On Friday we had a Dumb and Dumber moment in the office when a colleague for a few seconds thought that Australia had lost its AAA rating. The error was quickly realised (it was Austria that was downgraded) and Australia kept its AAA rating across the board that it has had with Moody’s and S&P since 2002 and 2003 respectively (although Fitch only upgraded Australia’s foreign currency rating to AAA in November 2011).
There were however some disturbing figures that came out of Australia on Friday – foreign investors bought a record AUD$23.9bn (=US$23.9bn) of Australian government bonds in Q3 2011, resulting in foreign ownership soaring to 80.4%, which is also a record. Judging by the price action on Aussie bonds and the Aussie Dollar in Q4, foreign ownership is likely to have jumped further in Q4. For us, this is worrying as heavy foreign ownership of government bonds can be very dangerous, particularly when this is combined with a country running a current account deficit (i.e. the country is reliant on capital inflows from abroad). Ireland and Portugal, which saw similar levels of foreign ownership before the crisis hit, are great (or poor?) examples of how this combination can leave a country’s exchange rate and solvency very exposed if the country hits a crisis.
Of course, Australia does have some big advantages over the Ireland of 2006. Australia has the ability to print its own currency and set its own interest rates (just ask the Irish how much they would like this power right now). Secondly, despite the massive expansion in credit and house prices that Australia has experienced over the last two decades, Ireland’s was comparatively greater. The run up in Australian house prices since 1990 is reflective of a massive increase in household debt (fuelled by the Aussie banks) and is not the product of more fundamental factors such as population changes or rental income equivalents. Additionally, there is likely to have been a change in demand, as years of rising prices that have made the Australian housing market one of the most expensive markets in the world on price-to-income and price-to-rent ratios (as The Economist pointed out last November) have probably changed household formation dynamics.
Australia’s current account deficit is currently only 1.5% of GDP which is far from alarming. However, on a cumulative basis, Australia has averaged a deficit of 4.8% since the beginning of 2003 which should have investors’ alarm bells ringing. The credit bubble in Australia (credit bubbles usually accompany large credit account deficits) has never really popped (we wrote about Aussie housing market here). The end of a bubble is always difficult to predict and identifying the trigger for such an unwind is similarly fraught with difficulty. Given that markets are extremely sensitive to the potential for asset price bubbles bursting and with the effects of such events still in mind, the Australian housing data are key to AUD maintaining its lofty levels. Something else that is worrisome is that the Australian banking sector dwarfs the size of Australia’s economy at 3.5 times nominal GDP (Ireland’s banking sector was 4.4 times GDP in 2008). The key challenge facing the Australian banking sector is its exposure to the housing market, with about two thirds of assets on the banks books consisting of housing loans.
The following chart shows the AUD/USD currency rate versus foreign ownership of Australian government bonds going back to 1989. It appears that there is a positive correlation which makes a lot of sense – obviously if foreigners are buying government bonds in large size then the currency should strengthen. In fact, we think this is precisely why the British Pound has been surprisingly strong over the last six to nine months as the UK government is one of the few AAA sovereigns still standing and has been the beneficiary of a huge safe haven bid. Of course, if this safe haven status gets called into question, which could easily happen in both Australia and the UK, then capital outflows would leave their respective currencies extremely vulnerable. On this front the UK’s current account deficit of 4% of GDP recorded in Q3 2011 wasn’t exactly encouraging – since 1955, it has only been worse in Q2 1974 (which preceded sterling’s 1975-76 collapse and IMF bailout) and from Q4 1988 to Q2 1990 (which was a symptom of the UK’s housing bubble and preceded the pound’s sharp fall after it was booted out of ERM in 1992)
The obvious catalyst for the popping of the great Aussie bubble is China, as that’s essentially all that matters if you’re taking a view on Australia’s economy. Almost 70% of Western Australian and Queensland mining exports go to China. If China has a hard landing then Australia is in serious trouble, and even if it has a soft landing then Australia may be in trouble anyway. If China wobbles or the Australian housing market starts to correct, the RBA would be forced to cut interest rates as it did late last year, reducing the Aussie Dollar’s appeal as a higher yielding currency. The Aussie Dollar is only just over 3% below its strongest ever on a trade weighted basis, and we think that leaves it looking very vulnerable. With the market pricing in a reduction in the RBA cash rate of 1% to 3.25% by August, will the hot money fly away from Australia in the summer?