalanced. It has Sydney – a huge financial city in three big rings. Inner Sydney is a financial city of very high wealth. By repute owners of almost half of the wealth of Australia reside East of the Sydney Harbour Bridge. And it is only 4 km (3 miles) to the ocean! [The entire city of Brisbane is east of the bridge too, but the wealth is in Sydney.]

The financial sector is hurt but not badly as credit markets never closed here for longer than a few hours.

Beyond this Sydney has a service ring – mostly people who service the financial city (cleaners, plumbers, school teachers).

Outer Sydney (fully an hour drive from my home) is a manufacturing centre and it is hurting – but not as badly as I thought. Indeed a falling currency seemed to keep it quite well adjusted.

Almost all of Sydney is NOT resource dependent. It is the least resource dependent city in Australia. (In order Perth, Darwin, Brisbane, Adelaide, Melbourne, Hobart, Sydney.) Hence the recession is nastiest in New South Wales – and even then it is not bad. [Sydney is the capital of the state New South Wales.]

China has taken off again – or at least Chinese commodity demand has resumed. Australia is going to have to have a big internal adjustment – which will downplay the role of Sydney. However as there has not been a financial system crash here that will be an adjustment which for the moment looks manageable. As long as the adjustment happens at less than say 80 thousand jobs per year it will happen without great financial stress. For that we need China to keep on demanding our commodities.

The insane Sydney Housing Market

I am long Sydney Housing. I own a nice house. I would prefer bet against the price of my house (a nice but not large house without beach views in the fashionable suburb of Bronte worth about AUD3 million). I assure you it is not quite as glamorous as Sheila Bair’s recently advertised palace. Really it is solid upper middle class suburbia but with a silly price tag.

Indeed I would generally prefer bet against Sydney generally as it makes no sense. Both of us at Bronte Capital live East of the Harbour Bridge. Both of us are owners of insane real estate. Australian housing is amongst the most expensive in the world relative to the incomes of the people who live in them (see this report from Demographia).

It is that insane real estate which is the risk to Australian banks – which are loaded with mortgages on overpriced housing and overpriced commercial property. Unlike in America though these mortgages are largely recourse to the other assets of individuals (there is no jingle mail in Australia).

And they are insane loans within a country that makes a lot of sense and which has a government which has been so fiscally responsible as to allow us to run deficits of 6-8% of GDP during a financial crisis without any real risk to long term solvency. [Contrast this to America which was running insane deficits in good times – and which thus runs some risk of impinging the ability to run necessary deficits in bad times…]

An adjustment path from here is easier for Australia (because of our macroeconomic miracle). But it would help a lot if Chinese commodity demand does not wane - and hence allows us time to adjust.

Anyway in summary:

I don’t like unbalanced economies. The global problems we are now having is because the economy globally had been so unbalanced for a decade before that. However we are and remain unbalanced within Australia. However a relatively mobile labour market (compared to Europe but not to the US), increasing internal migration and a common currency and language should fix that over time.

Australia – I like it. I do not like the price. As an investment we are far more likely to be short Sydney consumption – and short Australian stocks – but it is not a bet against Australia – it’s a bet against the unbalanced bits of Sydney. And none of that should be unmanageable.

As for Australian banks other than our insane housing market the biggest problems are on the other side of the ditch. New Zealand is Australia's Eastern Europe - the over-indebted place without the historical advantages and with which we are not quite politically and economically integrated. When it comes to the crunch Australia will not guarantee New Zealand's debts - but the Australian banks will - which as Europeans are discovering comes down to the same thing.


Disclosure: I have worked for both Australian and New Zealand Treasuries. I have very strong views – perhaps little jaundiced by personal experience – about which is run better. The voting system in New Zealand is insane – whereas Australia’s parliamentary democracy is amongst the finest in the world. The Treasury has an easier time in Australia and is far more talented. For macroeconomic management this matters. But not as much as the resources that Australia has and New Zealand does not.

PS. I should link to this - which makes a fair point about just how far Australian and New Zealand housing prices have run - but without the necessary observations about recourse.


Anonymous said...

so australian hookers ARE expensive then.
but this post is timely. come wednesday they'll get their pricing in line. it's all downhill from here for the miracle.

babar ganesh said...

so why not rent a house?

Slow Morning said...

John - another excellent blog. Shiller has used Sydney house prices as an example of a housing bubble and the Economist tables consistently shows our housing to be overpriced relative to other places. Real Estate agents and their associations continually tell us that we are different.... tax treatments etc... time will tell ...

John Hempton said...

So why not rent a house?

