• suggested that a recession could be avoided, and that the budget would remain in surplus despite the need for a large fiscal stimulus [1];
• endorsed the need to deal with the 'cause of the fire', as well as 'fire-fighting' (Dodson l., op cit);
• suggested that 'extreme capitalism' and 'free market ideologues' were the problem (Rudd K., 'Realism and true grit will get us through this', Financial Review, 16/10/08; Madigan M., 'Rudd blasts money-men', Courier Mail,  6/10/08);
• nominated better regulation as the key to preventing future 'fires' (Tingle L., op cit) - with particular reference to global regulatory regimes (Rudd K., op cit);
• suggested linking capital adequacy requirements for banks to executive remuneration to inhibit unrestrained greed (op cit);
• indicated that it was planning for further 'new, big and different' initiatives (Dodson L. et al 'Business calls for reform despite crisis', Financial Review, 18-19/10/08);
• suggested that tax cuts due for 2009 could be brought forward (Milne G., etal 'Fallback plan for rescue package', Sunday Mail, 19/10/08;
• indicated that immigration levels would be reduced if unemployment increased [1, 2];
• referred to a $76bn infrastructure fund which could be financed from surpluses - a claim that the opposition disputed [1].

Maintaining Capital Inflow

Australia's supposed 'economic fortress' might prove to have an indefensible front door because of its current account deficit and consequent need to continue attracting capital inflows (which had long been around $60bn pa until reduced somewhat by strong export demand for minerals and energy) to fund investment.

This is not simply an academic issue as withdrawal of foreign capital after the near collapse of Barings bank was a major factor in the collapse of many Australian banks in the 1890s. As land was the main security held by Australia's banks, withdrawal of capital forced large scale sale of land and a price collapse which further undermined banks' balance sheets [1]

The Bank of International Settlements (BIS) reportedly warned in 2007 that the A$ was more at risk of capital flight than any other (apart from the Turkish Lira) because of the growth of Australia's foreign debts and dependence on the 'carry trade' to provide capital inflow (Uren D., 'Ignoring foreign debt puts dollar in peril', Australian, 26/3/07). When the commodity boom was seen to be unstoppable, $A investments were attractive and the $A was strong (as the $A is viewed by investors as a substitute for commodity investment). But the commodity boom, and thus the $A as a currency for investment, are now much less secure.

Furthermore Australia's current account deficit has apparently been covered mainly by banks borrowing in international markets to make property investments. Australia, like many other countries, has experienced a huge increase in property values over the past decade at least partly as a by-product of easy credit. Deflation of what proved to be a property bubble has been the initial source of the financial crisis in the US. Domestic property bubbles have apparently also deflated in UK, France, Ireland, Spain, emerging Europe, China and elsewhere. The IMF has reportedly ranked Australia as highly susceptible to a similar house price slump (see Rollins A., Financial Review, 4/4/08). Other observers have argued that Australia has borrowed and spent too much money on real estate and now has to devote 4% of GDP to repayments, double that of the US (Why real estate spending could make Australia the new Iceland) . In December 2008 an 11% decline in business credit was viewed by the RBA as a fall in foreign currency dominated lending [1]

If a property slump emerges (and there are signs that one is possible - eg see Harley R., 'Property the experts are divided', Financial review, 18-19/10/08, and Uren D. 'RBA to cut as housing prices crash', Australian, 4/11/08), then:

• those who have invested in property in the hope of short term capital gain but with inadequate financial capacity will be in difficulties. Investors who confronted unexpected declines in property values (not home occupiers) were apparently the primary trigger for the sub-prime crisis in the US - and concern has been expressed [1] that aggressive marketing of property investment in recent years has led significant numbers of buyers to falsify applications for deposit bonds (which create an obligation to pay but does not require up-front cash) in securing properties they can't now afford to buy;
• Australia's banks (and other financial institutions) will:
  • be less able to justify international borrowing for property investment to balance Australia's current account deficit;
  • be exposed to losses which, though probably less severe than those experienced in US because of very limited US-style 'sub-prime' adventurism, will none-the-less erode their reserves and potentially require 'rescue' operations. Most of the losses incurred from falling property values elsewhere have involved supposedly 'prime' mortgages where large falls in values left owners with negative equity;
  • potentially disrupt normal activity with a credit freeze (like that in US / UK / parts of Europe) because non-transparent derivates contracts will make it impossible to know who actually carries the resulting losses;
• government guarantees on deposits with regulated financial institutions could result on large costs to taxpayers.

In June 2009 it was reported that:

•  Australia had funded its current account deficit with equity rather than with debt as had long been the practice - because offshore equity investments were repatriated home (and there was some reduction in the current account deficit because of large commodity revenues and a fall in domestic investment) [1]
• big companies are increasingly looking to Asian debt markets to meet their funding needs [1];
• bank chiefs have warned that Australia's heavy reliance on off-shore funding and low rate of deposits to loans is making banking system vulnerable and threatening economic recovery [1]

In late 2009:

•  the need for huge government fiscal intervention in 2008 to protect Australia's financial system was identified, as was the ongoing financial dependence on China growth.
• it was reported that a year earlier all major Australian banks found difficulty rolling over their foreign loans and would have (a) had to withdraw credit from domestic borrowers (b) eventually gone bankrupt. Government guarantees of bank deposits were vital to prevent this happening [1];
• it was noted that the number of housing starts was falling - indicating perhaps that property investors are starting to expect a price crash [1]

In 2010, it was suggested that:

•  first home buyers (enticed into the housing markets by government grants) were frequently (ie in 45% of cases) struggling to maintain their mortgage payments in the face of rising interest rates and various price increases [1].
• Australia had avoided the boom and bust in house prices the US experienced, and the factors that gave housing market strength continued to the point that a bubble mentality is developing and affordability is again of concern.  US hose prices were driven up by low interest rates, abundant credit and sub-prime loans - and then fell 30% after 2006. In Australia prices were flat for years 2002, as interest rates were raised. They fell only modestly during financial crisis, and have since risen again (starting with first home buyers). A crisis was avoided because of: limited low-doc loans; constraints on building; stronger bank balance sheets; recession was only shallow; immigration was strong; full recourse loans are made; government grants were generous. Housing construction has been low by historical standards, while population growth has been high. Supply side difficulties are likely to push prices higher - so planning guidelines and infrastructure constraints need attention. Investors are now looking for price gains. Rises will be constrained by increased interest rates in a couple of years - especially given affordability concerns. But this is likely to involve slowdown, not bust [1]
• Australia is in an unsustainable housing bubble (according to Edward Chancellor, GMO). House prices need to fall by 1/3 (some of which could be made up by rising incomes). Australia's banking system (seen as a cartel) was said to have avoided problems because of lack of competition that forced extreme risk-taking in US. Problems face first home buyers given rising interest rates - and housing market is likely to fall due to problems of affordability. Australia's other risk is a collapse in commodities demand from China. Australia is not yet out of the woods - and in fact has not yet entered the woods [1]
• Steven Keen (UWS) has long been convinced that Australia's house prices are dangerously high - and has now been joined by the influential Jeremy Grantham. He suggested that Australian and UK housing markets are the two outstanding bubbles - on the basis that house prices in long run average 3.5 times household incomes, yet are now 7.5 times in Australia. Keen relies rather on long term graph of real house prices that seems to skyrocket in recent years. RBA argues that house prices have increased relative to incomes because of: structural decline in inflation / interest rates; financial deregulation ended the need for banks to ration housing credit - which made affordability into the rationing device; lack of adequate supply of new housing (which made price the means of rationing); Australia is highly urbanised and faces development constraints on denser housing. Unlike US bubble there seemed to be no glut of new homes - with rental vacancy rates at lows. Australia's rapid population growth also keeps spurring demand. Mortgage stress affects relatively few households. HIA data suggests that average house price has been $498,000 compared with average household income of $125,000 - a ratio of 4:1.  Average mortgage repayments are likely to be about 30% of income - which suggests limits to further increases. Keen's chart needs to be given a logarithmic scale to show that real price growth is only slightly greater than real GDP. Australia's house prices are likely to remain uncomfortably high unless there is a sudden increase in interest rates or a sudden rise in interest rates  (Bassanese D 'Disputing the doomsayers' view of housing', AFR, 19-20/6/10) (Comment: ABS's publication (Household Income and Income Distribution 2007-08, 6523.0) suggested that mean household income in Australia was $1649 per week (ie $85,750 pa) and this implies that households on average income (which is well in excess of the income of the average household) would have to pay 52% of their after-tax income on their mortgage assuming: property cost of $498,000; 6.75% interest rate; a 30 year term; a 20% deposit; and a 30% average tax rate).
• foreign investors frequently express concern about Australia's housing market when expected to provide the funds required to balance Australia's current account deficits [1]
• large increases in global wholesale funding of Australia's banks would be needed to achieve the economic growth rates forecast by the federal government. As this may well not be available, banks will need to fill the funding gap by increasing interest rates, and when this is passed on to mortgages the effect on housing could be significant [1]
• construction industry claims that Australia has 190,000 families desperately seeking housing who are unable to find it. But no one is able to find them - and they may be a fiction.  HIA claims average first home buyer spending $535,000 whereas ABS suggests that they borow $292,000 . HIA suggests that there will be 466,000 shortfall of houses in 2020 - but there are large areas of zoned land waiting for houses to be built. Vacancy rates would be low if there were a housing shortfall - but this is above 3% in all cites but Canberra and Adelaide. Rental growth has also been subdued. One observer suggests that we are now going into housing over-supply because much population increase has involved family reunions which simply increased home occupancy rates [1]

In May 2011 it was argued that: (a) deregulation of mortgage lending and a structural decline in interest rates is mainly responsible for the escalation of housing prices in Australia. Prior to financial deregulation prices had been very low because credit was limited and provided by banks to customers with the best credit rating. Deregulation resulted in large inflows of capital, which made affordability the basis of credit rationing - so that many more people were able to afford to buy; and (b) it is none-the-less unlikely that prices will crash [1]. [CPDS comment: Affordability was not the sole basis on which credit was sought for property purchases, so was the once off super-fast surge in property prices which encouraged the view that this was the best path to wealth for investors]

 

There is no point relying on domestic economic strength in an unsustainable economic global environment. Australia can't succeed by simply trying to protect its status-quo from symptoms of broader problems. The need for more is illustrated by China: Victor of Victim?. In brief this argued that:

• global financial imbalances are central to the current financial crisis - a view apparently accepted by the BIS. Those imbalances (characterised by a 'savings glut' in East Asia and large current account deficits by the US, Australia and a few other countries) have required the US in particular to provide levels of demand well in excess of its income. Funding this high level of demand depended on the development of an asset bubble - whose bursting has resulted in the current crisis;
• China (and others with variations of the macroeconomically-unsustainable Asian economic model) are likely to be victims of the financial crisis. Financial system reforms in the US must stifle the financial imbalances that have protected East-Asia against defects in their economic / financial / monetary systems. And foreign exchange holdings that have been built up in the past will not go very far.

In view of what has happened in the US, other countries will be unwise to try to step into its shoes and provide the excess demand required to drive global growth in the face of Asian demand-deficits. This applies particularly to Australia, in view of its probable exposure to current account problems (as mentioned above).

Unfortunately current international proposals for reform, such as the work of the Financial Stability Forum which Australia's Prime Minister Mr Rudd, endorsed in his address to the UN General Assembly, have focused narrowly on financial regulation and do not seem to deal with the broader (financial imbalances) issue.

The confidence that Mr Rudd expressed in China's strong growth continuing to stabilize the global economy in the face of weakness elsewhere (Chalmers E., 'PM puts his faith in China', Courier Mail,  4-5/10/08) is probably misplaced. China was little affected by the 1997 Asian crisis and could provide strong growth to stabilize Asia generally because it was backstopped by strong US demand which provided it (and Japan) with current account surpluses - and thus no need for foreign capital. Others in Asia learned from this experience, and the ever-larger fiscal imbalances that are a major factor in the current global crisis resulted. But strong cash flow without worrying about its banks' balance sheets can't continue to be available to China as the US's financial system reforms must drastically reduce credit-based consumption.

Defending 'Fortress Australia' would require a lot of resources, and be subject to practical constraints. For example:

• reducing RBA interest rates may not affect the interest rates that banks charge in an environment in which most of their funding sources are constrained;
• revenue falls and increases in spending to compensate for reduced investment and consumption by business and households could be very significant;
• spin-offs from the global financial crisis must now escalate - and these have already been stressing Australia's financial / business institutions and households (eg see Escalating Concerns which refers, for example, to: problems in corporate cash flow / investment financing / aggressive valuations of commercial property; blow out in bad debts affecting financial institutions; and evidence of ending of property boom);
• defending the integrity of financial institutions in the face of a large (eg 10-20%) decline in property values could require many times the $4bn that the federal Treasurer recently committed for investment in home mortgages;
• there is no effective machinery for determining what to increase public spending on. Presumably infrastructure would be a priority. The federal government set up Infrastructure Australia (IA) to suggest projects, but this can't be realistic (see Infrastructure Magic?) because: (a) central planning can't take account of all the local considerations that are critical to such decisions; and (b) the environment is changing rapidly and the resource industry emphasis built into IA's terms of reference must now be uncertain. To oversimplify, those who could have the information to make sensible decisions don't have the financial capacity to make them, and those with the finance can't access the information - which is precisely the reason that central planning of any economic function must fail. Moreover at present state infrastructure machinery is likely to be no more realistic (eg see Brisbane's Transportation Monster) as a result of systemic weaknesses in Australia's system of government that have now become chronic (see Infrastructure Constraints on Australia's Economy).

• the guarantees provided to deposits with, and loans to, Australia's banks, building societies and credit unions:
  • could well result in large costs to taxpayers (eg $50-100bn) - if financial  institutions (like their counterparts elsewhere) are adversely affected by losses through derivatives trades which have been 'below the radar' of Australia's financial regulators (see below);
  • appear to be difficult to implement because of the complexities involved with many different types of institution and financial instrument (eg see Tingle L., op cit);
  • put benefited institutions in a significantly stronger competitive position relative to other financial institutions, and thus enable them to pay lower interest rates to investors while their competitors lose the ability to do business and have grounds for complaint about sovereign risk. This issue seems to concern the RBA (RBA warned against bank guarantee: report);
  • have made it difficult and more expensive for state governments to fund infrastructure investment [1];
• despite Australia's initially relatively strong government fiscal position, maintaining a strong fiscal stimulus in the long term (which seems likely to be needed because of macroeconomic obstacles to early recovery) may prove challenging. The federal government's view that the budget would remain in surplus after the proposed spending increases seems implausible. If the budget is likely to be in surplus. as a result of increased public spending, then the latter was probably not required. Australia's Future Fund reportedly suggested that it is unrealistic to expect that budget surpluses will fund the $41bn that the Federal Government wants to commit for infrastructure, education and health in the short term [1];
• a large fiscal stimulus in Australia which leads to a level of growth out of balance with that achieved elsewhere would exacerbate any potential current account problems Australia may face (see above, and note the adverse balance of payments effect of the commodities crash [1]). As noted below many countries do not have the ability to mount a strong fiscal stimulus;
• it has been suggested that proposals to increase first home-owners grants could be counter-productive. For example these might:
  • result in many buyers with negative equity (Milne etal 'Fallback plan for rescue package', Sunday Mail, 19/10/08);
  • simply encourage an expansion of a major cause of the financial crisis - through encouraging households to take on more debt. Booms and busts are regular events. in the past these were dependent on business balance sheets - but they now depend on household balance sheets. Debt financing has been made available to households on an unprecedented scale, creating a new source of potential instability [1] ;
  • have put bank's AA credit rating at risk by encouraging the emergence of a form of sub-prime lending to those with limited capacity to repay [1]
• reducing immigration levels to counteract increases in unemployment could: (a) take away a significant source of demand for housing and thus make a slump in housing prices (which could adversely affect bank balance sheets) more likely; and (b) perhaps increase unemployment for reasons outlined below;
• the federal government was already virtually logged-jammed with issues that it has been seeking to micro-manage - noting: (a) the large number of inquiries commissioned into diverse subjects about which reports are almost due; and (b) the tendency to announce initiatives which are more symbolic than substantial (eg see Productivity Magic?; Fixing Australia's Health and Hospital Systems? ; Apology Magic?; Infrastructure Magic?; Australia's New 'Cooperative' Federalism). Significant decentralization of functional responsibility (and financial capacity) seems likely to be required to avoid gridlocked governance in the face of now-prevailing complexity;
• guarantees of bank deposits in Australia - which were intended to stabilize them - led to a crisis for other institutions (eg cash management trusts and mortgage funds) which had no such guarantee and subsequently experienced a run on their funds. Moreover:
  • those guarantees did not provide benefited institutions with the AAA rating that was intended because that rating apparently requires payments to be made within 24 hours, while action under the guarantee would require legislation;
  • the OECD has warned that such guarantees could encourage reckless lending that makes the financial crisis worse [1];
  • Australia's banks have remained successful in international borrowing [perhaps due to these guarantees] and this will reduce pressure on SMEs [1];
• arrangements by Australia's federal government to provide credit for commercial real estate in partnership with Australian banks where foreign banks withdraw from the Australian market and thus don't roll-over the debts of major companies have been suggested to:
  • perhaps actually accelerate such institutions' withdrawal from the Australian market - by making this painless for them [1];
  • be needed to guard against large falls in the value of assets - which would discourage further investment - though the Reserve Bank is concerned that the arrangement would interfere with normal workings of the market [1];
  • be intended to forestall a rout in property values that could spill over to affect the housing market [1];
  • to be likely to protect construction employment in the government's opinion - though this view is disputed [1];
  • need very careful design to ensure that all losses are not born by the Commonwealth - because Treasury officials will not tend to have the same level of commercial skill as banks[1];
  • be used very carefully so as not to prop up dubious projects [1];
  • be likely to conceal sloppy lending practices by banks during the property boom [1]. Increasing numbers of observers are suggesting that projects were financed during the boom on a continuing 'blue skies' basis [1];
  • be heavily weighed in favour of banks at the expense of taxpayers [1];
  • possible be illegal through contravention of trade practices legislation [1].
• political pressure in Australia on banks to lower home loan lending rates forces them to change very high interest rates to small and medium enterprises (the largest sector providing jobs) with the result that job prospects are more limited than they otherwise would be [1]
• a proposed $42bn  fiscal stimulus by Australia's federal government in early 2009 was criticised on the basis that:
  • large government budge deficits pose problems for Australia because of its dependence on foreign capital [1];
  • 'pump priming' will only retard recovery and leave a painful legacy of debt. The problem arises because of lax monetary policy for over a decade. Unwinding the misallocation of resources that results from this will be painful, but 'pump priming' will prevent this. The focus should be on increasing savings [1]
  • Australia's fiscal position had already deteriorated more than most as a result of crisis - though its economic situation was not as bad. Fiscal expansion (in small open economy) may merely raise interest rates, induce capital inflow, inflate the $A and reduce exports. Monetary policy would be better. Proposed spending is too much too soon - because unemployment is not yet rising significantly. There is thus a risk of crowding out other activities. Unproductive spending creates long term problems - because it doesn't contribute to tax revenues. The stimulus proposal contains no details of how to return to budget balance [1]
  • any large payments to households are more likely to be saved than spent [1];
  • the stimulus is solely focussed on increasing the demand side of the economy - not on boosting supply. Australia has a deficiency on the supply side - as indicated by its current account deficits - and its households (who ultimately have to pay for government spending) carry heavy debt burdens [1];
  • this will increase the capital shortage in Australia and force the sale of assets at the bottom of the cycle. Australian business and households took on too much debt during the boom [1];
  • Australia's fiscal position is deteriorating faster than comparable countries. Fiscal policy may not be effective in a small open economy (ie it may simply raise interest rates, induce capital inflow, cause currency appreciation and reduce exports).  Higher budget deficits can significantly increase interest rates in Australia. The fiscal stimulus is too much - and before symptoms are apparent. There will be little room for future manoeuvring. employment is more likely to be relocated than created. There is no credible strategy for returning to budget balance [1]
  • households chose to save any extra income they received because their debt levels had increased significantly since 2000 [1];
  • economic growth depends ultimately on the productive use of savings - and much of the stimulus involved unproductive spending which must undermine Australia's economic prospects [1];
  • a large stimulus in an open economy has perverse effects - eg increasing demand for capital, forcing up interest rates, attracting foreign capital, increasing exchange rates, depressing exports and thereby increasing current account deficits. The impact of stimulatory spending has been over-estimated because these consequences have been assumed away [1]
• a state government in Australia was suggested to be at risk of causing panic by referring to the need to go on a 'war footing' because of the potential impact of the crisis, while not revealing to the public the reasons for this conclusion [1]
• legislation proposed by the federal government that would apparently require lenders to take responsibility for the ability of borrowers to repay loans could seriously impede the provision of credit - and thus make it impossible for the community to achieve the levels of spending required to avoid recession [1]

Similar concerns about the unintended consequences of policy action have emerged elsewhere (see details in Global Financial Crisis: The Second Test)

Overlooked Issues Affecting Australia's Banking System (email sent 23/10/10)

Hon Joe Hockey, MP,
Member for North Sydney,
Shadow Treasurer

Re: 'New-era finance sector must be held accountable', The Australian, 22/10/10

Your article suggested the need to review the way Australia's banking system operates.

My interpretation of your article: A socially responsible compact with banks is needed, as is a major debate about banking and financial services in Australia. The industry is changing worldwide as a result of Basel 3 rules. Government intensive-care of major banks is ending. Asia will be the most important source of future finance - though most major banks are in US and Europe. Some Australian banks are looking for growth in Asia. Two have indicated that they want to be growth based, rather than yield-based investments. However governments underwrite bank risks, and taxpayers have recently guaranteed bank deposits and spent billions to re-inflate residential mortgage backed securities. While recovery of international markets from GFC will take many years, recently funding costs have been flat. There must be a debate about the role of banks and their relationship with community, as they are not only custodians of deposits but also of superannuation. Treasurer has often asked banks not to increase interest rates above Reserve Bank changes - but this achieved nothing. There is a need for a social compact with banks, and a mature debate on where financial services are headed. This might result in: more liquidity in mortgage-backed securities; simplification of legislation; better prudential standards; less price signalling. Banking systems' direction must be acceptable to the taxpayers, shareholders and depositors, because taxpayers ultimately foot the bill in the event of bank failures.

While there are valid domestic reasons for such a review (eg the prospective shift to risky strategies by traditionally-conservative taxpayer-underwritten institutions), it is submitted that there is also a need for deeper consideration of the international issues affecting Australia's banking system than those mentioned in your article.

My reasons for suggesting this are outlined below. In brief it is suggested that: (a) Australia's banking system and its economy generally are dependent on the international financial system; (b) there are continuing instabilities in that system that have not been resolved through the G20; (c) Australia's banking system has been, and remains, exposed to this instability - and this poses risks to the economy generally; and (d) the future reliance on 'Asian' finance that your article suggested would tend to limit scope for 'free' enterprise, because the region's major financial systems don't operate on a Western-style capitalistic basis.

In any review of Australia's banking system such considerations should not be overlooked. It is noted that, in the various positive and negative reactions to your proposal (some of which are outlined below), the international issues that I have suggested seem to be generally overlooked.

John Craig

Detailed Comments

Domestic Banking Issues

There is no doubt that there are important domestic questions about Australia's banking system.

For example: shifting from yield-based to growth-based investment status implies shifting from deposit-taking / conservative investment activities towards more commercially-risky 'investment banking' activities. Keeping a separation between deposit-taking banks (which justify government underwriting of losses) and riskier investment banking was one of the key lessons of the Great Depression. This resulted in the Glass-Seagall Act in the US, and progressive repeal of that Act (in 1980 and 1999) is seen by many observers as facilitating the financial excesses in the US that contributed to the global financial crisis (GFC)

Australia's Dependency on International Financial Systems

However the international environment in which Australia's banks operate, and on which they (and through them Australia's economy) are dependent, is much more hazardous than your article indicated.

