Is It Enough to Plug the Gap?

Dear Reader,

Aussie stocks had one of their sharpest rises in history yesterday. The ASX 200 surged 7%.

The expectation, and confirmation, of another massive bailout package from the government was behind the rally. Yesterday afternoon, the Morrison government unveiled a $130 billion wage subsidy package designed to pay the recently unemployed $1,500 a fortnight for six months.

In an economy built on debt, this is a painful but necessary move from the government. Debt needs to be serviced. If it’s not, the asset (which is financed by the debt) loses value. If assets lose value it threatens the solvency of the banking system.

That’s not good…

The shutdown caused by the virus has effectively evaporated much of the income flowing through the economy. That income, through the payment of rent and mortgages, services our debts and keeps our creditors happy.

Who are our creditors?

Mostly foreigners. For years we have consumed more than we produced as a nation. As a result, we are a ‘net debtor’ nation. That means we must borrow from the rest of the world to finance our standard of living.

(This excess consumption trend changed recently with the creation of a major LNG export industry, along with still robust exports of iron ore and coal. From late 2016 we have more or less run a trade surplus. Although with the collapse of the oil price — and the Aussie dollar — the size of the surplus will surely reduce.)

Anyway, decades of excess consumption mean we don’t have the required pool of domestic savings to support our standard of living. So we borrow from foreigners.

That’s why our net foreign debt is $1.143 trillion, as at December 2019.

How did it get so large? It works like this…

When you apply for a home loan, the bank credits your account with the loan. But when you pay for the house, the money goes out of the bank to the seller’s bank. So your bank needs to borrow money to finance the house. It does so using domestic deposits and borrowing offshore.

Over the years, we’ve had to borrow a lot from offshore. As mentioned above, our cumulative (net) borrowing from foreigners is now over a trillion dollars. Servicing that debt is expensive. It requires income. In the December quarter the bill was about $12.5 billion. Annualised, that’s a $50 billion income bill to service our foreign loans.

So when the economy collapses and income evaporates, our foreign creditors are going to get very nervous about rolling over our loans. The risk/reward equation just skewed to lots of risk for not much reward.

This is why Morrison knows he can’t afford to shut the economy down completely. If foreigners stop lending to us, we would be looking at a depression, not a recession.

And a depression would kill far more people than COVID-19. Did you know that suicide in Australia already accounts for around 3,000 deaths a year? Imagine what a depression would do to that number?

So the government is absolutely right to try to get the balance right between stopping the spread of the virus and saving lives and livelihoods by avoiding economic Armageddon.

But he’s not going to give a sermon on foreign debt on the nightly news, is he?

No, he’s just going to throw everything at the economy to save it.

The bailout is the largest in history. And it will go a long way towards softening the blow that this virus has caused the economy. From the Financial Review:

The $130 billion in wage subsidies announced by the Morrison government equates to 6.65 per cent of GDP. Total fiscal stimulus so far is $214 billion, or more than 11 per cent of GDP.

Combined with the $105 billion from the Reserve Bank and other fiscal measures the total stimulus tally is now $320 billion, equating to 16.4 per cent of GDP.’

While on the surface that is a massive injection of funds, keep in mind there is a massive hole to fill. This is not stimulus. It is merely plugging the gap.

It won’t be enough to stop the economy contracting. Everyone is stuck at home and can’t ‘consume’, and consumption accounts for over 60% of economic growth.

But it should be enough to make sure rent, mortgages and essential services are paid. That’s probably why the financials index surged 8.8% yesterday, the telecommunication index was up 7% and utilities jumped 6.2%.

Positively, the Aussie dollar didn’t tank on the news. The dollar made its panic low on Thursday 19 March (see chart below). It hit an intraday low of 55 US cents. It’s now trading around 61 US cents.


The Rum Rebellion

Source: Optuma

[Click to open in a new window]

In other words, foreign creditors are OK with the government going deeper into debt to pay them the interest on the household sector’s massive debt load. It sounds bizarre, but there is logic to it.

If the government had done nothing, our dollar would be in the 40s and we’d soon start to see inflation in imported goods. No income, plus rising costs, is an ugly mix.

The thing is, when your standard of living depends on the ongoing flow of foreign credit, there are no good options in a crisis.

There are only ‘least bad’ ones. Time will tell, but I think the government just took the least bad option for Australia. Hopefully it’s the last time they’ll have to do it in this crisis.

Let’s not even think about the payback…

Regards,


Signature
Greg Canavan,
Editor, The Rum Rebellion

Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates.

Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.

Learn more about Greg Canavan's Investment Advisory Service.


Leave a Reply

Your email address will not be published. Required fields are marked *

The Rum Rebellion