Well once I said "I do" to the most delightful woman I know that decision got taken away from me.

Happy wife = happy life.


Anonymous said...

Believe It or Not tall tales: Where I went to school, our geography teacher told us that Australia is New Zealand's 4th island (NZ comprising of 4 islands ie North Island, South Island, Stewart Island and finally the smallest island being Australia. Australia is also famous for its flies underarm cricket cheats and Russell Crowe.
p.s. John, aren't you afraid your beloved Sydney is going to run out of drinking water due to the water crisis due to global warming?

Anonymous said...


you say that sydney is the least resource dependent city in Aus. In that case we should be in the BEST position when China really crumbles (commodity speculation still running there for now; buoying our exports and putting a floor under our own economy). This is (one of) the lessons of the '30's global depression (big export profile economies: the harder they fall)

I would proffer another point: Sydney fell the hardest bcause it is the most 'financialised' of any of the capital cities: hedge funds, B&B, Macquarie, HQ of foreign banks, etc. MUCH less demand for what they are selling, now. See SMH today: piece on the 'unattractiveness' of Macq's infrastructure funds.

Our longrunning infrastructure train wreck doesn't help either, but that's another story


John Hempton said...

As for Sydney falling hard because it is a financial centre - its BS. Sure Babcocks failed - and Allco and a few others.

But the big fee stream - compulsory super - is continuing apace. The fees are off with the market - but they are still fat.

And for Sydney infrastructure - spot on. Sydney is dysfunctional. One reason why my house is worth so much money is that you do not have to deal with dross of living in Sydney if you live in Bronte. Sydney is parched, oversized, terrible transport etc ad nauseum. Unless you are wealthy it is now a very difficult city to live in. That is a problem and indicative of more problems.


John Hempton said...

The deliberate and non-deliberate lies that New Zealand tells itself about its history amaze me...

Its not just that Australia is the fourth island - but its that most New Zealanders cannot identify a single battle or consequence of things like the Musket Wars.

I am kind of fond of this book for instance (though not its price)

One day on the blog I will give John Hempton's potted (and deeply offensive) version of New Zealand history.

But then nobody from Aoeteroa will ever speak to me again.


John Hempton said...
This comment has been removed by the author.
John Hempton said...

That book. Requested it on Kindle. Much better for out-of-print exercises...


Anonymous said...

John great article.

I think house prices will fall a lot across all australian cities. I think it could be a greater than 30% fall.

What would that do to the banks and the overall strength of the economy?

John Hempton said...

A house price fall like that (which does not strike me as too unlikely) will crush consuption in the cities - and probably result in a fall of the AUD.

It will however not impair the solvency of the banks (though it would smash their profits).

The fallen AUD would help various industries... We would get a fast adjustment to the Australian macroeconomic imbalance.

A slow solution would be better - but... sometimes you don't get that choice.


elliot said...

Unfortunately the author is spot on re: NZ (and I am a Kiwi). Our housing market is extremely overvalued and I expect a 50% fall in real terms over the next 5 years. The country has been run extremely badly by a Labour government prior to the recently elected National government. Similar to UK Labour govt: pro-cyclical and ineffective spending. Proof is terrible productivity and low real wages relative to Australia.

On the outlook, NZ does have advantages relative to Australia:
i) our bad debt is held by Aussie banks and so they will probably end up bailing us out to some degree.
ii) i think food commodities will go better than metals in next 5 years
iii) NZ Govt. better than Aussie government for first time in long time.
iv) smaller manufacturing sector to hurt

M said...

Living in the UK, I would love to hear why the Australian property market hasn't taken a nose dive yet like it has here (in alot of areas). I still have mates back in aus telling me property is a great investment, then again, they tend to skip the World section and head straight for the sports...

John Hempton said...

The short answer as to why property has not taken a nosedive is that the banks have not ever been defunded.

Northern Rock comes first - not second. The bank problems killed the property market in the UK - not the reverse.


Anonymous said...

I have to say I never understood Kiwi housing market - the ingrained faith of even quite smart people that it can go only up, and the huge bubble - paying left right and center for (really) unproductive assets, funded by foreign lending.
I can understand short-term reason for Au banks in NZ, but overall I think Lloyds did the smart thing to sell NBNZ when they did.

Anonymous said...