Australia's banks (and non-bank financial institutions) have strong linkages with the international financial system. One reason for this is that Australia's economy has traditionally run current account deficits (eg $50-60bn pa) which have had to be covered by capital inflow - and it is understood that this inflow has mainly been achieved by banks (and the originators of residential mortgage backed securities, RMBS) borrowing in international financial markets, for real estate lending. Thus Australia's economy is also macroeconomically dependent on offshore borrowing by banks (and RMBS originators).

Instability in International Financial Systems

Unfortunately the international financial system remains unstable and potentially crisis prone despite reform proposals such as Basel 3, and the efforts of the G20.

In brief the problem seems to be that: (a) some financial systems have been organised so as to gain mercantilist advantages in international trade; and (b) unsustainable financial imbalances have developed as a consequence, and have contributed to financial crises (especially to the GFC that emerged in 2007). In particular, it is noted that:

• East Asian economic models appear to use financial systems as a form of protectionism (ie as a means for transferring income from the economy generally to subsidise state-backed export-oriented production), though the whole-of-society arrangements through which this is achieved have not been appreciated by most Western analysts - see Resist Protectionism: A Call That is Decades Too Late;
• that form of protectionism has made global growth macroeconomically unsustainable, as it requires large domestic 'demand deficits' in countries with such financial systems and thus a willingness and ability by their trading partners to provide demand in excess of their income and thus to increase their debts indefinitely (see Structural Incompatibility Puts Global Growth at Risk, 2003). This probably played a significant role in the the emergence of the asset bubbles that led to the GFC (see Financial Imbalances in Global Financial Instability, 2007 and GFC Causes);
• increasing concern has been expressed about the possibility of 'currency wars' in response to the associated trade imbalances. For example the US Federal Reserve apparently intends to use quantitative easing (QE, ie printing money) to stimulate the economy by purchasing US Treasury bonds. Given the de-leveraging by US households (who provide 70% of US demand) there is no chance that QE by the Federal Reserve is going to stimulate the US economy directly (ie few now want to borrow). Rather QE will presumably create a $US 'carry trade' which stimulates asset inflation and spending in countries whose economies are currently stronger (mainly the emerging economies) and thereby (hopefully) boost US exports and incomes (without further increasing US debts). This is the same as Japan has been doing since the 1990s through its monetary policies (ie creating cheap credit for which there was no local demand, and thus feeding into asset inflation and spending elsewhere through a Yen carry trade), and equivalent to what emerging economies (especially those in East Asia) have been doing by organising financial systems to ensure current account surpluses, and thus a flood of liquidity into other economies (especially the US).

Such problems have simply not yet been addressed by the G20 in its efforts to create the framework for a stable future global financial system (see Too Hard for the G20?). The most recent development in G20 deliberations involves an attempt by the US Government to head of 'currency wars' by seeking the adoption of rules to govern trade imbalances. However little progress is likely until the origin of major components of those imbalances in the way some systems of socio-political-economy are organised is recognised.

Australia's Exposure to Risks

Australia's banking system has been, and remains, exposed to this instability, and this has broader policy implications. For example:

• the 'carry trades' (eg especially Yen in the past, and possibly $US in the future) that result from the creation of virtually zero-interest credit by Reserve Banks facing deflation risks have provided a source of cheap credit which has presumably boosted asset inflation (especially of real estate) in Australia, and thus contributed to problems in housing affordability when rates increase;
• Australia's economy generally has been at risk because of the complex (virtuous or vicious feedback) relationship between: (a) the need for substantial international borrowing to cover Australia's current account deficits; (b) the balance sheets of Australia's banks and non-bank financial institutions; (c) the value of real estate; and (d) potential disruptions to the availability of capital through international financial markets (see, for example, Maintaining Capital Inflow). This vulnerability is indicated by:
  • the disruption of international capital inflow to Australia in the 1890s that led to: a withdrawal from property lending by banks; a collapse in property values; failures by banks when the biggest item on their balance sheets devalued; and a depression;
  • numerous warnings by the Bank of International Settlements (and others) in recent years about Australia's vulnerability to a currency crisis;
  • the federal government's blanket guarantees of bank deposits at the height of the credit crunch associated with GFC, (presumably) to prevent a recurrence of something like the events of the 1890s, and the need to provide capital injections to support RMBS originators;
  • Treasury Red Book advice to the incoming Gillard Government.

Though the issues involved in creating the potential for instability in the international financial system are hard, there are scenarios under which:

• the present trend towards a 'currency war' could result in a severe disruption of the international financial system, and / or a dislocation of the 'China boom' on which Australia's economy has become dependent;
• Australia comes to depend on finance from 'Asia' provided through neo-Confucian systems of socio-political-economy with which most Australians are unfamiliar (see Some Thoughts on the 'China Era').

Thus, though Australia traditionally relies on others to deal with such 'hard' issues, on this occasion there seems to be no safe alternative to doing so.

Reliance on Finance from 'Asia' Implies Constraints on 'Free' Enterprise

It is noted that some objections to your proposal for a social compact with Australia's banks have been based on this being a restriction on 'free enterprise'. However if, as your article suggested, Australia depends increasingly in future on finance from 'Asia' then this in itself implies constraints on 'free' enterprise, because financial systems in the region tend to provide finance selectively on the basis of connections with ethnic social elites (in the expectation of increasing the latter's economic power and thus the economic power of their ethnic communities) rather than to enterprises that simply have capitalistic prospects of profitability for investors (see Understanding East Asia's Economic Models).

ASX Merger with Singapore Exchange (email sent 25/10/10)

Tim Boreham

Re: Fund managers welcome Asian tie-up through Singapore Exchange , The Australian, 25/10/10

Your article noted:

In this respect, it is worth considering the sensitivities that were exposed to Singaporean investment some years ago (see Competing and Collaborating Economically in South and East Asia) and also the comments that tend to be made about Singapore's system of socio-political-economy (see various articles in East Asia). The latter referred, for example: to (a) Singapore's emergence as a centre allowing secret banking - as Switzerland is forced to more openness; (b) Singapore's original success arising from money laundering for corrupt Indonesian officials; (c) China's probable shift towards something like a Singaporean model - which would not involve true democracy; (d) Singapore's society being highly patriarchal and based on Confucianism - with reforms not leading to democracy; (e) the prevalence of old-style authoritarian capitalism - and hypocritical Asian values which suppress political opposition and dissent; (f) Singapore's competitiveness constraints due to heavy state intervention; (g) Singapore's 'soft' authoritarianism; and (h) 50% of Singapore's people reportedly wanting to leave.

For Australia, reliance on 'Asian' finance generally poses difficult issues which are only now starting to be seriously considered (see Overlooked Issues Affecting Australia's Banking System) and, though Singapore is a 'soft' version of 'Asia', it raises much the same issues. Moreover, as the latter document also implies, the financial systems emerging under 'Asian' models of socio-political-economy arguably contain macroeconomic distortions that make global economic growth unsustainable - a fact which seems likely to trigger an international crisis fairly soon because it is colliding with the economic welfare of the world's only superpower (see Instability in International Financial Systems). In this environment the assured access by 'Asia' to Australia's coal and iron ore resources (and thus influence over institutions through which mineral and energy projects in Australia are organised) will be increasingly strategically significant.

John Craig

Proposed ASX Takeover: Lifting the Level of Debate (email sent 1/11/10)

Rowan Callick,
The Australian 

Re ‘Merger talk shows our ugly side’, The Australian, 29/10/10

 Your article correctly suggested that the proposed merger between the Australian and Singaporean Stock Exchanges could show Australia’s ugly side.  

My interpretation of your article: Australian politicians have reacted shamefully to the ASX takeover. Goh Eng Yeow (Straits Times) described this as a ‘vitriolic outpouring’. The details of the deal are not yet known, and debate is needed because regulatory changes are being sought. But the tone of the debate is that Australia is superior to Asia – with an instinctive resistance to engagement. All that is needed is for Pauline Hanson, the queen of such posturing to get involved. The PM has spoken out against the Hansonist anti-reformists in the Coalition – but won’t take on the Greens over this. It sounds in Asia as if the Ugly Australia is back. Goh Eng Yeow wrote that independent politicians had too much power in Australia, and that parochialism could scupper the deal. Swedish SXG CEO (Magnus Bocker) has experience in merging exchanges, and has made an effort to achieve this. Greens mentioned Lee Kuan Yew’s warning about Australia as ‘poor white trash of Asia’, and this would have been true if Australia had not opened in ways Greens would oppose. Greens’ leader said that Australians are not regarded as equals. There seems to be an assumption that because the process through which shares are bought and sold involved an overseas exchange, the way in which business raises funds would become tainted.   The Coalition did not wait for more information, or welcome engagement with Australia’s Asian neighbourhood. Opposition Treasury spokesman (Joe Hockey) suggested that Singapore was Australia’s competitor for financial services jobs. When Hansonism was surging, many expressed concerns about the long term consequences, but none have gone in to bat for closer engagement. Australia is happy to celebrate its good fortune due to resource demand, but does not want to have much to do with it after shipping them out. Australia depends increasingly on Asian capital to keep businesses going, and Singapore has invited Australians onto boards – a step that has not been reciprocated. Australians are not white trash, but sometimes they talk as if they are.

One of the uglier sides of Australian politics is that attempts are made from time to time to sway debate about issues by alleging that opposing arguments must be based on racism (see examples at the end of this email).

It would be a pity to see this happen in relation to the proposed Singaporean takeover of the ASX, because there are real and difficult issues to consider in potentially changing the way such an institution is controlled (as the ASX can potentially influence, or facilitate access to strategic information about, the way businesses are being financed). Issues that may need to be considered in relation to that proposal are suggested below. They include:

• differences between East-Asian systems of socio-political-economy, such as that in Singapore, and Australia’s individualistic, democratic, capitalistic practices, and consequent differences in the goals of ‘business’ (ie seeking economic power for elites on behalf of their ethnic communities, as compared with seeking profits for investors);
• the risks that Australia faces through increasing reliance on ‘Asian’ finance and economic growth, because the macroeconomic distortions that are embodied in financial systems in East Asia are unsustainable, and probably nearing their ‘use-by’ date;  
• the sensitivities that have long arisen in Australia as a result of exposure to Singapore’s system of socio-political economy; and
• the potential to reduce the tax revenues that Australia gains from mining investments, if investments were facilitated under ‘Asian’ business practices.

Such issues need to be understood, and taken into account, in making any decision about the proposed takeover of the ASX – though this will clearly be difficult because of the pervasive lack of Asia literacy that prevails in Australia even amongst those who purport to be experts (see Babes in the Asian Woods).

In this environment, playing the ‘racism card’ (which can do nothing but stifle serious debate about the complex issues involved) would not be helpful.

John Craig

Issues Requiring Consideration in Relation to ASX Takeover

The systems of socio-political-economy that have emerged in East Asia (and in Singapore) arise from cultural traditions that are quite unlike the West’s classical Greek and Judo-Christian heritage (see East Asia in Competing Civilizations). Though those systems have strengths (eg allowing accelerated catch-up economic development) their characteristics need to be considered in relation to questions about control of the ASX (as the latter can influence, or provide access to strategic information about, the way businesses are being financed).

In brief East Asian systems of socio-political-economy involve: (a) economic activities that are coordinated by relationships amongst social elites and their subordinates, rather than on the basis of the profitability of independent enterprises; (b) seeking to maximize market-share / cash flow rather than business profitability; and (c) a consequent necessity for ‘demand deficits’ (ie a very high savings rate and thus current account surpluses) to avoid the need to borrow in international markets because institutions tend to have unsound balance sheets (see Understanding East Asian Economic Models).

Australia needs to seriously consider the risks associated with increasing economic reliance on ‘Asian’ growth or finance. This has not yet been done, though it involves difficult and increasingly important issues (see Overlooked Issues Affecting Australia's Banking System). Amongst other things the latter document noted that the financial systems emerging under 'Asian' models of socio-political-economy:

• embody a novel form of protectionism by transferring national savings to state-supported producers at the expense of the economy generally;
• contain macroeconomic distortions that make global economic growth unsustainable – because of the necessity they create for their trading partners to be willing and able to run current account deficits and accumulate increasing debt levels indefinitely;
• are likely to trigger an international crisis fairly soon, because the macroeconomic distortions they embody have reached their limits. In the event of such a crisis, access by 'Asia' to Australia's coal, natural gas and iron ore resources (and thus influence over institutions through which mineral and energy projects in Australia are organised) could become strategically significant for geopolitical reasons that are not limited to economics. 

Options to reduce such risks include: (a) taking the development of Australia’s economy seriously (eg as suggested in A Case for Innovative Economic Leadership); and (b) ‘nation building’ to make governments, and other important institutions, more effective (see A Nation Building Agenda).

As implied above, business’ goals in ‘Asia’ are quite different to those that are traditional in Australia (ie the difference between seeking economic power for social elites presumably acting on behalf of their ethnic communities; and seeking ‘profitability’ for investors).  And, though Singapore is an extremely attractive version of 'Asia', the way business is done there has caused concern to diverse observers. Consider, for example:

• Singapore has few peers for one-party rule. There are no political independents – and Singapore’s ethos involves merging mammon and political muscle. Singapore’s parliament comprises hand-picked loyalists and is mainly a rubber stamp. Real power in every institution gathers pyramidally and peaks with one of the world’s most powerful families, the Lees. Singapore has little corruption, but a great deal of intimidation by well-rewarded cronies. The Lee family has a role in the proposed ASX takeover. In the past other takeovers in which the Lees were involved have been successful through offering premium payments, by drawing upon the wealth of Singaporeans generally ….. [and more on suggestions of crony capitalism associated with Singapore] (Ellis E. ‘The money-making machine of Singapore Inc, 30/10/10)
• the sensitivities that Singaporean investment caused some years ago (see Competing and Collaborating Economically in South and East Asia);
• diverse comments by observers about Singapore's system of socio-political-economy (see East Asia), such as: (a) Singapore's emergence as a centre allowing secret banking - as Switzerland is forced to more openness; (b) Singapore's original success arising from money laundering for corrupt Indonesian officials; (c) China's probable shift towards something like a Singaporean model - which would not involve true democracy; (d) Singapore's society being highly patriarchal and based on Confucianism - with reforms not leading to democracy; (e) the prevalence of old-style authoritarian capitalism - and hypocritical Asian values which suppress political opposition and dissent; (f) Singapore's competitiveness constraints due to heavy state intervention; (g) Singapore's 'soft' authoritarianism; and (h) 50% of Singapore's people reportedly wanting to leave.

Similar observations added later: Treasurer accepted FIRB advice to reject ASX takeover because it would be contrary to national interest (as a result of Singapore Government control of ASX and loss of jobs). Study suggests that ASX takeover would have created no synergies and had negative economic impact. Takeover failed 5 of FIRB's 6 tests. Singapore government is main shareholder in SGX - through Temasek (Singapore's sovereign wealth fund) whose CEO is PM's wife. Temasek is supposed to have non-voting role - but this is a veil. There are many connections between SGX, its regulator (Monetary Authority of Singapore), Singapore Government and Singapore's ruling families. A director of SGX is PM's brother. Singapore media also have to do government's bidding. There is a form of crony / state capitalism where powerful can do what they like - with little evidence of a rule of law. SGX and its regulators are notorious for poor corporate governance and a lack of transparency. SGX is in partnership with Chi-X which is alternative exchange in Australia, and this would have limited competition. ASICs ability to regulate ASX under SGX control would be limited as the latter is subject to direction by Monetary Authority of Singapore.

Pollies need Asia-literate help in deciding on Asia links (email sent 9/12/10)

Bryan Frith
The Australian

Re: ‘Pollies need to decide whether we swim in Asia or sink at home’, The Australian, 9/12/10

Your article outlined the support which a study by Access Economics has given to the proposal to sell Australia’s stock exchange (the ASX) to Singapore’s exchange (the SGX). However that analysis was a grossly inadequate form of national ‘due diligence’, as it made no mention of the nature or implications of the difference between Singapore’s neo-Confucian system of socio-political-economy and Australia’s liberal-democratic-capitalist traditions.

In a parallel article another journalist, Glenda Korpooral, supported your implication that Australia needs to rely increasingly on Asian capital. However this also raised issues (such as the durability of the ‘East Asian’ economic models) that can’t be properly understood on the basis of simplistic economic hype.

Thus, for reasons that are outlined further below, I respectfully suggest that Australia’s politicians need to look beyond Asia-illiterate advisers in considering questions such as the proposed Singaporean takeover of the ASX.

John Craig

Outline of Article and Detailed Comments

My interpretation of your article: Some argue that ASX should acquire Singapore’s stock exchange, but the decision to allow other operators into Australia reduced ASX capitalization and its ability to take the leading role. Access Economics found that proposed merger would: lower capital costs for Australian companies; improve Australia’s chance of becoming a financial hub; and improve Australia’s ability to diversify savings. It rejected sovereignty concerns (noting that regulatory oversight would remain with ASIC and RBA). The 23% Singaporean Government holding in SGX was seen as irrelevant, as it involves no voting rights. Access Economics also noted that: stock exchange consolidation is a global trend; the merger would build conduits to Asian capital, and connect Australia fund managers to Asian savings pools; there are complementarities between ASX and SGX capabilities; SGX is the most logical partner for ASX; rejection of mergers has tended to be based only on public opinion. Politicians need to decide whether Australia and its funds management industry are to be connected to fast-growing Asian capital markets or stagnate in a domestic pond.

There is no doubt that Australia needs to make decisions in relation to connecting the Asian capital markets (such as by a Singaporean takeover of the ASX). However politicians needs Asia-literate help in making that decision, which Access Economics appears unable or unwilling to provide. Some speculations about the issues involved are outlined in Proposed ASX Takeover: Lifting the Level of Debate. For example, Access Economics noted the lack of voting rights which the Singaporean Government has in the SGX as a reason to ignore the substantial Singapore Government's substantial shareholding in the SGX, but this is beside the point under neo-Confucian systems of socio-political-economy where political and economic power are linked through social relationships amongst ethnic elites, rather than by legal formalities such as voting rights as they would be in Australia.

It is noted that Glenda Korpooral’s parallel article today supported your implication that Australia needs to rely increasingly on Asian capital.

My interpretation of Ms Korpooral’s article: Hong Kong has become home of the largest pool of new listings in the world. The proposed ASX- SGX deal needs to be considered in the light of Asia as an emerging capital raising power-house. New listings in Hong Kong have raised $US 50bn this year – so that, despite weaknesses in Europe and US, this year is likely to set a new record for global capital raising. Many IPO’s in Asia have been over-subscribed. Relatively modest amounts of capital have been raised through the ASX. Australian politicians are continuing to argue about dividing the pie, while Asia is focused on growth and new sources of growth. Supporters of ASX-SGX merger suggest that it would be like putting a pipe directly into Asian savings pools and create much wider range of investments for Australians’s superannuation funds. Past attempts to generate cross-border flows of funds informally have been unsuccessful. Australian institutions can have quite different perceptions to international investors. Queensland’s Treasurer, Andrew Fraser, noted this difference. There are serious questions to consider in relation to ASX-SGX merger, but this needs to be debated in terms of merits of the deal, and how Australia can tap into the Asian economic powerhouse, rather than in terms of populist reactions.( Vale's Hong Kong listing an eye-opener, The Australian, 9/12/10)

Creating a situation in which Australia relies heavily on obtaining capital in Asia raises very complex questions, and these also require Asia-literate analysis to which Australia’s politicians clearly do not yet have access. For example:

• The very high rates of savings in ‘Asia’, which help make the region into a possible source of capital, are also the ‘savings gluts’ (and consequent domestic demand deficits) that pose serious global macroeconomic difficulties in sustaining economic growth (see Understanding East Asia's Economic Models and Impacting the Global Economy). To over-simplify, neo-Confucian models of socio-political economy involve resource allocation by ethnic social elites and their subordinates seeking to maximizing cash flow / turnover (ie to increasing the economic power of their communities), rather than independent enterprises seeking profitability. This arrangement is only viable so long as domestic demand is suppressed so that there is no need to borrow in international markets, thus requiring also that trading partners be willing and able to perpetually run current account deficits (and sustain rising debts) to counter-balance local demand deficits. Though the US is still naively struggling to support an international economy where financial imbalances have escalated, because many economies have moved away from the US’s liberal-democratic-capitalist ideal, it is likely that economic models reliant on favourable imbalances are approaching their use-by date (see G20 in Korea: Unreal Optimism?);
• Where financial systems are rigged to provide subsidies to state-favoured producers at the expense of a community generally (see Resist Protectionism: A Call That is Decades Too Late ), the balance sheets of banks are likely to be suspect. There thus appears to be something of a ‘Ponzi’ quality to financial systems in countries such as China (see China’s Ponzi-like Economy). Certainly ‘Asia’ is seeking to promote growth and new economic activity, but this may a reflection of desperation because, if the money shuffling stops, balance sheets might be found to be unsound (just as happened to the ‘empires’ of the entrepreneurs who built financial houses-of-cards in Australia after deregulation in the 1980s). It can also be noted that: (a) Ireland’s financial disaster was seen to be linked to its shift to unsafe reliance on property after its foreign-investment and export-led growth faltered (see Arlidge J., 'Irishman walks into a bubble', The Australian, 17/11/10); and (b) about 60% of China’s GDP involves investment – a not inconsiderable component of which involves property and the creation of apparent-over-capacity in various industries;
• Cash-flow / turnover (ie economic power) oriented investors in ‘Asia’ undoubtedly have a different perception of investment opportunities in Australia compared with profit-seeking local institutions. Where ‘Asian’ producers reliant on Australian raw materials could have the opportunity to directly control mining operations and then sell commodities on very low margins, the scope to thereby avoid paying profit-based Australian taxes is presumably appealing – but not necessarily in Australian’s interest (eg see RSPT Won't Hurt Miners: But Pity Help Naive Australians).

  ---

ASX Takeover Proposal - email sent 4/1/11

Professor Peter Swan
University of NSW

Re: Treasurer should ban ASX takeover, The Australian, 4/1/11

Your reservations concerning the ASX takeover proposal (ie the small scale and relative inefficiency of Singaporean exchange) seem appropriate.

I should like to suggest that there is also a need to take account of the character of the systems of socio-political-economy that appear to prevail in countries such as Singapore (see Pollies need Asia-literate help in deciding on Asia links).

In terms of the issues raised in your article this (probably) has relevance because, in financing the ASX takeover proposal, the Singaporean exchange is likely to be: (a) drawing on the resources of Singapore as a whole orchestrated through political connections – rather than the resources of private investors; and (b) motivated by a desire to increase economic power (ie market share and turnover) rather than profitability. This same feature tends to invalidate the argument developed in Access Economics’ report on the proposal – ie that this takeover would facilitate access to ‘Asian capital’ – because ‘Asian capital’ is not able to be provided on the basis of the balance sheets of financial institutions, but rather requires drawing upon cash flows generated by high-turnover production with limited regard to profitability and enforcing a high rate of national savings. As the demand deficits and international imbalances this strategy requires are getting close to disrupting global economic growth, ‘Asian capital’ could cease to be available to anyone (because, if the strong cash flows abate, there would be no basis for providing capital) .

Another point of relevance relates to your observation about transparency (and its effect on transactions through an exchange). East Asian economic / financial systems are arranged to boost the prospects of ‘insiders’ connected to the local regime, not of ‘outsiders’ – so transparency is not valued. The fact that South Korea seems (based on comments about this in your article, and some other indications) to have moved away from the type of system that prevails in various ways in Japan, China and Singapore is interesting.

