In Australia, All That Glitters Isn't Gold
If Australia is an economic miracle -- the so-called Lucky Country, beneficiary of more than a quarter century of uninterrupted growth -- then its banks are its most visible sign of strength. After a near-death experience in the 1990s, they’ve reformed and bounced back dramatically: Returns on equity now average around 15 percent, compared to single digits in the U.S. Share prices and dividends have risen strongly over the past decade. At around twice book value, market valuations are well above global levels.
In fact, though, this ruddy good health masks some deeply worrying trends. The balance sheets of Australia’s biggest banks are far more vulnerable than they may seem on the surface -- and that means Australia is, too.
To most observers, this might sound alarmist. Scared straight after a mountain of bad loans nearly brought them down at the beginning of the 1990s, the banks reformed and minimized their international exposure, which meant they were insulated from the worst effects of the Asian financial crisis and the 2009 crash. Today they face little competition in their home market and have benefited tremendously from Australia’s strong growth, underpinned by China's seemingly insatiable demand for the country’s gas, coal, iron ore and other raw materials. During the 2012 European debt crisis, Australia's banks were worth more than all of Europe's.
But Australian financial institutions have made the same fundamental mistake the rest of the country has, assuming that growth based on “houses and holes” -- rising property prices and resources buried underground -- can continue indefinitely. In fact, despite a recent rebound in Chinese demand, commodities prices look set to remain weak for the foreseeable future. Banks’ exposure to the slowing natural resources sector has reached nearly $50 billion in loans outstanding -- worryingly large relative to their capital resources.
If anything, their exposure to the property sector is even more dangerous. Mortgages make up a much bigger proportion of bank portfolios than before -- more than half, double the level in the 1990s. And they’re riskier than they used to be: Many loans are interest-only, while around 80 percent have variable rates. With a downturn likely -- everything from price-to-income to price-to-rent ratios suggests houses are massively overvalued -- losses are likely to rise, especially if economy activity weakens.
Australian banks are also more vulnerable to outside shocks than they may first appear. Their loan-to-deposit ratio is around 110 percent. Domestic deposits fund only around 60 percent of bank assets; the rest of their financing has to come from overseas. While that hasn’t been a problem recently, Australia’s external position is deteriorating. The current account deficit is expected to grow to 4.75 percent in the current financial year. Weak terms of trade, a rising budget deficit, slower growth and a falling currency are likely to drive up the cost of funds. If Australia’s economy or the financial sector’s performance falters, or international markets are disrupted, banks’ access to external funds could be threatened.
Risks to the financial sector should be getting far more attention than they are in Australia’s ongoing -- and terrifically anodyne -- parliamentary election campaign. Banks have grown immensely since the 1990s and now make up a much bigger part of the Australian economy. The top four are among the country's largest listed companies, accounting for more than a third of total market capitalization. Their combined assets are around 130 percent of GDP.
Any pain they feel could thus spread quickly throughout the real economy. Falling bank stocks could well drive down share prices more broadly. Shrinking dividends -- which have traditionally been quite high, around three-quarters of earnings -- would hammer investors, especially self-funded retirees, and threaten consumption. An economy addicted to a ready supply of cheap credit would struggle to keep growing.
Meanwhile, the government’s options are limited. Cutting interest rates further to spur economic activity would risk worsening the housing bubble and adding to sky-high levels of household debt, already around 130 percent of nominal GDP and nearly 200 percent of household disposable income. Raising rates, on the other hand, could trigger defaults, especially on riskier loans such as those to property developers. Fiscal policy is similarly constrained: Increasing debt beyond certain levels would threaten Australia’s credit rating and thus banks’ access to offshore funding.
Pundits have been saying for years that Australia needs to diversify its economy, boosting services exports -- primarily tourism, education and health -- rather than continuing to depend on resources and debt-fueled property growth. Banks need to do the same, reducing their exposure to the housing market and the mining industry. At the same time, they should move swiftly to shore up their balance sheets, aggressively increasing bad-debt reserves, raising capital and gradually trimming dividends. Even their otherwise enviable luck can’t last forever.
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