JH - This post reminds me somewhat of real estate agents here in the States talking about how the high end will hold up. Perhaps not as much wealth as % of GDP is concentrated in Beverly Hills and Manhattan as it is in posh areas of Sydney (I wonder if K-Rudd and Swanny will address that concentration in the years ahead). What IS selling in those US markets is about -15% from peak so back to about 2004 levels, but not much is trading as owners are stuck back in 2006 and buyers understand the "new normal" status quo. But it's not these markets that eviscerated the capital of many global banking institutions, it was the levered homeowner on the brink of insolvency. Given that Australia had similar homeowner savings patterns as % of disposable income, the recourse feature of loans may not be that material if there are no other assets aside from the home (given the post '92 recession one-way train in real estate, im sure there are some out there). And given affordability metrics for median incomes are at levels as high, if not higher, as the US in 2006, I would definitely looking to be hedge longs in real estate. I hope for Australia's sake that what I deem the biggest (and least priced) risk at this precarious moment for the world economy, a NPL-driven deflationary bust in China, does not happen because the secondary and tertiary effects on Australia will be vast.

Anon @ 1:21 - simple choice: future potential water crisis/global warming or continued economic growth? Australians don't have to keep selling commodities to fuel Chinese factories and cities that have at the margin driven so much of the environment deterioration of the last decade. Or, just as American foreign policy has had a prominent human rights school and lobby, AU foreign policy could incorporate a much stronger environmental side to it and attach strings and constraints to exports of commodities. The choice AU has made and continues to make is very clear.

M said...

Thanks for your response John.

Northern Rock is a good example but rather I understand it as a victim of the general credit freeze or "crunch" as they like to call it. It just happened to be in a more precarious position when LIBOR etc got out of control and when the defaults became public the run occurred etc. There doesn't need to be a run on banks for house prices to fall however.

Are you suggesting that

a) Australian Banks retain higher cash ratio's to those in the US and the UK (if so is this for regulatory reasons or risk aversion?); or

b) Australian banks are sufficiently isolated from foreign debt markets that they were able to maintain cash flow? I would be very surprised if the answer to this one is yes.

Brian said...


Thank you for a great post (as always). I am curious, what do you think would be some good ways to gain short exposure to AUS/NZ real estate?


John Hempton said...

QBE has a mortgage insurance business in Australia. Its attached to a large insurance company.

But then hey - we know what happens when you attach credit insurance businesses to large insurance companies... don't we?

Anonymous said...

Interesting blog thanks, at least as far as the economic analysis goes. But mind your history (ref comment June 30 2.17pm).

New Zealanders are indead very good at telling ourselves 'deliberate and non-deliberate' lies about our history. You failed to mention the australian talent for doing the very same thing. Many of us don't seem to have gotten past the 'empty land' myth.

And since we are comparing the two countries, the important task of improving the lot of indigenous people has proceeded alot further in NZ than in AU.

Jonathan said...

Great post as always.
While its possible to intimate large losses from the PMI business under dire economic conditions (high unemployment, fall in property prices etc), their loan loss charge is currently quite low and also historically has been extremely low (even in past recessions). It could be argued they are also quite well provisioned around 8-9 times historical losses. Additionally, the major banks actually contain as much, if not more risk than this attached credit insurance business. While you are correct to see this acquisition as a risky proposition for QBE, without a real systematic collapse in the economy and property market in Aus(evidence still highly uncompelling despite bearish opinion) and management’s obvious reticence to disclose information, I see no major catalyst. Regards

John Hempton said...

I am well aware of the differences in how Australia and New Zealand treated their indigenous populations.

But the short (and slightly offensive) version comes down to

(a). The Maori were farming warriors but the Aborigines were hunter-gatherers.

(b). The Pakeha/Europeans found it easy enough to kill off the Aborigines with disease mostly but in some instance with guns. They found it hard to kill off the Maori because they were effective warriors and had more immunity to European diseases due to the long time between contact and settlement.

(c). As a result the first major contact was trade with the Maori but just displacement with the Aborigines. The Maori sold what they had to sell (which was their women) and purchased what they really wanted (muskets) so they could beat up on the real enemy (which was not Pakeha - it was just the neighbouring tribe).

(d). Whereas Aborigines were maginalised completely Maori were not. Warriors with muskets.

(e). However the Maori tribes beat up on each other during the Musket Wars (1806-1839). The map of New Zealand in 1840 makes about as muchy sense as a map of Europe in 1940. However that was the date that they signed the treaty.

(f). Treaty implementation is based on the map in 1840. Winning tribes (Waikato, Northland, South Island) have had big settlements (particualarly Waikato). Losing tribes (Taranaki area, the largely Maori depopulated area around Martinboroug) are big losers.

(g). Almost all Pakeha (at least when I last lived in New Zealand) had no understanding of the unequal settlements based on 1840 borders.