John Craig

Blocking the ASX Takeover: The Effect on Australia's Image in Asia (email sent 6/4/11)

John Durie,
The Australian

Re: ‘Singapore sting hurts our image’, The Australian, 6/4/11

Your article suggested that there are defects in the way a decision was reached about the proposed ASX takeover. Your article was introduced by the subheading ‘Strategic leaks suggest that the decision making process was flawed’, and it then went on to state:

“Treasurer Wayne Swan has put politics ahead of due process in signalling opposition to the Singapore takeover of the Australian stock exchange without proper examination. The move -- and how it was done by way of a negative indication before a final decision -- neatly explains why foreign investors are increasingly weighing up sovereign risks when deciding on Australian investments. There is growing evidence the government's decision-making process lacks integrity.”

There is no doubt that the decision making process was not transparent. No one knows why the Foreign Investment Review Board (FIRB) concluded that the takeover would not be in Australia’s interest. The decision may have reflected the xenophobia of economic nationalists, as one observer feared (Keane B. ‘Australia’s black box of foreign investment regulation’, Crikey, 6/4/11). Or, as perceived by an international observer, the FIRB may simply have continued Australia’s well-recognised aversion to the takeover of strategic businesses by state-linked investors.

“Australia's foreign-investment approval process has been criticized for decades as being opaque and unpredictable, but two clear trends have emerged: the vast majority of applications are uncontentious and approved, but problems are likely to arise when state-linked investors look to take control of a strategic business.” (Australia Defends Blocking ASX-SGX Deal, Says Open to Investment, CNBC, 5/4/11).

Alternately the FIRB may even have taken Asia-literate account of the effect on Australia’s future prospects of control of the ASX (an institution which can influence how business financing occurs) by the SGX (an institution effectively, though non-transparently, controlled by the families who also control Singapore’s Government). As was suggested in Proposed ASX Takeover: Lifting the Level of Debate (2010), it was impossible to assess the implications of the proposed takeover on the basis of economic principles relevant to Western systems of political economy, because of the radically different character of the neo-Confucian systems of socio-political-economy that appear to prevail in countries such as Singapore..

Whether or not an Asia-literate approach was taken to assessing the ASX takeover proposal, the lack of transparency associated with the decision to recommend against it should improve Australia’s image in ‘Asia’, because it conforms with traditional ‘Asian’ practices.

John Craig

Finding Australia's Place in the International Financial System (email sent 7/4/11)

Editor
The Australian – for consideration not for publication

Re: ‘Acting in the national interest’. Editorial, The Australian, 7/4/11

I should like to try to add value to your suggestion about moving on from Singapore’s ASX takeover proposal towards finding effective ways for Australia to participate in international financial markets.

My interpretation of your editorial: The SGX bid was for a takeover not a merger. But given a choice between market forces and politically expedient populism, the markets are better. Governments must keep the nation open for business. A case can be made that ASX should follow global trend towards merging with larger exchanges, though this would have left it subject to directions by Monetary Authority of Singapore. A relevant question is what would have happened if ASX had wanted to buy SGX – and Singapore Government (which has large stakes in key companies) would have rejected this. Wayne Swan has left the door open to the SGX to give reasons not to accept FIRB recommendations, but is most unlikely to do so. Having to give reasons for this could damage international relations. Now the priority must be to set policies that allow Australia to take its pick of international investments (as countries such as Singapore have been able to do) – eg by a dedicated savings fund to lock in benefits of the mining boom.

Firstly your observation about the desirability of acting in accordance with market forces rather than political considerations makes a great deal of sense. The fact that East Asian systems of socio-political-economy make no distinction between politics and market forces (ie markets are orchestrated / rigged by the social elites who also control governments) is the reason that it was impossible to realistically assess the ASX takeover proposal without understanding how those systems work (eg see Pollies need Asia-literate help in deciding on Asia links and Blocking the ASX Takeover: The Effect on Australia's Image in Asia). Unfortunately it seems that journalists writing for The Australian continue to comment on this issue without the Asia-literacy to do so competently (as illustrated by examples following this email).

Secondly the international financial system that Australia needs to participate in effectively, both as provider of financial services and as the originator and destination of foreign investment, is in crisis and likely to undergo very significant changes. Current arrangements are made unsustainable by structural macroeconomic imbalances in ‘Asia’ that translate into ‘savings gluts’, and require international financial imbalances. Serious attempts to find a solution to this problem have not yet been made (eg see G20 in Korea: Unreal Optimism) because the way in which neo-Confucian systems work and contribute to the imbalances is not easily perceived by the Asia-illiterate. The excess savings that seem to make strong links to ‘Asia’ attractive in order to finance investment in Australia at present are also the reasons that global economic growth will prove unsustainable unless those systems are transformed (see Should Fixing the International Monetary System Start in Asia?).

In order to position Australia in the international financial system that is likely to emerge over the next few years there is a need to look beyond the current environment and consider what sort of environment is likely to exist in 5-10 years’ time.

Finally, in seeking options for Australia to participate in the expected future international environment, there is a need to involve all elements of the current financial system (and their international associates) in a process of discovery about that likely environment and how complementary initiatives could be taken to benefit from it. What will be required for success is systemic change, rather than isolated initiatives (such as the savings fund suggested in your editorial) as the latter would not necessarily be compatible with, or complementary to, other initiatives. Accelerated development of the financial system as a whole might be achieved by methods similar to those suggested for developing Australia’s innovation capabilities in A Case for Innovative Economic Leadership

John Craig

Examples of Articles that Reflect Little Asia-Literacy

In today’s Australian articles concerning the ASX takeover proposal have simply referred to:

• the lack of public access to reasons for rejecting the ASX takeover, and questions about what happens now (Main A., ‘ASX kept from Singapore sling’ );
• the political opposition in Australia that the ASX takeover faced (Uren D., ‘Deal never seemed to be worth the fight’);
• the main objection to the takeover involved control of clearing and settlement functions – which could have been easily fixed by legislative changes (Durie J., ‘Control an easy fix in ASX drama’ and A lot of spin in commercial logic );
• Singapore is likely to press ahead with deal, and thus force government to give details of why it was rejected (Lee T., ‘Singapore presses on with ASX bid, despite likely rejection’);
• the fact that the FIRB and the Treasurer both used the other as the reason for rejecting the ASX takeover. The rejection will shock both ASX and SGX. ASX has no other option for improving access to Asian markets (Stevens M. ‘Failure to clear even first hurdle shocked bourses’);.
• the situation resurrecting 1960’s debates over ‘selling the farm’. Australia needs foreign investment – and integrating Australia’s markets with high-savings Asia would be of benefit (Stutchbury M., ‘ASX snub sends wrong message to foreign investors’);
• Australia’s risk of becoming a capital market backwater (Gulyas R., ‘Warning that the ASX will become a backwater’);
• Exacerbating concerns in Asia about sovereign risk and policy uncertainty (Sainsbury M and Callick R., ‘Merger rejection exacerbates sovereign risk concerns’);
• The ASX being in difficulties if it has to operate alone (Boreham T., ‘The ASX likely to stand alone’).

None of these writers seemed able to view the issue except in terms of the market logic that makes sense in Western economies, but does not really apply in anything like the same way in ‘Asia’ (eg see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy). Many other examples of Asia-illiterate policy analysis are outlined in Risks from Asia-illiterate Policy Making

ASX and the Free Market - email sent 14/4/11

John Roskham,
IPA

Re: ‘Free market in chains’, Australian Financial Review, 8/4/11

Your article suggested that the government’s decision to block the proposed Singaporean takeover of the ASX showed a lack of commitment to the free market principles that have boosted Australia’s economic performance since the 1980s.

However this is quite the reverse of the real situation – as there is nothing ‘free’ about markets in neo-Confucian ‘Asia’ (including Singapore). One reason given by the government for blocking the takeover was Australia’s inability to then regulate the market. What needs to be recognised is that markets (and everything else) in neo-Confucian ‘Asia’ are governed by a ‘rule of man’, rather than by a ‘rule of law’ (see East Asia in Competing Civilizations). Thus, had the takeover proceeded, a key element of Australia’s economic infrastructure would no longer have been regulated under a ‘rule of law’ (which is the basic requirement for a ‘free’ market). Rather it would have been subject to control by the social elites who control Singapore’s government and ‘market’ economy and whose anything-but-free-market reputation is outlined in Proposed ASX Takeover: Lifting the Level of Debate.

The pervasive lack of Asia-literacy in Australian institutions remains the major obstacle to the survival of the free market. Similar points were made earlier in Finding Australia's Place in the International Financial System.

Regards

John Craig

Benign Effects - So Far - email sent 11/7/12

Professor Mark Wooden
University of Melbourne

Re: The benign effects of the ‘Great recession’, The Conversation, 10/7/12

Your article drew attention to the benign effects of the ‘Great Recession’ that has accompanied what has been called the Global Financial Crisis (GFC).

I should like to submit, with respect, that ‘you probably ain’t seen nothing yet’ – because there has been no serious effort to come to grips with the implications of the GFC for the sustainability of global economic growth (ie those related to the international financial imbalances that played a key role in generating the GFC).

Australia was initially expected to suffer from the effect of the Asian Financial Crisis in the late 1990s, but was little affected because commodity exports remained strong. Those commodity exports were not ultimately to ‘Asia’ (which was in recession at that time) but rather mainly involved providing inputs to exports from ‘Asia’ to the US and Europe (whose demand was not much affected by the Asian crisis).

Australia has also been relatively sheltered from the effects of the GFC (so far) because strong commodity export demand has resulted from counter-cyclical responses to the GFC in the US and China (in particular) involving fiscal and monetary policy measures which both have had the effect of escalating public debts. However, as was suggested in an initial assessment of the GFC’s challenge to Australia (Defending Australia from the Financial Crisis? , 2008) further stages of the GFC were likely to involve:

• sovereign debt problems - which are now apparent in Europe, and on the point of gaining recognition in the USA as it approaches its ‘fiscal cliff’; and
• economic problems in ‘Asia’ because poorly developed financial systems would be in crisis when external demand proved insufficient to provide the protection that current account surpluses provide.

As nothing has been done to address the problems associated with financial imbalances, the GFC is presumably anything but over (eg see G20 in Washington: Waiting for Hell to Freeze Over?, 2011). And further stages are very likely to adversely affect Australia’s major commodity markets (eg see Are East Asian Economic Models Sustainable? and China: Heading for a Crash?). Moreover the number of economies that are likely to experience problems when major deficit economies are eventually forced into general austerity has escalated. One effect of the Asian crisis was that many more countries with poorly developed (eg crony capitalist) financial systems discovered that (like Japan and China) they also could obtain protection from such crises by seeking current account surpluses and thus adding to the constraints on the global economy associated with financial imbalances (see Leadership by Emerging Economies?).

I would be interested in your response to my speculations.

John Craig

A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time? [Working Draft]

In April 2016 Australia's federal Labor opposition proposed a two year royal commission into Australia's banking system because of various scandals and behaviours that have adversely affected the community. The federal government responded by suggesting that the Australian Security and Investment Commission (ASIC) could be more effective than a royal commission in dealing with those issues. Independent observers have expressed various views about this matter including preference for the royal commission option (eg see Ferguson A., ASIC moves welcome but banks must feel the royal commission blowtorch, Business Day, 20/4/16)

However, while there are undoubtedly non-trivial issues that such a commission could investigate, the issue is arguably more complex than 'royal commission' advocates (and their opponents) have considered. A desk-top study to identify those complexities would be a wiser way to start than a royal commission to deal with what could be a small part of a big issue.

For reasons outlined below Australia faces a non-trivial risk of financial and banking crises.  If a royal commission applies a 'blowtorch' to Australia's banks to achieve domestic political goals in the middle of a financial / banking crisis which partly has its source in international financial instabilities, banks would be even more severely hampered in their ability to deal with that emergency. 

Australia's Risk of Financial / Banking Crises as Growth is Driven by Rapidly Rising and Often Misdirected Debt  [<]

The sources mentioned above suggest that Australia has (after China) apparently been the second most reliant country (perhaps the most reliant) on rapid increases in debt to support economic growth in recent years. This creates risks because: Australia's overall 'national' (ie household, government and corporate) debt / GDP ratio has become very high;  a significant component (eg 40%) of new debt has been off-shore funded - and thus would be at risk (or at least more expensive) if Australia's national creditworthiness worsened; undisciplined investment in the post resource-boom era has created risks of significant financial losses due to a large over-supply of apartments in major cities; and rapidly rising government debts have reduced the credibility of government guarantees of Australia's banks who traditionally borrowed offshore to cover Australia's current account deficits and are heavily (eg 60%) exposed to real estate.

Australia's national debt was 243% of GDP in mid 2016 and has not been incurred productively with $9 debt required for each $1 rise in GDP [1]. National debt ($3.5tr) was 217% of GDP ($1.5tr) in 2014. Private debt was $1.7tr [1] . Household debt (130% of GDP) is higher than than anywhere else in developed world [1].  Private debt / GDP ratio has never previously been as high as it is now - with the previous record being 60% of GDP during 1880s' property bubble [1]. Property investment has been a major factor in rising household debt. Mortgage debt rose from 15% of GDP in the late 1980s to 95% of GDP [1]. Following GFC the average private debt in developed economies fell from 170% of GDP to 160%. In Australia it rose over 20%. in 2016 private debt is likely to be $3.4bn while GDP is around $1.6bn [1].

The IMF suggested that Australia faces risks because of its high debt levels. // Australia's net foreign debt ($US1.045tr) has been rated as extreme by Standard and Poors. // Australians are deeper in debt than ever and wages are growing at the slowest pace. The RBA warned that debt / income ratio is the worst ever - weakening Australia's ability to withstand a financial shock. Households' ability to borrow further to sustain demand is constrained because the household-debt to GDP ratio is now very high (because low interest rates encouraged high debt levels to acquire real estate).

The high rate of borrowing to sustain economic growth as the resource investment boom weakened has been heavily focused on real estate. Australia's banks have traditionally imported capital to offset Australia's structural current account deficits and directed this to real estate. There has also been a boom in the development of Australian apartments (apparently driven largely by Chinese investors - though the actual extent of this is uncertain). The boom created a significant over-supply as had previously occurred in China and thus a potential for large financial losses.

Australia's very high economic dependence on increasing debt to sustain growth (eg because post resource boom growth has been driven by debt-financed apartment building rather than by competitive advantages) has been seen as a risk. // Morgan Stanley has warned about economic dangers associated with Australia's apartment market.

High-risk mortgage loans could threaten major banks equity base according to Melbourne mortgage broker.

APRA has sought to reduce these risks by tighter prudential regulation (eg to increase banks' capital base relative to their lending and tighten lending conditions). At the same time China has made increasing desperate efforts to control capital outflow / flight because of concern about its own risks of a debt crisis (see below) .

Australia's post-GFC control over government spending has been the worst of any G20 nation, and the opportunity that strong growth provided to bring the deficit under control was lost.

However others suggest that these risks are limited because: (a) Australia's institutions are quite effective and high household debts are usually incurred by those with a sound capacity to pay; and (b) the balance sheets of banks are sound after 25 years of growth .

International financial markets have come to view investment in Australia as a 'proxy' for investment in China. Investment in Australia is much less complicated than investing in China and Australia's economy has benefited from (and become highly dependent on) the commodity demand (especially coal and iron ore) that has been associated with China's industrial, property and infrastructure driven growth. The 'China boom' (which escalated after the GFC) has been suggested to have made Australia into little more than an emerging economy.

Also, as Australia's resource investment boom declined, a property investment boom sustained Australia's economic growth. Apartment development in Australia was heavily funded by Chinese investors (eg 20-40-80% - though no one was really sure as something like 50% of purchases involved only family money (so banks will have no records of loan approvals) and there was no need to register off-the-plan purchases with  Australia's Foreign Investment Review Board).   In early 2017 it was indicated that about 80% of new apartments in Sydney and Melbourne (and a lower percentage elsewhere) had been being bought by Chinese investors 2-3 years previously and that (because of difficulties gaining finance this had fallen to 50% while non-Asian investors picked up the balance because they had lost faith in the superannuation system. It was indicated a few weeks later that Chinese purchases of new apartments had fallen to 25% (and was still falling) and that enthusiasm for property purchases in Sydney seemed to be evaporating (presumably because there were not enough wealthy investors who were being forced by the $1.6m limit rule to pull money out of superannuation before July 2017 to compensate for rapidly-declining Chinese interest).

Thus if China suffered a serious set-back (and this increasingly seems unavoidable as indicated below) Australia could lose its ability to obtain at low interest rates the (say) $50-60bn pa capital inflows that are: (a) required to compensate for persistent current account deficits; and (b) traditionally obtained by Australia’s banks mainly for investment in real estate (see above).

Risks are already seen to be developing in Australia's property markets (see Are Unfinished Apartments a Risk in Australia Also?).

The latter refers to factors that indicate the existence of such risks including:

• Australia’s property values represent over half of the assets that underpin the value of loans to / deposits with banks;
• property prices have collapsed in those regions where strong demand had been driven by the resources' investment boom;
• in major cities housing prices are almost the most unaffordable in the world (in terms of median property values relative to per capita incomes). Prices have been high because: (a) domestic investors have viewed property favourably as a source of capital gains; (b) Chinese investors' have sought ways of getting money out of China; and (c) urban population growth has been strong - as the resources' boom sustained high rates of immigration; 
• an apartment construction boom, significantly (eg 40% or perhaps even 80%) driven by Chinese investors, has been a major factor in Australia's economic growth as the resource investment boom phased down. A large (over) supply of apartments (especially in Sydney, Melbourne and Brisbane) has resulted - suggesting that prices will fall significantly, because:
  • as price growth moderated (and reversed in some areas) the (at one time about 40% of) domestic demand from investors fell - and could potentially reverse.
  • immigration (and thus urban population growth) has moderated;
  • prudential regulation has made it harder to finance property purchases;
  • in early 2016 China made it harder for investors to get money out to complete property purchases, and domestic banks tightened conditions on foreign buyers. Despite this many Chinese families could get around the loose restrictions on foreign real estate investment (so demand remained strong). In late 2016 efforts announced made to block off those routes though phone apps and online platforms can make international transfers that do not go near China's banking system and will hard to control;
  • in late 2016 China decided that it would need to accept a slower rate of economic growth because its rapid expansion in debt was creating risks of a financial crisis. As any reduction in China's rate of increasing debt directly subtracts from demand growth, it is inevitable that China will need to crack down heavily on the capital flight that has been resulting in large scale purchases of apartments in Australia and North America (because this outflow also has a contractionary economic effect in China); 
  • With very large numbers of new apartments hitting the market over next 18 months in late 2016 a 'hard landing' in apartment prices seemed likely
• banks carry risks from apartment developments - as they have financed developers on the basis of off-the-plan sales (which required only 10% deposits) and those who entered 'off the plan' buying commitments are finding it much harder to finance settlement (eg because resale values may be significantly below off-the-plan prices);
• ALP proposals to change the negative gearing arrangements affecting property investment would reduce investors' motivation to buy (and increase their motivation to sell) investment properties - while the Coalition government's preference for discouraging the use of superannuation as a tax-minimization tactic would presumably have the reverse effect;

In the 1890s an international financial crisis led to: (a) severe constraints on capital inflows to Australia and thus on banks’ ability to provide funds for real estate; (b) a property market collapse; (c) banking failures; and (d) a depression.

Following financial deregulation as part of Australia's 1980s economic reform agenda, banks have become a major component of Australia's economy and share-market.

After the 2008 Global Financial Crisis (GFC) severely constrained the availability of credit worldwide, the federal government guaranteed all capital advanced to Australia’s banks to prevent any repeat of what happened in the 1890s (which was not impossible even then because of Australia's very high levels of lending for property development).

The federal government's ability to provide credible credit guarantees now is less certain as its debt / GDP level is no longer negligible (given substantial debt-financing of government spending partly as a result of committing for ongoing spending the revenues gained at the peak of a capital gains' tax boom associated with resource investment). The risk of the federal government losing its AAA credit rating is increasingly discussed - eg see here and here - though is not considered imminent.

 In late 2015 losses on banks' loans seemed likely and were already starting to cause concern (eg see 1).

Examples of areas where bank's losses were of concern:

• industrial operations adversely affected by: (a) China's industrial overcapacity and dumping in international markets (eg steel); (b) problems besetting the dairy industry; and (c) Australia's recent lack of emphasis on boosting international competitiveness;
• fund a resource investment boom - where the security of loans depends on the continuance of a strong commodities' demand from China (and consequent high commodity prices). The latter in turn depends heavily on China's economy: (a) remaining heavily investment driven - despite the Chinese government's attempts to shift from an investment-driven to a domestic-demand driven economy; and (b) avoiding what seems to be a potential financial crisis because of its dependence on rapidly rising debts to sustain growth (see below);
• contribute to a China-stimulated apartment-construction boom which sustained Australia's economic growth in the post-commodity-investment-boom era - and created a significant level of exposure for Australia's banks because the total investment involved was about 60% of that in the resources boom. And the apartment investment boom seems likely to prove to be a bubble as a similar boom did in China (see below); and

In early 2016 an international credit rating agency identified Australia's rising house prices and the leverage involved as a credit negative for Australia's major banks because of the risk of a price slump. In May 2016 a 50% (?) fall in Chinese investment in Australian apartments was reported. And as property values were then declining slightly, this was seen to create major risks to Australia's economy and banking system. After a recovery  falling prices were again seen in late 2016 to be a risk due to: (a) the torrent of new apartments due to be settled in major cities; (b) tighter lending conditions by Australian banks; (c) and efforts by China to eliminate ways that its people been found to get around its restrictions on capital outflow - restrictions that seemed likely to intensify in 2017 as China finally started to confront its debt crisis.

External sources of risks to Australia's ability to obtain the capital inflow needed to counter-balance its structural current account deficits without paying higher interest rates are:(a) a likely set-back for China's economy; (b) a potential international financial crisis (see below); and (c) the apparently accelerating global trend towards higher interest rates the emerged in late 2016 as the 30 year reliance on ever-easier money policies as the basis for macro-economic management came to an end and bonds thus ceased providing 'risk free reward' and became a source of 'reward free risks' (see Risks Facing Australia's Banks). 

In early 2017 Standard and Poors suggested that Australian banks were under credit rating risk because the increased chance of a property price correction, increasing economic imbalances (related to significant role of property in economy) and weakening of sovereign support (due to higher government debt levels). Residential loans are 2/3 of banks lending assets - which is above the global average and leaves banks exposed to property pullback. The risk is likely to increase because low interest rates, benign economic outlook and imbalance between housing supply and demand [1]

Household wealth rose to $11.7tr last quarter of 2016 as cash holdings exceeded $1tr. Wealth net of liabilities exceeded $9.4tr mainly because of $247 rise in house prices to $6.4tr. GDP is $1.7tr. High household wealth is the reason that RBA is not too concerned about debt-fuelled property speculation.  Debt is a problem especially as it increases faster than GDP - but asset side of balance sheet is good. Mortgage debt is $1.7tr - which is only 27% of house and land values [1] 

Future generations will pay the price if a sustainable future for all is not prioritized over entitlements for the few. Middle-class welfare for those who could afford to look after themselves is unsustainable. Social security ay 42% of all commonwealth payments is unsustainable. Now there are 4.7 working Australians for every person over 2.7. This will drop to 2.7 by 2055 if immigration rates are maintained . Australia is likely to collapse in same way as Japan. It did well after WWII but failed to adjust - which led to years of negative growth and falling wages, fewer opportunities and unsustainable debts. There needs to be a healthy safety net - but with net debt of #317bn culture of entitlement must end  [1] 

Australia has been able to attract foreign capital because it provided relatively high interest rates. Now that Federal Reserve is raising rates and the RBA is holding them down, Australia's interest rate advantage is disappearing. $A could collapse bringing high inflation and a need for significantly higher rates while economy remains weak.

Importing Risks from China  [<]

For reasons suggested above China's financial / economic / political system has significant economic implications for Australia.

China's Financial Risks  [<]

There have been concerns about China's financial system for many years. In 2013 China sought to reduce this perception by announcing proposals for financial liberalization and writing off bad debts and arguing that investing the 'wall of money' that rich Chinese held would benefit the whole world. However those claims seemed unrealistic (see Preparing for a Financial Con? - Late 2013).

China's financial / economic risks subsequently became increasingly severe. Though it is difficult to get data about China's non-transparent situation and debt levels are by no means the limits of China's economic risks, some notes on a range of (not always compatible) observations from 2015 about China's debt exposure outlined at the latter link are outlined below. And China's financial / economic risks are compounded by serious political risks.  In early 2017 there were indicators that these problems were coming to a head and that China faced a major debt crisis which would be extremely disruptive and difficult to resolve.

Examples of Observers' Views of China's Looming a Debt Crisis: - from sources here

GDP: China's GDP was estimated to have been $US11.4tr [1, 2] in 2016 - up from $11.2tr in 2015, $6.1tr in 2010 and $2.3tr in 2005.

Total Debts: Credit has risen 100% over 5 years - twice the rate in Japan before the Nikkei bubble burst in 1990. Total credit exceeds 250% of GDP // Budget deficits exceed 10% of GDP. China's credit growth was 20% of GDP pa in mid 2015 - a major problem because its debt growth was 2-3 times faster than GDP growth // China's private debt / GDP ratio is the world's highest at 290% - and has been increasing 28% pa. // China's fixed capital investment is $5tr pa (equal to Europe and North America combined) - and is producing massive excess capacity.// China's local government debts rose 30% over 18 months, while revenues fell. // China's overall debts ($28tr) are half the world's total [while its economy accounts for about 15% of global GDP]. // China's increase in debt since 2008 was 50% of the world total. China's corporate debts have grown at twice the rate of next highest country. // China's total debt levels are estimated at 308% of GDP ($30tr) and have risen enormously in 2016. Much of this went into property which government sees as a growth engine despite a 2-5 year glut of unsold properties. // China's debts are rising $4tr pa - ie about 25% of China's GDP. // In July 2016 it was believed that China not only had a very high debt / GDP ratio (ie over 250% of GDP) but that this was being increased by $1tr / quarter (ie about 25% of GDP) largely for speculative investment rather than, as it had been, for investment in real (if not always needed) assets - infrastructure and property.

Bad debts: China's concealed bad-debts are estimated at 70-140% of GDP - while unfunded pension liabilities could be 40% of GDP. // Much of China's increased debts has been taken by local governments and is hidden in SOEs. // China's banks have $34tr in credit - up from $3tr 10 years ago - and loans (eg for inefficient infrastructure projects) were made on the basis of political connections rather than on the basis of borrowers' ability to repay. // China's banks are using wealth management products to hide debt levels. Many firms have declining ability to repay debts. // The gross debt / earning ratio has doubled since 2010. // Median days to pay suppliers have risen to 70 - as compared with 35-45 that is normal elsewhere. // Potential loans at risk are 15% of GDP.  // Much of China's rapidly rising credit is simply being used to repay old loans. // The IMF estimates that 14% of Chinese companies' debt is 'bad' though others put this figure at 28%. Non-performing loans by China's banks are estimated at 19% - not the official 1.6% and global average of 4.5%. // China's banks face $1.7tr losses - and 60% of their capital is at risk. // SOE debt restructuring would endanger 50% of banks' capital.  SOE liabilities are 115% of GDP. // Many asset bubbles have been created by torrents of money. // China's official debts are only part of the story - as banks are disguising $2tr of loans (mainly to property developers) as investments and thus not maintaining capital reserves to guard against losses. Any slowdown in the rate of credit creation which adversely affected property markets could have serious consequences for banks;

Economic Impacts: Low cost exports have declined as a share of China's economy. // To maintain growth China's leaders have embraced monetary and fiscal stimulus which escalated outstanding debt to 250% of GDP. // In late 2016 data suggested that China is not rebalancing as growth was confined to old economy functions while services and retail weakened. It is thus wrong to believe that China is stable. // China has a property bubble - and belief that China will strengthen global commodities demand could be wrong. // Credit continues to be provided to technically bankrupt companies - mainly SOEs - at the same time as China's unemployment rises, manufacturing employment falls, there are bond defaults, foreign investment falls and property experiences declines.

Credit Assessments: Rating agencies are downgrading China - and its debts are seen to have reached crisis levels. // Shadow (ie off balance sheet) financing by banks has reached 59% of GDP. // Investment remains the main driver of growth (46% of GDP). A gigantic monetary bubble is seen to have corrupted every aspect of the country. // A large proportion of credit has been given to companies that can't account for it - and a great deal of it is believed to have been stolen.

China has created the biggest pool of domestic liquidity in history to stimulate its economy and finance a crushing debt burden. // Between 2007 and 2015 China created 63% ($16tr) of additions to the world's money supply. // China's problem is that debts are increasing almost as fast as money is generated to service them. // China will have a problem when it ceases creating money fast enough to service debts that are now 250% of GDP.

In the late 1990s China overcame problems in its financial system because options were then available for rapid economic growth when it entered the WTO. However a major new external source of growth is not available 2016. 

Even if China's banks are insolvent China is unlikely to experience a financial crisis like that which could occur in Europe or US. The government controls what is a non-commercial financial system and can move money around (including foreign exchange reserves) to deal with whatever is seen as the main current problem. China probably faces a long period of economic stagnation rather than any sudden crisis.

China has already put measures in place to reduce its risks. Major banks are well capitalized to deal with large numbers of NPLs. However as long as debts rise 2-3 times faster than GDP it will be hard to prevent the problem escalating.

Why China Has a Financial Problem: Introduction  [<]

China’s problem in late 2016 was that (a) it had run up massive national debts (about 300% of GDP); and (b) come to rely on VERY LARGE increases in those debts  to maintain sufficient economic growth to avoid political instability. China's national debts had been rising about $US4-5tr pa - which was some 50% of the total increase of debt globally though China only accounted for 15% of global GDP.

For complex reasons developed further below, the main sources of China's debt problem are that:

• China's growth has been accompanied by a rapid rise in debt levels (and bad debts) ever since the start of its export-manufacturing 'miracle' in the late 1970s because:
  • to achieve real-economy ‘miracles’ China implemented a variation of the neo-Confucian methods that Japan had pioneered. Development of 'real economy' capabilities was catalyzed within hierarchical social networks across whole industry clusters by highly educated officials and national savings were allocated to state-linked enterprises by the consensus of state-linked social elites to achieve nationalistic / mercantilist goals. Credit was expanded with limited concern for the profitable use of capital in particular enterprises / projects;
  •  the bad balance sheets in banks and enterprises that resulted could be ignored so long as there was no external scrutiny of their financial positions. In China, as in Japan until the 1990s, scrutiny was avoided by ‘financial repression’ (ie constraining household incomes) to ensure strong current account surpluses as manufacturing production capacity increased and thus that large foreign exchange reserves accumulated. National (bad) debts could increase almost without limit to provide capital for investment;
• From about the time of the GFC export demand weakened as a driver of China's economic growth (because of the effect of financial crises and of stronger competition in labour intensive manufacturing). The demand needed to sustain rapid growth (and avoid political instability) became dependent on high levels of credit-funded domestic over-investment (in infrastructure, property and industrial capacity). The domestic consumption that was being encouraged as an alternative from 2011 did not maintain a sufficiently-high rate of economic growth to prevent political instability

Similar financial practices were a key part of the non-capitalist neo-Confucian systems that allowed 'real economy' miracles in East Asia, and had led to financial crises elsewhere in the 1980s and 1990s:

• After Japan's export-manufacturing economic miracle had reached its limit, it experienced a financial crisis in the late 1980s after industrial over-investment was accompanied by investment in areas subject to market forces (ie extensive property investment led to a real estate bubble which burst and offshore assets were bought at the top of the market). Japan's financial crisis saw a 70-80% fall in Japan's share and property values and ongoing economic stagnation from which Japan has not yet really recovered.
• Financial indiscipline also led to crises in 1997 in many East Asian countries that had not taken the precaution that Japan and China did of accumulating large foreign exchange reserves through financial repression (eg suppressing household incomes to limit consumer spending and imports) to protect state-linked banks and companies with bad balance sheets from international scrutiny by giving those nations as a whole an impression of creditworthiness.

China's problem has been compounded by the apparently unrecognized effect of:

•  its regime's plan (through its 12th Five Year Plan, 2011-2015) to emphasise growth driven by domestic demand / consumption rather than by export-oriented manufacturing in the hope of thereby avoiding the 'low income trap' that many emerging economies have encountered. That shift made it necessary to boost domestic demand and thus impossible to continue relying on 'financial repression' to build up its foreign exchange reserves with large current account surpluses;
• encouraging foreign investment by Chinese companies and seeking IMF 'reserve currency' status for China's currency in 2016 [1]. These made falls in its foreign exchange reserves possible.

Given increasingly open capital markets, huge national debts and a chronically irresponsible state-controlled financial system, many Chinese took the opportunity to increase their financial security by shifting assets off-shore – and China’s foreign exchange reserves (and the protection they provide to banks and enterprises with bad balance sheets) started falling rapidly in 2015.

China faces structural obstacles to economic growth if large foreign exchange reserves are not available to reduce the risk of a financial crisis by protecting banks and companies with bad balance sheets from market scrutiny. Firstly there are massive cultural obstacles (in the way information is used and in traditional social organisation) in shifting to a financial system in which return on / of capital is taken seriously so bad debts would not automatically increase as a by-product of economic growth. Secondly the methods that China trialed to obtain capital without simply rapidly increasing its national debt failed (eg inflating asset values and trying to attract foreign investment). They are likely to continue to fail as long as China maintains: (a) its irresponsible financial system; and (b) its corporate state (ie an expectation that ‘private’ businesses will act as extensions of the state in pursuing nationalistic / mercantilist goals rather than as independent profit-focused undertakings).

Why China Has a Financial Problem: Elaboration  [<]

To properly appreciate China's problem it needs to be recognised that:

• East Asia societies with an ancient Chinese cultural heritage have significant differences to Western societies (see Competing Civilizations and Babes in the Asian Woods). This results in incompatible financial systems (see A Generally Unrecognised 'Financial War'? and Structural Incompatibility Puts Global growth at Risk). Traditional ways of thinking and social organisation make it difficult to rely on 'capitalistic' calculations of profitability by independent enterprises. Power is not associated with making decisions but with having subordinates who will do so. Abstract / rational decision making works reasonably well in 'liberal' Western economic environments, but can't be reliable in a complex social environment. It is presumed that coordination of economic activities through social networks produces greater economic benefits - an assumption that can be true in relation to achieving 'real economy' miracles, but false in relation to the productive use of national savings;  
• in major East Asian 'market' economies (eg Japan and China) significant investment tend to be determined by the consensus of hierarchical state-centered social elites, rather than by 'capitalistic' calculations of profitability by independent enterprises (see evidence); .
• The balance sheets of major enterprises and banks (all of which are linked to the state by hierarchical social networks) are unreliable. Thus obtaining capital from profit-focused international financial systems: is never straight forward; and creates risks of financial crises because it could reveal institutions’ bad balance sheets;
• In China (as in Japan until perhaps the 1990s) obtaining significant foreign capital was rendered unnecessary by 'financial repression' (ie suppressing domestic consumption to ensure high national savings, large current account surpluses and the accumulation of substantial foreign exchange reserves). The latter ensured that China was given a sound credit rating despite the largely-undisclosed bad balance sheets of its banks and major enterprises. The capital needed for major investment could be mobilized by its state-orchestrated banking system (despite its bad balances sheets) from national savings and by expanding national debt (see Understanding East Asia’s neo-Confucian Systems of Socio-Political Economy). The international financial imbalances created by 'financial repression' had major adverse effects on international financial stability (see Impacting the Global Economy) - ie maintaining global growth in the face of structural demand deficits in some economies required the use of neo-liberal systems of political economy and easy monetary policies that had adverse long-term side effects (ie distorting investment and ultimately creating social / political instability). Ironically this also contributed to China's capital flight risk in 2016 (see below);
• Elsewhere in East Asia variations of the post-WWII methods that Japan had pioneered to generate 'real economy' miracles (despite financial weaknesses) were adopted from the 1960s by countries that also had historical exposure to Confucian systems of government. However only in Japan and China was the precaution of large current account surpluses put in place.  The result was that the weak balance sheets that resulted from what some called 'crony capitalism' led to a major financial crisis in many smaller countries in East Asia in 1997 (ie in the so-called Asian Financial Crisis);
• China’s pre-2013 system (where the role of a traditional Confucian bureaucracy was not played by a real imperially-accountable bureaucracy as it was in Japan) had allowed Communist Party insiders (ie often 'China's princelings' (the descendants of the earliest prominent / influential Communist Party officials) to corruptly enrich themselves / their families by exploiting their positions in the neo-Confucian social / economic / political hierarchy by which all aspects of China had been increasingly orchestrated since the late 1970s. This seemed similar to the official corruption that plagued Russia's transfer of assets from state ownership after Communism collapsed. To counter this, China tried to ‘purify’ the Chinese regime (on Confucian principles) under its new president (Xi Jinping). A major anti-corruption drive was launched in 2013;
• Suppressing domestic consumption to provide a tame source of capital for investment could not be continued in China if future growth was to be significantly driven by domestic demand. China officially adopted a shift from investment / export driven growth to domestic demand driven growth in 2011 - presumably because it could not avoid the low-income trap that developing countries face if they  continue to rely on export-driven growth whose competitiveness depends on low average wage rates. It was, however, anything but straight forward to achieve this.

The Challenge in Shifting to Domestic-Demand-Driven Growth

• changing to consumer driven growth required changes on the demand side as well as on the supply side - and while China had decades of experience in orchestrating the latter, the former was new;
• China relied on neo-Confucian methods in orchestrating economic change - rather than independent profit-focused decisions within a free-market. The former involved financially-hazardous resource allocation by consensus rather than by calculation of return on capital;
• shifting to domestic demand driven growth implied eliminating / reducing the large current account surpluses that allowed foreign exchange reserves to accumulate and prevent external scrutiny of the balance sheets of China's banks and companies; .

• China thus apparently tried to engineer financial booms (in property and share-markets) so as to mobilize capital for investment without increasing the bad debts that its undisciplined financial system generated.  Those state-orchestrated booms turned out to be perceived / actual bubbles.
  •  China’s property boom has produced significant over-supply (eg many Chinese cities were left as virtual ghost towns with large numbers of uncompleted and / or unoccupied apartments). In 2014 it was expected that the perceived 'bubble' would burst (as again in 2016). However, despite downturns the 'bubble' has continued growing because: (a) an apparently very conservative approach has been taken to property investment (ie few owners have mortgages and property purchases have only been allowed when buyers has large existing assets); and (b) the government-controlled financial system has reduced interest rates to re-ignite demand whenever prices fall. This process is only sustainable so long as the 'wealth' that households have to support property purchases (especially their savings in state-controlled banks) is accepted to be real.  This would no longer be so if China's extreme overall national debt levels (and dependence on rapidly rising debt to drive economic growth) encourage large capital outflows and thus cause China's foreign reserves to be seen to be inadequate as a protection for its currency value;
  • China's ham-fisted response to the 2015-16 collapse of its share-market bubble caused its government to lose a lot of credibility. The difficulties that systems reliant on consensual decision making have in dealing with rapidly changing situations was apparently seen by Sir William Slim as a factor in constraints on the effectiveness of the Japanese army during WWII.
  • China has more recently also sought to obtain capital (without simply suppressing domestic consumption) by seeking international investment in its financial system (eg buying Chinese bonds). However the value of all such assets are artificial (because of dubious accounting practices) as 'markets' in China are simply political tools;
  • In May 2016 a massive speculative boom and bust in China's commodity markets was perceived as another risk to China's financial system and economy;
• China also seemed to hope that large quantities of foreign capital could be obtained to finance investment (eg in domestic-demand-driven industries). However, for reasons outline below, this was limited, eg: (a) successful direct investment depended on obtaining reliable connections to China's non-transparent corporate state; and (b) the Chinese companies in which portfolio investment could be made were constrained by pressure from the 'connections' in China's corporate state to pursue mercantilist rather than commercial goals; 
• In early 2015 slow diversification to domestic demand and constrained credit led to a major downturn in China’s economy (which risked political instability). Thus escalation of credit growth resumed in early 2016. This policy reversal: (a) boosted China's investment-driven growth; (b) reversed (at least temporarily) the global commodity price crash that had created problems for economies dependent on providing inputs to China's economy; and (c) put China back on a path to a Japan-like financial crisis. There were then: (a) indications in April 2016 that this policy might be being reversed again; (b) indications in May 2016 that this may not happen; (c) indications of disputes at the highest level of the Chinese state about what to do - and who to blame; and (d) an apparent decision in December 2016 that China's high and rapidly escalating debt / GDP ratio was so dangerous that reforms were needed. In December 2016 China's central bank increased its efforts to drain cash from that county's financial system - to reduce excess borrowing and frothy markets. China's government also introduced new measures (M&As, bankruptcies, debt / equity swaps; and debt securitisation)  to try to deal with its corporate debt mountain - though observers were not convinced this would work. It also proposed taking even tougher measures to block capital flight (eg by family purchases of foreign property) - though those measures may be hard to put into practice because digital tools for capital transfer can remove transfers from the banking system;
• Having avoided the worst of the 1997 Asian Financial Crisis, Japan and China long seemed to have believed that serious reform of their financial systems was not required (ie they could get away with bad debts if they maintained large foreign exchange reserves as a shield behind which balance sheets could be manipulated). However in China's case that expectation was undermined (despite government efforts to control it) by a significant capital outflow that put China at risk of significant currency devaluation – which could lead to uncontrollable capital flight - while also restricting money supply and thus constraining economic growth. This arguably arose because: 
  • President Xi's anti-corruption drive presumably motivated attempts to get corruptly-acquired wealth out of China - as may apply to some (much?) of what is being invested by Chinese people in apartments in North America and Australia;
  • recognition of widespread official corruption undermined many Chinese people's willingness to believe in and support claims that the regime was acting in the community interest.  It also compounded grass-roots concerns about whether China would emphasis social equality - as eliminating the social hierarchy involved in China's traditional Confucian system of government had been the main, and widely supported, goal of Mao's Cultural Revolution. Thus the case for sacrificing individual / family interests for the nation as a whole was weakened - and interest is emerging in the foundations of Western liberalism (see The Western Path to Progress);
  • China faced a general risk of a debt crisis. And its regime had lost economic credibility because of its poor responses to asset booms and busts;
  • Chinese companies had borrowed heavily at very low rates in $US after Federal Reserve had been forced to adopt extremely easy monetary policy to facilitate recovery from the effects of the 2008 financial crisis (partly because of the international financial imbalances associated with neo-Confucian systems of socio-political-economy). Rising future interest rates would make repaying those debts ever more expensive and thus required early action;
  • the Chinese yuan is believed to be over-valued on a trade-weighted basis - and increasing capital outflows are seen to be likely especially as $US strengthens because of rising US interest rates;
  • China's government encouraged the use of the yuan as an international currency;
• There were flaws in the view that China's risk of a financial crisis was limited because: debt problems were limited to domestic institutions; China's government controlled the whole financial system; and China had large foreign exchange reserves.

China's Weakening Foreign Exchange Reserves - referring to diverse sources outlined here and here

China's foreign exchange reserves peaked (at $US4tr) in mid 2014. There was a serious loss of confidence in the economic competence of China's regime related to the stock market bubble and bust in 2015 - after which China started to experience capital outflow and has had to tighten controls on capital movement to prevent this. China has increasingly had to sell its foreign exchange reserves to defend the $US value of the yuan - and would experience an even bigger flight of capital if it failed to do so. Capital outflows were estimated at $100bn per month in late 2015 - with $57bn in foreign exchange reserves being sold each month to defend the yuan. China probably has $900bn in reserves that could be used this way without leading to a serious problem. Chinese exporters want to hold reserves in $US - and their trading partners don't want yuan. When the US started raising interest rates investment capital inflows into China were reversed.  Using foreign exchange reserves to prevent yuan devaluation has the effect of tightening the availability of domestic credit - and thus restricting economic growth just as the reverse (ie adding to foreign exchange reserved) long had an expansionary economic impact. China's FOREX reserves may be either: (a) only $2.1-2.2tr after allowing for China's sovereign wealth fund - which is below the $2.7tr needed for safety; or (b) $3.2tr not including China's sovereign wealth fund. 

Chinese companies with non-transparent financial positions are investing offshore. However such offshore investing is increasingly failing as government tries to block offshore capital movements.

Officials fear that Chinese people believe that they would be better off getting their money out of China - as capital flight would sap the liquidity needed to keep China's bubble from bursting. There has been a boom in Chinese buying of offshore real estate. As much was invested in the first half of 2016 as in 2015. Money is getting out despite government efforts to stop it. In October 2016 China's headline foreign exchange reserves fell by $100bn - five times as much as in September. In December 2016 China indicated an intent to close loopholes in measures that were in place to restrict capital outflow. 

However phone apps and online platforms can make international transfers that do not go near China's banking system and will hard to control. Companies can disguise capital flight as normal business tractions. Exerting complete control over capital flows would be incompatible with the reserve currency status for the yuan that China sought and obtained from the IMF.

• the adoption of a more liberal economic system and a rule of law had been announced by President Xi as part of a major 2013 reform agenda. However it was probably impossible to achieve this. The methods used to achieve change in recent decades (including China's 'real economy' miracle) have been incompatible with the liberalizing changes that were now allegedly to achieve (ie they involved stimulating change through hierarchical state-centered social networks rather than through independent initiative under (say) a rule of law). China's president's attempt to suppress corruption was seen to suppress economic initiative because personal profit had often gone had in hand with official leadership of economic change. In early 2017 China's response to the situation it confronted involved an abandonment of attempts to liberalize its economy with an emphasis on maintaining control by the ruling regime by continuing to maximize growth despite its exposed financial position

Why China Faces Political Instability   [<]

Political instability has plagued China's neo-Confucian regime since its establishment in the late 1970s (see Political Constraints, 2004). For example, it was autocratic and faced a seething mass of local protests that it suppressed - eg related to official corruption. These were amplified by: growth at all costs policies; the perceived collapse of public morality; economic underdevelopment in NE China which has fought many civil wars with more-commercially-successful southern China in the past; extreme income inequality; and the emergence of Falun Gong in 1992 in the tradition of the White Lotus society which had been the source of earlier attempts to gain political power in China.

There were later signs of a loss of confidence in economic tactics for further boosting China's power and status (see Discord / Conflict, 2009+). Observers started suspecting that a military route to the expansion of China's power was being emphasised (see Comments on Australia's Strategic Edge in 2030, 2011). Also an increasingly autocratic domestic approach by China's regime was put place from 2012 under president Xi Jinping (see The Resurgence of Ancient Authoritarianism in China, 2014) - and this was the opposite of what was needed to sustain rapid market-driven economic progress.