(h). There was a liberal-pretense that they were somehow doing this well - when in fact the holes were self evident.

But then Maori-Pakeha relations are not the subject of this blog even if I once knew quite a lot about the subject. (Not something I have studied for a decade - so I am not up to date.)

Australian Aborigine - majority polulation relations are terrible. Just terrible.

New Zealand has done more - but it started in a different position due to the Warrior Farmer nature of the population and it has not done that good a job. They just pretend they have.


John Hempton said...

That last post was targeted at anonymous of 9.26 am 2 June.

It I think requires a strong interest in Maori-Pakeha relations - something I once had but no longer make any claim to.


Thomas Beagle said...

I think your knowledge of NZ attitudes to its history is a little out of date - you seem to think your description is a bit radical but I'd more describe it as the common understanding.

nfpsheppard said...

An excellent read, and a nice concise history of indigenous relations in Australasia.

Looking forward to more posts - would you be looking at the NZ economy sometime?

John Hempton said...

I suspect my view of the Kiwi history is out of date. I last lived in New Zealand in 1999 - and have paid the country very little attention since.

I pay this country some attention - but not all that much. If you look at the blog you will find less attention here than you would guess from my domicile (Bronte Beach).

And if I wanted to get into a screaming match about Kiwi history I would need to do some more research. I started writing a post about differences between New Zealand and Australian macroeconomic policy 1900-1983/84 but found my knowledge missing in the middle bit.

I had a good idea of how the "settlement" [centrally fixed wages, protectionism, white Australia/New Zealand policies] were formed.

And I understood the denoument in both countries - and just how vicious it was in the end in New Zealand (Muldoonism, Think Big). But if you wanted me to explain differences in 1950 I was at a loss. So I gave up the post as just too hard.

I have some understanding of the differences between Keating/Hawke and Roger Douglas. Also nuanced differences in micro policy (particularly tax and telecommunications from that period). But that is about where I end.

I still had the perception that I knew far more about New Zealand economic history and economic than the average kiwi. But then - time passes... and ideas and knowledge level changes.

Monko Anime said...

Hi John,

great post. my mates in Tokyo don't believe me when I say Sydney is much more expensive than Tokyo (as a local) - If I had a Japanese wife , instead of an ex- who prefers Melbourne :-( I'd buy and live in Tokyo (or Yokohama) anyday!



Anonymous said...

Monko, I'm an ex-Sydneysider now living in Tokyo - I concur with your remarks. Australian property (not just Sydney) is definitely insane, but unlike Japan, I don't think Australians have either the reserves nor the ticker to wear a propety crash. Hence the ever increasing insanity of the Australian housing bubble - I expect it to go for another 10 years at least.

Aki_Izayoi said...

I am going to try to use this blog post to solicit information:

Does anyone have any data about the percentage of sovereign, household, and corporate debt from emerging markets (specfically Indonesia, India, and Brazil) are demoninated in local currency as they are floating (and maybe some additional info to see if the debt is held domestically). I want to see if those countries can "decouple" from global capital markets and developed nations.

I wonder if emerging markets can get the luxury of floating exchange rates and debt in their own currecncies too.

Anonymous said...

For Australia it will be a slow adjustment.A lost generation as you say. The bankers will not pull the tent down on themselves and solved the issue last time back in 1980 by telling everyone that their loan terms had been extended out another 5 years.This meant the interest payments went down and there was no loan default.

BruceG said...

John, great topic which I have been trying to understand for some months. If you care, I'd appreciate your views on the following:

- Net Foreign Debt 62% gdp
- CAD was 6.6% before dropping to 3.2% gdp
- our banks' reliance on foreign wholesale funding has grown to ~30%, most of which Aussies use to bid up resi property. every year as more debt free dwellings are sold at market rates (via retirees), our foreign debt goes up....presuming a trade surplus does not miraculously offset income in current account)

I understand Japan has a NFD ~150%. What do you think the Aussie nfd and cad limit is? Do you think the Pitchford Thesis has limits the RBA won't elaborate?

Obviously we can't keep borrowing foreign capital to bid up non productive property, when we simultaneously have negative cash flow (CAD) with the world.....unless we just keep selling assets like mining companies.

Australia has low savings rate. Do you accept the argument that that is offset by our super industry?

Thanks in advance.
Love your cooking recipes.

Anonymous said...

The 2017 Sydney housing market makes the 2008 Sydney housing market look positively sane.

I've been short Sydney property (i.e. a renter) for more than 10 years now ... it really hurts.

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