The neo-Confucian system of government that China's 'Communist' Party adopted (initially to achieve its economic 'miracle' and later to enforce national discipline) is arguably increasingly at risk (eg another anti-Confucian cultural revolution is possible) because:

• Neo-Confucian methods require the existence of a social hierarchy. In a 'Confucian' system progress depends (not on rational decisions by individuals in liberal institutions but rather) on educated elites guiding changes in their subordinates' behaviour and everyone valuing the (eg economic / geopolitical) interests of the ethnic nation above their own;
• There has been strong grass-roots resentment of the late-1970s’ re-emergence of a neo-Confucian social hierarchy in China. Mao's late-1960s-early-1970s cultural revolution had sought to eliminate China's hierarchical Confucian cultural tradition - as it was seen to be oppressive - and replace it with notions of social equality. It was reintroduced in the post-Mao era (as neo-Confucianism which incorporated Daoism and officially called 'socialism with Chinese characteristics') because this had been the basis of achieving the economic 'miracles' that Japan had first demonstrated. And, as in Japan, the existence of a neo-Confucian social hierarchy has remained critical to achieving significant economic change / development in China - while the risks of financial crises escalated;
• In late 2016 it was suggested that a significant populist movement  had developed that could challenge China's regime. It rejects official 'economy first' priorities and supports Mao's egalitarian ideas. It can also be noted that China's long term history has seen repeated civil wars between 'spiritual' factions in north China and the 'commercial' south - which have seen the latter driven out to become the Chinese diaspora in SE Asia. The latter arguably regained power through an ideological takeover of the (so-called) 'Communist' Party after Mao's death because the PLA believed that economic success would be the best way to boost China's military strength;
•  China generated the massive wealth-imbalances mentioned above (ie many connected with the so-called ‘Communist’ Party exploited their positions to become exceedingly and corruptly rich). This led to the need for an anti-corruption crackdown in 2013;
• the legitimacy of the so-called ‘Communist’ Party has rested mainly on its economic success – but many of China’s economic policy initiatives in recent years have been ineffectual. Disputes over who is to blame for China's debt crisis have emerged;
• China's people have had a strong emphasis on savings (for cultural reasons and because of the lack of a social safety net). This includes deposits with China's state-controlled banking system where savings have been used for investment to achieve nationalist goals but with little regard for return on / return of capital. The credibility of deposits with those institutions depends on the regime's ability (by maintaining large foreign exchange reserves) to prevent their balance sheets being subject to scrutiny by foreign investors. China's debt crisis has the potential over the next few years to alienate China's citizens by eroding their household wealth;
• Falun Gong (an exercise / spiritually oriented group) has been persecuted by China's regime since 1999. It has about as many members as the Communist Party, is independent of them, has its own ideology and cuts across socio-economic lines;
• there is also resentment in the so-called ‘Communist’ Party about President Xi’s attempt to give himself absolute control of everything so he can fix all of China’s problems (which is equated with Maoism).

Various observers have expressed concern that China seems to be focused only on gaining power rather than with the changes needed to achieve ongoing economic success. Others expressed concern that China seemed to be making preparations for war.

China's Likely 2017 Financial Crisis   [<]

In early 2017 there were indications that in December 2016 China's government had finally accepted  that: (a) its extremely high debt / GDP ratio and heavy dependence on rising debt to sustain growth create unacceptable financial risks; and (b) a slower rate of economic growth was needed in the interests of 'stability'.  External observers remained very concerned about China's risk of a debt crisis (op cit). And the reforms announced in early 2017 to deal with China's problem seemed inadequate.

In relation to China's problem, the Chinese Academy of Social Sciences had reportedly indicated that 'stability' could be achieved by reducing China's growth rate by a fraction of a percent (eg from 6.5% pa to 6.4% pa), while a US observer speculated that giving up half a percentage point in growth would ensure against bond / currency market instability. 

However such modest adjustments seem unrealistic. It seemed likely that if China implements the policy shift apparently intended in late 2016 (ie stabilizing its debt / GDP ratio) it would experience a 'hard landing' while other economies dependent on China's imports or foreign investment would suffer setbacks.  However China's challenge was arguably more severe that this, because (if a liberal international economic and political order remains dominant) China's system of socio-political-economy would be incompatible with its regime's desire to avoid the 'low-income trap' that had limited the performance of many emerging economies by shifting to domestic-demand / consumer driven growth.

An Overview of China's Apparent Financial Predicament in Early 2017

Based on an undoubtedly-improvable attempt to form a 'consensus' of the diverse and not always compatible sources that are outlined above, it seemed that:

• China’s total debt levels: (a) had been rising about 3 times faster than GDP growth (ie about 20% pa or $US1+tr / quarter) to sustain the 6-7% pa rate of economic growth that China has needed to avoid political instability; and (b) have now reached around 300% of GDP (ie about $US30tr);
• China’s dependence on rapidly rising debt and its overall debt level were almost universally seen by external observers as posing risks of a debt crisis – though this risk has been able to be managed in ways that would have been impossible elsewhere because China's government has had extensive control over the financial system and its large foreign exchange reserves could be shifted to boost any area that was then seen to be exposed;
• Despite determined government efforts to prevent this, China’s foreign exchange reserves were eroding quickly as a result of net capital outflows (ie falling by 25% from their $US4tr peak in early 2014 to $US3tr – ie an average of around $US30bn / month with a November 2016 fall of about $US80bn). This will have reflected the combined effect of:
  • China's current account surplus - which peaked at around $US400b pa in 2008 before declining steadily to $US200bn pa in 2016);
  • outward corporate foreign investment (which grew from around $US3bn in 2005 to $US170bn in 2016 - with a particularly large growth in 2016); 
  • inward foreign investment - which had been rising steadily (ie from (approx) $US155bn in 2009 to $US200bn in 2015) before falling about $US45bn to about $US155bn in 2016 [Note - there are many different estimates of China's foreign investment and the specific source of the latter more-or-less typical figures can no longer be located];
  • sale of China's Forex reserves by PBOC to defend the value of yuan - (say) $US300-400bn [1, 2, 3];
  • capital flight (eg related to concerns about China's overall debt position and its state-manipulated financial system). This might have grown to $US400-500bn in 2016 - a CPDS' guess-timate based on the above rough / improvable estimates of other factors affecting the approx $700bn fall in China's foreign exchange reserves in 2016;
• Running down foreign exchange reserves to defend yuan value has the effect of tightening domestic liquidity and thus suppressing domestic economic activity - just as increasing those reserves once had an expansionary effect by increasing domestic liquidity;
• The IMF reportedly believes that the minimum foreign exchange reserves China needs for safety (eg because of its managed exchange rate) is about $US 2.7 tr. This level would be reached before mid 2017 if late 2016 rates of decline were maintained. Other observers have suggested that: (a) there would be concern about their adequacy if reserves fall much below $3tr - given the scale of China's financial pressures and its economic structure; (b) the PBOC could continue selling FX until reserves fall to $US1.8tr (given China's export income, broad money, foreign liabilities and capital controls); (c) $US3tr is ample foreign exchange reserves for China given that its liquid external assets are greater than its external debts and its current account is in surplus [1]; and (d) China has $3tr in foreign exchange reserves of which $2tr are illiquid or needed to bail out its banking system, leaving $1tr still to be used to defend the yuan in the face of capital outflow [1]. Perhaps China's 'safe' FX reserve limit depends on how reliable financial markets think that China's state-manipulated financial system as a whole is;
• Concerns about the adequacy of foreign exchange reserves are however merely a symptom of China's underlying problem (ie stabilizing its huge debt / GDP ratio in the face of its economy's dependence on rapidly expanding debt). The debt problem won't be solved by stabilizing FOREX reserves or showing their 'adequacy'. Moreover, for reasons suggested below, China's system of socio-political economy seems incompatible with mobilizing large quantities of capital without merely increasing its national (bad) debts;
• Extensive bad debts have accumulated which would need to be written-off or rationalized in some other way in order to restore international credibility to China's financial system;

New debt can directly add to an economies' final demand (a fact that is being explored as part of the development of Credit Impulse theories). Thus reducing China's rate of creating new debt (which has been about $US4-5tr pa)  will tend directly and indirectly to reduce demand, and affect economic growth. It is very hard to reduce dependence on rapid debt growth as the source of economic demand and potentially very economically disruptive to do so.

Merely stabilizing China's debt / GDP ratio at its current very high level (ie about 300%) would perhaps require reducing the new debt created each year by (say) $US2.5-3.5tr pa (ie cut current $US4-5tr pa new debt creation by about 2/3) – eg by:

• slashing the creation of new debt for (industrial, infrastructure, property) investment or for domestic consumption by (say) $US2-3tr - which would result in a (say) 10-15% cut in final demand (and a similar effect on GDP);
• clamping down very firmly on capital outflow by Chinese companies and households (eg with a $US500bn cut). Such a cut (which, for reasons suggested above, might not happen without a financial crisis) would weaken the economies of the many countries that have come to depend on capital from China as the world's largest post-GFC credit creator. This (and the reason it was needed) would also perhaps put the reserve currency status of China's yuan with the IMF at risk;

China's Clampdown on New Debt and Capital Outflows: It can be noted that in late 2016 China's commerce minister had made reference to restricting foreign investment by Chinese firms and encouraging foreign investment in China because outflows had risen rapidly while inflows were stable and there was concern about capital flight.

In January 2017 one observer suggested that Chinese companies backed out of $36bn in foreign acquisitions in 2016 (a 7 fold increase on 2015) and that many of the record $225bn in foreign acquisitions by Chinese companies that had been announced in 2016 were stalled because of regulatory constraints. [Another observer suggested that the value of deals that Chinese companies backed out of in 2016 was $75bn - and that European / US asset sellers were now hesitant about selling to Chinese buyers].

In February 2017 it was noted that: (a) China had added strict new measures to prevent capital outflow for the purchase of real estate; (b) total capital outflow from China had fallen to zero in December 2016; (c) Chinese purchases of certain apartments in Australia was 25% of total demand (down from 80% at one time and 50% in late 2016) and falling fast; (d) the decline in Chinese buyers could affect real estate demand in Australia's major capital cities; (e) China's credit growth slowed in January 2017 indicating concerns about risks with rising debt .

In March 2017 it was suggested that China had decided that clampdown on offshore property purchases by small Chinese investors would / might be relaxed after a year (ie at the end of 2017). Chinese buyers rushed back into the market - buying 50% of off-the-plan apartments which would settle in 2-3 years. Australian-born Chinese investors were buying another 25%.

In April 2017 there seemed to be significant differences in reports about what was happening. It was suggested that:

•  Chinese banks were lending abroad at record rates in a bid to tap new growth helped by state-backed ambitions to build infrastructure worldwide. Particular emphasis is given to OBOR projects - with loans for hundreds of projects envisaged along ancient trade routes promising profitability options in place of declining returns in China [1];
•  measures that restrict money leaving China were being relaxed [1];
• China's continued rapid expansion of its debt was creating the risk of a crisis;
• defaults were increasing across China exposing the hidden debts of companies across the country. Borrowers have often extended their guarantees to each other raising the risk that one failure could trigger others [1]
• China was clamping down hard on investment
• China's credit crackdown was adversely affecting its sharemarket. China's government was committed to reducing financial risk despite this [1]

In May 2017 it seemed that China's attempts to contain its debt crisis could be getting out of control. It was suggested that:

•  China was clamping down hard on credit in order to prevent the Communist Party being engulfed by financial crisis and that this would have a large worldwide impact because China had been the source of 50% of global growth [1];
• waves of regulations aimed at cutting risk to China's financial system were sending banks and companies scrambling for funds. Shares fell 5% in a month and interest rates shot up. Commodity prices have been hurt by uncertainty about China's future. Market turbulence will challenge Beijing's resolve to deal with China's snowballing debt. Some fear the regulatory wave could be too strong. Liquidity and new lending is being drained from markets / economy - increasing funding costs and defaults. China's debt / GDP ratio (258%) will continue rising - as all regulators can do is slow the rate of increase [1];
• China's foreign exchange reserves rose in April for the third straight month to $3.03tr [1];
• China is not manipulating its currency to lower it. It has propped up the yuan to prevent economic destruction. Shadow banks have lent companies huge amounts at low rates which they can't repay. However yuan peg is unsustainable. China is too over-leveraged for capital controls to be effective.  After adjustments China's foreign exchange reserves (officially $3.005tr) are only $US1.69tr (ie below the critical $2tr level). A global financial crisis will result and take down commodities as China consumes 50% globally.
• China is trying to crack down on risky debt and causing interest rates to rise, equities to fall and an increase in defaults;
• a major Chinese SOE (Sinopec) said that it intends to double its foreign investment to $30b but not stated when this might happen [1];
• the World Bank warned about China's continuing debt problems (eg off balance sheet borrowing, poor returns on investments, not monitoring borrowing through special financial vehicles by local governments, who are responsible for most government investment );
• In the first three months of 2017 $US1tr in new debt was created in China, even though authorities had started tightening credit,  [CPDS Comment: $1tr was roughly the amount of new debt that was being created quarterly before there was official recognition in late 2016 that China overall debt levels (about 300% of GDP) and dependence on increasing debt about three times faster than GDP was hazardous].
• China's crackdown on debt had led to a 'liquidity shock' that was causing economic disruption and financial instability. Signs of this first appeared in November 2016. It was being moderated. The shadow banking system is out of control, but government is not willing to confront this. China's credit cycle is globally significant - and the effects will be felt in commodity markets, emerging economies and Europe [1]
• China's central bank injected a large amount into the countries' fragile financial markets in April 2017 because of concern about the effects of clamping down on speculative excesses;
• China's credit rating was downgraded from AA to A by Moody's - who reportedly also suggested that further downgrades were likely if China's 'debt bubble' was not fixed;
• China is constraining its economic slowdown. It is trying to tighten the housing bubble without going too far [1] . 

The global impact of restricting debt creation by China enough to stabilize its debt / GDP ratio would be severe. China has been creating 50% (or slightly less or more) of total new global new credit. Thus the 2/3 reduction in the rate at which China creates credit that is apparently necessary just to stabilize its debt / GDP ratio would cut the amount of debt created globally by about 1/3. At the same time monetary polices are likely to be being tightened: (a) in Europe by tapering the ECB's bond buying program; and (b) in the US by likely Fed increases in interest rates during 2017.

If China wanted to do more than stabilize it high debt / GDP ratio, even greater cuts would be needed.

While there was a behind-the-scenes recognition that there is a financial problem that needs to be addressed in late 2016, taking official action (except by clamping own on outward capital flows as noted above and discrete increases in interest rates from November 2016) will apparently be delayed because it depends on a new Politbureau being appointed by the 19th National Congress of the Chinese Communist Party in late 2017. 

One observer (Charlene Chu, Autonomous) reportedly suggested that the adjustment process could be slow (because China's government has tight control over the 'financial levers') and that it might also involve: (a) attracting foreign investment (eg by raising interest rates); (b) devaluation of the yuan (presumably to reduce the incentive to get money out because devaluation is expected in future); and (c) possibly benefitting from weakening of the $US to which yuan has been more-or-less linked.

However, though there might be ways mentioned below to marginally reduce China's reliance on rapidly increasing debt to drive growth, financial adjustment might not be slow and tightly government controlled. Given that: (a) constraining capital outflow is difficult; (b) the pace of capital outflow from China was accelerating; and (c) China's foreign exchange reserves were expected to be below the safe level recommended by the IMF by mid 2017, a response delayed until late 2017 (ie until after the 19th Congress of the Communist Party) might be too late to avoid an uncontrolled market-driven crisis (as was the case for China's ham-fisted responses to its 2015 share-market crash). 

More determined efforts to constrain outward foreign investment appeared to be put in place in late 2016 - and there were indications that this would limit or perhaps stop much foreign investment. The economic stimulus that (say) $200+bn of China's foreign investment would have provided to trading partners would be lost. And the rate at which China approached what the IMF saw as its least safe level of foreign exchange reserves ($2.7tr) would be reduced - with that level not being reached until (say) September 2017 rather than (say) April 2017.

Significantly boosting demand from other sources (eg from domestic consumption) would also allow the rate of debt creation to be reduced without adversely affecting total demand.

Background on Consumer Demand in China:

• Services are expected to be China's new economic engine [1];
• China’s initial strategy of suppressing consumption to boost investment significantly reduced consumption as a percentage of its economy (ie from 51% of GDP in 1985, 43% 1995; 38% in 2005; 34% in 2013). However, as China's economic growth was fast (eg from 2000 to 2010, China’s GDP doubled), consumption grew strongly (ie from $650bn to $$1.4 tr)  even though it fell as a percentage of total GDP   [1];  
• Consumer demand in China has recently been increasing about 10% pa [1], In 2015 private consumption was estimated as $4.2tr (compared with total GDP of about $11.2tr ) and by 2020 private consumption has been estimated to be $6.4tr [1]. China’s household income is now $5tr pa, and discretionary spending is increasing [1];
• Factors driving increased consumer spending have been seen as: rise of upper middle class; a new generation of free spending sophisticated consumers; and the role of ecommerce [1] .

Despite the rapid (about 10%pa) growth in consumer demand, this is limited as a way of reducing China's dependence on rapidly increasing its national debt to drive growth, because:

• The reduction in annual credit creation needed to stabilize China debt / GDP ratio in the absence of other changes is some $2.5-3tr. The annual increase in consumer spending is about $220bn;
• Rising consumer spending depends on a high rate of stimulus spending to boost household incomes [1].  Consumer spending also relies to some extent on the availability of new credit;
• China's households are conditioned to a high saving rate - for cultural reasons and because of the lack of a social safety net [1];
• Households' increasing affluence includes their savings in China's state-owned banking system, and the value of those savings has been has been constantly eroded because of: (a) the irresponsible use of national savings in financing investment; and (b) the resulting bad debts and suspect balance sheets of China's banks and companies. If China suffers a significant financial crisis the value of savings held in China's banks (and thus consumer spending) could fall dramatically.

Attracting a lot more foreign investment would also reduce the need for an economic 'hard landing' to stabilize China's high debt / GDP ratio and eliminate dependence on very high rates of new domestic debt creation to sustain growth. However this is unlikely to be easy because:

• as noted above, China's high and rapidly rising debt / GDP ratio (which causes financial instability) will continue to worsen unless the rate at which new credit is created is slashed (eg cut by something like $US2.5-3.5tr pa not just by the $US100-200bn that would be the most optimistic view of potential new foreign investment);
• many now try to get money out of China or are increasingly reluctant to invest in China because the risk of losses associated with China's unreliable financial system and heavily debt-exposed economy.  China's corporatist system of socio-political-economy has been able to engineer 'real economy' miracles but has been unreliable financially because:(a) government controlled the 'financial levers'; and (b) for complex cultural reasons financial results had no priority  (see Why China Has a Financial Problem). Outright fraud has also been a non-trivial issue. Fixing the problems in China's state-manipulated financial system will probably be needed before unwanted capital outflows will ease or foreign investment can significantly increase;
• a very large increase in inward foreign investment would be needed to make any useful difference. Reversing the approx. $US45bn pa fall in inward foreign investment in 2016 would provide only a fraction of the new credit needed to allow China's debt / GDP ratio to be stabilized without a large cut to final demand and GDP. Attracting foreign investment would be hard because:
  • the opportunities that attracted many companies to invest in China have not proven as good as expected because: (a) running retail operations is difficult and expensive; (b) China's growth rate has slowed; and (c) the expected boom in consumer spending has not happened [1]
  • direct foreign investment in China has been anything but straightforward (eg consider the OECD's index of investment restrictions and Australia's experience). Investment success has required reliable 'connections' to China's corporate state. Given the mess that Chinese government manipulation of 'financial levers' has created, direct foreign investors are likely to remain hesitant in the absence of a transparent business environment (eg one based on law rather than on 'connections' to China's corporate state). Creating an attractive environment for foreign investment (ie eliminating dependence on reliable 'connections' to China's financially-irresponsible corporate state) will take a major cultural / political shift. It can be noted however that doing so would also: (a) remedy the bad trading reputation China has had due to its non-tariff barriers; and (b) remove the main obstacle to the creation of a stable international financial system (see Donald Trump is Not Alone in Facing Dilemmas, 2017);
  • portfolio foreign investment in China has tended to provide investors with limited ability to exert any control over the enterprises they invest in. China has a corporate state (ie so-called 'private' enterprises are seen as extensions of the state). Control of enterprises (eg Alibaba) remains in the hands of Chinese principals [1, 2, 3] who will conform to the nationalistic / mercantilist pressures they are subject to through their social relationships - rather than maximizing return to investors. Creating an environment in which portfolio investment in China results in the ability to gain control and focus on return on capital would require dissolving China's corporate state;
  • selling state-owned enterprises (SOEs) could in theory attract increased foreign investment in China. However this would not be straight forward because: (a) given the large and often unknown / concealed bad debts association with such enterprises, determining a value that external investors could rely upon would not be possible without fundamental reforms of China's whole financial system; (b) the widespread incidence of corruption in China's financial and corporate systems (which government anti-corruption programs are targeting) implies that abuses of the process of selling SOEs could be as widespread as in post-Communist Russia; and (c) nationalistic, rather than commercially oriented, Chinese control of such enterprises would presumably still be sought, thus creating the same problems for ex-SOE investors that are now associated with portfolio investment. 
• Goldman Sachs suggested in early 2017 that China could attract large quantities of capital inflow by liberalizing its bond market to the extent that its ($US1.7tr) outstanding pool of bonds  could be included in in global bond indices. The trouble is that, because of the character of the state-manipulated financial system that China has used, the value of bonds would be: (a) highly uncertain and dependent on China's ability to prevent capital outflow which could expose its banks' / companies' balance sheets to critical examination; and (b) constantly worsening because of the nature of its manipulated financial system (see Why China has a Financial Problem). In March 2017 the PBOC announced that Chinese bonds would be available to foreign investors but not included on global bond indices.

It has been suggested that a large yuan devaluation might be an option to boost China's economy (by increasing its international export competitiveness) while reducing dependence on creating new debt. Problems with that option are that:

•  this would be a reversal to some extent of China's attempt to change its economy from dependence on exports sustained by low wages towards domestic demand - and thus confuse official efforts to set directions for China's future economic growth;
• if devaluation (say) reversed the $200bn decline in China's trade surplus from 2008, this would make little difference to the cuts to domestic credit creation needed to stabilize China's debt / GDP ratio;
• the credibility of China's financial system would remain in tatters unless devaluation was accompanied by structural changes to China's financial system (ie towards a system where major resource allocation depended on return on / return of capital rather than on insider connections). 

China's financial challenge was not however limited to the immediate issues it faced in early 2017. If a liberal international economic and political order remained dominant, China's neo-Confucian system of socio-political-economy seemed incompatible with its regime's desire to shift its economy to domestic-demand / consumer driven growth (for reasons outlined in Why China Has a Financial Problem).

The latter suggested that China's neo-Confucian system of socio-political-economy makes it impossible to generate capital for investment without merely increasing its national bad debt levels (eg its state-controlled financial system could not take profitability seriously and attempts to gain capital by boosting asset values / attracting foreign investment failed). China's regime thus faced a choice between:

• radically changing / liberalizing China's system of socio-political-economy - and suffering severe economic damage and political instability in the process;
• internal political and economic crackdowns, turning inward (as it did in 1525 perhaps because its political elite were afraid of free trade [1]) and accepting economic backwardness;
• going all out to achieve its apparent long term goal of creating a new international order in which the constraints that liberal international political and economic institutions impose on the exercise of power through authoritarian state-centred social hierarchies might be eliminated.

China's Inadequate Reform Proposals in Early 2017 [<]

At the time of the March 2017 meeting of the National Congress, China's regime acknowledged its debt crisis and announced many steps that were to be be taken. This could deceive anyone who had not actually 'done the sums' into believing that China's debt crisis was being dealt with - presumably to maintain the impression of economic power that its political elite needs to maintain their authoritarian rule.  China's debt problems are an order of magnitude greater than the 'solutions' that were being offered in early 2017 (ie a cut of some $US2.5-3.5tr in China's rate of increasing its national debt is needed to merely stabilize its dangerously high debt / GDP ratio).  What has been announced might only achieve a $200-300bn cut. This would only result in only a small decline in China's rate of economic growth, but would not deal with China's debt crisis. This seemed like a repeat of the efforts that China made in 2013 to convince the world that its financial system was being 'fixed' and that Chinese capital could make a major difference to the world economy (Preparing for a Financial Con? - Late 2013) - assurances which had been followed by ever increasing problems in China's financial system.

Reform Proposals in Early 2017

China's president (Xi Jinping) indicated that a major change could be made to China's economy by winding down heavily indebted SOEs to make room for more private service industry companies. [CPDS Comment: While this would presumably reduce the rate at which bad debts accumulate, there would be little short-term impact and constrained long-term impact on China's need for rapidly-escalating national debts because: (a) as indicated above likely increases domestic consumption can do little to compensate for the very large cuts to new debt that are needed to stabilize its debt / GDP ratio; and (b) China's corporate state system pressures 'private' enterprises to achieve mercantilist, rather than simply commercial, goals while its banking system places little emphasis on actual return on capital].

China's premier (Li Kequiang) indicated a desire for a slight reduction in growth by reducing the availability of credit. It was noted that in 2016 Li had supported economic stimulus measures and been criticized by an 'authoritative' figure for supporting debt-driven growth. The Chinese regime was seen to be more interested in maintaining political stability than in economic reform.

China's premier also indicated a desire to increase employment while avoiding strong stimulus measures. More foreign and private Chinese investment would be encouraged while the availability of credit would be restricted. [CPDS Comment: As noted above, foreign investment is unlikely to make much difference without significant reform of China's whole system of socio-political economy. And 'private' investment within China's 'corporate state' comes with a lesser version of the same problems (ie pressure from state-linked social networks to achieve mercantilist rather than commercial goals) that afflict SOEs. Very limited reductions in debt-based stimulus measures are likely to be possible if a high rate of employment creation is to be achieved in an attempt to maintain political stability. To stabilize (quite apart from reducing) China's debt / GDP ratio arguably requires cutting annual creation of new debt by $US2.5-3tr - and reform proposals would seem unlikely to achieve more than a cut of a few $US00bn].

In February 2017 China's foreign exchange reserves reportedly increased (about $7bn) in the face of expectations that they would fall significantly (about $30bn) - a fact which indicated that the PBOC had again started buying to increase China's foreign exchange reserves. China's gold holdings also reportedly increased [CPDS Comment: Buying assets to increase FOREX reserves could be expected to: (a) weaken the value of yuan and thus boost China's international competitiveness - while increasing the risk of a trade war with US; (b) perhaps reduce the incentive for capital flight associated with reserves declining to unsafe levels; (c) increase China's national debt levels - unless increases to FOREX reserves were funded by sale of undeclared national assets - such as its gold reserves; and (d) provide a domestic economic stimulus by increasing liquidity.  The possibility that sale of gold reserves was involved in purchase of other FOREX reserves is suggested by: (a) the fact that the PBOC made a point of declaring an increase in China's gold reserves; and (b) China's actual gold reserves are often suggested to be (perhaps much) greater than officially stated].

In March 2017 a stunning reversal of China's clampdown on Australian apartment purchasers appeared likely after 12 months - resulting in restoration of Chinese buyers as the dominant force in the 'off-the-plan' apartment market  [CPDS Comment: Chinese buyers of apartments faced massive losses as an apartment boom driven by offshore buyers risked collapsing as their ability to settle on purchases disappeared.  This attempt by Chinese authorities to prevent this by 'managing' a speculative market (ie by announcing a policy reversal after a couple of months) bears some resemblance to what was done as China's domestic sharemarket boom turned into a bust in 2015. A chaotic outcome seems likely]

In March 2017 the PBOC acknowledged that China's debt levels were too high and stated that: (a) this could not be corrected in the short term; and (b) Chinese bonds would not be included in global bond indexes [CPDS Comment: Including Chinese bonds in global bond indices would have meant that index organizers would have had to be given access to the books of the institutions that issued the bonds to assess their soundness, China's regime did not allow this]

In March 2017 senior officials acknowledged that China's debt levels were too high. Finance minister (Xiao Jie) said that there was a lot of room for central government to raise more money (eg to cover bad debts of local governments). As China's economy grows bigger so will China's fiscal revenues. [CPDS Comment: China's problem is that its national debt levels are extremely high, and that its growth depends on raising them much faster than its economy (and fiscal revenues) are growing. Shifting debts from local to national government levels is not a solution to that problem]

In March 2017 China reportedly introduced new regulations to cover outbound investment to stem capital outflow and speculative investments. Emphasis would be given to strategic investments.[CPDS Comment: China has always sought to identify 'strategic' investments and has succeeded in finding those likely to achieve market demand but are relatively unprofitable and require large increases in national debts. Continuing to do this won't eliminate China's debt problem. Increased reliance on 'private' enterprise won't do so either as long as China maintains a corporate state (ie a system in which large independently-owned enterprises act as extensions of the state rather than as independent profit-driven undertakings).

In March 2017 external observers suggested that:

• (a) severe monetary tightening seemed to have occurred which could erode the value of China's equities and property markets; and (b) inflation was rising fast perhaps requiring even tighter monetary policy and increasing the risk of capital flight. (see here)
• China's growth (which was strong initially) could weaken because slowing consumption shows that demand is not strong enough to pick up the slack from waning stimulus policies. Economists see China as walking a fine line in trying to stimulate economy enough to prevent sharp drop in output while addressing rising debt and industrial over-capacity that resulted from years of stimulus [1]
• Both US and China are on a path to higher interest rates - and though reasons are different they are linked. Positive economic data spurred rising rates in US. China's concern is rampant asset bubbles as post GFC cash found its way from stocks to real estate.  But China is also concerned that a stronger $US could accelerate capital flows out of China. Fed rate increases put PBOC under pressure to do the same. As bond yields rise Chinese companies find it cheaper to borrow outside China in $US.  But while leverage in China's financial markets fell, the broader economy remains highly dependent on debt - and this will take years to resolve  [1]
• China is not overleveraged according to Prudential CEO (Mike Wells). The structure of leverage is improving. China is at the middle end of an industrial phase. There will be more structural reform and production efficiency. It has not yet really tapped consumerism [1].

In March 2017 China's State Research Centre suggested that the risk to China's growth had fallen - and there had been a shift from falling to steady growth. Growth was achieved through record bank loans, a speculative housing boom and massive government investment. As housing market is cooled, growth will depend more on domestic consumption and private investment. China's industrial output grew 6% in January and February 2017 - and fixed asset investment was similar to that in late 2016. China had a trade gap in February 2017 as the construction boom increased imports more than expected  [1]

In May 2017 it was suggested that China was increasing interest rates, reducing share values and increasing debt defaults by trying to crack down on risky debt [CPDS Comment: While it is possible for governments to identify the types of practices that are likely to lead to risky debt, it is not possible for them to determine which particular investments are most undesirable. Investment in a market context is always 'risky' and those who are directly involved (and thus have the most relevant information) are most likely to be best able to determine the extent of the risk)]

In may 2017 it also became apparent that determined efforts were being made to address China's potential debt crisis - though this might prove to be inadequate (see China's Clampdown on New Debt and Capital Outflows).

Suggestions also emerged that China had a 'secret weapon' (ie a new approach to innovation) which it expected to transform its economy.

• China has hundreds of large companies with innovative / superior products who have been developing within China's domestic market and will now start 'taking on the world' in the same way that Alibaba and Huawei did - see here

CPDS Comment: China could expect this 'secret weapon' to reduce or reverse the limits imposed by its debt crisis (ie dangerously high debt levels; economic dependence on fast rising debts; and capital flight which risked eroding the ability of its FOREX reserves to prevent external scrutiny of the poor balance sheets of its banks / companies). Establishing such companies might generate additional current account surpluses and thus prevent or reverse the collapse of China's FOREX reserves. China's export-oriented capital intensive manufacturing (combined with suppressed domestic consumption) had achieved this during China's initial industrialization. However:

• the hoped-for resurgence of current account surpluses might not happen through a new competitive challenge to what have now become the world's highest valued-added industries (as capital-intensive manufacturing had been in the 1960s). Large current account surpluses had been achieved by export-oriented manufacturing in Japan and China because: (a) domestic demand was suppressed; and (b) easy money policies were adopted elsewhere to compensate for those demand deficits by creating a wealth effect and making it easier to build up large debt levels. Domestic demand can't now be suppressed by China because it is increasingly being relied upon as a driver of China's economic growth. And the days in which the US (for example) was willing and able to compensate for current account deficits by building up debt levels with ultra-easy monetary policies are presumably at an end because the side effects are social inequality and political instability. And competitor nations have new options to boost their economic capabilities (eg see Getting out of the Economic Quicksand, 2011);
• even if large increases in current account surpluses were to emerge, establishing the economic capabilities to achieve this will presumably add a great deal to China's national debts (and bad debts) - and thus merely disguise, rather than resolve, China's fundamental problem (ie the incompatability between the liberal economic / financial regime that could allow China to overcome its debt crisis and the autocratic political system through which it would have to achieve that change). 

• China has started beating the US at innovation by investing heavily in the process of turning discoveries into commercial products ;
• China's start-up companies now seek to operate globally rather than just in China - a process started by companies such as Alibaba;
• European firms have suggested that China is rapidly closing the innovation gap [1]

Despite this, as 2017 progressed there were signs that China was facing increasing financial problems because of its debt / bad-debt problems (see China's Clampdown on New Debt and Capital Outflows).

Importing Global Risks   [<]

It also needs to be considered that:

• There has been and remains a real risk of a global credit crisis. By way of background it is noted that:
  • economic growth has been driven since the late 1980s by ever accelerating increases in credit as a consequence of easy money policies and ultimately ultra-low interest rates / quantitative easing. This process started as a way of preventing financial crises (ie the 1987 stock market crash in the first instance) from impacting the real economy;
  • easy money policies then had to be maintained to create a wealth effect amongst those with significant existing assets (eg through rising asset values) to generate the demand needed to compensate for demand deficits that resulted from suppressing consumption / ‘savings gluts’ in East Asia (and elsewhere);
  • ultra-low rates boosted asset values (eg stimulated property booms such as that which burst in the US in 2008 giving rise to the Global Financial Crisis) but:
    • impeded ‘real economy’ growth in developed economies (and thus economic growth) by biasing investment towards the relatively easy gains to be made by 'playing the (financial and property) markets'; and
    • contributed to global deflation by encouraging investors to seek higher returns in emerging economies where export-oriented industrial over-capacity emerged. Ultra-low rates arguably also had a deflationary impact by forcing those in or approaching retirement (and increasing population share in developed economies) to increase savings and reduce consumption;
  • this also led to increasing social inequality in developed economies (ie the rich got richer – while others didn’t):
  • that inequality is now leading to potential political instability and incompetent governance (ie it seems to be the reason that Donald Trump emerged as a significant Presidential candidate in US – and is one of the reasons for equally irresponsible groups making political gains elsewhere);
  • overall debt levels globally are now very high by historical standards relative to global GDP - suggesting that rapid debt growth and debt driven economic growth may soon come to an end; and
  • slow overall economic growth as well as over-commitments associated with the asset booms created by US quantitative easing and China’s pre-2013 investment / debt driven economy have been putting various heavily indebted financial institutions / systems worldwide at risk of failure. This was presumably the explanation of severe falls in stock-market values in early 2016;
• Recent attempts have been made (especially in Japan and Europe) to boost the debt-driven growth of recent years by shifting to negative official interest rates. However this is leading to economic stagnation while putting banks at increased risk of failure;
• In the US the Federal Reserve which started the ultra-low interest rate trends seems to be confronting both slow economic growth and increasing inflation. The latter, combined with the various adverse economic / social / political consequences of ultra-low interest rates, will require lifting interest rates. When this happens servicing the massive government, corporate and household debt levels that have been encouraged by ultra-low rates will probably prove impossible – and a renewal of the global financial crisis is very likely;
• in particular corporate debt has reportedly exploded in emerging economies to $US 25tr. Zero interest rates and QE flooded developing nations with cheap credit - and much of this was wasted. They also imported deformities of Western finance that they could not deal with. Some countries are experiencing premature de-industrialization. The middle income trap closed in on Latin America and the non-oil Middle Eastern states a long time ago - and is now starting to affect Malaysia, Thailand and China. Yet the liabilities associated with QE remain. In late 2016 it was similarly noted as the $US strengthened due to rising domestic interest rates, that the about $US20tr of US denominated debts in emerging markets could create risks. In early 2017 it was suggested that Emirates Airlines (which has become a major force in global aviation and was investing in the expectation that its future was unlimited) could be in trouble  - a situation which illustrated the exposure of emerging economies more generally because of their lack of a disciplined approach to investment;
• Donald Trump's proposals for significant fiscal policy stimulus to US economy have boosted $US value and reduced international availably of $US, and this is expected to have more serious adverse effects for emerging economies (eg for companies that borrowed in $US) than his protectionist policies;
• as noted above, China’s 2015 attempt wean itself from rapid growth in debt levels was a factor in the severe global share-market downturn in early 2016 – because of the adverse effect on global trade / commodity prices and recognition of the likely emergence of serious losses given high debt levels globally and weak economic growth. Then China’s shift back to rapidly increasing debt (which was unlikely to be sustainable) was probably a significant factor in the subsequent uncertain global share-market recovery. In late 2016 this seemed likely to be reversed because further escalating China's risk of a debt crisis was clearly not working as its economic growth continued falling.
• there now seems to be fairly general acceptance by economists that: (a) low rates have pushed investors into property, stocks and bonds which drive up market prices while doing little to fuel economic growth; and (b) big shakeouts are likely in financial markets as interest rates are normalized.
• major banks in Europe who are experiencing financial difficulties are likely to see 'bail-ins' of investors rather than 'bail-outs' by governments and this will lead to a retreat from all potentially troubled financial institutions

An Appropriate Response?

Any investigation of Australia's banking system in the near future should arguably include an emphasis on the risk of financial / banking crises and banks' ability to respond to such events.  

Moreover as China recognised in 2013, reliance on fast growing debts to ensure economic growth is a formula for a financial crisis - even though it benefits banks. Australia (which has apparently been second to China in relying on rising debt to sustain growth) also needs to moderate that trend. Even though Australia's financial systems are more reliable than (say) China's, Australians are not forced to invest in nationalistic undertakings or organised to produce goods and services through state-linked social hierarchies as they are in China. And Australia's ability to obtain credit depends on reliable accounting and sound balance sheets.

Suggestions about what might be required to sustain growth without rapidly-rising national debt are in Alternatives to Monetary Policy.

Problems in the Banking System Need a Desktop Analysis First - email sent 23/4/16

Sid Maher and Paul Kelly
The Australian

Re: Scott Morrison on the attack over ‘little list’ of bank problems and Federal election 2016: bank blitz goes far beyond a stunt (The Australian 22/4/16)

In the first of these two articles, Sid Maher reported that the ALP’s proposal for a royal commission into Australia banks was being ridiculed by the Treasurer (Scott Morrison) as not dealing with matters of real substance.

Why: The Opposition leader (Bill Shorten) had only expressed concern about: vertical integration; banks’ involvement in too many products; pressure to cross-sell things; remuneration structures; selling products customers don’t need; and irresponsible lending.

In the second article, Paul Kelly suggested that a royal commission could address very substantial matters and make a big difference to Australia’s banking system.

Why: Most of the scandals that have affected banks arise from their wealth management functions – ie from producing and distributing financial products. Vertical integration (which involves banks providing insurance / financial advice while also playing money markets) reduces their ability to deal with their core borrowing / lending function. The ALP does not trust the banking system as a consequence of the 2008-09 global financial crisis. It is perhaps seeking whistle-blower protections, better-defined remuneration packages, fewer conflicts of interest and definite compensation schemes.

However seeking substantial reforms of Australia’s banking system through a royal commission to promote domestic goals could be hazardous as far as Australia’s economic future is concerned. It could have the effect of applying a ‘blowtorch’ to bank managements who are simultaneously struggling to deal with a major financial crisis that is largely due to international developments (see A Royal Commission and a Potential Banking Crisis at the Same Time?).

There is undoubtedly a need to improve Australia’s banking system. But there is first a need to be clear about the full extent of the problems that affect that system – many of which are the result of international developments (eg for reasons suggested in An Approaching Crisis - From Late 2013? and Alternatives to Monetary Policy). A desktop analysis of the whole situation would be highly desirable before sponsoring a royal commission to deal with a part of it.

John Craig

Interest Rates and The Challenge of Stimulating a Deflationary Economy - email sent 8/5/16

Patrick Commins,
Australian Financial Review

Re: Why Australian interest rates are heading to zero , Australian Financial Review, 6/5/16 (also here)

Your article highlighted suggestions by a respected credit analyst (Alberto Gallo) that Australia is likely to have to move towards the ‘new normal’ of zero interest rates once it loses the protection its economy has had from strong commodity demands from China. While it is refreshing to see an analyst confronting the question of what needs to happen in Australia as China’s likely debt crisis unfolds, Mr Gallo’s suggestion (ie that even lower / zero / negative interest rates would be the best available option) is suspect.

My Interpretation of your article: Australia may be headed to zero interest rates – according to Alberto Gallo (former head of global credit research at RBS). Australian economists dismiss this – though last week’s March quarter deflation data sparked an immediate interest rate cut by the RBA. Mr Gallo forecasts a long period of low, near zero or negative rates. Quantitative easing permitted higher growth after the GFC but has led to adverse side effects (eg asset bubbles, resource misallocation, inequality, political risk and low productivity). Australia has had extreme over-investment in mining and energy which needs to be unwound. Australia’s exports to China have grown from 3% to 30% over past 25 years – and Australia now depends on housing investment which is increasingly funded by foreign (mainly Chinese) investors. Australia is the classic case of a country that has relied on the credit boom and the China boom. Commodity prices soared again in recent months as China again stimulated its ‘old economy’ (ie infrastructure and property). This is unlikely to be unsustainable as China’s total credit went from 200% to 230% of GDP - and, if China slows again, Australia will need further stimulus. Interest rates in Australia will need to hit zero in next 5 years because of China slowdown. There is a vicious circle involved as quantitative easing leads to slower growth which requires more monetary stimulus. Australia is fortunate that the RBA and regulators have restricted investment and required banks to raise more capital buffers. However it took 20 years to gear up Australia’s economy – and it won’t adjust quickly. The asset management industry is not well prepared for this environment

Mr Gallo’s observation about the strategic financial and economic environment that Australia faces seem reasonable given the necessary constraints of space in a brief article. They are a refreshing change from the official ‘no-problem-here’ view of Australia’s financial and economic position that has made it hard to develop a realistic policy response (eg see Creighton A., ‘Treasury Paints Too Rosy Picture of a Debt-laden Economy, The Australian, 7/5/16).

The present writer’s interpretation of Australia’s difficult financial / economic environment is in A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time? This dealt with:

• Australia’s risk of a financial / banking crisis due to: (a) a high level of ‘bubble’ investment over many years (especially in city apartments in recent years); and (b) a lack of serious attention to boosting economic competitiveness;
• the risks that Australia is importing from China – due to continued dependence on exports to, and finance from, China as the latter’s credit bubble presumably bursts as Japan’s did in the late 1980s; and
• the risks of a global financial crisis because of the world’s long dependence on ever-easier monetary policy (and escalating debts) to sustain growth in the face of the demand deficits / ‘savings gluts’ many economies required to reduce the risk of financial crises (eg the risks that resulted in East Asia from the non-capitalist / neo-Confucian methods they used to achieve ‘economic miracles’).

Mr Gallo’s observations about the adverse side effects of low interest rates (which include distorting investment, financial instability, social inequality and increasing political instability) also seem reasonable up to a point. However those low rates and quantitative easing (QE) have also been a major factor in generating the deflation that the RBA recently lowered Australia’s official interest rates to supposedly counteract. Ultra-low interest rates and QE arguably distorted investment globally so as to contribute to a deflationary imbalance between the growth of an export-oriented over-supply of goods in emerging economies (which attracted real-economy investment because of their higher interest rates) and weakening demand in their more developed target markets (where rational investors focused more on the speculative investments that falling interest rates boosted though they did little to boost national income or the incomes (and thus consumer spending) of all but a few segments of society) - see Alternatives to Monetary Policy.

As Mr Gallo also did, the latter suggested that ultra-low interest rates and QE have contributed to a global financial, economic, social and political crisis. Thus (even though perpetuating low rates and QE might allow unproductive speculative investments to drive economic growth for another couple of years) it would be foolish to regard this as the ‘solution’ to the crises they helped create. Rather it suggested that:

• there is a long overdue need to raise the policy and operational competence of governments (and of the civil institutions that provide inputs to political debates);
• there are alternatives to financial stimulation – eg accelerating growth by improving developed-economies’ access to and ability to use information (which economists have long recognised as the major factor in economic growth); and
• low interest rates were used in the first place partly because of a neglected cultural incompatibly that has distorted the international financial system for many decades and is long overdue for attention.

Unless there is a shift from the perception that perpetuating low / zero / negative interest rates is the ‘solution’ to current economic constraints, the world is headed for catastrophe. The reported proposal by the controversial US presidential candidate, Donald Trump, to exploit ultra-low rates by increasing US government debts without concern and then defaulting if deemed necessary would undoubtedly lead to a breakdown of confidence in US Treasuries (traditionally a fall-back asset class in times of instability) and perhaps also the $US which has been the world’s major reserve currency. However even just maintaining zero / negative interest rates for much longer seems likely to have a similar effect on monetary systems - by encouraging, and ultimately forcing, investors to dump anything dependent on the value of fiat ‘money’.

John Craig

Good Question - But Decades Late - email sent 21/5/16

Mark Mulligan
Fairfax Media

Re: Understanding how interest rates got so low, Business Day, 20/5/16

Your article pointed to the extreme difficulty that ultra-low interest rates pose for those approaching, or in, retirement – and highlighted the need to understand why rates had become so low.

However the issue is vastly more complex than your article indicated:

Suggestions in your article: “ After the galloping inflation and oil shocks of 1970s, central banks determined to make price movements crucial to their policy deliberations. Deregulation of financial markets and the ever-quicker flow of information and money around the world then helped create the conditions that led to the GFC. In terms of supply-demand dynamics, it also provided a taste of what was to come. Because just as border-less, easy credit and demand facilitated the rampant overstocking of residential property markets that brought down the US, Ireland and Spain, so, too, emerging market powerhouses such as China, Russia and Brazil were able to ramp up production capacity in energy, metals, and manufactured goods. As demand from the GFC-ravaged developed world fell, so did prices. Partly as a result, Brazil is now mired in recession and China is cooling fast. Meanwhile, deflationary pressures, both imported and homegrown, have troubled most of the advanced world. Welcome to the new normal.”

An attempt to address the very complex issues involved is in Global Financial Crisis: The Second Test of Globalization (2008+).

A core problem has arguably been the neo-Confucian methods for exerting power through elite-dominated social hierarchies that (as compared with Western style profit-focused investment by independent entities) have been the basis for achieving economic ‘miracles’ in East Asia (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009).

The chronic lack of attention to the cultural issues involved in what amounts to a ‘clash of civilizations’ has had serious adverse consequences (see Competing Civilizations, 2001+). In brief those neo-Confucian methods:

• (a) allowed rapid progress in the development of ‘real economy’ production; (b) required suppressing domestic demand to avoid financial crises because mercantilism (ie increasing national economic power) rather than capitalist profitability was the basis of major resource allocation; (c) led East Asia (Japan initially in the 1950s, then the Asian ‘tigers’ and ultimately China from the late 1970s) to ‘miracle’ gains in competitiveness in mass production manufacturing that had previously been the main basis of broadly based high incomes in developed Western economies – and thus to deindustrialization in Europe and North America in the 1960s and 1970s; and (d) required market liberalization in developed economies from the 1980s to prevent interest group pressures slowing economic change after government attempts to speed adjustment in Europe in the 1970s had been shown to be counter-productive (see China as a Dominant Power, 2014):
• Led to increased Japan-led efforts to create an international financial system that was compatible with ‘mercantilist’ East Asian, rather than ‘capitalist’ Western, traditions (see A Generally Unrecognised 'Financial War'?, 2001+);
• Created a global financial economic / economic environment that was intrinsically unsustainable – because: (a) the ‘savings gluts’ / demand deficits needed to avoid the risk of financial crises had to be compensated for by the willingness and ability of their trading partners (especially the US which had been the world’s ‘consumer of last resort’ to encourage the spread of a liberal political and economic systems) to tolerate current account deficits and continually rising debts (see Structural Incompatibility Puts Global Growth at Risk, 2003+). Easy money policies started to be used in 1987 to prevent a share market crash from adversely affecting the real economy – and these continued to induce a wealth effect amongst those with significant existing assets (by boosting asset prices) and thus high levels of consumer demand and public spending – as well as the risk of financial instability (see Impacting the Global Economy, 2009+);
• Have been put in the ‘too hard’ basket by the G20 which was (theoretically) established to deal with problems in the international financial system (see Refusing to Face Up to East-West Structural Incompatabilities and Will China's Presidency in 2016 End the G20's Chronic Failure?).

As your article noted, there are indeed risks to the global economy and financial system, but suggesting that low interest rates are the ‘new normal’ that might continue indefinitely as the ‘solution’ is fanciful – for reasons suggested in Alternatives to Monetary Policy. Ultra-low rates have: (a) distorted investment and raised risks of financial instability; (b) contributed to a deflationary constraint on global economic growth; (c) contributed to serious social inequality – and thus to potentially crippling political instability (eg in US); and (d) been increasingly recognised to be economically ineffectual. And at the same time the major (ie East Asian) sources of the macro-economic imbalances that required low-rates in the first place might now be forced to adapt despite the massive cultural obstacles they face in doing so (eg see Japan's Predicament, 2009 and Continuing Concerns about China’s Financial / Economic Sustainability) – though war is another possible outcome.

It is indeed unfortunate that there has been such determined resistance to considering the practical consequences of differences in cultural assumptions / traditions (and thus of why ultra-low interest rates have come to be seen to be ‘normal’).

John Craig

Sustainable Growth Requires Ending Low Interest Rates - email sent 4/6/16

Jessica Irvine
Fairfax Media

Re: Cheer up, the Reserve Bank's low interest rates are working, Business Day, 4/6/16

Irrespective of whether, as your article suggests, the RBA’s low interest rates can be seen to be ‘working’ at the moment, I submit that they seem to be leading Australia towards a crippling financial crisis. Alternative ways of boosting economic growth (eg apolitical processes that would use strategic information to build on, and build up, competitive advantages in regional industry clusters) are arguably available and need to be put in place as a matter of urgency.

My Interpretation of your article: Those who believe that Australia’s economy is in trouble are wrong. Global markets were concerned at the start of 2016 about China’s economy. However Australia’s economy expanded a solid 1.1% in the first 3 months. This was above expectations and could point to a 4% annual expansion. The 2016 March quarter expansion was driven by a large increase in net exports – due to surging mineral exports (especially gas). This occurred because rising export volumes more than offset falling commodity prices. And while iron ore exports are now near maximum, there is still scope for increased gas exports. Also services exports (eg tourism and education) are growing – because $A is weaker. Low interest rates are also helping – by stimulating the construction / renovation of houses. Business investment has however fallen sharply for mining and remained subdued in other areas. And Australians’ income has been falling for 4 years. But the latest data show that at least people still have jobs – and that the economy is growing above its trend rate. Treasury estimates potential growth at 2.75% pa. Growth depends on population, participation and productivity (the 3 ‘Ps’). Potential growth has declined because the first two have been weaker (eg because of a fall in the population growth that had been associated with the resources boom and population aging). Productivity is crucial. Above-trend growth suggests that the economy is starting to use some of spare capacity developed since the GFC.

Unfortunately as well as the 3 ‘Ps’ that your article mentioned, avoiding a financial / debt crisis is also a critical requirement for strong economic and jobs’ growth. And in this respect Australia seems to be headed for trouble (eg see outline of Alan Kohler’s The Trouble with Harry and A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time?).

Australia’s economic growth has been driven by rapidly rising national debt – to finance relatively unproductive spending. Households have borrowed to fund consumption and speculative (property) investment while governments have borrowed to fund infrastructure, tax relief, income transfers and the provision of public services. China’s economy (on which Australia largely depends for strong commodity demand) has been facing much the same problem (because its rapid growth has depended on state-supported over-investment in industry / infrastructure / property with little regard to return on spending) and its current autocratic regime does not seem to have a solution (see Importing Risks from China).

Observers are increasingly drawing attention also to the risks that Australia’s high debt levels pose (see How Durable is Australia’s Luck? – 2016). Avoiding this risk arguably requires a significant increase in interest rates to: (a) discourage borrowing for economically unproductive spending; (b) encourage savings; and (c) force a shift from speculative (eg property) investment to that which is productive without reliance on every-falling interest rates.

The risk associated with Australia’s high national debt / GDP ratio and the dependence of growth on rapidly rising national debts does not seem to be officially recognised. The RBA apparently regards further increasing debt levels (via low interest rates to encourage more speculative investment, household consumption and government debts) as the key to stimulating growth. Political parties express various levels of concern about government deficits (and the possibility of a future downgrade in the federal government’s credit rating). But they do not seem to acknowledge the credit risk that the nation faces as a whole – especially if a similar problem leads to a crisis in China (as many observers expect).

Limits to low interest rates as a method for stimulating economic growth are now widely recognised internationally (eg see Interest Rates and The Challenge of Stimulating a Deflationary Economy). As the latter points out experience suggests that ultra-low rates have adverse long-term side effects including distorting investment, financial instability, social inequality and political instability – while also (probably) accentuating the deflation that that they are now supposedly being maintained to counteract. Those countries that are experimenting with negative rates have found no positive economic effects – though they are increasing the risks facing their banking systems. Speculations that ‘helicopter money’ (ie printing money to fund government spending) could be the solution to the world’s apparent low growth trap raise the specter of hyperinflation – because, rather than merely increasing liquidity by buying existing financial assets, reserve banks would then be increasing money supply (and the velocity of money). The US Federal Reserve now responsibly seems to be hoping for an opportunity to normalize interest rates – and thus reduce the distortions that long-term low interest rate policies have generated.

Suggestions about options to create a basis for sustainable economic growth in Australia are in Alternatives to Monetary Policy. The latter speculated that, as an alternative to low interest rates or increased government borrowing to fund infrastructure, growth might best be made sustainable by an emphasis on:

• Restoring competence to government administration;
• Using information (which economists recognise as the most important factor in economic growth), rather than money, as the key to boosting economic growth – eg by facilitating apolitical processes to use strategic information relevant to existing competitive advantages to stimulate the development of integrated regional industry clusters which could provide market-driven support for ongoing innovative initiatives by enterprises and individuals. Doing so would create more opportunities for the genuinely highly-productive opportunities that investors would be forced to seek by higher interest rates;
• Encouraging international attention to the obstacles to global economic growth that distorted financial systems (especially the non-capitalist / mercantilist systems in East Asia) have by requiring: (a) domestic savings gluts; and (b) that their trading partners provide demand in excess of their national incomes and tolerate ever rising debt levels supported by very low interest rates which (as noted above) have severe adverse long term impacts.

Whatever low interest rates are currently doing, they are not creating a basis for sustainable economic and jobs growth in Australia.

Regards

John Craig

Don't Overlook Australia's Risk of a 'National' Credit Crisis - email sent 19/6/16

Adam Bandt, MP
Australian Greens

On ABC TV this morning you were advocating federal government borrowing to fund environmentally-beneficial investments (ie related to climate change and public transport). However Australia is increasing being seen by financial experts as having a potential problem due to its high ‘national’ debt – and its dependence on rapidly increasing that debt to sustain growth (see references amongst other material here – and a summary in The Risk from Rapidly Increasing Debt to Sustain Growth). ‘National’ debt has been suggested to be rising many times faster than GDP – as compared with a 1:1 ratio a few years ago.

And, though there has been little public awareness of the rapidly-escalating ‘national’ debt problem in spite of attention to questions about ‘government’ debts, it is possible that this will have changed by July 2. The following illustrates the fact that public awareness of what has so only far been recognised by experts is likely to increase.

Australia and China adopted mirror strategies deal with GFC - and both now face similar problems (which the IMF has highlighted in China's case). Both invested heavily after GFC in resource industries as well as housing and construction. IMF warns that China needs to deal with rising corporate debt or face dangers. China may have $1.3tr lent to borrowers who lack income to repay it. China has accumulated debt (now 247% of GDP) faster than any other country - but Australia is close behind. Vimal Got (BT) argues that during commodity boom Australia's banks borrowed heavily - mainly through long term bonds in foreign markets. This borrowing against future income assumed that rising commodity prices would continue forever. The money went to housing credit - which rose 20% pa - so benefits of Australia's mining boom mainly went to funding Australian house prices. The income windfall from rising commodity prices was spent as soon as earned. The balance sheets of CBA, Westpac and NAB more than doubled from 2003 to 2008 - as foreigners were happy to provide loans. Banks are now restricted from borrowing - but federal government borrowing is replacing them in allowing Australians to live beyond their means. Australia's current account deficit remains large - and more is being borrowed than earned. Australia thus needs to make adjustments like China is facing - but this does not seem to be understood politically. BT suggests that Australia's inability to tackle debt will force $A down to US40 cents. China's transition away from commodity-driven export industries will compound the problem (Gottleibsen R., China’s looming debt crisis has an Australian Echo, The Australian, 17/6/16)

It would be desirable to consider the implications of this issue in advocating borrowing for public spending. Though ‘government’ debt levels are by no means critical, ‘national’ debt levels may lead to significant constraints on further increasing overall ‘national’ (including 'government') debts (especially in the event of an anything-but-impossible Chinese and or international financial crisis).

[Note added later: It has been argued that though Australia's government debt / GDP ratio may be lower than in other developed countries, the rate at which it is being increased [a consequence of budget deficits] poses significant risks, and that political parties' claims that deficits will fall are fictitious].

A suggestion about what might help prevent this risk from translating into a ‘national’ credit crisis is in Another Approach to 'My Big Idea'.

John Craig

Are We Prepared for the End of China's 'Never-ending' Boom? - email sent 7/9/16

Brian Robins,
Sydney Morning Herald

Re: China's never ending boom - but are we prepared? Brisbane Times, 7/9/16

There is something strange about the analysis by the Australian Centre for Financial Studies (ACFS) that your article reviewed (ie The Long Boom: What Rebalancing Means for Australia’s Future). It seems out of sync with information and ideas that are coming from many other sources.

My Interpretation of your article: Last decade no one could have anticipated the effect of the commodity boom on Australia’s economy. Now China’s shift to greater reliance on services raises questions about Australia’s preparedness for major impacts on healthcare, education, tourism, financial services and construction – according to a recent Australia China report by the Australian Centre for Financial Services. 25% of Australia’s services could be destined for China. China now has the world’s largest middle class. Its shift from an investment-heavy economy to one driven by domestic consumption will change its links with Australia – according for John Brumby, chair of the Australia China Business Council which commissioned the study. Australia needs to study what is needed for success in this market. Edward Buckingham (Monash University) believes that China’s future growth will demand a much wider variety of goods and services. This raises strategic questions that need to be considered. Australia faces competition from other countries – and also from domestic service providers in China. Expanding services exports requires far more customisation than mining or agricultural trade. The last time a single market was as important to Australia as China was with the UK (40%) in 1952-53. China now takes 28% of Australia’s exports – though this could rise to 33% if China’s growth is faster than expected. Rebalancing may lead to gains by education and tourism – as well as construction. Much more of Australia’s exports could go to China in future. Also financial services could benefit. This is Australia’s largest industry and such services are poorly developed in China. Exports to China could rise from 11% to 16-19% of Australia’s financial services. Exports of healthcare and social assistance could rise to be equivalent to Australia’s mining exports in a decade.

Nothing in the ‘Long Boom’ report suggests that the ACFS appreciates that financial experts almost everywhere seem to expect China to soon suffer a financial crisis like that that ended Japan’s ‘long boom’ in about 1990 (see overview of typical views in Importing Risks from China). If such a crisis arises, it would invalidate claims about large economic opportunities for Australia from a new ‘long boom’ associated with China’s rebalancing.

ACFS’s attempt to produce a report on improving Australia – China relations purely in terms of specific economic opportunities seemed unwise also because:

• encouraging reform of major East Asian financial systems (eg by international regulation of financial standards) is probably the key to achieving the G20s’ goal of reinvigorating global trade and investment;

Why is There a Problem? Economic Babes in the Asian Woods, in commenting on another report on China / Australia economic relations, noted the huge differences and incompatibilities between:

• liberal / Western-style global financial systems - which emphasise market-oriented investment with a view to profitability by independent enterprises; and
• those associated with East Asian ‘real economy’ miracles. The latter: (a) involve major resource allocation by state-linked-and-nationalistically-motivated financial institutions that have limited regard to return of / return on, capital; (b) have led to poor resource allocation and financial crises in East Asia; and (c) played a significant role in creating financial, economic, social and political problems elsewhere.

• Rather than reforming its financial system (which is almost impossible because China's system of government is constrained in making any economically liberalizing change by the same excessive centralization that is leading to a financial crisis) China seems to be trying to head off the risks of a financial crisis that it now faces under prevailing Western-style international financial practices by creating a new international order like that by which Asia was administered from China prior to Western expansion. That system involved trade-tribute relationships whereby businesses with social connections with China’s autocratic regime would organise economic opportunities for those who accepted a subordinate political relationship with the Chinese state. In relation to this it is noted that:
  • Claims have been made that groups with connections to the Chinese state have been trying to manipulate public policies and attitudes in Australia;
  • There has also been growing concern about Australia’s national security in relation to growing challenges to the continued dominance of the liberal post-WWII international order; and
  • An alternative economic strategy was suggested on the grounds that emphasising economic opportunities like those advocated in the ACFS’s ‘Long Boom’ report would make Australia totally dependent on China’s ‘totalitarian’ regime. The present writer’s speculations about the framework for an economic strategy are in Alternatives to Monetary Policy.

Might it be worth writing another article which examines the ACFS’s ‘Long Boom’ report from a broader perspective?

John Craig

Risks Facing Australia's Banks - email sent 19/11/16

Robert Gottleibsen,
The Australian

Re: What could cause our banks to go belly up, The Australian, 17/11/16

Your article suggested that a stress test arranged by APRA is showing that the risks that Australia’s banks fear most are cyber-attacks and major commercial property losses.

My Interpretation of your article: APRA is conducting important stress tests on Australian banks. This is showing that banks are afraid of catastrophic internet / computer failure - potentially due to external attack. Banks no longer have paper back-ups. The second concern relates to substantial collapse in Australia's economy - in the commercial property market - rather than for housing. The most probable cause of a breakdown would be China pulling the plug. Trump intends to build US defence strength against China - and China might react by attacking economically

It is timely for a stress test to be conducted on Australia's banks.

However the risk factors that should arguably be considered are broader than those identified in your article (see A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time?). This speculated about risks related to: (a) Australia’s heavy reliance on debt to finance growth and high national debt / GDP ratio; (b) a likely debt crisis in China on which Australia’s economy has become highly dependent; and (c) another major global credit crisis. Needless to say the accelerating trend towards higher interest rates (due to the economic inadequacy of easy money policies and the US’s likely shift to fiscal stimulus under president-elect Donald Trump) will exacerbate those risks.

John Craig

You ain't seen nothing yet - email sent 8/2/17

Emily Cadman and Chris Bourke

RE: With $1 trillion of Australian mortgages, the RBA might be getting worried, Brisbane Times, 8/2/17

Your article pointed to the rise of mortgage stress in Australia and to the high levels of total mortgage and household debt.

The underlying problem will probably dramatically increase because several independent factors are likely to reduce the availability of cheap credit (ie give rise to a severe credit squeeze). In particular:

• China, whose investment in Australian property has been very significant, is struggling to deal with a massive debt crisis – and has recently started trying to contain this by clamping down severely on outbound foreign investment and capital flight. However China is likely to have to do much more than this to reduce its (and the world economy's) dependence on the rapid (ie 28% / $4-5tr pa) escalation of its national debt - given that its (300%) debt / GDP ratio is already dangerously high (see outline of what seems to be happening in The Risks from China and 'Trumponics' Both Matter);
• The US Federal Reserve has been seeking to normalize (ie significantly increase) interest rates because: (a) while monetary policy can help boost liquidity in a financial crisis, the long term effects of ultra-low rates are highly dysfunctional (ie directly increasing the value of financial assets and property which biases investment towards speculative asset appreciation rather than ‘real economy’ investment and thus increases social inequality and political instability); (b) there is a need to normalize rates to have some ‘ammunition’ to use during the next financial crisis; and (c) President Trump’s economic agenda is believed to be likely to increase inflation in the US;
• The European Central Bank has stated that it will soon start tapering its purchases of bonds – and warned of the constraints that this will impose on liquidity / the availability of cheap credit. The 'taper tantrum' that followed a similar change by the US Federal Reserve in 2013 provides a precedent;
• Bond markets have experienced significant falls (and rising yields) because of expectations of rising interest rates – which would turn bonds' ‘risk-free-reward’ (when interest rates were constantly falling) into ‘reward-free-risk’;
• ‘bail in’ rather than ‘bail out’ arrangements (ie imposing losses on investors rather than on governments) have become widely practised (and were apparently accepted by G20 countries at their 2014 Brisbane meeting in relation to any future failures by major financial institutions) – thus ensuring that investors will desert any potentially exposed financial institutions almost immediately. The latter will have to greatly increase the return on investors' funds if they want to continue trading;
• while it might seem that global liquidity (and thus cheapish credit) might be increased by the IMF, this would not overcome the fundamental problem associated with the irresponsible use of ultra-cheap credit – a problem that has been most extreme in the major neo-Confucian non-capitalistic systems in East Asia in the absence of international regulation of lending standards.

The RBA is well aware of these international trends and thus that domestic attempts to counter-balance them by lowering Australian rates would have little effect. Doing so could in fact exacerbate a crisis by reducing Australia’s attractiveness to foreign investment in the face of: (a) the above indicators of a looming global credit squeeze; (b) the second highest national debt / GDP ratio in the world; (c) a need to maintain significant capital inflows to offset large structural current account deficits; and (d) the exposure of Australia’s banks to a financial crisis if capital inflows sufficient to maintain property values are not maintained (see Australia's Risk of Financial / Banking Crises as Growth is Driven by Rapidly Rising and Often Misdirected Debt).

John Craig

How Credible are Chinese Investment Proposals? Do the Sums!! - email sent 7/3/17

Rosanne Barrett and Ben Wilmott
The Australian

Re: Chinese to build $1bn city on coast, The Australian, 4/3/17

Your article suggested that a Chinese theme park entrepreneur is seeking control over a large area of sugar cane land on the northern tip of the Gold Coast in order to develop a $1bn city over the next 25 years.

Might I respectfully suggest that, rather than simply reporting such proposals, it would be desirable to critically consider their credibility. China is facing a massive debt crisis (see China's Likely 2017 Financial Crisis and Why China Has a Financial Problem). And, in response to the capital flight that has resulted from its debt problems, China is clamping down VERY severely on foreign investment (see China’s Clampdown on New Debt and Capital Outflows).

It can be also noted that a predominantly Chinese company taking the lead in trying to organise a $3bn casino / hotel project on the Southport Spit was reportedly running out of money (see Klan A., Audit raises doubts about ASF, firm picked to lead $3bn resort, The Australian, 7/3/17).

‘Doing the sums’ on China debt crisis is not easy, yet doing so suggests that China faces a problem that its proposed policy responses to date (as well as the almost complete blockage of outward capital flow) will be totally inadequate to deal with.

John Craig

If There is Too Much Risky Debt, Why Not Do Something About It? - email sent 7/4/17

Dr Philip Lowe,
Governor, Reserve Bank of Australia

Re: Uren D., Economy at risk as debt bomb grows, The Australian, 5/4/17

You reportedly pointed to the risk Australia’s economy faces due to high household debts in the context of property booms mainly in Sydney and Melbourne. You then suggested options to limit risky lending, but did not mention: (a) the role that easy money policies have played in this; or (b) the risk of a debt crisis because of high national debt levels and the dependence of economic growth on rapidly increasing poorly-directed debt.

Themes Developed Below - The long term and largely ineffectual use of easy money policies as a means for macroeconomic management has adverse side effects that need to be acknowledged. Slowly normalising interest rates would be a useful step towards: (a) easing risky debt-fuelled property booms in Australia’s largest cities; and (b) placing the economy on a path to sustainable growth. The risks with proposals to boost growth via public investments (eg in regional development or infrastructure) that would not produce short term financial returns also need to be emphasised, while new methods to encourage increased private investments likely to have shorter term financial returns should be considered. Reducing the supply-demand imbalance that is a major factor in rising house prices requires more effectively developing urban infrastructure. This in turn requires significant reforms to Australia’s machinery of government.

My Interpretation of the article in which you were quoted: RBA governor (Philip Lowe) warned that a debt-fuelled surge in Sydney / Melbourne property markets threatens the national economy. Housing debts are rising twice as fast as household incomes. Banks lend to people who can’t afford to repay. Stretched balance sheets create problems in a downturn. High debt levels with low wage growth are a bad combination. David Murray (chairman of the Financial System Inquiry, FSI) suggests that the housing boom could be followed by crisis like that of 1890 property collapse – which led to the failure of half of Australia’s banks. Capital city house prices have risen 12.9% over the past year (18.9% in Sydney and 15.9% in Melbourne). Dr Lowe’s comments are part of campaign by the Council of Financial Regulators to restrain property investment in Sydney and Melbourne. APRA and ASIC have announced steps to limit risky bank lending. RBA held the benchmark cash rate at 1.5%. RBA sees signs of improvements in the world economy but has concern about Australia. Dr Lowe does not accept that banks’ financial stability is at risk because they are soundly capitalised. However he is concerned that economic downturn could cause problems for indebted property investors / homebuyers. Housing related debt rose 6.5% over the past year while household income rose only 3%. Arrears are however low and many have built up buffers in mortgage offset accounts. Dr Lowe criticised lending to borrowers who could not afford it and interest only loans. RBA has called for negative gearing and capital gains tax incentives to be reviewed. Dr Lowe said that interest-only loans, as in Australia, were unusual. They were only allowed in other countries where borrowers already had a lot of equity. Loans are being made where borrowers have little income buffer above interest payments. Dr Lowe said that the root cause of the housing boom was governments’ failure to provide transport infrastructure to support fast growing populations. Good transport links would increase supply of well-located land. Under-investment in transport pushes housing prices up. Dr Lowe rejected claims that easy credit was the primary cause of the boom. Prices were subdued in some cities. Treasury is expected to have a housing affordability package for next month’s budget which focuses on increasing land supply. Mr Murray called for implementation of FSI inquiry recommendation about preventing superannuation funds from borrowing.

As you and others observers have noted, many factors apart from monetary policy contribute to Australia’s debt-fuelled property booms (eg supply-demand imbalances; infrastructure constraints on land supply; high immigration levels; centralized economic / population growth; foreign / Chinese investment; banks’ / non-banks' lending practices; and governments’ policies on superannuation, pensions and taxing property).

Ending the Use of Unsafe and Ineffectual Monetary Policies

Since the late 1980s reserve banks (initially the US Federal Reserve) have found that providing emergency access to additional credit has been very useful in preventing financial crises from affecting the real economy. Doing so has limited the amplifying effect of failures by major financial institutions on the financial system and economy as a whole.

However reliance on easy money policies as the main method for countercyclical macroeconomic management (which has become a global phenomenon) has had quite negative consequences – including large increases in debt, asset bubbles and increased risk of financial crises.

Over the long term easy money policies distort investment by encouraging a bias towards assets likely to benefit from those interventions. As benchmark interest rates fall, the price earnings ratio for assets with reasonably predictable earnings rise. Thus the prices bid for such assets (eg bonds, property and share-buybacks) will rise and ownership provides a relatively ‘risk free reward’. Encouraging a preference for investment in such assets: (a) constrains increases in GDP (because value added is deferred until assets are sold); (b) shifts emphasis from investment in assets that would strengthen the ‘real economy’ on which business profits, household incomes and government taxes mainly depend; (c) increases the risk of financial crises when asset booms are disrupted; and (d) constrains demand by reducing the incomes of those (especially retirees) whose incomes depend on the interest earned on savings and confronting governments with ongoing budget deficits for social transfer payments.

Another Investment Distortion (note added later): At about the same time that the use of easy money policies started encouraging investment in assets that would benefit from monetary interventions by reserve banks, the 1988 Basel Capital Accord encouraged banks to favour mortgage lending. Bank prudential rules allowed mortgages to households to be presumed to be safe. Banks had to hold only 25% of the capital for these that they did for business-loans. In the 1980s 2/3 of loans by Australia banks were for business, but this has fallen to 1/3. In the late 1980s mortgage debt was about 15% of Australia's GDP. It has since risen to 95% - and this is a major component in concerns about Australia's very high national debt / GDP ratio.

Easy Money Policies are Not the Only Factor (note added later): In May 2017, the RBA noted that property price increases varied considerably across Australia [1]. This is clear evidence that ultra-low interest cannot be the only factor involved in the lack of affordable housing in major cities such as Sydney and Melbourne.

As well as distorting investment, social inequality can be increased because the major benefits will tend to accrue to those with existing assets. The prices of some of their existing assets will be driven up by easy monetary policy and the incentives given to banks to favour household mortgage lending.  And existing equity can be the foundation of further borrowing to obtain relatively ‘risk free rewards’. Rising inequality associated with boosting the wealth of the already-affluent and the limited economic prospects that many face when ‘real economy’ investment is less favoured have led to political instability, and thus disrupted government efforts to manage the situation competently.

There seems to be increasingly widespread recognition of these problems and of the fact that low rates for a decade have been unable to prevent ongoing economic stagnation. The need to normalize interest rates is thus being recognized (see Do Low Rate Help?). The US Federal Reserve seems to be taking a lead in doing so even though the process is risky and needs to be slow. The European Monetary Union now seems likely to taper its bond-buying programs.

What does not yet seem to have received serious attention is the role that distortions in state-manipulated financial systems in East Asia have played in the first place in creating a need for easy money policies as a means to stimulate sufficient demand to prevent the global economy stagnating. Reasons for this (which require considering the practical implications of cultural differences – especially those related to social organisation and the way information is used) are outlined very briefly in International Regulation of Lending Standards. As the latter suggested, eliminating those distortions would seem essential to allow interest rates to be normalised and thus eliminate the economic, social and political problems associated with the long-term use of easy money policies to try to maintain growth. Changing the Basel Capital Accord's reported presumption that mortgage lending to households by banks should be treated as being low risk would also seem desirable.

Reducing National Debt Risks

As you reportedly noted, rising household debts associated with booming property markets are a potential risk to Australia’s economy.

However surely Australia’s national debt problem is broader than that associated with property markets (see Australia's Risk of Financial / Banking Crises as Growth is Driven by Rapidly Rising and Often Misdirected Debt). Australia’s debt / GDP ratio is high and economic growth has come to depend on increasing national debts through investments that contribute little to GDP. This has been seen to create the risk of a financial / banking crisis partly because of: (a) the need for extensive foreign capital to cover structural current account deficits; (b) the extent to which investment has been in a debt-driven property boom; (c) the high dependence of bank balance sheets on property assets; and (d) rapidly rising federal government debts to meet community desires for government services and transfers which undermine the credibility of any guarantees that might be offered in relation to Australia’s banks. Those domestic risks are compounded by the risk that debt crises could affect China (on whose economy Australia has become highly dependent) and / or the global economy.

The warning that David Murray reportedly offered about a crisis like that Australia suffered in the 1890s might be an overstatement if external risks do not arise – but under other circumstances it might not.

Australia’s risk of a national debt crisis makes it essential (as you reportedly suggested) to avoid problems related to high rates of household investment in urban property markets.

However there would also seem to be a need to ensure that any increases national debts should be in undertakings / projects that generate substantial increases in national income / GDP in the short term – to prevent further increases in Australia’s hazardously high national-debt / GDP ratio. The implications of this for regional development and the provision of infrastructure are suggested respectively in Reducing Congestion by Accelerating the Growth of Australia's Second-tier Cities and Alternatives to Monetary Policy. Proposals to boost economic growth by public spending on regional development and / or infrastructure projects whose financial returns were either uncertain or likely to be delayed would seem highly undesirable.

Private market-oriented investments are likely to have much greater financial returns in the relatively short term. Methods to increase the attractiveness of such investments are suggested in A Case for Innovative Economic Leadership, 2009 (in relation to theory) and Developing a Regional Industry Cluster, 2000 (in relation to methods the present writer used experimentally in the 1980s). Modern economic growth theories recognise that, though labour and capital inputs are necessary, information / knowledge is the primary driver of growth. The suggested methods involve more effectively mobilizing strategic information to speed the development of market-responsive and high productivity industry clusters. The effect would be comparable with: (a) innovation within individual enterprises; and (b) the neo-Confucian methods that have been the basis of ‘real economy’ miracles in East Asia in recent decades (though without the distorted financial systems the latter have used). Such methods could:

• Boost economic growth, business profits, household incomes and governments’ tax revenues much more effectively than easy money policies are ever likely to;
• Reduce Australia’s debt / GDP ratio;
• Provide better opportunities for household investment than debt-driven property speculation; and
• Create high income population ‘magnets’ in some major regional centres to potentially promote decentralization and thus reduce population growth and the need for unmanageably high rates of housing investment in major cities (see Reinventing the Regions, 2010 and Reducing Congestion by Accelerating the Growth of Australia's Second-tier Cities, 2017).

Urban and Infrastructure Development

You reportedly also drew attention to the need for improvements in the development of infrastructure to increase the supply of housing (and thus reduce the supply-demand imbalance). This arguably requires quite significant changes to Australia’s machinery of government – for reasons suggested in Bring Infrastructure into the 21st Century: Some Suggestions. The difficulty of making those changes could be reduced by temporary cuts to Australia’s high levels of international immigration, because such cuts would reduce the currently-intense / unmanageable ‘pressure’ that exists on urban and infrastructure development systems in major cities.

John Craig

Avoiding a Market 'Solution' To Australia's Overinvestment in Real Estate - email sent 11/4/17

Simon Benson
The Australian

Re Scott Morrison’s cradle-to-grave housing plan, The Australian, 10/4/17

Your article outlined what seems likely to be the Federal Government’s proposals for dealing with housing affordability (and briefly mentioned the federal Opposition’s critical response). Neither the government nor the opposition seem to have recognised the relationship between escalating problems in housing affordability and Australians’ unbalanced patterns of investment in recent decades.

My Interpretation of your article: The Turnbull Government will pursue a ‘cradle to grave’ housing affordability package – probably including: a mutual-obligation plan for first home buyers; tax breaks for downsizing the family home in retirement; a social housing plan to alleviate rental stress; use of federal / state land for housing to address housing supply issues. Institutional investment in social / affordable housing is planned. 1.3m Australians now negatively gear properties. The federal government will intervene in the life cycle of home ownership by addressing barriers to entry, institutional investment in social housing, rental affordability, regional relocation incentives, investment and housing in retirement. Superannuation model could allow first-home buyers to divert superannuation contributions to a home savings account to be matched $ for $ by personal contributions. Tax disincentives for retirees downsizing family home may be removed. Retirees using superannuation to pay off mortgage will be addressed. Stamp duty changes for foreign property purchases are being considered. Changes won’t be made to negative gearing – as this could lead to a rental crisis. Migrants may get incentives to settle in regional areas. Agreements on grants to states to provide public/ social housing will be rewritten. Mr Morrison said the budget package would lay the foundation to address fundamental problems – but not be a one-off panacea for the housing crisis. 2m taxpayers have an interest in residential investment, 72% own one, 90% have no more than 2. Reforms to alleviate rental stress are needed which now affects 40% of renters. Government is likely to adopt Britain’s ‘bond aggregator’ model to encourage investment in social housing through access to cheaper finance. There is a need for more housing for home owners / renters / key workers who can’t afford to rent or buy / those on low incomes / disabled / disadvantaged. Intervention in an area driven largely by interest rates and state governments will come with political risk. Opposition finance spokesman rejected Mr Morrison’s proposed changes – arguing that negative gearing and capital gains discounts need reform.

The nature of the problem and how it might be addressed is suggested in If There is Too Much Risky Debt, Why Not Do Something About It? .

In simple terms the latter suggested that since the late 1980s Australians have invested very heavily in housing. Strong incentives to do so have been implicit in the financial system (ie in the use of monetary policy for macroeconomic management and the Basel rules that allowed banks to treat household mortgages as low risk assets). Domestic investment in business undertakings has been limited by comparison. In the resources’ boom a decade ago a great deal of investment came from offshore, rather than from domestic sources. Investment in housing is relatively unproductive in contributing to GDP compared with investment in business. Much of the gains from housing investment will be locked into future capital gains. The latter will create a wealth effect for those who own houses but make limited immediate contribution to business profits, employee incomes and government’s tax bases. Over-investment in housing and under-investment in productive businesses has arguably:

• created a national debt / GDP ratio which is so high (mainly because of a massive rise in the household mortgage / GDP ratio) that there have been repeatedly warnings of Australia’s risk of a national debt crisis; and
• left large segments of the community with limited incomes to try to buy or rent from a housing stock which is very expensive because so much has been invested in developing it.

The pattern of investment in Australia’s economy needs to change. Government intervention would be complex and ineffectual if it merely tries to allow those whose incomes are low due to under-investment in productive businesses to meet the cost of accommodation that is high because of housing over-investment. Such intervention would not prevent the underlying problem from escalating. Unless a serious effort is made to rebalance investment in Australia, the market is likely to impose a ‘solution’ in the form of a collapse in property values. This would be economically disastrous, but would ultimately restore a balance between the value of housing and the general community’s capacity to pay.

John Craig

The Most Disturbing Signs Beyond the Housing Boom Will Have Their Source in China - email sent 8/5/17

Robert Gottliebsen,
The Australian

Re: The disturbing sign lurking past the housing boom, The Australian, 28/4/17 (which is outlined here)

You suggested that efforts by governments and regulators to make housing more affordable in major cities could go too far and have serious adverse effects on Australia’s economy (eg if Chinese investors have difficulty in buying in Australia). However, while government and regulators are likely to reduce prices modestly in their enthusiasm to make houses more affordable, China’s crackdown on new debt and capital outflows is likely to have much greater effects.

Australia’s economy will soon be exposed to a major financial and economic setback because China seems to be seriously (desperately?) trying to deal with its debt crisis. My reasons for suggesting this are outlined in an attachment to this email. The latter referred to:

• why China faces a debt crisis and indicators that China is finally trying to deal with it;
• the adverse effect this will have on Australia’s economy because of the dependence that has emerged on providing raw materials for unrepayable-debt-funded over-investment in China; and
• the limited prospects that Australia’s governments, businesses and households will have in the fairly near future of borrowing at low interest rates.

The latter will presumably trigger significant falls in asset values (including housing) and cast further doubt on current federal government proposals to borrow at low rates to fund a major stimulatory infrastructure investment program.

John Craig

Attachment: China Seems to Be Serious in Trying to Deal with Its Debt Crisis and The Effect on Australia Could be Nasty: China’s economy has driven 50% of global growth. This has been funded by rapidly-increasing (and often unrepayable) debt. Though it is difficult to get reliable information about China’s economy, an overview of what diverse expert and other observers have reported about China’s widely recognised potential for a debt crisis is outlined in A Looming Debt Crisis.

China has been responsible for about 50% of the new credit created worldwide. Amongst other things this drove the commodity demand that led to Australia’s mining investment boom over the past decade – ie to supply materials used in industrial, infrastructure and property development in China. Chinese off-the-plan buyers also played a significant role in the apartment investment boom that helped sustain Australia’s economic growth as the resource investment boom faded. Most of the latter was apparently not officially recorded because it did not involve borrowing through Australian financial institutions.

China faces a major problem because it has come to have extremely high debt levels (about 300% of GDP) and its economic growth has depended on large ongoing increases in debt (eg 20-25% pa increases which is about three times faster than China’s GDP growth). There was official recognition of the need to deal with this in late 2016 – after capital flight had led to a rapid fall in China’s foreign exchange reserves to levels that were potentially hazardous because of the financial irresponsibility of its state-linked banking systems and non-government financial institutions. The latter can only be concealed if large foreign exchange reserves are available. Nothing happened for a while and it seemed that a response would be delayed until late 2017. However it now looks as if a severe clampdown could be in place (see China's Clampdown on New Debt and Capital Outflows). It is unclear how much of a reduction is ultimately intended in China’s (about $US4tr) annual increase in debt. However the cut would need to be about $US3tr pa if an attempt were to be made to stabilize China’s debt / GDP ratio – and more if the latter is to be reduced. Such a cut would be around 30% of the total global growth in debt that has been adding to economic demand.

China’s clampdown on new debt is starting to have a significant effect on commodity markets – because much of China’s investment has been going into industrial, infrastructure and property overcapacity (which stimulated demand for iron ore and energy for example). Reports like the following are starting to appear:

Oil prices have fallen due to over-supply. Iron ore crashed. IHS Materials Price Index has fallen 10% since February. Credit curbs in China and rising US interest rates are taking a toll. Freight rates for dry goods have fallen 30%. Growth dependent commodities have suffered losses because of weak China data. Infrastructure spending is fading. Credit squeeze in China is starting to bite. Property investment is being restricted. This might be a cyclical downturn or a reflection of China's credit exhaustion [1]

The price of Australia’s biggest export (iron ore) has fallen because of rising supplies and the effect of tighter financial conditions in China. This will affect the outlook for Australia’s federal budget [1]

An important segment of Australia’s economy (ie mineral and energy exports) will suffer a significant setback as China seems to be making a serious (rather than a superficial) attempt to deal with its debt crisis - though the timing will depend on contractual agreements. Likewise China’s (apparently serious) clampdown on capital outflows is likely to amplify the slight reversal in property prices (especially for apartments in major cities) that is currently expected to result from action by governments and regulators.

Australia (like China) has a problem with a hazardously large national debt and an economy that has depended on rapidly increasing it. Assuming mineral and energy exports suffer major reversals over the next year because of China’s clampdown on new debt and monetary policy tightening in the US continues, Australia’s banks will tend to lose their ability to borrow cheaply offshore to: (a) cover current account deficits; and (b) fund housing investment and thereby prevent a significant slide in housing prices.

Australia would be badly affected by an economic slowdown in China. If China's growth halved, Australia would be forced into recession - as it no longer has any ammunition to resist this. Effects would include: loss of national income; higher unemployment; a house price decline; share-market losses; devaluation of $A; reduced business profits / investments. A China crisis is not certain - but it has too much debt, is over-built, has overcapacity in many areas and an economy that still relies on stimulus. Compared with GFC in 2007-08 Australia's ability to resist recession is reduced by already low interest rates and $A, federal deficits, high household borrowings. Other scenarios can be developed that are more promising [1]

If $A loses its status as high-yielding currency it could fall to US62c (generating a significant inflationary shock) and force RBA to raise rates despite still-weak growth. Australia has offered higher interest rates to attract international capital - but the yield advantage is disappearing as US engages in monetary tightening while RBA keeps rates steady [1]

China's economy is slowing. Copper imports fell 30% month on month in April 2017. Copper inventories are increasing rapidly. Iron ore imports fell 13%. This is due to deliberate tightening of credit. Broad credit growth is now 15% pa down from 25% pa at start of 2016. It is unclear whether this is a standard Chinese slowdown or something more sinister. China can't go on increasing credit / debt forever. Commodity price downturn is not yet sufficient to suggest major problems in China's economy - though such problems could unfold. If China has problems so would Australia - because its economy is driven by: (a) 'dirt' shipped to China; and (b) debt to speculate on house prices. If income from 'dirt' falls, foreign creditors may demand higher interest rates - causing problems in housing markets and potentially major problems for economy [1] 

Hedge funds have lost confidence in $A. Net long positions have fallen for last 6 weeks. Rising China's iron ore stockpiles have led to concern about extent of price route. Narrowing bond yield differential with US also causes concern [1]

Australia’s governments are also likely to lose their ability to borrow cheaply. This is another reason that federal government proposals to try to stimulate economic recovery by borrowing at low rates to fund an major program of infrastructure investment need reconsideration (see also Would an 'Infrastructure Boom' Be a Good Thing for Australia?).

What Happens to the Levy if Banks' 'Super Profits' Disappear? - email sent 13/5/17

John Durie,
The Australian

Re: Banks split on levy fightback, The Australian, 11/5/17

Your article highlighted the conflicting objectives that the major banks face in responding to the $6.2bn levy the federal government announced in its 2017-18 budget. You contrasted banks now with mining companies’ unity in 2010 in responding to proposals for additional taxes on those seen to be earning ‘super profits’.

However, as with the ‘super profits’ mining companies were earning at one time (see MRRT note below), the banks’ recent ‘super profits’ may also prove transitory.

The unfolding impact of China’s debt crisis is compounding Australia’s risk of a financial and economic crisis because of Australia's exposed ‘national’ (especially household) debt position. Suggestions are made below about how those risks could be reduced.

About the MRRT: The Minerals Resource Rent Tax (MRRT): This tax was introduced in 2012 as a replacement for the Resource Super Profits Tax which had been proposed in 2010. In response to objections from affected companies: (a) the resource rent tax rate was reduced; and (b) other revenues were increased by reducing tax concessions. The resource rent tax had been expected to raise $22.5bn over 4 years. However in practice very little extra revenue was generate because: (a) the rate was reduced; and (b) the ‘super profits’ that mining companies had earned at the start of the resource investment boom (and which had motivated the MRRT) proved transitory.

The resource-investment boom (which had initially allowed mining companies to earn ‘super profits’) created the capacity for large scale export of minerals and energy from Australia mainly to China. This became a significant source of economic growth and government revenues. Because of this, investment in Australia came to be seen internationally as a proxy for investment in China (ie Australia was seen as a relatively safe place to invest because of this linkage to a likely future economic powerhouse).

The ‘super profits’ that major banks have been achieving in recent years have apparently been driven by a boom in housing investment. A significant role has been played by Chinese investors in buying a high percentage of ‘off the plan’ apartments in Australia’s largest cities – largely without funding through Australian banks and perhaps as a reflection of the capital flight from China that had resulted from its potential debt crisis. However the housing boom this accelerated both; (a) led to high rates of mortgage lending by Australian banks; and (b) allowed banks to increase their lending margins. Banks’ profit spread on mortgage lending (ie the difference between mortgage rates and the RBA’s cash rate) reportedly rose from about 2% in 2006 to about 4% in early 2017 (Somasundaram N., A major tool that has helped Australian banks protect profits in the past may no longer be available to them, Business Insider, 11/5/17).

Investment in housing (a form of consumption) became a major driver of Australia’s economic growth in the post-resource-investment boom era.

Australia now faces significant economic and financial risks because serious problems have arisen in China (see The Most Disturbing Signs Beyond the Housing Boom Will Have Their Source in China). A debt crisis has long been seen to be inevitable because China’s economic growth has depended on extremely high and very rapidly rising levels of often unrepayable debt associated with financially-irresponsible lending practices and over-investment in industry, property and infrastructure (see Observer's Views of China's Looming Debt Crisis and Why China Has a Financial Problem).

Though China tried to continue ‘business as usual’, its risk of a financial crisis has apparently escalated to the point that this is impossible. A clampdown of new debt and capital outflows is now in place which will adversely affect:

• Australia’s mineral and energy exports. This is likely to reduce Australia’s credit rating for international borrowing. The latter has been very favourable because Australia was viewed as an investment ‘proxy’ for China;
• Governments’ ability to borrow internationally at relatively low rates. An expectation that this will be possible underpinned federal budget proposals for an ‘infrastructure’ boom (see Would an 'Infrastructure Boom' Be a Good Thing for Australia?);.
• Australian banks’ ability to borrow at low interest rates for real estate lending – a problem that the bank levy could perhaps increase (Yeates C., Banks warn on 'unintended consequences' of new tax hit, Brisbane Times, 12/5/17);
• Australia’s housing markets. The effect of China’s crackdown on capital outflows is being compounded by a shift towards normalization of interest rates – due to a loss of confidence in easy money policies as a route to economic recovery; and
• Banks’ current ‘super profits’ and the value of securities that support their loans. This will (at the very least) reduce their ability to pay the bank levy.

As for China, Australia’s ‘national’ debt levels are hazardously high relative to GDP, and economic growth has depended on rapidly increasing ‘national’ debt (ie the combined debts of governments, business and households). A major factor in rising ‘national’ debt has been the increase in household debts from about 15% of GDP in the late 1980s to about 95% - mainly for investment in housing because of the advantages that easy money policies provide for investors (see IfThere is Too Much Risky Debt, Why Not Do Something About It?). There have been many authoritative warnings about the resulting risk of a financial crisis (see Would an 'Infrastructure Boom' Be a Good Thing for Australia?). However, while there has been a lot of attention to rapidly rising public debts, Australia’s ‘national’ debt has received little public attention.

The key to reducing Australia’s ‘national’ debt risks will probably be to: (a) reduce investment in super-expensive housing (ie consumption); and (b) increase investment in economic functions that are likely to significantly increase GDP (ie increase household incomes, business profits, government tax revenues). Except in the construction stage, housing investment makes limited contribution to GDP (despite the wealth effect some enjoy). Major banks could potentially take a leading role in catalysing the necessary economic changes in ways that governments’ can’t to create scope for much more productive investment (see Reducing National Debt Risks).

Doing so would potentially:

• reduce Australia's 'national' debt / GDP ratio and thus foreign investors' potential concerns about investing;
• increase governments' revenue (because the tax base would be stronger) and thus allow: (a) public debts to be brought under control / reduced; and (b) public spending to rise;
• contribute to a solution to the housing affordability problem by: (a) reducing the (total invested in housing) / (household income) ratio; and (b) reducing the rate of population growth in major cities by creating population 'magnets' in regional centres (see Reducing Congestion by Accelerating the Growth of Australia's Second-tier Cities);
• significantly increase the economic benefits of governments' large investments in research (see Increasing the Return on State Funded University Research);
• speed development of northern Australia by building on and building up the competitive advantages of regional communities (see More on Rethinking the Government's Northern Development Plan).

If such steps are not taken, Australia probably faces a financial and economic crisis. Banks’ ‘super profits’ (or perhaps some banks themselves) are likely to disappear - along with the logic of a bank levy to boost government revenues. That risk of a crisis is increased by: (a) the unwillingness of Australia’s political system to recognise or do anything confront the ‘nation’ debt problem; and (b) the general community’s emphasis on ‘what my country can do for me’ rather than on what ‘I can do for my country’.

John Craig